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THE WIZARD OF BUBBLELAND
PART 4: The global money and currency markets
By Henry C K Liu

(Click here for previous parts)

Until the late 1950s, a currency's money market was based in the issuing nation's financial center: US dollars in New York, sterling in London, yen in Tokyo, Swiss francs in Zurich, etc. The Bretton Woods monetary regime of fixed exchange rates built around a gold-backed dollar did not consider unrestricted cross-border flow of funds desirable or necessary for facilitating international trade.

At the height of the Cold War, the Soviet Union became concerned that its dollar deposits in New York might be frozen by a hostile US government, as happened to the funds held in the United States by the People's Republic of China after the Korean War broke out. The USSR opened dollar accounts with European banks.

Then in 1963 the US introduced the populist Regulation Q, which for subsequent decades imposed limits and ceilings on bank and savings-and-loan (S&L) interest rates. Regulation Q created incentives for US banks to do business outside the reach of US law, and London came to dominate this offshore dollar business.

Bank accounts in London are subject only to the laws of England and Wales, so US sanctions, restrictions and taxes cannot apply to the dollars deposited in them. British law on international finance is well developed on account of the financial hegemony of the British Empire after the fall of Napoleon Bonaparte. In time, banks in London, often branches of US banks, started actively trading deposits in other currencies besides dollars as well, as it became possible for them to accept deposit in one currency in one country and lend in another currency in another country profitably.

Nowadays, financial regulation has become even lighter, so money can be moved to and from London with little cost; therefore the price of London money generally tracks very closely that of domestic money in many countries. But there have been differences between domestic and London interest rates. These differences have had different causes at different times: tax laws, bank regulations, the possibility that a country might introduce exchange controls, and the differences between the creditworthiness of the banks in London and those in the domestic market. The London money and foreign-exchange markets are dominant for trading currencies, raising capital and selling debt.

In 1971, the US detached the dollar from gold and made it a fiat currency based on the strength of the US economy, which allowed the dollar to continue to perform the role of the world's key reserve currency for international trade. This was the beginning of dollar hegemony.

When Regulation Q was phased out by 1986, US banks were allowed to pay interest on checking account - the NOW accounts, to lure depositors back from the money markets. The traditional interest-rate advantage of S&L banks was removed, to provide a "level playing field", forcing them to take the same risk as commercial banks to survive. Congress also lifted restrictions on S&L commercial lending, instead of the traditional home mortgages, which promptly got the whole S&L industry into bad-debt troubles that would soon required an unprecedented government tax money bailout of depositors in a S&L crisis. But the real-estate developers who made billions with S&L loans were allowed to walk away with their profits, leaving S&L banks with foreclosed properties with market values way below the values of their mortgages. State usury laws were unilaterally suspended by an act of Congress in a flagrant intrusion on state rights.

A political coalition of converging powerful interests was evident. Virulently high inflation had damaged the financial position of the holders of money, including small savers, created by a period of benign low inflation earlier, so that even progressives felt something has to be done to protect the propertied middle class, the anchor of political democracy by virtue of their opposition to economic democracy. The solution was to export inflation to low-labor-cost economies in newly industrialized countries (NICs) around the world, taming US domestic inflation with outsourcing employment overseas and exorcising the domestic inflation devil in the form of escalating US wages. Neo-liberalism was born with the twin midwives of dollar hegemony and unregulated global financial markets, disguising economic neo-imperialism as market fundamentalism. The debasement of the dollar, dragging down all other currencies, finds expression in the upward surge of commodities and asset prices, which pushes down global wages to keep US inflation low. This pathetic phenomenon is celebrated as economic growth by neo-liberals.

An operating detail about money markets has emerged as windows of opportunity for speculative profit. In most currencies, including US dollars, euros, yen and Swiss francs, the money market operates on "T+2". This means that settlement, when delivery of funds takes place, occurs two business days after the trade date. The settlement date is also known as the value date. So if on Monday, August 13, 2007, JPMorgan agrees to lend US dollars to Credit Suisse First Boston (CSFB) for three months, JPMorgan would pay this money to CSFB two days after trading, on August 15, and it would be returned with interest three months after that, on November 15, 2007. The main exception to T+2 is sterling, which is T+0, also known as same-day settlement. In sterling, standard practice is to settle a trade on the same day that it is agreed. However, counterparties can always agree to a non-standard settlement, but in the absence of such agreement, sterling is T+0 and almost all others are T+2.

There is a standard definition of the seemingly simple phrase "three months". For example, when is three months after November 30, 2009? It can't be February 30, 2010, because there isn't such a day. And it can't even be February 28, 2010, because that is a Sunday. As it is, the official definition from the International Swap Dealers Association (ISDA) says that three months after Monday, November 30, 2009, is Friday, February 26, 2010, but the point is that there is a precise trading definition. Payments in the real economy cause banks' balances with the central bank to rise and fall. A bank with a shortfall will want to borrow it from a bank with an excess, and hence there is an interbank deposit market (a money market).

This interbank deposit market exists, with maturities from one day to one year, in every currency, and in the major currencies it exists both domestically and in London. A market participant, by choosing to borrow or lend money at any particular maturity, is implicitly speculating against the forward rates implied by the spot rates. Banks also lend money against collateral; the secured nature of this lending reduces the credit risk, and hence it reduces the interest rate. Central banks have fiat control over short-term interest rates, motivated by monetary ideology and perceived forward-looking economic conditions. The euro when it was first introduced was a legal construct that made the national currency units in Euroland irrelevant to wholesale financial markets.

A money-market fund in the US is a type of mutual fund that is required by law to invest in lowest-risk securities. These funds have relatively low risks compared with other mutual funds and pay dividends that generally reflect short-term interest rates. Unlike a "money-market deposit account" at a bank, US money-market funds are not federally insured. Money-market funds typically invest in government securities, certificates of deposits, commercial paper of companies, and other highly liquid and low-risk securities. Money-market funds are regulated primarily under the Investment Company Act of 1940 and the rules adopted under that act, particularly Rule 2a-7. They attempt to keep their net asset value (NAV) at a constant $1.00 per share - only the dividend yield goes up and down. But a money market's per-share NAV may fall below $1.00 if the investments perform poorly. While investor losses in money market funds have been rare, they are possible in a financial panic.

The nature of financial panics
A panic is a species of neuralgia. A financial panic is cured by having it starved, stopping the drain of confidence from a market that runs on confidence. To cure a financial panic, the holders of cash reserves must, in contrast to natural instinct, be ready not only to keep the reserves for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to all market participants in need of liquidity whenever credit is otherwise good in normal situations.

The hesitance is related to the unhappy prospect of unnecessary larger loss in the event the cure fails to stem the panic, resulting in throwing good money after bad. And the cure will fail if any entity in the chain of credit should decide to bail itself out at the expense of the system. In wild periods of alarm, one failure will generate many others in a falling domino effect, and the best way to prevent the derivative failures is to arrest the primary failure which causes them.

This was easier to do when the number of counterparties in the distressed contract was relatively small, as in the case of the 1998 crisis involving Long Term Capital Management (LTCM), a large hedge fund, where they could all be gathered in one room is the New York Fed Building and work out a rescue deal. But in the case of the Refco collapse in 2005, where counterparties were spread over 240,000 customer accounts in 14 countries, it became a different problem. The identities of counterparties for over-the-counter derivative contracts were unknown as risks were unbundled and sold off to a variety of investors with varying appetite for risk.

Dealers such as Refco are intermediaries that earn their fees by providing the money to effectuate the performance of the contracts between remote and unidentified counterparties in synthetic collateral debt obligations (CDOs). Rather than the traditional pools of assets such as bonds and loans, the pools of credit derivatives that back synthetic CDOs include instruments such as credit default swaps, forward contracts, and options. When Refco, a large foreign-exchange and commodity broker providing clearing and execution services for global exchange-traded derivatives including futures, was forced into bankruptcy by alleged fraud in its parent holding entity, the funds and customer accounts in its unregulated over-the-counter derivative trading subsidiary were frozen.

Reuters reported last October 20 that a fund that tracks a commodities index created by investor Jim Rogers, former co-founder, with George Soros, of Quantum Fund, said it was unlikely to allow clients to immediately redeem investments as 63% of its assets were held by nearly collapsed Refco Inc. Beeland Management Co LLC, a Chicago-based manager for the Rogers International Raw Materials Fund LP, said it could not be sure if the fund would lose assets held by Refco Capital Markets. In a letter to investors, Beeland said it was unable to provide an accurate value of fund units because of Refco's bankruptcy. Beeland, Rogers' middle name, is majority controlled by Rogers. In Refco's bankruptcy filing, the Beeland fund was listed as a creditor with claims of US$75.2 million. Another Beeland-managed fund, the closely held Rogers Raw Materials Fund, has claims of $287.4 million. What is not known is how many other funds are affected by the Refco bankruptcy.

The management of a panic is mainly a confidence restoring problem. It is primarily a trading problem. All traders are under liabilities; they have obligations to meet that are time-sensitive and unconditional, and they can only meet those obligations by discounting obligations from other traders. In other words, all traders are dependent on borrowing money as bridge loans until settlement of their trades, and large traders are dependent on borrowing much money. At the slightest symptom of panic, traders want to borrow more than usual; they think they will supply themselves with the means of meeting their obligations while those means are still forthcoming. If the bankers gratify the traders, they must lend largely just when they like it least; if they do not gratify them, there is a panic. Fear generates more fear in a vortex toward an abyss.

There is a great structural inconsistency of logic in this. First, bank reserves are established where the last dollar in the economy is deposited and kept in a central bank. This final depository is also to be the lender of last resort; that out of it unbounded, or at any rate immense, advances are to be made when no one else can lend. Thus central banks posit themselves both as depositories of reserves and as lenders of last resort to the banking system. This seems like saying, first, that a bank reserve should be kept, and then that it need not be kept because in a real panic, the central bank will lend where bank reserve is insufficient. What is more problematic is that banks now constitute only a small part of the credit market. The lion's share is in the derivatives market. Granted, notional values in derivative contracts are not true risk exposures, but a swing of 1% in interest rate on a notional value of $220 trillion in the current derivative market is $2.2 trillion, approximately 20% of US gross domestic product.

When reduced to abstract principles, a financial panic is caused by a collective realization that the money in a system will not pay all creditors when those creditors all want to be paid at once. A panic can be starved out of existence by enabling those alarmed creditors who wish to be paid to get paid immediately. For this purpose, only relatively little money is needed. If the alarmed creditors are not satisfied, the alarm aggravates into a panic, which is a collective realization that all debtors, even highly creditworthy ones, cannot pay their creditors. A panic can only be cured by enabling all debtors to pay their creditors, which takes a great deal of money. No one has that much money, or anything like enough, but the lender of last resort - the central bank. And injecting that amount of money suddenly after a panic has begun will alter the financial system beyond recognition, and produce hyperinflation instantly, because the extinguishment of all credit with cash creates an astronomical increase in the money supply.

David Ricardo (1772-1823), brilliant British classical economist and a bullionist along the line of Henry Thornton (1760-1815), wrote: "On extraordinary occasions, a general panic may seize the country, when everyone becomes desirous of possessing himself of the precious metals as the most convenient mode of realizing or concealing his property, against such panic, banks have no security on any system." Thornton in his classic The Paper Credit of Great Britain (1802) provided the first description of the indirect mechanism by observing that new money created by banks enters the financial markets initially via an expansion of bank loans, through increasing the supply of lendable funds, temporarily reducing the loan rate of interest below the rate of return on new capital, thus stimulating additional investment and loan demand. This in turn pushes prices up, including capital good prices, drives up loan demands and eventually interest rates, bringing the system back into equilibrium indirectly.

The Bullionist Controversy emerged in the early 1800s regarding whether or not paper notes should be made convertible to gold on demand. But today, no central bank has enough precious metal (gold) to back its currency because the global currency system is based on fiat money. The use of credit enables debtors to use a large part of the money their creditors have lent them. If all those creditors were to demand all that money at once, their demands could not be met, for that which their debtors have used is for the time being employed, and not to be obtained for payment to the creditors. Moreover, every debtor is also a creditor in trade who can demand funds from other debtors. With the advantages of credit come disadvantages of illiquidity that require a store of ready reserve money, and advance out of it very freely in periods of panic, and in times of incipient alarm.

Notwithstanding the fact that the global money market has already run away from the control of every central bank, the management of the global money market is much more difficult than managing banking reserves in any particular country by its central bank, because periods of internal panic and external virtual demand for gold bullion commonly occur together. The virtual demand for gold bullion in today's fiat-currency world is expressed in the exchange rates of currencies. A falling exchange rate drains the global purchasing power of a currency and the resulting rise in the rate of discount, as expressed in a change in the exchange rate, tends to frighten the market. The holders of bank reserves have, therefore, to treat two opposite maladies at once: one requiring punitive remedies such as a rapid rise in the market rates of interest; and the other, an alleviative treatment with large and ready loans to combat illiquidity.

Experience suggests that the foreign drain must be counteracted by raising the rate of interest. Otherwise, the falling exchange rate will protract or exacerbate the alarm, generally known as a loss of confidence in the currency and the banking system and the functioning of the market. And at the rate of interest so raised, the holders of the final bank reserve must lend freely. Very large loans at very high rates are the best remedy for the worst malady of the money market when a foreign drain is added to a domestic drain. Any notion that money is not available, or that it may not be available at any price, only raises alarm to panic and enhances panic to madness, with a total loss of confidence. Yet the acceptance of loans at abnormally high interest rates is itself a sign of panic. This is the fate that awaits the dollar going forward. Against such contradictions, no central bank has found the appropriate wisdom. Former US Federal Reserve chairman Alan Greenspan's formula had always been more liquidity at low interest rates, which pushes the monetary system into what John Maynard Keynes called the liquidity trap. This transformed Greenspan from a wise central banker to a wizard of bubbleland.

And great as the delicacy of such a problem in all countries, it is far greater in the US now than it was or is elsewhere because of dollar hegemony. The strain thrown by a panic on the final bank reserve is proportional to the magnitude of a country's trade, and to the number and size of the dependent banks and financial institutions holding no cash reserve that is grouped around the Federal Reserve. There are very many more entities under great liabilities than there are, or ever were, anywhere else because of the emergence of the debt-driven US economy. At the commencement of every panic, all entities under such liabilities try to supply themselves with the means of meeting those liabilities while they can. This causes a great demand for new loans while loans are still available. And so far from being able to meet it, the bankers who do not keep extra reserve at that time borrow largely, or do not renew large loans, or very likely do both. The repo (repurchase agreement) market relieves the need of any bank or institutions to hold extra reserves, as new loans are supposed to be always available.

Money-center bankers in New York and London, other than the Fed and the Bank of England, effectuate this in several ways. First, they have probably discounted bills to a large amount for the bill brokers, and if these bills are paid, they decline discounting any others to replace them.

In the panic of 1857, the London and Westminster Bank discounted millions of such bills, and they justly said that if those bills were paid they would have an amount of cash far more than sufficient for any demand. But how were those bills to be paid? Someone else must lend the money to pay them. The mercantile community could not suddenly bear to lose so large a sum of borrowed money; they had been conditioned to rely on it, and they could not carry on their business without it. They could not handle it at the beginning of a panic, when everybody wanted more money than usual. Speaking broadly, those bills could only be paid by the discount of other bills. When the bills of a Manchester warehouseman that he gave to the manufacturer became due, he could not, as a rule, pay for them at once in cash; he had bought on credit, and he had sold on credit. He was but a middleman. To pay his own bill to the maker of the goods, he must discount the bills he had received from the shopkeepers to whom he had sold the goods; but if there is a sudden cessation in the means of discount, he would not be able to discount them. The entire mercantile community must obtain new loans to pay old debts. If someone else did not pour into the market the money which the banks like the London and Westminster Bank took out of it, the bills held by the London and Westminster Bank could not be paid.

Who then was to pour in the new money? Certainly not the bill brokers who had been used to rediscount with such banks as the London and Westminster millions of bills, and if they saw that they were not likely to be able to rediscount those bills, they would instantly protect themselves and would not discount them. Their business did not allow them to keep much cash unemployed. They paid interest for all the money deposited with them at rates often nearly approaching the rate they could charge; as they could only keep a small reserve a panic affected them more quickly than on anyone else. They stopped their discounts, or much diminished their discounts, immediately. There was no new money to be had from them, and the only place at which they could have it was the Bank of England. The same situation occurred in the 1907 banking crisis in the US that led to the creation of the Federal Reserve. A panic can be caused by a number of developments. In the case of LCTM, it was an unexpected Russian default of sovereign debts. In the case of Refco, it appears to be a relatively minor fraud that might bring down an otherwise well-hedged operation.

A bank that is uncertain of its credit standing, and wants to increase its cash reserve, may have money on deposit at the bill brokers. If it wants to replenish its reserve, it may ask for it, suppose, just when the alarm is beginning. But if a great number of banks do this very suddenly, the bill brokers will not at once be able to pay without borrowing. They have excellent bills in their case, but these will not be due for some days; and the demand from the more or less alarmed banks is for payment at once and today. Accordingly, the bill brokers take refuge at the central bank, the only place where at such a moment new money is available. The case is just the same if the bank wants to sell government securities, or to call in money lent on securities in the repo market. These the bank reckons as part of its reserve. And in normal times, nothing can work better.

In England, there is a saying: "You can sell consols (sovereign debt) on a Sunday." In a time of no alarm, or in any alarm affecting that particular banker only, the bank can rely on such reserve without misgiving. But not so in a general panic. Then, if the bank wants to sell $50 billion worth of government securities, it will not find $50 billion of fresh money ready to come into the market. All ordinary banks are trying to sell, or thinking they may have to sell. The only resource is the Fed. In a great panic, consols (consolidated annuities) could not be sold unless the Bank of England would advance to the buyer, and no buyer could obtain advances on consols at such a time unless the Bank of England would lend to him. The same is true with the Fed.

The case is worse if the alarm is not confined to the money-center banks, but is diffused throughout the economy and around the world because of the existence of Eurodollars and the systemic effects of dollar hegemony. As a rule, local bankers only keep enough cash as is necessary for their common business. All the rest they leave at the bill brokers, or at the interest-paying banks, or invest in government securities in the repo market. But in a panic they come to New York and London to find this money. And it is only from the Fed that they can get it, for all the rest of New York and London want their money for themselves.

History tells us that the liabilities of Lombard Street (the name of the London money market, as Wall Street is the name of the US equity market) payable on demand were far larger than those of any like market, and that the liabilities of the country were greater still, the magnitude of the pressure on the Bank of England when both Lombard Street and the country suddenly and at once came upon it for aid. No other bank was ever exposed to a demand so formidable, for none ever before kept the banking reserve for such a nation as the English. The mode in which the Bank of England met this great responsibility was very curious. It unquestionably did make enormous advances in every panic.

Credit in business is like loyalty in government. You must take what you can find of it, and work with it if possible. Every banker knows that if he has to prove that he is worthy of credit, however good may be his arguments, in fact his credit is gone. The whole rests on an instinctive confidence generated by use and tradition. A many-reserve system, if some miracle should suddenly put it down in Lombard Street, would seem monstrous there. Nobody would understand it, or confide in it. Credit is a power that may grow, but cannot be constructed. Those who live under a great and firm system of credit must consider that if they break up that one, they will never see another, for it would take years upon years to make a successor to it. The Fed has been abusing this truism for too long. The damage Greenspan has done to the creditworthiness of the dollar monetary system would take decades to restore and would require much systemic pain.

How banking evolved
Banking was not consciously or rationally designed. It evolved as an institution by meeting the changing needs of stages of evolving economies that have later become obsolete. The institution of banking frequently trails behind current financial needs of a contemporary economy.

The earliest banks of Italy, where the name began from a bench for counting money, were finance companies. The Bank of St George at Genoa, as with other banks founded in imitation of it, was at first only a finance company for making loans to and float loans for the governments of the city-states where it operated. Money is an urgent want of governments in all times, and seldom more urgent than it was in the tumultuous Italian Republics of the High Middle Ages. After these banks had been well established as finance companies, they began to do what today is referred to as banking business but was originally never contemplated.

The great banks of Northern Europe had their origin in a want still more curious. The prime business of a bank was to give good coin. Adam Smith (1723-1790), the Scottish moral philosopher whose ideas so influenced US free marketeers, describes it clearly:

The currency of a great state, such as France or England, generally consists almost entirely of its own coin. Should this currency, therefore, be at any time worn, clipt, or otherwise degraded below its standard value, the state by a reformation of its coin can effectually re-establish its currency. But the currency of a small state, such as Genoa or Hamburg, can seldom consist altogether in its own coin, but must be made up, in a great measure, of the coins of all the neighboring states with which its inhabitants have a continual intercourse. Such a state, therefore, by reforming its coin, will not always be able to reform its currency. If foreign bills of exchange are paid in this currency, the uncertain value of any sum, of what is in its own nature so uncertain, must render the exchange always very much against such a state, its currency being, in all foreign states, necessarily valued even below what it is worth.

Smith was giving an early description of currency hegemony, linking great statehood with sound money. It was the opposite of Greenspan's approach of debasing the US dollar through over-issuance to maintaining the economy of a great state, notwithstanding Greenspan's repeated expression of fidelity to the ideas of Adam Smith.

Smith went on to observe that "in order to remedy the inconvenience to which this disadvantageous exchange must have subjected their merchants, such small states, when they began to attend to the interest of trade, have frequently enacted that foreign bills of exchange of a certain value should be paid not in common currency, but by an order upon, or by a transfer in the books of a certain bank, established upon the credit, and under the protection of the state, this bank being always obliged to pay, in good and true money, exactly according to the standard of the state". Thus fixed exchange rates set by government are a necessity for small states to overcome the disadvantages of market forces on the value of currencies.

Before the Bank of Amsterdam, also known as the Wissel Bank, was founded in 1609, an important date in banking, the great quantity of clipped and worn foreign coins, which the extensive trade of Amsterdam brought from all parts of Europe, reduced the value of its currency about 9% below that of good money fresh from the mint. Such good money no sooner appeared than it was melted down or carried away from general circulation, as prescribed by Gresham's Law of bad money driving out good. Nobel laureate economist Robert Mundell asserts that the correct expression of Gresham's Law is: "Cheap money drives out dear, if they exchange for the same price."

It is a proposition that defines the relation between paper money and the precious metals. David Hume, writing in 1752, went to great pains to demonstrate that the existence of paper credit would mean a correspondingly lower quantity of gold, and that an increase in paper credit would drive out an equal quantity of gold. Hume went on to explain why some countries had more gold - in proportion to population and wealth - than others; it was because there was no credit to displace gold.

Adam Smith developed the same idea in The Wealth of Nations with the use of paper money and applauded its use in the nation: "The substitution of paper in the room of gold and silver money, replaces a very expensive instrument of commerce with one much less costly, and sometimes equally convenient. Circulation comes to be carried on by a new wheel, which it costs less both to erect and to maintain than the old one." But by accepting the use of paper money, Smith was not necessarily advocating debased money.

Smith went on to say that merchants, with plenty of currency, could not always find a sufficient quantity of good money to pay their bills of exchange; and the value of those bills, in spite of several regulations that were made to prevent it, became in a great measure uncertain. To remedy these inconveniences, a bank was established in 1609 under the guarantee of the City of Amsterdam. This bank received both foreign coin and the light and worn coin of the country at its real intrinsic value in the good standard money of the country, deducting only so much as was necessary for defraying the expense of coinage, and the other necessary expense of management. For the value that remained, after this small deduction was made, it gave a credit in its books. This credit was called bank money, which, as it represented money exactly according to the standard of the mint, was always of the same real value, and intrinsically worth more than current money. It was at the same time enacted that all bills drawn upon or negotiated at Amsterdam of the value of 600 guilders and upward should be paid in bank money, which at once took away all uncertainty in the value of those bills. Every merchant, in consequence of this regulation, was obliged to keep an account with the bank in order to pay his foreign bills of exchange, which necessarily occasioned a certain demand for bank money.

On this simple principle, the Bretton Woods regime set out in 1944 a gold-backed dollar as the reserve currency for postwar international trade. Since then, the central bank of every trading nation has been obliged to keep a dollar reserve account with the US Federal Reserve to support the value of its currency, even when the dollar was taken off the gold standard in 1971.

An important function of early banks, which modern banks have retained, is the function of remitting money to facilitate trade. A customer brings money to the bank to meet a payment obligation at a great distance, and the bank, having a connection with other banks at that location, causes the destination bank to pay by debiting the account of the originating bank. The instant and regular remittance of money is an early necessity of growing trade. By providing these services, banks gained the credit rating that over time enabled them to make profits as deposit banks.

Being trusted for one purpose, they came to be trusted for a purpose quite different, ultimately far more important, as depository and intermediary of money and credit. But these services only affect a small number of customers. The real function deposit banks perform is the supply of paper-money circulation to the economy. Up to 1830 in England, the main profit of banks was derived from the circulation, and for many years after that the deposits were treated as very minor matters, and the whole of so-called banking discussion turned on questions of circulation.

Today, most of the circulation is handled electronically as virtual money instead of paper money. Banks are in fact a retail network for the central banks for circulating the money central banks issue. The US Federal Reserve, with its unlimited power to create money as a lender of last resort, is owned by its member banks, not by the people of the United States. This arrangement is the key obstacle to economic/financial democracy in the US.

The Fed and the value of money
The Fed, though not part of the US government, and not collectively owned by the people but by commercial banks, enjoys a monopoly on the creation of money. The Fed has some extra-constitutional power to fixing the value of money, through the setting of short-term interest rates and its control of the money supply. The Fed sets the minimum rate of discount from time to time that all banks must accept.

Liberal economists view money as a commodity, and only a commodity. Why then is its value fixed by fiat and not the way in which the values of all other commodities are fixed, by supply and demand in the market? The answer is that the issuing of money as a legal tender is a government monopoly that gives government pricing power over money. But the Fed, by its own definition of being politically independent, is not part of the government. The Fed, owned by its member banks, is a living example of a financial oligarchy. While the Fed claims that its monetary-policy measures are designed to sustain the health of the whole economy, it sees the health of the economy's financial heart, the banks in the Federal Reserve System, as the paramount objective.

In normal times, there is not money enough in the money markets to discount all the bills outstanding without taking money from the Fed. As soon as the Fed funds rate target is fixed, market participants who have bills to discount try to discount these bills cheaper than the Fed funds rate. But they seldom can get them discounted cheaper, for if they did everyone would leave the Fed, and the outer market would have more bills than it could handle and the rate would rise to the rate set by the Fed.

In practice, when the Fed finds this process beginning, and sees that its business is diminishing, it lowers the Fed funds rate target, so as to secure a reasonable portion of the business to itself, and to keep a fair part of its deposits employed. At Dutch auctions an upset or maximum price is fixed by the seller, and he comes down in his bidding until he finds a buyer. The value of money is fixed in the money market in much the same way, only that the upset price is not that of all sellers, but that of one very important seller, the Fed, some part of whose supply is essential.
The notion that the Fed has a control over the money market, and can fix the rate of discount as it likes, has survived from the old days before 1844, when the Bank of England could issue as many notes as it liked. But even then the notion was a mistake. A bank with a monopoly of note issue has great sudden power in the money market, but no permanent power: it can affect the rate of discount at any particular moment, but it cannot affect the average rate. And the reason is that any momentary fall in money, caused by the fiat of such a bank, of itself tends to create an immediate and equal rise, so that upon an average the value is not altered. Also the amount of outstanding long-term debt is infinitely greater than short-term debt, making it difficult for short-term interest rates to dictate long-term rates. This is the cause of what Greenspan calls the interest-rate conundrum.

If money of constant value were all held by its owners, or by banks that did not pay an interest for it, the value of money might not fall quickly. Money would, in the market phrase, be "well held". The holders would be under no pressure to employ it all; or they might chose to employ part at a high rate rather than all at a low rate. Thus the three conditions that compel money to be constantly employed are taxes and interest and mild inflation.

Taxes are not levied to finance government expenditure, but to keep the population productive. Similarly, interest on money is not to reward the holders of money, but to keep the borrowers working for it. Prosperity is produced by work, not profits. But in the money market, money is very largely held by those who do pay an interest for it, such as money-market funds, and such entities must employ it all to avoid insolvency. Such entities do not so much care at what rate of interest they employ their money: they can reduce the dividend they pay in proportion to that which they can make, but they must pay something. The fluctuations in the value of money are therefore greater than those on the value of most other commodities. At times, there is an excessive pressure to borrow it, and at times an excessive pressure to lend it, and so the price is forced up and down.

These considerations define the responsibility thrust on the Fed and other central banks. The Fed cannot control the permanent value of money, but it can fully control its momentary value. It cannot change the average value, but it can determine the deviations from the average. If the Fed badly manages, the rate of interest will at one time be excessively low, and at another time excessively high. The economy will experience pernicious booms and busts. But if the Fed manages well, the rate of interest will not deviate much from the average rate. As far as anything can be steady the value of money will then be steady, and probably in consequence trade will be steady too at least a principal cause of periodical disturbance will have been withdrawn from it.

This is the view of Milton Friedman, who coined the slogans "money matters" and "inflation is everywhere and anywhere a monetary phenomenon". Friedman advocated a fixed expansion of M1 at 3% long-term to moderate the runaway business cycle over-stimulated by Keynesian deficit-financing measures. But economies can develop imbalances from monetary causes independent of inflation, as the US economy has from dollar hegemony. Greenspan's solution was to keep a steady expansion of the money supply to neutralize the imbalances with debt, thus postponing the day of reckoning by accepting a bigger crash that requires a bigger cleanup.

The rise of prices is the quickest way to improve the state of credit. Prices in general are mostly determined by wholesale transactions, which are commonly not cash transactions, but bill transactions. Years of improving credit, if there be no disturbing causes, are years of rising prices, and years of decaying credit years of falling prices. Deflation is the deadly enemy of outstanding debt.

In the United States, when house prices have generally tripled in less than a decade, it is evidence that the value of the dollar has declined by a factor of three in the same time period. Consumer prices have not risen by the same amount because of outsourcing of manufacturing to low-wage economies overseas also acts as a depressant on domestic wages. Imbalance in the economy appears if wages and earnings have not risen proportional to prices. A homeowner whose house has increased 300% in market price while his income has risen only 30% has not become richer. He has become a victim of uneven inflation. He may enjoy a one-time joyride with cash-out financing with a new mortgage, but his income cannot sustain the new mortgage payments if interest rates rise, and he will lose his home. And interest rates will rise if his income increases, because that is how the Fed defines inflation. Thus when his income rises, the market price of his home will fall, giving him an incentive to walk away from a big mortgage in which he has little equity tie-up. This can become a systemic problem for the mortgage-backed security sector.

Under every system of banking, there will always be securities dealers who, by attending only to one class of securities, come to be particularly well acquainted with that class. The Fed recognizes them as primary dealers. And as these specially qualified dealers can for the most part lend much more than their own capital, they will always be ready to borrow largely from bankers and others and in the repo market, and to deposit the securities they know to be good as a pledge for the loan. They act thus as intermediaries between the borrowing public and the less qualified capitalists. Knowing better than the ordinary capitalists which loans are better and which are worse, specialist dealers borrow from them, and gain a profit by charging to the public more than they pay to the lenders.

Many stockbrokers transact such business on an enormous scale. They lend large sums on domestic and foreign bonds or infrastructure shares or other such securities, and borrow those sums from bankers, depositing the securities with the bankers, and generally, though not always, giving their guarantee. But with the development of deregulated capital and debt markets, banks are increasingly reduced to the role of market participants rather than intermediaries, by proprietary trading. By far the greatest of these new intermediate dealers are the bill-brokers. Mercantile bills are a kind of security that only professionals understand. In the US, they are called commercial papers, short-term obligations with maturity ranging from two to 270 days issued by banks, corporations and other institutional borrowers to investors with temporary idle cash. Such instruments are unsecured and usually discounted, though some are interest-bearing.

In the US, the money market is a subsection of the fixed-income market. A bond is one type of fixed income security. The difference between the money market and the bond market is that the money market specializes in very short-term debt securities (debt that matures in less than one year). Money-market investments are also called cash investments because of their short maturities. Money-market securities are in essence IOUs issued by governments, financial institutions and large corporations of top credit ratings. These instruments are very liquid and considered extraordinarily safe. Because they are extremely conservative, money-market securities offer significantly lower return than most other securities.

One of the main differences between the money market and the stock market is that most money-market securities trade in very high denominations. This limits the access of the individual investor. Furthermore, the money market is a dealer market, which means that firms buy and sell securities in their own accounts, at their own risk. Compare this with the stock market, where a broker receives a commission to act as an agent, while the investor takes the risk of holding the stock. Another characteristic of a dealer market is the lack of a central trading floor or exchange. Deals are transacted over the phone or through electronic systems. Individuals gain access to the money market through money-market mutual funds, or sometimes through money-market bank accounts. These accounts and funds pool together the assets of hundreds of thousands of investors to buy the money-market securities on their behalf. However, some money-market instruments, such as Treasury bills, may be purchased directly from the Treasury in denominations of $10,000 or larger. Alternatively, they can be acquired through other large financial institutions with direct access to these markets.

There are different instruments in the money market, offering different returns and different risks. The desire of major corporations to avoid banks as much as possible has led to the widespread popularity of commercial paper. Commercial paper is an unsecured, short-term loan issued by a corporation, typically for financing accounts receivables and inventories. It is usually issued at a discount, reflecting current market interest rates. Maturities on commercial paper are usually no longer than nine months, with maturities of one to two months being the average.

For the most part, commercial paper is a very safe investment because the financial situation of a company can easily be predicted over a few months. Furthermore, typically only companies with high credit ratings and creditworthiness issue commercial paper. Over the past four decades, there have only been a handful of cases where corporations have defaulted on their commercial-paper repayment. Commercial paper is usually issued with denominations of $100,000 or multiples thereof. Therefore, small investors can only invest in commercial paper indirectly through money market funds.

On December 23, 2005, commercial paper placed directly by GE Capital Corp was 4.26% on 30-44 days and 4.56% on 266-270 days, while the Fed funds rate target was 4.25% and the discount rate was 5.25%, both effective since December 13. Through the commercial-paper market, GE has become the world's biggest non-bank finance company.

Next: The commercial paper predicament

Henry C K Liu is chairman of a New York-based private investment group.

http://www.atimes.com/atimes/Global_Economy/GE26Dj02.html
Global Economy
May 26, 2005



The real problems with $50 oil
By Henry C K Liu

After oil prices peaked above US$58 a barrel in early April, and stayed around their current $50 range, the White House announced that it wanted oil to go back down to $25 a barrel. There is a common misconception in life that if only things could go back to the ways they were in the good old days, life would be good again like in the good old days. Unfortunately, good old days never return as good old days because what makes the old days good is often just bad memory. The problem with market capitalism is that while markets can go up and markets can go down, they never end up in the same spot. The term "business cycle" is a misnomer because the end of the cycle is a very different place from the beginning of a cycle. A more accurate term would be "business spiral", either up or down or simply sideways.

Oil is a good example whereby this market truism can be observed. When oil rises above $50 a barrel and stays there for an extended period, the resultant changes in the economy become normalized facts. These changes go way beyond fluctuations in the price of oil to produce a very different economy. Below are 10 new economic facts created by $50 oil.

Fact 1: Oil-related transactions involving the same material quantity involve greater cash flow, with each barrel of oil generating $50 instead of $25. The United States now consumes about 20 million barrels of oil each day, about 25% of world consumption of 84 million barrels. At $50 a barrel, the aggregate oil bill for the US comes to $1 billion a day, $365 billion a year, about 3% of 2004 US gross domestic product (GDP). About 60% of US consumption is imported at a cost of $600 million a day, or $219 billion a year. Oil and gas import is the single largest component in the US trade deficit, not imports from Japan or China.

As oil prices rise, consumers pay more for heating oil and gasoline, airlines pay more for jet fuel, utility companies pay more for oil, petrochemical companies pay more for raw material, and the whole economy pays more for electricity. Now those extra payments do not disappear into a black hole in the universe. They go into someone's pocket as revenue and translate into profits for some businesses and losses for others. In other words, higher energy prices do not take money out of the economy, they merely shift profit allocation from one business sector to another. More than $200 billion a year goes to foreign oil producers who then must recycle their oil dollars back into US Treasury bonds or other dollar assets, as part of the rules of the game of dollar hegemony. The simple fact is that a rise in monetary value of assets adds to the monetary wealth of the economy.

Fact 2: Since energy is a basic commodity and oil is the predominant energy source, high energy cost translates into a high cost of living, which can also result in a higher standard of living if income can keep up. High energy cost translates into reduced consumption in other sectors unless higher income can be generated from the increased cash flow. Unfortunately, in the modern market economy, higher income for the general public often means working longer hours, since pay raises typically have a long time lag behind price increases. Working longer hours does not translate into productivity increases, but it does increase income. Those who cannot find overtime work will look for a second or third job, or put a hitherto non-working spouse back in the labor market. This generally lowers the standard of living, with less time for rest and leisure and for family and social life.

With higher prices, companies will hire more workers, since with wages remaining stagnant and the cost of worker benefits declining while company cash flow increases, adding employees will not hurt profitability and will enhance prospects for growth. Those who get paid by fixed commission on transaction volume are the winners. They see their income rise as the monetary value of the transaction rises. This ranges from sales agents and gas-station operators to real-estate brokers, investment bankers, mortgage brokers, credit-card issuers, etc. This translates into higher aggregate revenue for the economy and explains why corporate profit is up even when consumer discretionary spending slows. It also explains why employment can be up while the unemployment rate remains constant, because the new work goes mostly to those already employed or those newly entering the job market, but not to the chronically unemployed, who remain unemployed. A steady unemployment rate in an expanding labor pool means that unemployment is growing at the same rate as new employment. An unemployment rate of 5.2% - the US rate in April - is within the structural range (4-6%) of what neo-classical economists call a non-accelerating inflation rate of unemployment (NAIRU), thus presenting no inflation threat.

Fact 3: As cash flow increases for the same amount of material activities, the GDP rises while the economy stagnates. Companies are buying and selling the same amount or maybe even less, but at a higher price and profit margin and with slightly more employees at lower pay per unit of revenue. US prices for existing homes have been rising more than 30% annually for almost a decade, adding significantly to GDP growth. As the oil price rose within a decade from about $10 a barrel to $50, a fivefold increase, those who owned oil reserves saw their asset value increase also fivefold. Those who did not own oil reserves protected themselves with hedges in the rapidly expanding structured finance world. Since GDP is a generally accepted measure of economic health, the US economy then is judged to be growing at a very acceptable rate while running in place. People eat less beef and put the meat money into the gas tanks of their cars to pollute the air, shifting cancer risks from their colons to their lungs.

Fact 4: With asset value ballooning from the impact of a sharp rise in energy prices, which in turn leads the entire commodity price chain in an upward spiral, the economy can carry more debt without increasing its debt-to-equity ratio, giving much-needed substance to the debt bubble that had been in danger of bursting before oil prices began to rise. Since the monetary value of assets tends to rise in tandem over time, the net effect is a de facto depreciation of money, misidentified as growth.

Fact 5: High oil prices threaten the economic viability of some commercial sectors, such as airlines and motor vehicles. US airlines United and Delta recently won court approval to dump their pension obligations in a bankruptcy proceeding. A need to bolster pension costs, underfunded by $5.3 billion, over the next three years would worsen Delta's cash flow problems. Delta faces $3.1 billion in pension costs between 2006 and 2008. A bill under consideration by the US Senate would stretch out employee pension payments over 25 years, and could ease the airline's liabilities.

United Airlines sought and received approval of its plan to have the government's pension insurer take over its defined-benefit plans, resulting in the largest-ever US pension default. United workers will lose about a quarter of their total pensions if their accounts are shifted to the government-run Pension Benefit Guaranty Corp (PBGC). United's effort to dump its pensions is being watched closely by the rest of the airline industry, where record high fuel costs, the lowest fares since the early 1990s and stiff deregulated competition have caused network carriers to lose billions of dollars. Delta lost over $1 billion in the first quarter of 2005. A successful move by United to get out from under its pension obligations, following a similar step taken successfully by US Airways Group Inc in February, cleared the way for similar actions elsewhere in the industry and the economy. American Airlines, the largest US carrier and a unit of AMR Corp, has said it will keep its pension plans but is concerned about No 2 United gaining a financial advantage with the elimination of its pension obligations. Pension arbitrage is producing the same destructive effect on labor as cross-border wage arbitrage.

Detroit, namely Ford and General Motors, with their most profitable models being the gas-guzzling trucks and sport utility vehicles (SUVs) that can take more than $100 to fill their tanks, are going down the same route with their pension obligations. General Motors Acceptance Corp (GMAC), a huge $300 billion credit-finance company, is facing financial problems created by the falling dollar, rising interest rates, and falling auto sales. GMAC debt, at about $260 billion, has fallen to junk status. GM's pension fund is underfunded by $17 billion, at only 80% of its obligations. The prospect of a private pension collapse is more pressing than the accounting crisis in Social Security. As Ford and GM fall into financial stress, their extended network of parts and material suppliers is also falling into insolvency.

The result is that the PBGC will fail financially as more companies default on their pension obligations, the same away the Federal Deposit Insurance Corp (FDIC) did during the savings and loan crisis of the 1980s. On September 2, Labor Day 1974, the landmark Employee Retirement Income Security Act (ERISA) became law in the US, with the government insuring pensions for millions of workers. Since then, PBGC has paid more than $8 billion in benefits to retirees under private-sector-defined benefit pension plans in the agency's care.

PBGC already administers the retirement benefits of almost 500,000 workers and retirees who were covered by about 2,700 terminated pension plans. Nearly half of them worked in five major industries: primary metals; airlines; industrial machinery; motor vehicles and parts; and rubber and plastics. PBGC insures more than 44,000 private-sector pension plans covering some 42 million workers, about one in every three US workers. Before PBGC was created, many workers labored without assurance of receiving the pensions they earned. In those not-so-good old days, there were instances where thousands of people lost all retirement benefits when their companies failed and could not keep pension commitments. Because of PBGC, this can no longer happen. When business failures occur and companies can no longer support their defined benefit pensions, PBGC will pay worker benefits as ERISA provides. But with entire industries going down the drain, PBGC, an insurance enterprise operating on the actuary principle of occasional unit default within healthy industries, cannot shoulder the cost of industrywide defaults without a federal bailout. Fifty-dollar oil will accelerate this crisis in government pension insurance.

Fact 6: Industrial plastics, the materials most in demand in modern manufacturing, more than steel or cement, are all derived from oil. Higher prices of industrial plastics will mean lower wages for workers who assemble them into products. But even steel and cement require energy to produce and their prices will also go up along with oil prices. While low Asian wages are keeping global inflation in check through cross-border wage arbitrage, rising energy prices are the unrelenting factor behind global inflation that no interest-rate policy from any central bank can contain. Ironically, from a central bank's perspective, a commodity-price-pushed asset appreciation, which central banks do not define as inflation, is the best cure for a debt bubble that the central banks themselves created.

Fact 7: War-making is a gluttonous oil consumer. With high oil prices, America's wars will carry a higher price, which will either lead to a higher federal budget deficit, or lower social spending, or both. This translates into rising dollar interest rates, which is structurally recessionary for the globalized economy. But while war is relentlessly inflationary, war spending is an economic stimulant, at least as long as collateral damage from war occurs only on foreign soil. War profits are always good for business, and the need for soldiers reduces unemployment. Fighting for oil faces little popular opposition at home, even though for the United States the need for oil is not a credible justification for war. The fact of the matter is that the US already controls most of the world's oil without war, by virtue of oil being denominated in dollars that the US can print at will with little penalty.

Fact 8: There is a supply/demand myth that if oil prices rise, they will attract more exploration for new oil, which will bring prices back down in time. This was true in the good old days when oil in the ground stayed a dormant financial asset. But now, as explained by Facts 3 and 4 above, in a debt bubble, oil in the ground can be more valuable than oil above ground because it can serve as a monetizable asset through asset-backed securities (ABS) in the wild, wild world of structured finance (derivatives). So while there is incentive to find more oil to enlarge the asset base, there is little incentive to pump it out of the ground merely to keep prices low.

Gasoline prices also will not come down, not because there is a shortage of crude oil, but because there is a shortage of refinery capacity. The refinery deficiency is created by the appearance of gas-guzzlers that Detroit pushed on the consuming public when gasoline was cheaper than bottled water, at less than a $1 a US gallon (26.5 cents a liter). Refineries are among the most capital-intensive investments, with nightmarish regulatory hurdles. Refineries need to be located where the demand for gasoline is, but families that own three cars do not want to live near a refinery. Thus there is no incentive to expand refinery capacity to bring gasoline prices down because the return on new investment will need high gasoline prices to pay for it. After all, the market is not a charity organization for the promotion of human welfare. It is a place where investors try to get the highest price for products to repay their investment with highest profit. It is not the nature of the market to reduce the price of output from investment so that consumers can drive gas-guzzling SUVs that burn most of their fuel sitting in traffic jams on freeways.

Fact 9: According to the US Geological Survey, the Middle East has only half to one-third of known world oil reserves. There is a large supply of oil elsewhere in the world that would be available at higher but still economically viable prices. The idea that only the Middle East has the key to the world's energy future is flawed and is geopolitically hazardous.

The United States has large proven oil reserves that get larger with rising oil prices. Proven reserves of oil are generally taken to be those quantities that geological and engineering information indicates with reasonable certainty can be recovered in the future from known reservoirs under existing economic and geological conditions. According to the Energy Information Administration (EIA), the US had 21.8 billion barrels of proven oil reserves as of January 1, 2001, twelfth-highest in the world. These reserves are concentrated overwhelmingly (more than 80%) in four states - Texas (25%, including the state's reserves in the Gulf of Mexico), Alaska (24%), California (21%), and Louisiana (14%, including the state's reserves in the Gulf of Mexico).

US proven oil reserves had declined by about 20% since 1990, with the largest single-year decline (1.6 billion barrels) occurring in 1991. But this was due mostly to the falling price of oil, which shrank proven reserves by definition. At $50 a barrel, the reserve numbers can expand greatly. The reason the US imports oil is that importing is cheaper and cleaner than extracting domestic oil. At a certain price level, the US may find it more economic to develop domestic oil instead of importing. The idea of achieving oil independence as a strategy for cheap oil is unworthy of serious discussion.

And then there are "unconventional" petroleum reserves that include heavy oils, which can be pumped and refined just like conventional petroleum except that they are thicker and have more sulfur and heavy-metal contamination, necessitating more extensive and costly refining. Venezuela's Orinoco heavy-oil belt is the best-known example of this kind of unconventional reserves, currently estimated to be 1.2 trillion barrels. Tar sands can be recovered via surface mining or in-situ collection techniques. This is more expensive than lifting conventional petroleum but not prohibitively so. Canada's Athabasca Tar Sands are the best-known example of this kind of unconventional reserves, currently estimated to be 1.8 trillion barrels. Oil shale requires extensive processing and consumes large amounts of water. Still, unconventional reserves far exceed the current supply of conventional oil.

The economics of petroleum are as important as geology in coming up with reserve estimates since a proven reserve is one that can be developed economically. If the Mideast and the Persian Gulf implode geopolitically and oil from this region stops flowing, the US will be the main beneficiary of $50 oil, or even $100 oil, as would Britain with its North Sea oil and countries such as Norway and Indonesia. But the big winner will be Russia. For China, it would be a wash, because China imports energy not for domestic consumption, but to fuel its growing export machine, and can pass on the added cost to foreign buyers. In fact, the likelihood of the US bartering below-market Texas crude for low-cost Chinese manufactured goods is very real possibility in the future. Similar bilateral arrangements between China-Russia, China-Venezuela and China-Indonesia are also good prospects.

Fact 10: Fifty-dollar oil will buy the US debt bubble a little more time, albeit bubbles never last forever. But in a democracy, the White House is under pressure from a misinformed public to bring the oil price back down to $25, not realizing that the price for cheap oil can be the bursting of the debt bubble. Despite all the grandstand warnings about the need to reduce the US trade deficit, a case can be made that the United States cannot drastically reduce its trade deficit without paying the price of a sharp recession that could trigger a global depression.

The economics of oil
Since the discovery of petroleum, its economics has never been about cutting a square deal for the consumer, corporate or individual, let alone the little guys or the working poor. It has to do with squeezing the most financial value out of this black gold.

John D Rockefeller consolidated the US oil industry into a monopoly by eliminating chaotic competition to keep the price high, not to push prices down. Neo-classical economics views higher prices of consumables as inflation, but asset appreciation is viewed as growth, not inflation. Since oil is both an asset and a consumable commodity, neo-classical economics presents a dilemma for oil economics. The size of oil reserves is exponentially greater than the annual flow of oil to the market. What is even more fundamental is that as the flow of oil to the market is reduced, the price of oil goes up, enlarging proven reserves by definition. Thus while a rise in the market price of oil adds to inflation, the corresponding rise of the asset value and size of oil reserves create a wealth effect that more than neutralizes the inflationary impact of market oil prices. The world should not care about an added percentage point in inflation if the world's assets would appreciate 17% as a result, except that when oil is not owned equally among the world's population, a conflict emerges between consumers and producers.

In fact, on an aggregate basis, cheap oil can have a deflationary impact on the economy by reducing the wealth effect. For the US economy, since the United States is a major possessor of oil assets, both on- and offshore, high oil prices are in the national interest. What we have is not an inflation problem in rising oil prices, but a pricing problem that distributes unevenly the benefits and pains of price adjustment among oil owners and oil consumers, both domestically and internationally.

On March 12, 1999, St Louis Federal Reserve Bank president William Poole said in a speech that the growth of the US money supply, which was then at more than 8% when inflation was below 2% annually, was "a source of concern" because it outpaced the rate of inflation. The M2 money supply had been growing at an 8.6% annual rate for the previous 52 weeks to keep the economy from stalling before the 2000 election. The US Federal Reserve was also watching the rate of inflation, held down mostly by low oil prices.

The rises and falls of OPEC
Failure by the Organization of Petroleum Exporting Countries (OPEC) to cut production at its meeting in November 1998 prompted prices to collapse to a 12-year low of $10.35 a barrel in New York the following month. A combination of excess production, rising inventories and poor demand for winter heating fuels pushed prices down. In March 1999, oil prices climbed 17%, going higher as oil-producing countries, unified by low prices, succeed in cutting output. Oil prices began making a sharp recovery in the late winter of 1999, rising from the low teens at the beginning of the year to more than $22 a barrel by the early autumn, and crossed $30 a barrel in mid-February 2000. A major cause was production cuts settled upon in March 1999 by OPEC and other major oil-exporting nations. Poole warned that "we cannot continue to rely on the decline of oil prices at the pace of the last couple of years". He said investors who had pushed bond yields to their highest level in six months were correct in assuming the Fed's next move would be to increase interest rates. The Fed Open Market Committee (FOMC), when it met on February 2, 1999, had left the Fed Funds rate (FFR) target at 4.75%. Poole voted in 1998 for the FOMC to cut the FFR target three times between September and November to 4.75% when oil was at $12.

Today, with oil at around $48, the FFR target is 3% effective since May 3. Annualized growth rate for M2 in April 2005 (relative to April 2004) was 4.139%, a fall by more than half of the 1999 growth rate of 8.6%. If the Fed is really concerned with fighting inflation, $48 oil and a 3% FFR target simply do not mix, even with a lowered money-supply growth rate. There is strong evidence that instead of worrying about inflation, the Fed is really more worried about the debt bubble, which stealth inflation through asset appreciation can help to deflate with less or no pain.

In July 1993, when the US economy had been growing for more than two years from M2 growth of over 6%, Fed chairman Alan Greenspan remarked in congressional testimony that "if the historical relationships between M2 and nominal income had remained intact, the behavior of M2 in recent years would have been consistent with an economy in severe contraction". With the M2 growth rate down to 1.44% in July 1993, Greenspan said, "The historical relationships between money and income, and between money and the price level, have largely broken down, depriving the aggregates of much of their usefulness as guides to policy. At least for the time being, M2 has been downgraded as a reliable indicator of financial conditions in the economy, and no single variable has yet been identified to take its place."

M2, adjusted for changes in the price level, remains a component of the Index of Leading Economic Indicators, which some market analysts use to forecast economic recessions and recoveries. A positive correlation between money-supply growth and economic growth exists only on inflation-adjusted M2 growth, and only if the new money goes into new investment rather than as debt to support speculation on rising asset prices. Sustainable economic expansions are based on real production, not on speculative debt.
In 2004, longer-term interest rates actually declined from their June high of 4.82% to 4.20% at year-end even as short-term rates rose and the money supply grew at a 5.67% annual rate. This reflected a credit market unconcerned with long-term inflation despite a sinking US dollar and oil prices rising above $50 a barrel. The reason is that $50 oil raised asset value at a faster pace than price inflation of commodities.

In March 2000, OPEC punctured the Greenspan easy-money bubble by reversing the fall of oil prices. The FOMC was forced to respond to the change in the rate of inflation, no longer being held down by declines in oil prices. Because the easy money stimulated only speculation that did not produce any real growth, the easy-money bubble of 2000 evolved into the current debt-driven asset bubble. The smart money realized in 2000 that the market's march toward $50 oil was on. And in 2005, $50 oil appears to be giving Greenspan's debt-driven asset bubble a second life, most of which ended in the real-estate sector. If oil should fall back to $25 a barrel, the debt-driven asset bubble will pop with a bang.

Oil is not included in the World Trade Organization (WTO) regime because it is not a commodity that can be produced at will by any nation, regardless of efficiency. Oil producers are members of a natural monopoly devoid of open competition. Yet OPEC is a cartel. As such, it will eventually conflict with the competition policy thrust of the WTO. Under WTO rules, oil-producing nations cannot be charged with price-fixing if they intervene to affect market prices. OPEC, the International Monetary Fund (IMF) and the WTO are among the most visible international economic organizations. The WTO regime imposes draconian free-market rules on trade except for oil and currencies, while OPEC blatantly practices intergovernmental manipulation of oil prices and the IMF acts as the world's policeman in defense of dollar hegemony. Neo-liberal economists do not see OPEC and the IMF as trade-restricting monopolies, arguing that their separate domains of oil and currencies are not part of the concern of the WTO regime. Concerted government intervention against market forces in the price of oil and currencies are tolerated in the name of needing to correct market failures. The fact of the matter is that the term "market" is a misnomer for oil and currency transactions. These commodities change hands not in a market, but in an allotment schema arranged from a central control point in a neo-feudal regime.

A major key to understanding the operation of OPEC is the internal battle for market share within OPEC by its members, causing aggregate OPEC production to be higher than what serves even the cartel's overall interest. Discontinuities in the production of Iraq and Iran were caused by the Iraq-Iran conflicts between 1980 and 1988. A second discontinuity in 1990 was caused by Iraq's invasion of Kuwait and the ensuing Gulf War. A third discontinuity occurred when the US invaded Iraq in 2003. A fourth discontinuity is pending over Iran's march toward nuclear-power status. As a major oil producer, Iran needs nuclear power for civilian use as much as coal-producing Newcastle needs oil. Obviously, other agendas are at work. OPEC was formed in 1960 with five founding members: Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. By the end of 1971, six other nations had joined the group: Qatar, Indonesia, Libya, the United Arab Emirates, Algeria and Nigeria. Of these, only Venezuela is non-Islamic. OPEC emerged as an effective cartel only after the Arab oil embargo that started on October 19, 1973, and ended on March 18, 1974. During that period, the price for benchmark Saudi Light increased from $2.59 in September 1973 to $11.65 six months later in March 1974. Since then, OPEC has been setting bottom benchmark prices for its various kinds of crude oil in the world market.

The oil price dipped below $10 after the Asian financial crisis of 1997. By 1984, the effects of seven years of high prices had taken its toll on demand in the form of more energy-efficient homes and industrial processes, and in substantial increases in automobile fuel efficiency, not to mention new competitive use of coal. At the same time, crude-oil production was increasing throughout the world, stimulated by higher prices. During this period, OPEC total production stayed relatively constant, around 30 million barrels per day. However, OPEC's market share was decreased from more than 50% in 1974 to 47% in 1979. The loss of market share was caused by non-OPEC production increases in the rest of the world. Higher crude prices caused by OPEC production sacrifices had made exploration more profitable for everyone, not just OPEC, and many non-OPEC producers around the world rushed to take advantage of it.

The rapid oil-price increases since 1980 served to accelerate consumer moves toward energy efficiency. In the US, conservation was also helped by tax incentives and new regulations. Sharp increases in non-OPEC production fueled by high oil prices were compounded by the deregulation of domestic crude-oil prices in the US.

Global demand for oil had peaked by 1979 and it became clear that the only way for OPEC to maintain prices was to reduce production further. OPEC reduced its total production by a third during the first half of the 1980s. As a result, the cartel's share in world oil production dropped below 30%. Non-OPEC producers got a big lift from higher prices, larger market shares, and an expanded definition of proven reserves.

Looking at OPEC members' production share within the organization and not their share of total world production, one could clearly see Saudi Arabia acting as swing producer for OPEC during the first half of the 1980s in the cartel's attempt to shore up declining prices. By 1986, the Saudis got tired of playing this role as other OPEC member countries were cheating on their quotas at Saudi expense. In response, Saudi Arabia rapidly increased production, causing a major price collapse. It created an oil boom in oil-consuming economies and a recession in oil-producing economies. But since the oil-producing economies were the consumers of the manufactured products made by the oil-consuming economies, recession in oil-producing economies caused a worldwide recession, as reflected in the 1987 crash in the US stock markets.

It took almost three years for oil prices to recover. The lower prices did have a long-term beneficial effect for OPEC. They encouraged increased consumption and halted production increases in much of the rest of the world, causing among other things the oil depression in Texas. By the end of the decade of the 1980s, prices finally stabilized. Throughout the late '80s, however, when oil prices plummeted, bankrupt oil drillers dragged Texas banks under, causing the entire oil-dominated Texas economy to go into convulsion. Today, in a globalized debt market, if a major borrower goes bust in Texas, it would only affect dispersed small units of commercial asset-backed security bonds of unbundled risks held in countless money managers' portfolios all over the world. The effect would be so diffused that no one would even notice. Securitization of debt now stands at more than $4 trillion globally, up from $375 billion in 1985.

OPEC, or any other cartel, faces a problem of optimization in its attempts to control prices. The problem is to determine the level of production that meets its collective goals of highest prices with the biggest volume over the longest sustainable period. For OPEC, this means maintaining production levels that ensure the highest oil prices possible without encouraging competitive production outside OPEC or significant conservation measures on the part of consumers everywhere.

The Saddam Hussein factor
In January 1990, Saudi Arabia and Kuwait had 24% and 9% of OPEC's total production. Iraq and Iran had 13% and 12% respectively. Iraq was involved at this time in a territorial dispute with Kuwait. Negotiations between the two Arab countries failed to produce any solution. In a meeting on July 25, 1990, between Iraqi president Saddam Hussein and US ambassador April Glaspie, Saddam was assured that the US would not become involved in the Arab-to-Arab political dispute. It was a major factor in Iraq's decision to reincorporate Kuwait by force. A week later, on August 2, 1990, Iraq invaded and occupied Kuwait, giving it control of 22% of OPEC production.

The United States, belatedly realizing that political consolidation of Arab oil was against its long-standing policy of divide and rule, reversed itself on the basis of defending the principle of state sovereignty, and became the major force in restoring Kuwait's questionable sovereignty and de facto oil ownership early in 1991. At this point, the US-engineered embargo prevented the export of Iraqi oil, and Kuwait's oilfields had been destroyed by war. Iraq and Kuwait had virtually no production and the slack was taken up by other OPEC members, primarily Saudi Arabia. In February 1991, Saudi Arabia's production accounted for more than 35% of OPEC output. The Saudis had increased production sufficiently to compensate for the loss of Kuwait's production as well as some of that of Iraq. The Saudis were forced by US pressure to pay for the cost of the Gulf War and by Arab pressure to provide financial aid to defeated Iraq under the table, all from the windfall revenue. Not much was changed in the oil economics of the region except in the political accounting.

By December 1998, Saudi Arabia's global market share was 29.7%, Kuwait's 7.4%, Iran's 13.0%, Iraq's 8.4% and Venezuela's 11.0%. Saudi Arabia had the greatest increase in market share compared with the pre-Gulf War period, although it had fallen back from its 35% postwar peak, as Kuwait and Iraq recovered. Venezuela was third, after Iran. In addition, the Saudis have always had the largest volume of production. At most times, the Saudis produce at least twice as much as the second-largest OPEC producer. Those who follow OPEC will recall that, especially in the 1980s, many of the negotiations over production quotas included discussions of what was equitable for the member countries. Among the factors considered were population, per capita income and the economic dependence upon crude-oil exports and, last but not least, economic threats to political stability.

By the end of the 1980s, most of the issues about the sharing of the total OPEC production pie had been resolved. But all of the explicit and implicit agreements in place at that time were disrupted by Iraq's invasion of Kuwait and the ensuing Gulf War. After the war, OPEC tried to move back toward the pre-Gulf War agreements on splitting up the production pie and return to the old method of doing business. Some consideration was given to the economic needs of OPEC members as well as non-OPEC members with emerging economies, such as Mexico.

The Hugo Chavez factor
Venezuela was a case in point. The country was on its economic knees or worse, victimized by neo-liberal policies of accepting foreign debt secured by oil exports and driven to the ground by IMF conditionality rescues. Despite the fact that Venezuela had increased its share of OPEC production significantly over the previous decade, OPEC declined to demand that Venezuela give up its gains. OPEC agreed on another cutback in production to boost prices in 1997 without requiring Venezuela to share proportionately in that cut. Yet Venezuela continued to view oil prices as too low to meet its needs in servicing foreign debt. OPEC was bending backward in vain to avoid pushing Venezuela into a left-leaning revolution. There was a lot of pressure from the US on Saudi Arabia to shoulder a disproportionate share of the cuts after 1997.

Under US pressure, OPEC tolerance changed after Hugo Chavez was elected president of Venezuela in 1998 with 56% of the vote, and re-elected in 2000 under the new constitution with 59% of the vote. In November 2000, the National Assembly granted Chavez the right to rule by decree for one year, and in November 2001, he made a set of 49 decrees, including fundamental reforms in oil and agrarian policy. In December 2001, the nation's largest business organizations and the right-dominated Petroleum Workers Union organized a general strike. In 2002, the US-backed opposition forces staged an unsuccessful coup that was foiled by a massive popular uprising, with support from the rank-and-file members of the military. Chavez was restored to the presidency after 48 hours. A recall referendum, certified by the Organization of American States and the Carter Center, failed by giving Chavez a 58% majority.

Chavez' popularity in Venezuela and throughout Latin America, where two-thirds of the South American continent have elected leftist presidencies, has grown. As oil prices soared in the wake of the second Iraq war and from booming Chinese demand, oil-rich Venezuela gained financial power to refuse predatory loans and aid from the United States, in its struggle to distance itself from US domination. Washington's influence in Caracas evaporated, as Chavez accused the administration of US President George W Bush of having staged the failed 2002 coup. A 35-year military agreement between the US and Venezuela was unilaterally annulled by Venezuela on April 24 this year.

Supply and demand
Current oil-price levels are a reflection of a fleeting inventory problem rather than a long-term pricing issue. There is of course no, and has never has been, a problem with the natural supply of oil. The world will still be awash with oil even after petroleum is rendered obsolete by new energy technology. When US president Bill Clinton threatened to release US strategic reserves in the 1990s, OPEC signaled its decision to increase production immediately more than once, not because of market fundamentals, but as political gestures. Many economists think that $35 oil in the long run is good for the global economy. At any rate, oil is no longer a critical factor for the US economy, which is increasingly less dependent on oil for growth. GE announced in February 2000 a new turbine that would be 60% more efficient than current models in generating electricity for the same energy input. The news did not help GE stock prices.

There was solid evidence that the 1970s recycling of petrodollars, which mostly ended up in the dollar assets in the United States anyway, contributed to US inflation as much as the higher retail price of gasoline. It in essence siphoned off additional global funds to purchase higher-priced oil for investment in US real estate, which was the only sector the then unsophisticated Arab money managers thought they knew enough about to handle. By the 1990s, they were more sophisticated. Some had expected that a new injection of petrodollars would sustain the collapsing "new economy" equity market of the '90s. It did not work because, even at $35, oil was still behind its pre-1973 price relative to the peak Nasdaq in June 1999, the equivalent of which would bring $120 oil.

The drop in oil prices after 1997 was mostly a cyclical effect of the drastic reduction of demand from the Asian financial crisis, which impacted the whole world. There was zero pressure even in the US to raise oil prices at that time, because of the effect they had on keeping easy-money inflation low. Even oil companies were not really upset by this temporary condition because, until oil prices dropped below $7 per barrel, it was not a big deal since that was the offshore production cost in the North Sea. The wellhead cost on land was less than $4 per barrel, plus market-induced leasehold costs. North Sea oil was higher because of fixed offshore drilling investments. In 1998, oil could stay at anywhere above $7 for quite a few years without doing any lasting harm to the US or Europe. It was widely expected to go back up to $35 by the end of 2000, and a lot of people would get rich in the process. OPEC was touting the line of argument that high prices would stimulate new exploration to get the non-OPEC consumers to accept costlier oil. In the long run, less new exploration would be good for OPEC. Before 1973, the whole world was happy with $3 oil. As for the US, cheap oil kept inflation (as measured by the Fed) low, the dollar high and dollar interest rates low. These benefits outweighed the oil-sector problems created by a collapse in oil prices. In oil, no one has told the truth for more than 80 years, or since its discovery.

There were all kinds of reasons that US president George H W Bush pushed Iraq out of Kuwait, Clinton bombed Iraq, and Bush Jr invaded and occupied it, but oil prices were very low on the list and terrorism was not even on the list. If Iraqi oil re-enters the world market, other OPEC members will reduce the production quota, so the real impact on prices will be minimum. Most market analysts have estimated the price movement at less that $1 under such development. So at the post-1997 price of $10-plus per barrel, only the profit margin was reduced and some idiotic oil brokers in Chicago holding high futures contracts, and some high-rolling investors in oil rigs in Texas, got wiped out, including a future occupant of the White House. But the good news for the oil industry was that it gave a big boost to oil-company mergers to consolidate the sector and reserves and downsize employment, which in better times the US government would have never approved for antitrust reasons.

As Asia recovered from the 1997 financial crisis, lifted mostly by China, the oil industry found itself in the position to command $50 oil in the next cycle, and enjoyed the inflated value of its global reserves, which it had bought up at low cost a decade ago. The low prices of the past decade had also put OPEC countries, predominantly Islamic, in their places, including the bonus of Indonesia and Russia, which had to live exclusively on oil exports (not really living, because all of the reduced revenue went to service foreign debts assumed in better times). With globalization, the US, the center, has been enjoying the rotting of the outer limbs of the global economy since the end of the Cold War, but it has yet to realize gangrene kills the whole organism.

Iraq was not an oil problem as far as Washington was concerned. In fact, low oil prices worked against Saddam in the black market. Saddam has been portrayed by the US as one of its worst enemies. But he has not always worn and will not always wear that honor, given the unpredictability of Iran. The terrorist attacks on the US on September 11, 2001, put a new dimension on the problem of Iraq. The reason the US failed to kill Saddam was not incompetence or Christian mercy, but the fact that Saddam might not have been the worst alternative. He was just a bad boy who misbehaved. What Washington wanted was for Saddam to be its bad boy. Saddam is far from totally finished politically. The world has seen stranger things than the political rehabilitation of Saddam Hussein. He has a major advantage over Bush Jr, as he did over Clinton and Bush Sr. Saddam has a focused purpose whereas Clinton, the Bushes, and US policy are all driven by complex incentives that are at times contradictory. The political economy of oil is no intellectual tea party. There is no price economics in oil. It's all politics of the dirtiest kind.

The problem with cheap oil
It is often overlooked that the United States is a major oil producer. In fact, before the discovery of oil in the Middle East in the 1930s, the US was the world's biggest exporter of oil. "Oil for the lamps of China" was a slogan of the Standard Oil monopoly. It is not clear that cheap oil is in the United States' national interest. Cheap oil distorts the US economy in unconstructive ways. In recent years of cheap oil, advances in conservation have all been abandoned. Until this year, US consumers were buying eight-cylinder SUVs that deliver only eight miles per gallon (29 liters per 100 kilometers), as well as air-conditioned convertibles. Even with $2 (53 cents per liter) gasoline, commuters face only a $500 annual increase in their gas bills. Vehicle prices have risen faster than gasoline prices in recent decades. Of course, the rest of the world outside the US has been operating on $4 (more than $1 per liter) gasoline for a long time.

It is an economic axiom that excessively low commodity pricing breeds abuse of that commodity. This truth can be observed in water, air, petrochemicals and energy. It holds true even for labor and capital. Higher labor cost drives productivity growth. Greenspan's favorite homely is: "Bad loans are made in good times."

OPEC had been permitted to assume an effective cartel role only at the pleasure of the United States. The existence of OPEC serves several convenient US geopolitical purposes. It deflects political opposition to the international oil regime from the US toward a mostly Arab/Islamic organization, yet the health of OPEC is inseparably tied to the health of the energy corporations of the West that control all the downstream operations. OPEC is an example of how economic nationalism can be co-opted into Western-dominated neo-imperialist globalization.

Excessively high oil prices are of course as detrimental to an economy as excessively low oil prices. The last downturn in crude-oil prices had immediate impacts on the exploration segment of the industry. Coincident with that was a decline in sales and manufacture of oil and gas equipment. Another segment of the industry that felt the pressure of the price decline was oil and gas services.

According to James Williams of WTRG Economics, oil prices behave much as any other commodity, with wide price swings in times of shortage or oversupply. US domestic oil prices were heavily regulated through production or price control throughout much of the 20th century. In the post-World War II era, oil prices averaged $19.27 per barrel in 1996 dollars. Through the same period, the median price for crude oil was $15.27 in 1996 prices. That meant that only half of the time from 1947 to 1997 did oil prices exceed $15.26 per barrel. Prices only exceeded $22 per barrel in response to war or conflict in the Middle East. In 1972, $3.50 oil translated to $11.50 in 1996 dollars and $16.29 in 2005 dollars.

The long-term view is much the same. Since 1869, US crude-oil prices adjusted for inflation have averaged $18.63 per barrel in 1996 dollars. Fifty percent of the time, prices were below $14.91. Using long-term history as a guide, those in the upstream segment of the crude-oil industry structured their business to be able to operate profitably below $15 per barrel half the time.

Pre-embargo crude-oil prices ranged between $2.50 and $3 from 1948 through the end of the 1960s. The price of oil rose from $2.50 in 1948 to about $3 in 1957. When viewed in 1996 dollars, an entirely different story emerges. In 1996 dollars, crude-oil prices fluctuated between $14 and $16 during the same period. The apparent price increases were just keeping up with inflation. From 1958 to 1970, prices were stable at about $3 per barrel, but in real terms the price of crude oil declined from above $15 to below $12 per barrel in 1996 dollars. The decline in the price of crude when adjusted for inflation was exacerbated in 1971 and 1972 by the weakness of the US dollar.

Member nations had experienced a decline in the real value of their oil since the foundation of OPEC. Throughout the post-World War II period, exporting countries found increasing demand for their crude oil was rewarded by a 40% decline in the purchasing power in the price of a barrel of crude until March 1971, when the balance of power shifted. That month, the Texas Railroad Commission set pro ration at 100% for the first time. This meant that Texas producers were no longer limited in the amount of oil that they could produce. More important, it meant that the power to control crude-oil prices shifted from the US cartel (Texas, Oklahoma and Louisiana) to OPEC.

In 1972, the price of crude oil was about $3 and by the end of 1974 had quadrupled to $12. The Yom Kippur War started on October 5, 1973. The US and many other Western countries gave strong support to Israel. To punish such support, Arab oil-exporting nations imposed an embargo on the nations supporting Israel. Arab nations curtailed production by 5 million barrels per day. About 1mbpd was made up by increased production of non-Arab/Islamic producer countries. The net loss of 4mbpd extended through March 1974 and represented 7% of Western world production. Any doubt that the ability to control crude-oil prices had passed from the US to OPEC was removed during the 1973 Arab oil embargo. The extreme sensitivity of prices to supply shortages became all too apparent, though obviously unsustainable over the long term. Prices increased 400% in six short months. The abrupt jump, not the high price itself, caused destabilizing damage to the US and other Western economies.

From 1974 to 1978, crude-oil prices increased at a moderate pace from $12 per barrel to $14, mostly due to adjustments in demand moderated by increases in alternative sources of supply. When adjusted for inflation, prices were constant over this period of time. War between Iran and Iraq led to another round of increases in 1980. The Iranian revolution resulted in the loss of 2-2.5mbpd between November 1978 and June 1979. Starting in 1980, Iraq's crude-oil production fell 2.7mbpd and Iran's by 600,000 barrels per day during the Iran-Iraq War. The combination of these two events resulted in crude-oil prices more than doubling from $14 in 1978 to $35 per barrel in 1981.

The rapid increase in crude prices in this period would have been much less were it not for US energy policy. The US imposed price controls on domestically produced oil in an attempt to lessen the impact of the 1973-74 price increase. The obvious result of the price controls was that US consumers of crude oil paid 48% more for imports than domestic production, while US producers received less. In the short term, the recession induced by the 1973-74 price rise was made less painful by oil price control. However, in the absence of price controls, US exploration and production would certainly have been significantly greater, counterbalancing the economic decline. The higher prices faced by consumers would have resulted in still lower rates of consumption: automobiles would have had higher fuel efficiency sooner, homes and commercial buildings would have been better insulated and improvements in industrial energy efficiency would have been greater than they were during this period, thus cushioning the recession. As a consequence, the US would have been less dependent on imports in 1979-80 and the price increase in response to Iranian and Iraqi supply interruptions would have been significantly less.

OPEC has seldom been effective as a cartel. During the 1979-80 period of rapidly increasing prices, Saudi Arabia's oil minister, Ahmed Yamani, repeatedly warned other members of OPEC that high prices would lead to a reduction in demand. For example, Armand Hammer's Occidental Oil joint venture with the Chinese Ministry of Coal to export coal-derivative fuel based on $50 oil was bound to head toward financial disaster. The coal project in China failed by 1986 as oil prices fell.

The rapid price increases caused several reactions among consumers: better insulation in new homes, increased insulation in many older homes, more energy efficiency in industrial processes, and automobiles with lower fuel consumption, all with various forms of government subsidies or tax relief. These factors along with a global recession caused a reduction in demand that led to further falling crude prices. Unfortunately for OPEC, while the global recession was temporary, nobody rushed to remove insulation from their homes or to replace energy-efficient plants and equipment when the economy recovered. Much of the consumer reaction to the oil-price increase of the end of the decade was permanent and would not respond to lower prices with increased demand for oil.

From 1982 to 1985, OPEC attempted to set production quotas low enough to stabilize prices. These attempts met with repeated failure as various members of OPEC continued to produce beyond their quotas. During most of this period, Saudi Arabia acted as the swing producer cutting its production to stem the free-falling prices, as it intends to do now to halt the rise in price. In August 1985, the Saudis, tired of this role, linked their oil prices to the spot market for crude and by early 1986, increased production from 2mbpd to 5mbpd. Crude-oil prices plummeted below $10 per barrel by mid-year. China had a new minister of coal that same year.

A December 1986 OPEC price accord set to target $18 per barrel was already breaking down by the following month. Prices remained weak. The price of crude oil spiked in 1990 with the uncertainty associated with the Iraqi invasion of Kuwait and the ensuing Gulf War. Within hours of the first air strike against Iraq in January 1991, the White House announced that president Bush Sr was authorizing a drawdown of the Strategic Petroleum Reserve (SPR), and the International Energy Agency (IEA) activated the plan on January 17. After the oil crisis of 1973-74, the IEA was created as a cooperative grouping of most of the member countries of the Organization for Economic Cooperation and Development, committed to responding swiftly and effectively in future oil emergencies and to reducing their dependence on oil.

Crude prices plummeted by nearly $10 a barrel in the next-day trading, falling below $20 for the first time since the Iraqi invasion of Kuwait. The price drop was attributed to optimistic reports about the allied forces' crippling of Iraqi air power and the diminished likelihood, despite the outbreak of war, of further jeopardy to world oil supply; the IEA plan and the SPR drawdown did not appear to be needed to help settle markets, and there was some criticism of it. Nonetheless, more than 30 million barrels of SPR oil was put out to bid, and 17.3 million barrels were sold and delivered in early 1991. But after the war, crude oil prices entered a steady decline until 1994, when inflation-adjusted prices attained their lowest level since 1973. The price cycle then turned up. With a strong economy in the US and a booming economy in Asia, increased demand led a steady price recovery well into 1997. This came to a rapid end as the impact of the 1997 financial crisis in Asia was underestimated by OPEC, being advised by the IMF. That December, OPEC increased its quotas by 10% to 27.5mbpd, but the rapid growth in Asian economies had come to a halt and reversed direction by half.

The rotary rig count is the average number of drilling rigs actively exploring for oil and gas. Drilling an oil or gas well is a high-risk, capital-intensive investment bet in the expectation of returns from the production of crude oil or natural gas in an uncertain market. Rig count is one of the primary measures of the health of the exploration segment of the oil and gas industry. In a very real sense, it is a measure of the oil and gas industry's confidence in its own future. At the end of the Arab oil embargo in 1974, rig count was below 1500. It rose steadily with regulated rise of crude-oil prices to more than 2000 in 1979. From 1978 to the beginning of 1981 domestic US crude-oil prices exploded from a combination of the rapid growth in world energy prices and deregulation of domestic prices. Forecasts of crude prices in excess of $100 per barrel fueled a drilling frenzy. By 1982, the number of rotary rigs running had more than doubled.

The peak in drilling occurred more than a year after oil prices had entered a steep decline that continued until the 1986 price collapse. The one-year lag between crude prices and rig count disappeared in the price collapse. For the next few years, towns in the oil patch were characterized by bankruptcies, bank failures and high unemployment. Investors as far-flung as Hong Kong, Tokyo, Singapore and London went under with it. Several trends were established in the wake of the collapse in crude prices. The lag of more than a year for drilling to respond to crude prices is now reduced to a matter of months. Like any other industry that goes through hard times, the oil business emerged smarter and much leaner. Industry participants, bankers and investors were far more aware of the risk of price movements. Companies long familiar with accessing geologic risk added price risk to their decision criteria. Financial hedging came into play in the construction of risk-management models.

Increased use of three-dimensional seismic data reduced drilling risk. Directional and horizontal drilling led to improved production in many reservoirs. Financial instruments were used to limit exposure to price movements. Increased use of floods to improve production in existing wells became common. Rig count is certainly a good measure of activity, but it is not a measure of success. After a well is drilled, it is classified either as an oil well, a natural gas well or a dry hole. The percentage of wells completed as oil or gas wells is frequently used as a measure of success, often referred to as the success rate.

Immediately after World War II, 35% of the wells drilled were dry wells. This percentage increased to about 43% by the end of the 1960s. It declined steadily during the 1970s to reach 30% at the end of the decade. This was followed by a plateau or modest increase through most of the 1980s. Beginning in 1990 shortly after the harsh lessons of the price collapse, non-completion rates decreased dramatically to 23%. These rates are closely watched by investors. Since the percentage completion rates are much lower for the more risky exploratory wells, a shift in emphasis away from development would be expected to result in lower overall completion rates. This, however, was not the case. An examination of completion rates for development and exploratory wells shows the same general pattern. The decline in dry holes was price-related. The higher the price, the fewer dry holes.

Some would argue that the periods of decline in successful drillings were a result of the fact that every year there is less oil to find. If the industry does not develop better technology and expertise every year, oil and gas completion rates should naturally decline. However, this does not explain the periods of increase. The increase of the 1970s was more related to price than technology. When a well is drilled, the fact that oil or gas is found does not mean that the well will be completed as a producing well. The determining factor is price economics (even though oil prices are fundamentally set politically). If the well can produce enough oil or gas at anticipated prices to cover the cost of completion and the ongoing production costs, it will be put into production. Otherwise, it is an economic dry hole even if crude oil or natural gas is found. The conclusion is that if real prices are increasing, we can expect a higher percentage of successful wells. Conversely if prices are declining, the opposite is true. Thus higher prices increase supply, regardless of natural conditions and technology.

The success-rate increases of the 1990s, however, could not be explained by higher prices alone. These increases were clearly also the result of improved technology. The increased use of and improvements in 3-D seismic data analysis combined with horizontal and directional drilling. Most dramatic was the improvement in the percentage of exploratory wells completed. In the 1990s completion rates have soared from 25% to 45%.

Worked-over rig count is a measure of the industry's investment in the maintenance of oil and gas wells. The Baker-Hughes worked-over rig count includes rigs involved in pulling production tubing from a well that is 1,500 feet (457 meters) or more in depth. Worked-over rig count is another measure of the health of the oil and gas industry. Most work-overs are associated with oil wells. Worked-over rigs are used to pull tubing for repair or replacement of rods, pumps and tubular goods that are subject to wear and corrosion. A low level of worked-over activity is particularly worrisome because it is indicative of deferred maintenance. When operators are in a weak cash position, work-overs are delayed as long as possible. Worked-over activity impacts manufacturers of tubing, rods and pumps. Service companies coating pipe and other tubular goods are heavily affected. This of course leads to lower supply down the road and higher prices. Higher prices reverse the process, which ends up with lower prices later. Fifty-dollar oil will keep the oil sector expanding for some time.

OPEC and the independents
A critical November 1998 OPEC meeting failed to reverse the decline in oil prices. OPEC in 1997 had an earlier failure when it approved a 10% quota increase at a time when the Asian economies were entering a prolonged slump after the financial crisis. As a result, OPEC, until the recent hike in oil prices that began around 2000, experienced the lowest prices for crude oil after adjusting for inflation since the pre-embargo days of 1972.

Market share and price are recurring themes at OPEC meetings. The problem is that you cannot have both for long. To increase market share, OPEC must increase production sufficiently to drive prices down to the point that it is not economical for non-OPEC producers to maintain current production rates. Unfortunately for OPEC, the full realization of the impact of lower prices on non-OPEC producers can be effectuated only over a period of several years. The effect of lower prices is greatest in countries and areas with the highest exploration and production costs. Onshore production in areas with high lifting cost is usually the first to show reduction in activity. Because of long-term decisions involved, offshore producers often take longer to react to lower prices.

The term "independent" in the oil business generally applies to a producer of oil or gas that does not also own downstream facilities such as refineries, gasoline or diesel distribution, or retail gas stations. A 1998 survey of 24 of the larger US oil companies indicated that on the average it cost $4.48 to "find" a barrel of oil and $4.12 to produce it. That means there will be no profit for this group below $8.60 per barrel for new oil and no positive cash flow from operations below $4.12 per barrel.

Of course industrial averages are quite different from specific reality for any one company. Average production costs are just that - averages. Many oilfields have much higher costs - in some cases, as much as four times the average. Many small independent producers were going under financially prior to the rise in oil prices. Independents had reduced their workforce by 20% and shut down 50% of their production. Any further reduction in production would cause significant damage to the reservoirs. One company reported that it reduced lifting cost to $8 per barrel, but is only receiving an average of $6.80 per barrel.

Traders watch crude prices through the NYMEX (New York Mercantile

that is the longest article.O_O

but the US dollar is losing its strength ..slowly..

holy sht, i think i could make an annual yield return on a government bond investment faster than the time it would take for me to read even one of the articles you posted.

http://www.atimes.com/atimes/China/HC22Ad02.html

Mar 22, 2006


THE WAGES OF NEO-LIBERALISM
PART 1:Core contradictions
By Henry C K Liu

The US trade deficit with China ballooned in 2005 to US$202 billion, more than one-quarter of the total deficit. Rising trade imbalance between the US and China in recent years has given rise to intense pressure from the United States on China to revalue the fixed exchange rate of its currency, which had been pegged at 8.28 yuan to a dollar within a narrow band of 0.03% for a decade, from 1995-2005.

On July 21, 2005, after repeated pronouncements that no revaluation was necessary or even being considered, China announced a surprise 2% appreciation of the currency, putting it at 8.11 yuan to the US dollar. It also announced that the yuan would henceforth be pegged with the same narrow range to a basket of foreign currencies that includes the dollar, the euro, the yen and others likely to reflect China's trade relationships with the



rest of the world. The components and weight of different currencies within the basket is not disclosed to the market. China appears to be following Singapore's managed-float model, keeping both weights and effective bands confidential to allow maximum flexibility within a narrow range tied to a reference peg to the dollar. Many saw it as an obvious political move to appease US pressure.

Yet US pressure on China to revalue the yuan further continues, as the trade deficit with China for January 2006 registered $17.9 billion, a 10% increase from the previous month. Total worldwide US trade deficit for the month was $68.5 billion despite a rise in US exports of aircraft and soybeans. This pressure from the US is motivated by the misguided conventional assumption that a lower exchange rate of the dollar will reduce the US trade deficit, despite clear historical data showing that past revaluations of the Japanese yen and the German mark had not reduced US trade deficits with these major trade partners in the long run.

All such revaluations did was to lower the domestic cost in local-currency terms more than raise the dollar price of Japanese and German exports. The net effect was deflation in Japan and Germany, with inflation in the US while the US trade deficit continued.

The dollar takes the form of a US Federal Reserve note, a monetary instrument issued by a central bank. The yuan takes the form of Chinese People's Currency (renminbi, or RMB) issued by the People's Bank of China (PBoC), another central bank. Both are fiat currencies issued by central banks in that they are money with no intrinsic value, not backed by gold or other species of value. Both currencies are not issued directly by their respective governments, but by their respective central banks. This means that the full faith and credit of the nation is not directly behind either of these currencies.

A holder of these fiat currencies cannot go to their government to claim a piece of the national wealth. The values of either of these currencies are determined by their purchasing powers in the respective economies as affected by the monetary policies of their respective issuers, ie, the respective central banks. The holder of a dollar is entitled to exchange it at the Fed for another dollar, no more, no less. The dollar's purchasing power within the US is affected by the Fed's monetary policy as such policy affects the inflation or deflation rates in the US economy. The same is true for the yuan. Thus the exchange rate of the two currencies reflects the domestic purchasing power differential caused by the monetary polices of their respective central banks, which are in principle politically independent.

The trade imbalance between the US and China is not caused by the exchange rate of the two currencies. It is caused mainly by a disparity in the factors of production, such as wages and rent as expressed in prices in the two trading economies. The Chinese trade imbalance with the US is primarily caused by Chinese wages and rent being too low compared with equivalent productivity in US wages and rent. The dysfunctionality in the exchange rate between the yuan and the dollar is the result, not the cause, of the trade imbalance. To correct this trade imbalance, Chinese wages and rent need to rise, not the Chinese currency. Wages and rent in the two trading economies need to converge toward parity, rather than the currencies to diverge from any particular exchange rate that has been in operation for a decade.

The yuan at 8.12 to $1 is already valued at twice the purchasing-power-parity gap of 4 between it and the dollar within their respective economies. Wage disparity between China and the US ranges from 20 to 50 times in various sectors, and an exchange rate that reflected such a wide disparity would border on the ridiculous.

A stable exchange rate is not only beneficial to trade, it is also fundamentally critical to global financial stability. Every financial crisis since the 1971 collapse of the Bretton Woods fixed-exchange-rate regime has been caused by exchange-rate instability. Exchange-rate policies cannot be substitutes for structural economic adjustments necessary for mutually beneficial trade between two economies. Nor can exchange-rate policies be substitutes for sound domestic monetary or economic policy.

When two economies at uneven stages of development trade, a trade surplus in favor of the less-developed economy is natural and just, until the less developed economy catches up with the more developed one, otherwise it would be imperialistic exploitation, not trade.

Market forces on exchange rates are derived from the relative strength of trading economies. Foreign-exchange markets express the net summary judgments of market participants on the economic health of trading economies as they are affected by government fiscal and central bank monetary policies. Markets use exchange-rate fluctuation to carry the message of aggregate judgments to the monetary and fiscal authorities of the trading economies. These authorities, usually the central bank and the Treasury, cannot ignore such market sentiments without a cost.

For economies where the currencies are freely convertible, the cost can be massive attacks on their currencies by speculators, such as hedge funds, that would quickly drain the government's foreign-exchange reserves and cause a collapse in the economy's debt market. For economies that practice exchange and capital control, the penalty would be a drain in foreign reserves and a reduction in trade in the case of a deficit. In the case of a trade surplus, the penalty would be a drain of domestic currency capital into growing foreign-exchange reserves.

In the current global central-banking regime, fiat currencies are issued mostly directly by central banks or by banks authorized by the central bank to issue currency, such as in former British colonies like Hong Kong. Central banks are supposed to be politically independent in their key role of maintaining the stability and the value of a nation's fiat money, unaffected by constant and relentless political pressure for easy money.

The value of the fiat currency of a sovereign nation is backed only by the nation's economic health and by the issuing government's acceptance of it for payment of taxes. It enjoys monopoly status as legal tender for settlement of all debts within the country's borders. Most sovereign nations allow only their own legal tenders to circulate within their borders and require that foreign currencies be first converted into local legal tenders before being used in domestic markets. For cross-border transactions, a foreign-exchange market is necessary to inter-convert legal tenders of trading nations at economically equitable rates.

When the foreign-exchange value of the fiat currency of a country moves beyond what the government or the foreign-exchange market deems appropriate, the correction needs to come from a readjustment of the structure of its economy, not from artificial manipulation of the exchange rate of its currency. Regardless of whether the exchange rate is fixed by government or by market forces, the volatility in the gap between the economic value of a fiat currency and its exchange rate is the main cause of financial instability. Such instability has caused recurring financial crises around the world in past decades since the collapse in 1971 of the Bretton Woods regime of fixed exchange rates based on a gold-backed dollar.

The philosophical underpinning of a central-banking regime is the assumption that a stable value for a fiat currency is necessary for the long-term health of the economy. In a globalized market economy, the domestic purchasing power of a fiat currency in large measure affects its exchange rate, not the other way around. Yet most central banks, including the US Federal Reserve, categorically defer exchange-rate policy to the Treasury or ministry of finance, because it is an issue of national economic security. Further, the raison d'etre for a central-banking regime is equally rooted in a contradicting assumption that monetary elasticity is necessary to respond to the changing financial needs of the economy to prevent cyclical bank crises and recessions or depressions.

Thus a central bank's first key function of preserving the domestic purchasing power of fiat money conflicts with its second key function of providing monetary elasticity to a slowing economy. A central bank must restrain commercial banks from creating money through excessive lending made possible by a partial reserve regulatory regime, while at the same time it must act as a lender of last resort in an approaching financial crisis or panic.

The function of a lender of last resort is to provide needed liquidity to a market in distress from already excessive debt. Without central-bank liquidity reserves, a distressed market may freeze in a circular domino effect of even creditworthy debtors being temporarily unable to meet their obligations because some less creditworthy debtors are unable to pay their debts to them. Such recurring banking crises had been regular in the US prior to the establishment of the Federal Reserve in 1913 and in recent decades in many other countries with dollar debts for which their central banks were unable to provide monetary elasticity in dollars because only the Fed can print dollars.

According to the quantity theory of money, monetary elasticity, when regularly invoked as convenient preventives against cyclical slowdowns in the economy, leads to a rise in "moral hazard", which is the encouragement to borrowers to take unwarranted financial risks with the knowledge that such risks would be protected by central-bank bailouts. Monetary elasticity is much easier to inject than to retract because deflation is more painful than inflation for debtors. Elasticity loss is eventually caused by fatigue, in the same way that rubber bands can get stretched or snapped.

The Fed under its former chairman Alan Greenspan repeatedly went on record to assert its belief in the heresy that "highly aggressive monetary ease was doubtless also a significant contributor to stability". Greenspan said in 2004 in hindsight after the bubble burst in 2000: "Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences, we chose, as we noted in our mid-1999 congressional testimony, to focus on policies to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion."

By "the next expansion", Greenspan meant the next bubble, which manifested itself in housing after 2000. The "mitigating" response was a massive injection of liquidity into the US banking system.

There is a structural reason that the housing bubble has replaced the high-tech bubble. The US trade deficit finances the US capital account surplus which provides low-cost mortgages for the US housing market. Houses cannot be imported from low-wage countries like manufactured goods, although many of the contents in houses, such as furniture, hardware, windows, kitchen equipment, bath fixtures and heating and air-conditioning equipment, are manufactured overseas. Construction jobs cannot be outsourced overseas to take advantage of cross-border wage arbitrage, although many low-skill construction jobs are filled by illegal immigrants. But a housing bubble is not different from any other types of debt bubbles. It will burst if income fails to grow with asset value to sustain debt-service payments.

Thus central banks are saddled with conceptual contradictions in assuming the dual role of a vigilant supervisor of the rules of prudence in the financial market while at the same time acting as a permissive cheerleader for the infraction of the same rules in the name of innovative economic expansion. Moreover, central-bank criteria for bailouts of distressed private firms are tied to their potential systemic impact. Such criteria are inherently undemocratic in that the large debtors unfailingly get preferred treatment merely because of their size. Hence the birth of a rule of finance that every borrower knows: if you owe the bank $10,000, you are beholden to the bank; but if you owe the bank $10 billion, the bank is beholden to you. It is known as the "too big to fail" syndrome.

What is even more pathetic is that in the US, the Federal Reserve is legally owned by its member banks, not the government, or the people, although some 98% of the profit made by the Fed goes to the US Treasury by law. Board members of the Fed are nominated by the member banks and appointed by the US president, and as a group they predominantly represent the special interests of the banking sector.

In China, the passage of the Central Bank Law in 1995 granted the People's Bank of China central-bank status, shifting it away from its previous role of a national bank. The difference between a national bank and a central bank is that a national bank serves the banking needs of the economy while a central bank seeks to maintain the stable value of the currency and at the same time to provide monetary elasticity to prevent banking crises, and to adopt an interest-rate policy that ensures profitability to the banking sector with the idea that the banking sector, the heart of the economy, must be protected at all cost for the good of the economy.

In the twilight zone of Chinese bank reform, no outsider knows how the process of nomination and appointment of the board members of the PBoC works. It is safe to say that the PBoC still follows the policy directives of the Chinese government, which in turn follows the policy directive of the Chinese Communist Party. To the extent that CCP policy drifts toward market fundamentalism with Chinese characteristics, PBoC will invariably also drifts toward representing the special interests of the banking sector and their big business clients at the expense of the interests of the proletariat and peasant masses, or Chinese banks cannot profitably compete in the world market. Such is the class contradiction of a "socialist market economy", no matter how the term is defined with doctrinal sophistry.

By the definition of the Bank of International Settlement (BIS), the super-national central bank for all national central banks, such an undemocratic special-interest posture is viewed as desirable "political independence" in a capitalist democratic society. Unlike the Fed, which has an arms-length relationship with the US Treasury, the PBoC manages the state treasury as its fiscal agent. In addition to regulating the inter-bank lending market, the PBoC also regulates the inter-bank bond market, the foreign-exchange market and the gold market in China.

Political independence is not a policy subject Chinese central bankers can discuss with ease as long as China still views itself as a socialist nation. They prefer more benign euphemism in the jargon of bank reform such as "conforming to international standards". There are signs that after almost three decades of headlong reform toward what Chinese officials call a socialist market economy, the adverse consequences are beginning to show.

Recent Chinese policy has shifted back in populist directions to provide affirmative financial assistance to the poor and the undeveloped rural and interior regions and to reverse blatant income disparity and economic imbalances. It can be anticipated that this policy shift will raise questions in the capitalist West about the political independence of the PBoC. Western neo-liberals will be predictably critical of the PBoC for directing money to where the country needs it most, rather then to that part of the economy where bank profit would be highest.

The birth of the Bretton Woods regime
After World War II, as the United States emerged as the only country the industrial sector of which had been left not only undamaged but actually strengthened by war, the US dollar by default became the uncontested world reserve currency for international trade.

As early as April 1942, the so-called White Plan, named after Harry Dexter White, US Treasury under secretary and a student of free-trade advocate and Harvard professor Frank W Taussig, proposed a United Nations Stabilization Fund and a Bank for Reconstruction and Development of the United and Associated Nations. The advantages of stable exchange rates that the automatic classical gold standard had provided while it lasted, from 1876 to 1914, had proved to be not so automatic after World War I. The classical gold standard was causing deflation around the world that translated into a worldwide depression, while mercantilism, the quest by nations for gold through exporting, was causing protectionist reaction in all countries.

The idea of the need for international cooperation in trade and for a new "gold exchange standard" that would make wider use of gold by supplementing it with an anchor currency that would be readily convertible into gold had been developed at a 1920 international conference in Genoa, Italy, but the participating governments failed to reach agreement because not all were ready to accept British sterling hegemony. This idea was incorporated two and a half decades later into the Bretton Woods regime with a gold-backed US dollar replacing the British pound. The challenge was to devise an operative international finance architecture out of fiat currencies anchored to a gold-backed dollar to accommodate postwar international trade.

On August 14, 1941, some fours months before the Japanese attack on Pearl Harbor, the United States, not yet at war, issued jointly with a Britain - already at war with Germany - the Atlantic Charter, which set out a postwar world vision as an unspoken condition for a pending US alliance with Britain. Among other provisions, the Atlantic Charter emphasized British commitment to postwar international cooperation, including support for US efforts to form a United Nations based on the principle of self-determination for former colonies. Six months later, in February 1942, barely two months after the Pearl Harbor attack, under the Lend-Lease Agreement, Britain agreed to a postwar multilateral payments system in exchange for US commitment to help Britain financially during and after the war.

Four months after the declaration of the Atlantic Charter, on Sunday, December 14, 1941, one week after the Pearl Harbor attack, while the US was mobilizing for all-out war, treasury secretary Henry Morgenthau was busy figuring out how to finance the war. He asked White to prepare a monetary-stabilization plan that would include all the Allies, while Britain was also busy with its own plan. One crucial difference between the US plan by White and the British plan by John Maynard Keynes was that the Stabilization Fund (SF) proposed by the US was to be based on a mixed bag of national currencies, while the Clearing Union (CU) proposed by Britain was to operate with a new international currency to be known as the bancor. The CU also had less strict rules than did the SF for its use by countries with balance-of-payments deficits.

The US was concerned about its own potential financial liability about the rights of creditor countries with balance-of-payments surpluses, which at that time meant only the United States. The US team voiced serious reservations about the British/Keynes plan, which had liberal liquidity provisions and ready access to liquidity for countries with temporary trade deficits. Britain anticipated huge wartime deficits as revenue from many parts of the British Empire was suddenly interrupted.

In addition, the White plan contemplated the forbiddance of exchange-rate intervention, an important feature for the United States, whereas the Keynes plan did not put much emphasis on limits on exchange-rate intervention and even advocated the use of capital controls for the weaker economies, of which Britain expected to become one in the course of the war. Britain imposed exchange control soon after the war began and kept it for four decades until the new Conservative government abolished exchange control in 1979.

The pre-1979 controls on direct investment restricted sterling-financed foreign investment except where it had a positive effect on the balance of payments. With respect to portfolio investment, the controls stipulated that purchase by United Kingdom residents of foreign exchange to invest overseas could be made only from the sale of existing foreign securities or from foreign-currency borrowing. A third element of the controls restricted the holding by UK residents of foreign-currency deposits as well as sterling lending to overseas residents.

The 1944-45 international conference at Bretton Woods, New Hampshire, was attended by representatives of 44 governments who agreed on "a framework for economic cooperation partly designed to avoid a repetition of the disastrous economic policies that had contributed to the Great Depression of the 1930s" and which led to a further eclipse of a British Empire already weakened by World War I.

British resistance, with US support, to a geopolitical challenge to its crumbling empire from rising powers such as Japan and Germany in the 1930s eventually led to World War II, which was a geopolitical contest between competing powers that morphed into an ideological contest between democracy and fascism, an image created by Anglo-US propaganda as a high-principle pretext to marshal domestic political support for war.

While constantly vowing in private that Britain did not go to war merely to give the empire away, prime minister Winston Churchill cleverly referred in public to the Allies as "the democracies", to appease historical US anti-colonial ideology. Churchill neutralized the isolationist elite in the United States by appealing to the anti-communist right in US politics with conservative rhetoric in his spirited speeches. Taking advantage of a common language, Churchill's ringing speeches sounded inspiring to the US public just as Adolf Hitler's firebrand speeches inspired the Austrians.

Churchill's protective posture toward fascist Spain illustrates his ambivalence toward fascism. On June 19, 1945, at the San Francisco Conference, the United Nations, a reincarnation of the Allied Powers, voted unanimously to exclude Francisco Franco's fascist Spain. Then, at the Potsdam Conference later that summer, Soviet leader Josef Stalin proposed a worldwide total boycott of fascist Spain, and that the Allies break diplomatic relations with Madrid and aid the "democratic opposition" within Spain.

US president Harry Truman was in favor, which was the only time he and Stalin ever agreed on anything, but Churchill opposed the idea, pointing out that Britain had strong trade links with Spain that a postwar Britain could not afford to break and that "interference in the internal affairs of other states was contrary to the United Nations Charter". Churchill was counting on the Spanish fascists to keep the communists from gaining back Spain, lost in the Civil War through Third Reich help to Franco.

The Soviet Union, while wanting to appear to be associated with plans being fashioned at Bretton Woods out of a desire to be perceived as a participating world power, showed little enthusiasm for monetary cooperation with US capitalism. Soviet economists were not interested in capitalist world trade and they lacked sufficient theoretical sophistication to understand the subtleties between the contested proposals in capitalist economies. The USSR agreed to send a technical observer delegation to the Bretton Woods conference without the commissar of finance.

Britain, concerned with preserving its special economic relationship with members of the Commonwealth, reorganized from a collapsed empire, also said it would not send cabinet-level officials to the conference. Both Britain and the Soviet Union asserted that participation in the conference in no way foreclosed their option to reject eventual membership in the proposed International Monetary Fund.

The Bretton Woods conference, predominantly a US-run show, produced an international financial regime that set the value of the US dollar at one-35th of an ounce of gold, with all other currencies of other participating nations set at fixed exchange rates to the dollar that were not expected to fluctuate beyond a narrow range of 1% from unruly market forces. Foreign-exchange control between borders was strictly enforced. Official exchange rates were determined by economic fundamentals and were expected to change only fundamentally, but not temporarily because of speculative forces, because trade was supposed to increase wealth for all trading nations proportionately and was not expected to alter their relative wealth.

Cross-border flows of funds were not considered by then-prevalent trade-economics theories as either necessary for trade or desirable for domestic development. All members of the United Nations were eligible to join, provided they were committed both to eliminating controls over foreign-exchange transactions and to establishing fixed exchange rates, to be altered only with the consent of the Fund.

Trade, though not unimportant, was considered to have only a supplementary function in a nation's economy, the main economic functions being in domestic economic development. A weak domestic economy could not possibly be expected to solve its problems through trade alone. National economic development was the goal of every nation, with trade being conducted only for auxiliary purposes. This was just common sense, for no nation would tolerate or could afford a sustained trade deficit. Trade among nations either had to be balanced or trade would soon stop until temporary trade deficits were eliminated. If every national economy were to seek growth only through exports, the aggregate effect for the world economy would be negative.

While World War II was a global conflict between the Allies and the Axis powers, a parallel undercurrent financial war was waged between the two leading allies. British historian Robert Skidelsky in his three-volume biography of John Maynard Keynes writes of the relationship between Keynes, who represented Britain, and White, who represented the US at Bretton Woods, as a "battle between the two ... one of the grand political duels of the Second World War, though it was largely buried in financial minutiae".

He sees the differences as the result of US malevolence: "Harry Dexter White of the US Treasury wanted to cripple Britain in order to clear the ground for a postwar American-Soviet alliance." Later, in the Joseph McCarthy era, White was accused unfairly of having been a communist, on flimsy circumstantial evidence, notwithstanding that in the 1920s, every thinking individual on the US cultural scene was to some degree sympathetic to communism. Critics on the right in the United States at the time saw Bretton Woods as an attempt to "set up a super-national Brains Trust which is to think for the world and plan for the world, and to tell the governments of the world what to do", wrote Skidelsky.

After the Dunkirk evacuation, when the badly mauled British military retrieved its expeditionary force of 300,000 by the skin of their teeth with the use of civilian small boats, the British had to make a choice: either to lose the military war to Germany as France did, or to lose the financial war to the United States. Churchill chose losing to the US, based on the time-honored strategic theory of keeping distant allies to oppose nearby enemies.

Churchill was out-and-out pro-US, with his American mother and close connection to the US moneyed elite. This policy was not unanimously supported by all in Britain, the Duke of Windsor being a prominent example. But Churchill's choice turned out to be the only sensible option, with Canada dominated by the US and Singapore, Malaysia, British Borneo, India and Australia threatened by a hostile Japan, an ally of Germany.

Moving US General Douglas MacArthur from embarrassing defeat by the Japanese in the Philippines to Australia cemented British-US interests in Asia and saved the United States from an unthinkable disgrace of having a top general surrender to what was commonly considered by US sentiment as an inferior race. Since 1941, Britain had been holding up a stiff-upper-lip facade, pretending to remain a world power in its de facto role of a US client state, a mere water boy on a powerful team. It did get some benefits from the Cold War, which was in no small way engineered by Churchill, exploiting the insecurity and paranoia of Truman to keep a crippled Britain a minor player in the power game of global geopolitics.

Bretton Woods called for a Bank for Reconstruction (now known as the World Bank) to finance investment in the postwar era, and an International Stabilization Fund to repair the flaws in the inter-war gold standard. This was to make explicit and to enforce the rules of behavior expected of trading nations, to manage exchange rates, to assist in resolving temporary balance-of-payments problems (the key operative word is "temporary", ie, not persistent), to encourage tariff reduction and free trade, and to control destabilizing movements of "hot money" across national borders, as in Mexico in 1995 and in Asia in 1997.

Keynes saw payments imbalance as a problem for both surplus and deficit countries, both of which needed to be encouraged to change their domestic policies, not rely on changing exchange rates to paper over unsustainable imbalances. White, representing the US, which anticipated huge trade surpluses, saw a balance-of-payments deficit as the problem that the countries running the deficit need to correct by changing their domestic policies.

John Maynard Keynes, father of Keynesianism, which became the theoretical fuel for US president Franklin Roosevelt's New Deal, and by 1941 an adviser to the British Treasury, came to Washington that July, some six months before the Pearl Harbor attack, to discuss with US officials the conditions for US wartime financial aid to Britain. The State Department gave him a draft agreement for defense aid that would include a provision for postwar arrangements in which there would be no discrimination by the United States or the United Kingdom against imports from any other country. This provision upset Keynes, because it meant abolishing the British imperial preference system that had been negotiated in Ottawa with the members of the Commonwealth in 1932.

Keynes, who had been working and writing on monetary and exchange-rate problems since World War I and who had come to prominence after that war with his criticisms of the reparations provisions of the Treaty of Versailles, was inclined, however, to look with favor on the benefits of stabilizing exchange rates. Keynes believed that it was possible and desirable to have a high degree of exchange-rate stability without the rigidity of classical gold standard.

Thus US and UK officials had a common starting point. Keynes, however, worried that the US might return to the pre-New Deal deflationary policies of the 1930s, and so favored a plan that would give the UK freedom to pursue domestic full-employment policies without having to be concerned about the impact on the resultant UK balance of payments.

The policy struggle between Keynes and White was geopolitical in a world of finance capitalism where national wealth determined national power more than the reverse, as in the age of imperialistic mercantilism. The subtle economics difference between the two plans represented a huge gulf geopolitically. The Keynes plan fit the need of a financially drained British Empire upon which the sun was about to set while the White plan fit the needs of a financially well-heeled US about to inherit the Earth.

British imperial conservatives believe that the US during World War II provided aid to Britain on measly terms guaranteed to destroy Britain as a super power. Skidelsky writes of financial war as the "intensity and often bitterness of the struggle between Britain and America for postwar position which went on under the facade of the Grand Alliance. When the European war started, Britain, not Germany, was seen by most American leaders as America's chief rival." He writes of how "Churchill fought to preserve Britain and its Empire against Nazi Germany. Keynes fought to preserve Britain as a Great Power against the United States. The war against Germany was won; but, in helping to win it, Britain lost both Empire and greatness."

He writes of how it was a tragedy that Hitler's being "in charge of a great nation ... threw Britain into the arms of America as a suppliant, and therefore subordinate: a subordination masked by the illusion of a 'special relationship'". Skidelsky saw that the British government's "underlying belief that the New World had to be yoked ... to the Old" led to "the deference Britain paid to America's wishes ... and its failure to exploit crucial elements in its bargaining position - like fighting a more limited war, or even making a separate peace with Germany."

Declassified documents on wartime Allied summits provide substantial evidence to support Skidelsky's observations. Until his untimely death, Roosevelt was on a collision course with Churchill on the "good" war's objective vis-a-vis British colonialism. It was not until Truman replaced Roosevelt as president that US policy accepted British insistence on the preservation of the British Empire as a war aim, in the name of anti-global-communism. This policy change greatly limited US options in developing a viable postwar foreign policy toward new emerging nations of the Third World, and this limitation eventually led to the Vietnam War by indiscriminately equating Third War nationalism with communism.

The idea that the United States should help Britain fight to defeat a tyranny, not to preserve an empire, was an embarrassing self-deception. The US only declared war on Germany after Japan attacked Pearl Harbor, Hawaii. German tyranny had by then been going on for a number of years. Kristallnacht, "the Night of Broken Glass", took place on November 9-10, 1938, a year before Britain and France declared war on Germany on September 3, 1939, and three years before the US entered the war. During Kristallnacht more than 7,500 Jewish shops were destroyed and 400 synagogues were burned to the ground all over Germany.

Ninety-one Jews were killed and an estimated 20,000 were sent to concentration camps, which until that time had been mainly for non-Jewish political prisoners. Prominent Americans were actively against US involvement in Europe and many were actively pro-Germany until after the Pearl Harbor attack.

World War II was a conflict of geopolitical interests among great powers. The "struggle against tyranny" image was an afterthought moral icing on the geopolitical cake. The "good war" was especially good for the US economy.

After World War II, Britain was still saddled with many of the costs of empire while losing most of the benefits. Colonial natives soon converged on the British Isles to take advantage of liberal social programs originally designed for native Britons - free health care and generous unemployment benefits. Even wealthy Third World elites would send their children to Britain for fancy orthodontic work and their pregnant mistresses to give birth in London hospitals, all for free, plus a British passport for the newborn, not to mention generous welfare payments for the unwed mother.

Aside from the pride of being on the "winning" side, Britain got pitifully few tangible benefits from the war. London and other industrial cities had suffered severe damage from Luftwaffe air raids and the country had in reality been an occupied territory by US forces after 1942.

The other disadvantage was that unlike Japan and Germany, Britain actually still had a performing democracy at the end of the war, though hardly a working one. This prevented the British communists from any real prospect of coming to power and thus did not rate serious US attention. Unlike Germany and Japan, on which much US aid was driven by the US fixation on anti-communism, Britain had an anti-communist Labour government, the worst of all possible combinations in terms of the postwar US geopolitical agenda. While the US hated and feared communists, it had even less respect for the social democrats in the Labour Party.

The US was set to teach European social democrats a lesson, and the British Empire was taken over by the United States in the name of communist-containment, with the pretense that British Labour was not trustworthy on the ideological struggle. Then there was the brain drain to the US, and the overvalued pound sterling devastated British trade. For five decades after World War II, British ingenuity expressed itself in pop culture rather than in independent national revival strategy.

Immigrants from the Commonwealth did not catch on until years later that they could get free rides on the welfare programs in Britain originally designed to serve only UK residents with money collected before the war from distant parts of the empire. But the programs put in place by the Labour government stayed operative long after the administration of prime minister Clement Atlee, until the Conservative Margaret Thatcher came to power. Not only Third World residents but US residents did the same thing.

Fulbright exchange students selected Britain mostly for its medical benefits for all residents regardless of citizenship. The returned US students taught their friends how to vacation in the United Kingdom for free dental work and childbirths. Socialism cannot work unless all who draw from the system also pay into the system. The residual effects of a collapsed empire were used by Thatcher to prove that social welfare did not work.

The collapse of the Bretton Woods regime
US president Richard Nixon's 1971 declaration "we are all Keynesians now" had the effect of rendering modern Keynesians monetarists, ending four decades of polarity in economics between Keynesianism and monetarism. The reason modern Keynesianism cannot avoid monetarism is the collapse of Bretton Woods in 1971, which exacerbated the monetary implications of fiscal policy. Any government today trying to repeat US president John Kennedy's 1960 New Economy of tax cuts and fiscal spending will face a market assault on its currency. That is, any government except the US, because of dollar hegemony.

Nixon's declaration served to cover up the impact of his historic abandonment of the Bretton Woods regime of gold standard/fixed exchange rates on August 15, 1971, a date that marked the end of US dominance of world finance derived from the strength of its monetary system, and put the US on a slippery slope of currency manipulation through dollar hegemony. To compensate for removing the dollar from its gold throne, Nixon imposed ineffective wage/price controls to arrest domestic inflation, which was really an institutional measure rather than a Keynesian one. The net result was that while wages were kept from rising legitimately, prices rose in the black or gray market that came into existence because of price-induced shortages.

Paul Volcker, Nixon's Treasury under secretary for monetary policy and international affairs, at first reassured foreign central bankers and finance ministers that the United States was merely looking for a "breathing space" to reconstruct an orderly monetary system. Later, Volcker admitted that the breakdown of Bretton Woods was a failure of US leadership and self-discipline to rein in US financial excesses.

With the collapse of the Bretton Woods regime, for the first time in the post-World War II economic order, inflation became exportable because of cross-border flows of funds, and the way to fight inflation was to force down wages in the exporting economies. A government willing to dilute the value of its currency by inflation could gain windfalls at the expense of its trading partners by temporary currency-exchange-rate and pricing advantages. With unregulated global foreign-exchange markets in the 1990s, the US was eventually able to maintain a strong dollar without merit, through the residual historical geopolitical arrangement of denominating oil (black gold) in dollars.

With dollar hegemony, this temporary advantage became permanent for the United States. It was able to devalue its currency domestically while keeping it strong in relation to other currencies. The boom in the US economy was being financed by deflation in the economies of its trading partners.

At Bretton Woods, Harry Dexter White used the gold-backed dollar to appropriate a century of British financial hegemony and to use the gold-backed US dollar as a disciplinary device to punish dishonest fiat currencies of countries that ran recurring deficits. It is ironic that by the 1990s, the dollar had become the dishonest fiat currency used by globalized currency markets to punish honest fiat currencies of countries that had accumulated surpluses.

Milton Friedman applauded the fall of the Bretton Woods regime in 1991, since he and other conservative monetarists of the Chicago School saw floating exchange rates as an excellent "laissez-faire" free-market solution, notwithstanding that events have since shown that currency markets, manipulated by hedge funds that created recurring financial crises around the globe, are anything but "free".

Friedman, father of modern monetarism, saw the development of foreign-exchange markets as forcing the US Federal Reserve to focus on the one thing it allegedly could control: the domestic money supply. Friedman was fixated on the truism of the theory and not particularly concerned with the practical effects on the economy from the violent volatility in interest rates that a steady money supply would generate.

Volcker, as Fed chairman, influenced by a Friedman, who had been buoyed by a general wave of conservatism into guru status among ideologue monetarists, adopted in 1980 a "new operating method" for the Fed as a therapeutic thunderbolt on Wall Street, which seemed to have lost faith in the Fed's political will to control inflation.

The new operating method, by concentrating on monetary aggregates, ie, money supply, and letting it dictate interest-rate swings within a range from 13-19%, to be authorized by the Federal Open Market Committee (FOMC), was an exercise in "creative uncertainty" to disrupt the financial market's complacency about interest-rate stability or gradualism, which was widely perceived as the key Fed policy objective. There had been a traditional expectation that even if the Fed were to raise rates, it would do so at a gradual pace to avoid causing the market to become volatile. The expectation of interest-rate gradualism was again justified by the Fed's most recent "measured paced" approach to interest-rate hikes in the final year of Greenspan's watch.

Volcker's failed monetary experiment in 1980 forced the Fed back on its old path: focusing on interest rates and not money supply, and ironically to vow again to focus on the long term. To avoid total economic collapse, the Fed had no choice but to maintain interest-rate gradualism over aggregate money stability that came with the unbearable price of interest-rate volatility.

For the long term, money supply was the correct barometer, while interest-rate policy was the appropriate tool for the short term. Since interest-rate volatility is unavoidable, the compromise is to make the change in rates gradual to reduce the volatility. But gradualism prolongs a short-term solution into a long-term cure, thus neutralizing the effectiveness of interest-rate policy as a short-term tool. That is the real conundrum of interest-rate policy, not the inverse yield curve as Greenspan suggests.

The surviving Bretton Woods twins
Two related super-national institutions were organized by the US-sponsored Bretton Woods conference: the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD), more commonly known as the World Bank. Both institutions have been dominated by the US since their inception, as the United Nations has been. Together, these two super-national agencies helped build the US global financial empire through world trade conducted under the auspices of the World Trade Organization, the rules of which are set by the strong, well-developed economies to the disadvantage of the weak, developing economies.

The IMF world view is expressed by its official statement of its function:

During that decade [1930s], as economic activity in the major industrial countries weakened, countries attempted to defend their economies by increasing restrictions on imports; but this just worsened the downward spiral in world trade, output, and employment. To conserve dwindling reserves of gold and foreign exchange, some countries curtailed their citizens' freedom to buy abroad, some devalued their currencies, and some introduced complicated restrictions on their citizens' freedom to hold foreign exchange. These fixes, however, also proved self-defeating, and no country was able to maintain its competitive edge for long. Such "beggar-thy-neighbor" policies devastated the international economy; world trade declined sharply, as did employment and living standards in many countries.

This of course is a free-trade view favored by the dominant economies, such as prewar Britain and the postwar US.

Among the official purposes of the IMF are: to promote exchange stability, to maintain orderly exchange arrangements among members, and to avoid competitive exchange depreciation; to assist in the establishment of a multilateral system of payments in respect of current transactions between members and in the elimination of foreign exchange restrictions that hamper the growth of world trade; to give confidence to members by making the general resources of the Fund temporarily available to them under adequate safeguards, thus providing them with opportunity to correct maladjustments in their balance of payments without resorting to measures destructive of national or international prosperity.

Only 29 of the 43 conference participants signed the IMF's Articles of Agreement in 1945 because many governments saw Bretton Woods as a US-British condominium, with Britain ceding many of its prewar financial hegemonic privileges to the US in exchange for being allowed to stay in the game. Thus when the US forced Japan and Germany to accept the Plaza Accord of 1985 to revalue the yen and the mark respectively, it amounted to forcing a "competitive exchange depreciation" of the dollar, in violation of IMF principle.

The overvaluation of the dollar in the 1980s was the result of Federal Reserve policy under Volcker, not of policies of the central banks of Germany or Japan. Similarly, pressure on China in recent years to revalue the yuan amounted to a comparable violation of the same IMF principles. The fall in the purchasing power of the dollar was the result of Fed policy under Alan Greenspan, and the unwarranted strength of the dollar exchange rate reflects the effects of dollar hegemony constructed by Robert Rubin, US treasury secretary under president Bill Clinton.

Unlike the IMF, whose function was to promote international trade with a currency-stabilizing fund, the official function of the World Bank was to promote long-term economic development, including financing of infrastructure projects, such as road-building and improving water supply. The so-called Bretton Woods twins, the IMF and the World Bank, because of critical noises made by Joseph Stiglitz, a former World Bank chief economist who had been forced out by US treasury secretary Lawrence Summers, appeared to be at odds in their policy focus. But this was mere sibling rivalry.

In late 1995, in the face of threats from the US Congress to cut US contributions to the bank, the World Bank embarked on a high-profile advertising campaign to underline its importance to the economies of donor countries. The World Bank announced that it "doesn't just lend money; it helps developing countries become tomorrow's markets". The US was getting back from the World Bank more than what it put in, so the argument went.

Social welfare has transformed into corporate welfare, with the World Bank clinging to the party line that what is good for Northern industry is also good for the poor of the South. The Summers' infamous World Bank memo, in which he, as the United States' chief economist, argued that the export of pollution to poor countries represented "immaculate" economic logic because Third World lives were worth less, is a classic example of warped neo-liberal mentality.

The amount of money the World Bank is throwing in the direction of the private sector and its new belief that corporations can handle development on their own, without government involvement, is manifested in the bank's shift from project lending to "policy" lending in the form of loans for removing trade barriers, privatizing government-owned companies and restructuring whole sectors of the economy to allow the entry of transnational corporations from the advanced economies. Private-sector projects have weaker information and disclosure policies, less accountability and less stringent environmental policies than public-sector projects.

For example, the World Bank has been one of the most powerful forces behind genetic erosion around the world for the past 50 years. This devastation has resulted from a wide range of activities in most of the sectors at the bank - in particular, agriculture, energy, forestry, infrastructure and industry. In the 1950s, the bank's agricultural focus was on cash crops (such as cacao, rubber and palm oil), which started the decline of diversity in farming systems and the crops themselves.

When the Ford Motor Co fell into decline after founder Henry Ford's death in 1947, it was "saved" by the "Whiz Kids" who managed to turn the company back toward profits by producing the worst cars in the industry through the application of a systems approach to management in which the quality and safety of a product was only a tradeoff component in the quest for profitability.

The Whiz Kids were led by Robert S McNamara, who went on to mislead US president Lyndon Johnson into the Vietnam War quagmire as the secretary of defense who promised to win an unwinnable war by committing more and more troops and money, after which he went on to become president of the World Bank (1968-81) with equally disastrous impact on the world's poor. McNamara's top-down anti-poverty strategy accelerated a process of agricultural modernization and integration into the global market that increased inequality, exacerbated poverty and had a devastating impact on biodiversity and the environment.

Ambitious land-clearing and settlement projects were another important component of the World Bank's purported poverty-alleviation strategy in the McNamara era. These often involved the decimation of vast areas of prime biodiversity habitats, particularly tropical rainforests. For example, in the 1970s, the bank approved a series of loans that cleared 526,000 hectares, or 6.5%, of Malaysia's rainforests, mainly to install mono-cultural plantations for the production of palm oil. Such areas experienced dramatic losses in biodiversity: in one fell swoop, diversity plummeted from thousands of species per hectare to a single lonely palm tree. All told, plantation forestry systems cover some 15 million hectares today, and they are still expanding.

These kinds of escapades continued into the 1980s. Brazil's infamous Polonoreste agricultural development program, funded by the World Bank to the tune of $443 million, singlehandedly increased the deforestation of the Brazilian Amazon from 1.7% in 1978 to 16.1% in 1991. More than half the loans financed the paving of a 1,500-kilometer dirt track through the rainforests of Rondnia. Most of the rest went into constructing feeder and access roads, and the establishment of 39 rural settlement centers to consolidate and attract settlers who were to raise tree crops (mainly cocoa and coffee) for export. Instead of the tens of thousands of settlers anticipated, half a million arrived in the space of five years.

Agricultural extension services and credit never materialized and resettlement officials were overwhelmed. To survive, the settlers tried, largely unsuccessfully, to grow crops such as rice, beans and corn (maize) in the poor soils, which would become exhausted in a year or two. Slash-and-burn went completely out of control, as the settlers were constantly forced to move on. The impact on the fragile rainforest environment was of course devastating. By the mid-1980s, the burning of Rondnia was identified by the US National Aeronautics and Space Administration as the single largest, most rapid human-caused change on Earth visible from space.

Indonesia's Transmigration program had an equally devastating impact on both biological and cultural diversity. Between 1976 and 1986 the World Bank lent $630 million to support the movement of millions of Javanese people to outlying islands. In addition, it provided $734 million for agricultural development, which either did not materialize or was used to provide rice that people tried, and failed, to grow in totally inappropriate environments, razing the environment in the process. By the late 1980s, transmigration was responsible for deforestation rates in the fragile forests of the outer islands reaching a rate of 5,000 square kilometers a year.

The results of the program were particularly devastating in Irian Jaya, now called West Papua, one of the world's great reservoirs of biological and cultural diversity. Here, transmigration was little more than an attempt to "Javanize" what the authorities viewed as backward and disrespectful ethnic groups. The original plan was to match the 1 million ethnic people, belonging to numerous tribal groups speaking more than 200 languages, with 1 million Javanese. This target was never actually reached because the program proved so disastrous, but transmigration did have its desired effect in decimating Papua's social and cultural fabric.

In the wake of the World Bank's advertising campaign, the US Treasury subsequently issued a report demonstrating that in just two years (1993-95), the World Bank and other multinational development banks had channeled nearly $5 billion of contracts to US firms. One major beneficiary was Cargill, the third-largest food corporation in the world. Cargill's 1995-96 sales were a mind-boggling $56 billion, which is roughly equivalent to the gross national product of Pakistan, Venezuela or the Philippines. Company earnings reached almost $1 billion and profits were 34% higher than in the previous year.

Next: The US-China trade imbalance

Henry C K Liu is chairman of a New York-based private investment group. His website is at HenryCKLiu.com .

(Copyright 2006 Asia Times Online Ltd. All rights reserved. Please contact us about sales, syndication and republishing .)

The hoax is that groups like the World Bank follow rules, ethics, guidelines, morals, etc. they would kill or rape for a penny. Infact one penny costs more than 1.4 cents to create.

thanks papabear you save me the trouble of surfing through the internet to read interesting news

http://www.atimes.com/atimes/Global_Economy/HE16Dj01.html

Back to the gold standard
By Peter Morici

Speaking Freely is an Asia Times Online feature that allows guest writers to have their say. Please click here if you are interested in contributing.

Gold is selling for more than US$700 an ounce, up from $258 in 2001 - and this is but one of the many signs of a flight to gold, which has become a worldwide phenomenon. We could yet see a return to the gold standard by the world's central banks. The main cause? The economic policies of the Bush White House - but this requires a bit of explanation.

Jewelry and industrial applications absorb 85% of new gold supplies. Although production has fallen a bit and industrial demand has increased, this alone cannot explain surging prices, because bringing new deposits on line would cost less than $700 an ounce. The big new players in the gold market are exchange-traded funds. These store bullion for investors who have lost confidence in the US dollar, and may be a precursor to a new gold standard.

In 1944, the International Monetary Fund established a system of fixed currency-exchange rates. The US dollar was fixed to gold and other currencies set to the dollar. This system ultimately failed because rising production costs pushed the industrial price of gold above its monetary value, and fixed exchange rates proved unsustainable. Productivity and competitiveness advanced more rapidly in Japan and Germany than in the United Kingdom, France and the United States, and trade imbalances caused crises for the pound, franc and dollar.

When the pound and franc became overvalued, those were devalued against the dollar, yen and mark. When the dollar became overvalued, US president Richard Nixon ended its convertibility into gold in 1972, and the system of fixed exchange rates was abandoned by the end of 1973. Subsequently, the price of gold rose from $100 an ounce to a peak of $700 in October 1980.

Over the next two decades, central banks demonetarized gold. They increasingly backed their currencies with US dollars, and to a lesser extent German marks (then euros) and Japanese yen. Many sold off significant portions of their gold. The price of gold fluctuated but trended to lows of $255 in July 1999 and $258 an ounce in April 2001.

Two things made this possible. In the United States, Federal Reserve chairman Paul Volcker whipped inflation and presidents Jimmy Carter and Ronald Reagan put the US economy on the path of deregulation. These steps unleashed mighty waves of productivity and innovation, created the US prosperity of the past 15 years, and made the dollar a better and more stable store of value than gold.

In recent years, though, record budget deficits, dysfunctional energy and environmental policies, and a dollar overvalued against the Chinese yuan and other Asian currencies have created huge US trade deficits. Dollars and dollar-denominated securities have flooded into international capital markets. These now total $5 trillion, increase $700 billion each year, and erode confidence in the dollar.

To keep the yuan from rising against the dollar, China purchases more than $200 billion in foreign securities every year. A few central banks are buying gold again, and some economists are counseling the People's Bank of China, the country's central bank, to diversify its reserves from dollars into gold.

A significant revaluation of the dollar against the yuan seems inevitable, and it will cause a wholesale adjustment for the dollar against other Asian currencies. With so much of what the world consumes now coming from China and other Asian economies, the dollar will be worth a lot less to gold miners in South Africa or Russia, and Asian currencies would be worth more. The Chinese yuan or South Korean won price of gold would not rise, and might fall, but the US dollar price of gold would increase, a lot.

International investors with wealth to park are foolish to put it in dollars; however, the currencies with the best prospects are backed by governments with poor track records for controlling inflation or honoring commitments to foreign investors. Could you tell your mother her money would be safe in Korean or Chinese bonds?

If private investors continue to doubt the dollar and bet on gold, central banks will be forced into gold. Investors won't trust currencies back by dollars, and central banks would be just as foolish as private investors to trust won- or yuan-denominated bonds.

What brought the US to this pass? The root causes, as mentioned, are high government deficits and bad policies on energy and the environment, which have added to the country's trade deficit by exacerbating its dependence on foreign oil. And on all these matters, the buck stops (to put it ironically) with the administration of President George W Bush. The decision last week not to cite China as a currency violator, which again showed the US president's refusal to address the root causes of the trade deficit, will not improve matters.

Unless the United States gets its economic house in order, gold will become money again, and national currencies will only be money if backed by gold.

Peter Morici is a professor at the University of Maryland's Robert H Smith School of Business, former chief economist at the US International Trade Commission, and a commentator on economic and political issues.

(Copyright 2006 Peter Morici. Used with permission.)

http://www.counterpunch.org/kolko06152006.html

June 15, 2006
"The Demons of Greed are Loose"
Why a Global Economic Deluge Looms

By GABRIEL KOLKO

People who know the most about the world financial system are increasingly worried, and for very good reasons. Dire warnings are coming from the most "respectable" sources. Reality has gotten out of hand. The demons of greed are loose.

What is that reality? It includes a number of factors. Alone they would be exceedingly serious; combined, they are very likely to be lethal.

First of all, the International Monetary Fund (IMF) has been undergoing both a structural and intellectual crisis. Structurally, its outstanding credit and loans have declined dramatically since 2003, from over $70 billion to a little over $20 billion today, leaving it with far less leverage over the economic policies of developing nations--and even less income than its expensive operations require. It is now in deficit.1

A large part of the IMF's problems are due to the doubling in world prices for all commodities since 2003 -- especially petroleum, copper, silver, zinc, nickel, and the like -- that the developing nations traditionally export. While there will be fluctuations in this upsurge, there is also reason to think it may endure because rapid economic growth in China, India, and elsewhere has created a burgeoning demand that did not exist before, when the balance-of-trade systematically favored the rich nations.

The U.S. has seen its net foreign asset position fall as Japan, emerging Asia, and oil exporting nations have become far more powerful over the past decade, and have increasingly become creditors to the U.S.2 As the U.S. deficits mount, with its imports being far greater than its exports, the value of the dollar has been declining -- 28 per cent against the euro from 2001 to 2005 alone.

Equally important, the IMF and World Bank were severely chastened by the 1997-2000 financial meltdowns in East Asia, Russia, and elsewhere, and many of the two institutions' key leaders lost faith in the anarchic premises, descended from classical laisser-faire economic thought, which guided policy advice until then. "{O]ur knowledge of economic growth is extremely incomplete," many in the IMF now admit, and "more humility" on its part is now warranted.3

Worse yet, the whole nature of the global financial system has changed radically in ways that have nothing whatsoever to do with "virtuous" national economic policies that follow IMF advic. These are ways the IMF cannot control. The investment managers of private equity funds and major banks have displaced national banks and international bodies such as the IMF, moving well beyond the existing regulatory structures and they have "reintermediated" themselves between the traditional borrowers, both national and individual, and markets. They have deregulated the world financial structure, making it far more unpredictable and susceptible to crises. They seek to generate high investment returns, which is the key to their compensation, and they take mounting risks to do so.

A "brave new world" has emerged in the global financial structure, one that is far less transparent because there are fewer reporting demands imposed on those who operate in it. Financial adventurers are constantly creating new "products" that defy both states and international banks. The IMF's managing director, Rodrigo de Rato, at the end of May, 2005, deplored these new risks -- risks the weakness of the U.S. dollar and its mounting trade deficits have magnified greatly.4

In March of this year the IMF released Garry J. Schinasi's book, Safeguarding Financial Stability, giving it unusual prominence then and thereafter. In essence, Schinasi's book is alarmist, and it both reveals and documents in great and disturbing detail the IMF's deep anxieties. Essentially, "deregulation and liberalization", which the IMF and proponents of the "Washington consensus" advocated for decades, have become a nightmare, creating "tremendous private and social benefits" but also holding "the potential (although not necessarily a high likelihood) for fragility, instability, systemic risk, and adverse economic consequences."

Anyone who reads the data in Schinasi's superbly documented book will share his real conclusion that the irrational development of global finance, combined with deregulation and liberalization, has "created scope for financial innovation and enhanced the mobility of risks". Schinasi and the IMF advocate a radical new framework to monitor and prevent the problems now able to emerge, but success "may have as much to do with good luck" as policy design and market surveillance.5 Leaving the future to luck is not what economics originally promised. The IMF is desperate, and not alone.

As the Argentina financial meltdown proved, countries that do not succumb to IMF and banker pressures can play on divisions within the IMF membership, particularly the U.S., comprising bankers and others to avoid many, although scarcely all, foreign demands. About $140 billion in sovereign bonds to private creditors and the IMF were at stake, terminating at the end of 2001 as the largest national default in history. Banks in the 1990s were eager to loan Argentina money and they ultimately paid for it. Since then, however, commodity prices have soared and the growth rate of developing nations in 2004 and 2005 was over double that of high income nation, a pattern projected to continue through 2008.

As early as 2003 developing countries were already the source of 37 percent of the foreign direct investment in other developing nations. China accounts for a great part of this growth, but it also means that the IMF and rich bankers of New York, Tokyo, and London have far less leverage than ever. Growing complexity is the order of the world economy that has emerged in the past decade, and with it has come the potential for far greater instability, and dangers for the rich.

High-speed Global Economics

The global financial problem that is emerging is entwined with an American fiscal and trade deficit that is rising quickly. Since Bush entered office in 2001 he had added over $3 trillion to federal borrowing limits, which are now almost $9 trillion. So long as there is a continued devaluation of the U.S. dollar, banks and financiers will seek to protect their money and risky financial adventures will appear increasingly worthwhile. This is the context, but Washington advocated greater financial liberalization well before the dollar weakened. The world now has a conjunction of factors that have created a far greater risk than the proponents of the "Washington consensus" ever believed possible.

There are now many hedge funds, with which we are familiar, but they now deal in credit derivatives and numerous other financial instruments. Markets for credit derivative futures are in the offing. The credit derivative market was almost nonexistent in 2001, grew fairly slowly until 2004 and then went into the stratosphere, reaching $17.3 trillion by the end of 2005.

What are credit derivatives? The Financial Times' chief capital markets writer, Gillian Tett, tried to find out. She failed. About ten years ago some J. P. Morgan bankers were in Boca Raton, Florida, drinking, throwing each other into the swimming pool, and the like, and they came up with a notion of a new financial instrument that was too complex to be easily copied (financial ideas cannot be copyrighted) and which was sure to make them money. But she was highly critical of its potential for causing a chain reaction of losses that will engulf the hedge funds that have leaped into this market.6 It for reasons such as these, as well as others, even more opaque, such as split capital trusts, collateralized debt obligations, and market credit default swaps, that the IMF and financial authorities are so worried.

Banks simply do not understand the chain of exposure and who owns what. Senior financial regulators and bankers now admit as much. The Long-Term Capital Management hedge fund meltdown in 1998, which involved only about $5 billion in equity, revealed this. The financial structure is now infinitely more complex and far larger. The top ten hedge funds alone in March 2006 had $157 billion in assets. Hedge funds claim to be honest but those who guide them are compensated for the profits they make, which means taking risks. But there are thousands of hedge funds and many collect inside information, which is technically illegal but it occurs anyway. The system is fraught with dangers, starting with the compensation structure, but it also assumes a constantly rising stock market and much, much else. Many fund managers are incompetent. But the 26 leading hedge fund managers earned an average of $363 million each in 2005; James Simons of Renaissance Technologies earned $1.5 billion.

There is now a consensus that all this, and much else, has created growing dangers. We can put aside the persistence of imbalanced budgets based on spending increases or tax cuts for the wealthy, much less the world's volatile stock and commodity markets which caused hedge funds in May to show far lower returns than they have in at least a year. It is anyone's guess which way the markets will go, and some will gain while others lose. Hedge funds still make lots of profits, and by the spring of 2006 they were worth about $1.2 trillion worldwide, but they are increasingly dangerous.

A great deal of money went from investors in rich nations into emerging market stocks, which have been especially hard-hit in the past weeks, and if they leave them the financial shock will be great. The dangers of a meltdown exist there too.

Problems are structural, such as the greatly increasing ratio of corporate debt loads to core earnings, which have grown substantially from four to six times over the past year because there are fewer legal clauses to protect investors from loss, and to keep companies from going bankrupt when they should. So long as interest rates have been low, leveraged loans have been the solution. With hedge funds and other financial instruments, there is now a market for incompetent, debt-ridden firms. The rules some once erroneously associated with capitalism -- probity and the like--no longer hold even on paper.

Problems are also inherent in speed and complexity, and these are very diverse and almost surreal. Credit derivatives are precarious enough, but at the end of May the International Swaps and Derivatives Association revealed that one in every five deals, many of them involving billions of dollars, involved major errors. As the volume of trade increased so did errors. They doubled in the period after 2004. Many deals were scribbled on scraps of paper and not properly recorded. "Unconscionable" was outgoing Fed chairman, Alan Greenspan's, description. He was "frankly shocked." Other trading, however, is determined by mathematical algorithm ("volume-weighted average price" it is called) for which PhDs trained in quantitative methods are hired.7 Efforts to remedy this mess only began in June of this year and they are very far from resolving a major and accumulated problem that involves stupendous sums.

Stephen Roach, Morgan Stanley's chief economist, on April 24 of this year wrote that a major financial crisis was in the offing and that the ability of global institutions to forestall it -- ranging from the IMF and World Bank to other mechanisms of the international financial architecture ­ are utterly inadequate. Hong Kong's chief secretary in early June deplored the hedge funds' risks and dangers. The IMF's iconoclastic chief economist, Raghuram Rajan, at the same time warned that the hedge funds' compensation structure encouraged those in charge of them to increasingly take risks, thereby endangering the whole financial system.

* * *

The entire global financial structure is becoming uncontrollable in crucial ways its nominal leaders never expected. Instability is increasingly its hallmark. Financial liberalization has produced a monster, and resolving the many problems that have emerged is scarcely possible for those who deplore controls on those who seek to make money, whatever means it takes to do so. Contradictions now wrack the world's financial system, and if we are to believe the institutions and personalities who have been in the forefront of the defense of capitalism, it may very well be on the verge of serious crises.

Gabriel Kolko is the leading historian of modern warfare. He is the author of the classic Century of War: Politics, Conflicts and Society Since 1914 and Another Century of War?. He has also written the best history of the Vietnam War, Anatomy of a War: Vietnam, the US and the Modern Historical Experience. His latest book, The Age of War, was published in March 2006.

He can be reached at: kolko@counterpunch.org.

Notes

1 IMF Survey, March 13, 2006, p. 66.

2 Philip R. Lane and G. M. Milesi-Ferretti, "Examining Global Imbalances," Finance & Development, March 2006, pp. 38-41.

3 Roberto Zagha et al, "Rethinking Growth," Finance & Development, March 2006, p. 11.

4 Raghuram Rajan, in Finance & Development, September 2005, pp. 54, 58; IMF Survey, May 29, 2006, p. 147.

5 Garry J. Schinasi, Safeguarding Financial Stability: Theory and Practice, pp. 8, 14, 17.

6 Gillian Tett, "The dream machine," Financial Times magazine, March 25/26, 2006, pp. 20-26. Also Financial Times, March 20, 2006.
7 Financial Times, May 31, 2006; June 8, 2006.

http://counterpunch.com/kolko06152006.html
Is a Global Economic Deluge Increasingly Likely?

By Gabriel Kolko


People who know the most about the world financial system are increasingly worried, and for very good reasons. Dire warnings are coming from the most "respectable" sources. Reality has gotten out of hand. The demons of greed are loose.

What is that reality? It includes a number of factors. Alone they would be exceedingly serious; combined, they are very likely to be lethal.

First of all, the International Monetary Fund (IMF) has been undergoing both a structural and intellectual crisis. Structurally, its outstanding credit and loans have declined dramatically since 2003, from over $70 billion to a little over $20 billion today, doubling its available resources and leaving it with far less leverage over the economic policies of developing nations – and even less income than its expensive operations require. It is now in deficit.1/ A large part of its problems are due to the doubling in world prices for all commodities since 2003 – especially petroleum, copper, silver, zinc, nickel, and the like-that the developing nations traditionally export. While there will be fluctuations in this upsurge, there is also reason to think it may endure because rapid economic growth in China, India, and elsewhere has created a burgeoning demand that did not exist before – when the balance-of-trade systematically favored the rich nations. The U.S. has seen its net foreign asset position fall as Japan, emerging Asia, and oil exporting nations have become far more powerful over the past decade, and they have increasingly become creditors to the U.S.2/ As the U.S. deficits mount with its imports being far greater than its exports, the value of the dollar has been declining – 28 percent against the euro from 2001 to 2005 alone.

Equally important, the IMF and World Bank were severely chastened by the 1997-2000 financial meltdowns in East Asia, Russia, and elsewhere, and many of its key leaders lost faith in the anarchic premises, descended from classical laissez-faire economic thought, which guided its policy advice until then. "[O]ur knowledge of economic growth is extremely incomplete," many in the IMF now admit, and "more humility" on its part is now warranted.3/

Worse yet, the whole nature of the global financial system has changed radically in ways that have nothing whatsoever to do with "virtuous" national economic policies that follow IMF advice – ways the IMF cannot control. The investment managers of private equity funds and major banks have displaced national banks and international bodies such as the IMF, moving well beyond the existing regulatory structures and they have "reintermediated" themselves between the traditional borrowers-both national and individual-and markets. They have deregulated the world financial structure, making it far more unpredictable and susceptible to crises. They seek to generate high investment returns – which is the key to their compensation – and they take mounting risks to do so.

A "brave new world" has emerged in the global financial structure, one that is far less transparent because there are fewer reporting demands imposed on those who operate in it. Financial adventurers are constantly creating new "products" that defy both states and international banks. The IMF's managing director, Rodrigo de Rato, at the end of last May deplored these new risks – risks the weakness of the U.S. dollar and its mounting trade deficits have magnified greatly.4/

In March of this year the IMF released Garry J. Schinasi's book, Safeguarding Financial Stability, giving it unusual prominence then and thereafter. Schinasi's book is virtually alarmist, and it both reveals and documents in great and disturbing detail the IMF's deep anxieties. Essentially, "deregulation and liberalization," which the IMF and proponents of the "Washington consensus" advocated for decades, has become a nightmare. It has created "tremendous private and social benefits" but it also holds "the potential (although not necessarily a high likelihood) for fragility, instability, systemic risk, and adverse economic consequences." Anyone who reads the data in Schinasi's superbly documented book will share his real conclusion that the irrational development of global finance, combined with deregulation and liberalization, has "created scope for financial innovation and enhanced the mobility of risks." Schinasi and the IMF advocate a radical new framework to monitor and prevent the problems now able to emerge, but success "may have as much to do with good luck" as policy design and market surveillance.5/ Leaving the future to luck is not what economics originally promised. The IMF is desperate, and not alone.

As the Argentina financial meltdown proved, countries that do not succumb to IMF and banker pressures can play on divisions within the IMF membership – particularly the U.S.-bankers and others to avoid many, although scarcely all, foreign demands. About $140 billion in sovereign bonds to private creditors and the IMF were at stake, terminating at the end of 2001 as the largest national default in history. Banks in the 1990s were eager to loan Argentina money and they ultimately paid for it. Since then, however, commodity prices have soared, the growth rate of developing nations in 2004 and 2005 was over double that of high income nations-a pattern projected to continue through 2008 – and as early as 2003 developing countries were already the source of 37 percent of the foreign direct investment in other developing nations. China accounts for a great part of this growth, but it also means that the IMF and rich bankers of New York, Tokyo, and London have far less leverage than ever. Growing complexity is the order of the world economy that has emerged in the past decade, and with it has come the potential for far greater instability – and dangers for the rich.

High-speed Global Economics

The global financial problem that is emerging is inextricable with an American fiscal and trade deficit that is rising quickly. Since Bush entered office in 2001 he had added over $3 trillion to federal borrowing limits, which are now almost $9 trillion. So long as there is a continued devaluation of the U.S. dollar, banks and financiers will seek to protect their money and risky financial adventures will appear increasingly worthwhile. This is the context, but Washington advocated greater financial liberalization well before the dollar weakened. The world now has a conjunction of factors that have created a far greater risk than the proponents of the "Washington consensus" ever believed possible.

There are now many hedge funds, with which we are familiar, but they now deal in credit derivatives and numerous other financial instruments, and markets for credit derivative futures are in the offing. The credit derivative market was almost nonexistent in 2001, grew fairly slowly until 2004 and then went into the stratosphere, reaching $17.3 trillion by the end of 2005.

What are credit derivatives? The Financial Times' chief capital markets writer, Gillian Tett, tried to find out but failed. About ten years ago some J. P. Morgan bankers were in Boca Raton, Florida, drinking, throwing each other into the swimming pool, and the like, and they came up with a notion of a new financial instrument that was too complex to be easily copied (financial ideas cannot be copyrighted) and which was sure to make them money. But she was highly critical of its potential for causing a chain reaction of losses that will engulf the hedge funds that have leaped into this market.6/ It for reasons such as these, and yet others such as split capital trusts, collateralized debt obligations, and market credit default swaps that are even more opaque, that the IMF and financial authorities are so worried.

Banks simply do not understand the chain of exposure and who owns what – senior financial regulators and bankers now admit this. The Long-Term Capital Management hedge fund meltdown in 1998, which involved only about $5 billion in equity, revealed this. The financial structure is now infinitely more complex and far larger – the top 10 hedge funds alone in March 2006 had $157 billion in assets. Hedge funds claim to be honest but those who guide them are compensated for the profits they make – which means taking risks. But there are thousands of hedge funds and many collect inside information, which is technically illegal but it occurs anyway. The system is fraught with dangers, starting with the compensation structure, but it also assumes a constantly rising stock market and much, much else. Many fund managers are incompetent. But the 26 leading hedge fund managers earned an average of $363 million each in 2005; James Simons of Renaissance Technologies earned $1.5 billion.

There is now a consensus that all this, and much else, has created growing dangers. We can put aside the persistence of imbalanced budgets based on spending increases or tax cuts for the wealthy, much less the world's volatile stock and commodity markets, which caused hedge funds in May to show far lower returns than they have in at least a year. It is anyone's guess which way the markets will go, and some will gain while others lose. Hedge funds still make lots of profits, and by the spring of 2006 they were worth about $1.2 trillion worldwide, but they are increasingly dangerous.

A great deal of money went from investors in rich nations into emerging market stocks, which have been especially hard-hit in the past weeks, and if they leave then the financial shock will be great-the dangers of a meltdown exist there too.

Problems are structural, such as the greatly increasing corporate debt loads to core earnings, which have grown substantially from four to six times over the past year because there are fewer legal clauses to protect investors from loss – and keep companies from going bankrupt when they should. So long as interest rates have been low, leveraged loans have been the solution. With hedge funds and other financial instruments, there is now a market for incompetent, debt-ridden firms. The rules some once erroneously associated with capitalism – probity and the like – no longer hold.

Problems are also inherent in speed and complexity, and these are very diverse and almost surrealist. Credit derivatives are precarious enough, but at the end of May the International Swaps and Derivatives Association revealed that one in every five deals, many of them involving billions of dollars, involved major errors – as the volume of trade increased so did errors. They doubled in the period after 2004. Many deals were recorded on scraps of paper and not properly recorded – "unconscionable" was Alan Greenspan's description. He was "frankly shocked." Other trading, however, is determined by mathematical algorithm ("volume-weighted average price" it is called) for which PhDs trained in quantitative methods are hired.7/ Efforts to remedy this mess only began in June of this year and they are very far from resolving a major and accumulated problem that involves stupendous sums.

Stephen Roach, Morgan Stanley's chief economist, on April 24 of this year wrote that a major financial crisis was in the offing and that the global institutions to forestall it – ranging from the IMF and World Bank to other mechanisms of the international financial architecture – were utterly inadequate. Hong Kong's chief secretary in early June deplored the hedge funds' risks and dangers. The IMF's iconoclastic chief economist, Raghuram Rajan, at the same time warned that the hedge funds' compensation structure encouraged those in charge of them to increasingly take risks, thereby endangering the whole financial system.

***

The entire global financial structure is becoming uncontrollable in crucial ways its nominal leaders never expected, and instability is increasingly its hallmark. Financial liberalization has produced a monster, and resolving the many problems that have emerged is scarcely possible for those who deplore controls on those who seek to make money – whatever means it takes to do so. Contradictions now wrack the world's financial system, and if we are to believe the institutions and personalities who have been in the forefront of the defense of capitalism, it may very well be on the verge of serious crises.


--------------------------------------------------------------------------------

Gabriel Kolko is one of the leading historians of modern warfare. He is the author of the classic Century of War: Politics, Conflicts and Society Since 1914 and Another Century of War?. He has also written a well regarded history of the Vietnam War, Anatomy of a War: Vietnam, the US and the Modern Historical Experience. His latest book, The Age of War, was published in March 2006.

He can be reached at: kolko@counterpunch.org.



Notes

1 IMF Survey, March 13, 2006, p. 66.

2 Philip R. Lane and G. M. Milesi-Ferretti, "Examining Global Imbalances," Finance & Development, March 2006, pp. 38-41.

3 Roberto Zagha et al, "Rethinking Growth," Finance & Development, March 2006, p. 11.

4 Raghuram Rajan, in Finance & Development, September 2005, pp. 54, 58; IMF Survey, May 29, 2006, p. 147.

5 Garry J. Schinasi, Safeguarding Financial Stability: Theory and Practice, pp. 8, 14, 17.

6 Gillian Tett, "The dream machine," Financial Times magazine, March 25/26, 2006, pp. 20-26. Also Financial Times, March 20, 2006.
7 Financial Times, May 31, 2006; June 8, 2006.

http://www.moneyweek.com/file/15199/why-an...inevitable.html

Why an inflationary bust is inevitable

12.07.2006

Based on the number of e-mails I receive and the types of questions I get asked, I have a fair idea of how investors are positioned. It is my impression, therefore, that the recent sudden sell-off in asset markets came as a surprise to the majority of investors and caught them — at least temporarily — on the wrong foot.

The end of the global economic boom: why did Gulf stock markets crash?

The most frequently asked questions came from India, where the market sold off within a few days by 20% from its high (it has since recovered modestly), and from Middle Eastern investors who were stunned when their stock markets declined by about 50% from their peak in late 2005. The decline in the Middle Eastern markets is remarkable because it occurred in an environment of near-record oil prices and at a time when liquidity was still increasing.

The best explanation I have for the decline in those markets is that, whereas Middle Eastern liquidity is still plentiful, the rate of growth has been slowing down. As my friends at GaveKal Research pointed out, “Bull markets, to keep going, need an ever growing stream of liquidity; for copper to rise 10% from US$2,000/ton to US$2,200/ton takes a little amount of money while a rise from US$8,000/ton to US$8,800/ton usually takes a lot more. In that respect, bull markets are like drug addicts whose next fix/liquidity injection provides diminishing returns. To get the same effects, the fix/liquidity injections need to always get bigger… Or serious withdrawal follows.”

The diminishing rate of liquidity growth aside, there may have been other reasons why stock markets in the Middle East tanked. The best time for equities tends to be at the end of an economic contraction or at the beginning of an expansion, when there is plenty of excess capacity. It is at these times that there is maximum liquidity in the system and, in the absence of heavy capital spending, stocks soar.

But once an increasing quantity of money is channelled from the financial sector into real economic activity — in the case of the Middle East, into grandiose residential and commercial construction projects and Ferraris — stocks frequently begin to stall or to decline abruptly. I mention this fact because the consensus among investors is that the global economy is booming. It is certainly the case that the boom is unprecedented in the history of capitalism.

The end of the global economic boom: an unprecedented expansion

Consider this: for the first 150 years of capitalism until the Second World War there was a colonial system in place. Under the colonial system, the rich industrial countries of the West (partly misguided by mercantilist economic policies) had little incentive to boost economic development and progress in the colonies.

The colonies were used principally to source raw materials, which were then processed into manufactured goods in the industrialised countries before being again exported to the colonies at high prices. These economic policies of imperialism led, in some cases, to a process of de-industrialisation in colonies such as 19th-century India. So, for the first 150 years of capitalism, the world didn’t experience strong, synchronized growth.

Then, following the breakdown of the colonial system during and immediately following the Second World War, close to 50% of the world’s population fell under communist and socialist rule, or had in place policies of “self-reliance” and “hostility towards foreign investors”.

Under these socialist systems, economic policies designed to stimulate the consumption of “butter” were avoided — largely at the expense of building an arsenal of heavy “guns” and unproductive heavy industries.

Following the breakdown of the socialist/communist ideology, which began with China’s Open Door Policy in 1978, the former socialist countries began to grow rapidly but in terms of size remained insignificant in the context of the global economy. In the 1980s, the Latin American countries went through a serious inflationary recession/depression, while declining oil prices took their toll on Russia and the Middle East.

Then, in the 1990s, Latin America began to recover strongly just as the world’s second-largest economy — Japan — went into a non-growth phase that lasted until just recently. At the same time, the Asian crisis of 1997 and the Russian crisis of 1998 lowered demand from Asia and the former Soviet Union.

The end of the global economic boom: the creation of imbalances

By contrast, look at the global economy today! US consumption is strong – in fact, so strong that it has led to an exploding trade and current account deficit. In turn, these growing deficits have greased the world with liquidity and boosted economic growth rates through capital spending and industrial production, particularly in the Asian region.

An Asian consumption boom has followed, driven largely by employment gains, huge productivity improvements in China, and declining prices for manufactured goods, which significantly enlarged their market potential. A consequence of this boom in the Asian economies — and, in particular, in the Chinese economy — has been a significant increase in the demand for commodities, which has lifted the economies of Latin America, Africa, the Middle East, and the former Soviet Union.

At the same time, Europe has experienced an export-led recovery, driven by the emerging world, and Japan, also partly driven by exports, has begun to grow once again.

I admit that the above historical perspective is simplistic, but my point is that, today, we can say that — at least from an economic perspective — “this time is different”. It is a fact that we are truly in the midst of an unprecedented global synchronized expansion. And not only that!

The expansion is reaching just about every corner of the world and almost every sector of its economy — admittedly, however, at different intensities. Still, as I have repeatedly pointed out in earlier reports, the current global economic boom is characterised by huge and growing imbalances. Steve Roach believes that these imbalances can be solved benignly, but I believe there will be some serious rebalancing consequences.

The end of the global economic boom: what happens as liquidity growth slows?

It is important to understand that even when central banks expand liquidity at an ever-increasing pace (Weimar hyperinflation, Latin America in the 1980s, Zimbabwe now), liquidity does tighten temporarily from time to time, as price and wage increases outpace money supply increases. So, whereas the German stock price index rose in paper marks from 100 in 1913 to 26 trillion in 1923, there were 20% short-term corrections (lasting usually just two months) in 1920, 1921, and 1922, and a 25% correction in 1923 (in US dollars).

(However, the index fell from 100 to a low of 2.72 in 1922, before recovering to 26.80 in December 1923.) As GaveKal Research pointed out (see above), in order to sustain a bull market in asset prices, an ever increasing pool of liquidity is required and this is, in the short run, impossible for a central bank to achieve — even if its intentions are “to print money”. In the example of the Middle Eastern stock markets referred to above, the prime drivers of liquidity are obviously oil production and oil prices.

Between 2002 and 2005, oil production soared from 25 million barrels a day to around 31 million barrels. The increase in production was accompanied by strong price increases (crude oil prices rose from $19 a barrel to $70). However, at the end of 2005, oil production began to decline moderately and oil prices no longer rose. So, whereas liquidity was still plentiful, the rate of increase declined and led to a relative tightening of monetary conditions, which I suppose explains the dismal performance of the Middle Eastern stock markets over the last six months.

Aside from the Middle East, it is apparent that liquidity conditions around the world, while still expansionary, are less expansionary than in the 1999–2005 time frame. (Remember that it is the rate of change that matters the most.) While bond yields are still below nominal GDP growth, they are no longer declining relative to nominal GDP growth, as they did between 2001 and 2004. So, we could argue that while an absolute tightening has not yet taken place, a relative tightening has been in force for the last 12 to 18 months. This would also seem to be confirmed by two other monetary indicators.

While Foreign Official Dollar Reserves are still expanding at an annual rate of 15% (no absolute tightening here), they are no longer increasing at an accelerating rate such as was the case between 2002 and 2005 — hence, a relative tightening is under way.

The end of the global economic boom: has the bear market begun?

Now, whenever central banks create excess liquidity, symptoms of inflation will show up somewhere. Sometimes wages and consumer prices will react the most to expansionary monetary policies (for example, the 1960s and 1970s), but in today’s world where, given the low wages in China and India, an almost unlimited labour arbitrage can take place, easy monetary policies drive asset prices such as homes, commodities, equities, art, and so on, higher, while wages and consumer prices rise only with a lengthy time lag (once commodity prices begin to be passed on in the prices of finished manufactured goods).

Therefore, it should come as no surprise that, when liquidity growth is slowing down, asset prices begin to cave in first. This is especially true of equities, since the stock market discounts economic events well ahead of time. In this respect, it is interesting to note that while home prices in the US have continued to rise nationwide, homebuilding shares peaked out in the summer of 2005.

Since I wrote extensively about the homebuilding industry last year, I shall refrain from making additional negative comments here, except to say that conditions have since deteriorated badly, with the number of total single-family homes available for sale (existing and new single-family homes) rising to a record high. At the same time, the Home Buying Intentions Index is at its lowest level since 1991. I might add that when homebuilding shares peaked in the summer of 2005, analysts remained very positive on this sector.

But, as I have repeatedly pointed out, it usually pays to listen to the market. And in this respect, we should take rather seriously the sharp break in equity and commodity prices, as well as in some of the emerging market currencies, that we experienced in the second half of May. The break may prove to be only of very brief duration with new highs to follow, but the impulsive nature of the break suggests differently — at least for now.

Naturally, investors will immediately ask why stocks and commodities should sell off when we are in the midst of a global synchronised economic expansion, when corporate profits are still expanding. The point is that, precisely because we are in a global boom, liquidity is likely to become tighter for a while and that, as just outlined, in such an environment equities and other asset prices are vulnerable until liquidity conditions improve once again.

Another reason for the sell-off could be accelerating inflation, about which we have frequently commented in recent reports and which may have a very negative impact on discretionary spending and corporate profitability, and could even lead to a global recession with some time lag. I hope that our US readers will have noticed that their cost of living is not currently rising by “core inflation” but by between 5% and 6% per annum. (The US Cleveland Fed Median CPI rose in April at an annual rate of close to 6%.)

Other reasons for the sudden decline in equities could be the threat of a pandemic or geopolitical tensions, which could lead, if not to a military conflict, then possibly to a trade war or competitive devaluations. It is important for investors to understand that when markets begin to move sharply in the opposite direction of the prevailing trend — that is, from down to up or from up to down, as was the case just recently — the reason for the trend reversal is usually not known for quite some time.

But a well-established fact is that equity bull markets get under way amidst dismal economic and financial conditions, while bear markets begin when everything looks at its brightest, such as was recently the case (at least superficially). Moreover, the more speculation there was in a market, the more likely it is that the correction could be serious and take the proportions of a bear market (down 20–40% or more).

The end of the global economic boom: why inflation is inevitable

I have to confess that I did hesitate for a long time before deciding to commit to paper the following observations, as they will undoubtedly cause some confusion, given the views I have expressed in earlier reports. However, there are times when, within a long-term view, short-term considerations become more significant. From a longer-term perspective, I still maintain that central banks — especially the US Federal Reserve — will have no other option than to print money and that, therefore, in the long run, asset prices will continue to increase — at least in nominal terms.

US MZM has soared as a percentage of GDP in recent years and, as in the case of Japan, has created a huge monetary overhang. And while monetary conditions have tightened relatively in both Japan and the US, because money supply is no longer expanding as a percentage of GDP, looking at credit growth there can be no question that monetary polices are still expansionary. I am grateful to Kurt Richebächer for having recently pointed out that, in the US, in the fourth quarter of 2005, non-financial credit expanded at a new annual record rate of US$2,445.7 billion.

According to Richebächer, this compares with US$1,710.5 billion in the second quarter of 2004, at the end of which the Fed started its rate hikes. Financial credit increased US$1,224.4 billion, as against US$932.7 billion in the second quarter of 2004. In aggregate, overall financial and non-financial credit growth accelerated over this period of rate hikes from US$2,643.2 billion in the second quarter of 2004 to US$3,670.1 billion in the fourth quarter of 2005. In percentage terms, borrowing and lending increased a staggering 38.9%.

According to Richebächer, “the fact to see is that all the rate hikes were undertaken in [the] complete absence of any monetary tightening. Plainly, the Fed has readily provided any bank reserves that the financial system has needed to maintain its credit expansion. It is a farce of monetary tightening. For all of 2005, total credit expanded by $3,340 trillion, to $40,230 trillion, up more than $500 billion from 2004’s record $2,818 trillion increase. For comparison, annual total credit growth averaged $1,237 trillion during the 1990s. Trying to capture the dynamics, we compare the credit expansion with the simultaneous increase in real and nominal GDP. Well, in real terms, it was up $378.9 billion in 2005, and in current dollars, 751.4 billion.”

So, in order to generate nominal GDP growth of US$751 billion, in 2005, total credit market debt had to increase by US$3,340 trillion — 4.4 times faster than GDP. Now, as is the case for the current account deficit, which hovers around 7% of GDP at present, the optimists will say that debt growth that is four times larger than GDP growth is sustainable. This may be the case for now, but the point is that, in the 1950s and 1960s, debt and GDP grew at about the same rate, with the result that in 1980, when Paul Volcker tightened meaningfully, total credit market debt was “only” about 130% of GDP.

Then, in the 1980s, debt grew at about two-and-a-half times GDP, in the 1990s at about three times GDP, and now at more than four times. In other words, as GaveKal Research pointed out, in order to sustain the asset bull markets and the economic expansion, debt growth will have to accelerate soon to initially five times GDP, later to six times, and if we extrapolate the trend that has prevailed since the 1960s, eventually to more than 20 times GDP.

Similarly, the current account deficit, which grew from 2% of GDP in 1998 to around 7% of GDP, would have to triple to around 20% of GDP in the next five to seven years in order to sustain the growth rates in foreign official dollar reserves (global liquidity) and economic growth around the world, if the recent trend is extrapolated. Also not forgotten is the US saving rate, which declined from an average of 9% in the 1970s to less than zero at present and turbo- charged the economy. If the stimulative economic impact of a declining saving rate is to be maintained, the saving rate will eventually have to be at around –10%.

Now, you don’t need to be an economist with a Harvard education to see that these trends are not sustainable in the long run. However, it is my belief that the Fed, and other central banks which are at least as agile at printing money as the Fed is, will try to postpone the hour of truth by a renewed massive liquidity injection when the next recession arrives. So, my concern remains the same: before the final debt crisis hits, we might see very high rates of inflation — most likely hyperinflation, with all asset and consumer prices soaring (amidst falling real incomes).

By Dr Marc Faber in Whiskey and Gunpowder.

http://www.amconmag.com/2006/2006_07_31/article1.html

July 31, 2006 Issue

Copyright © 2006 The American Conservative

Borrowed Empire

The dollar won’t necessarily collapse if oil is billed in euros—but our crushing trade deficits might do the trick.

By Paul Craig Roberts

In recent months a hot topic on Internet sites has been speculation that Iran will instigate a collapse of the dollar’s value by billing its oil in euros. As the argument goes, Iran’s desertion of the U.S. dollar would be followed by other oil producers, bringing to an end America’s financial hegemony and severely affecting the living standards of most Americans. This Iranian threat is often said to be a main reason for Bush administration plans to attack Iran. Saddam Hussein is said to have provoked the Bush administration’s attack on Iraq by harboring the same intention to switch oil bills to euros from dollars.

This argument assumes that the cost to the U.S. of oil being billed in euros is so great that it makes worthwhile wars of aggression that are illegal under international law, that turn most of the world against the U.S. and destroy its soft power, and that have massive financial costs running in the hundreds of billions of dollars—with no clear end in sight. Would abandonment of the dollar as oil currency impose costs greater than these on the U.S.?

The change, if it were to happen, would not be the catastrophe that some people believe. Saudi Arabia and the oil sheikdoms are too much in the American pocket to follow an Iranian move to euros, and the Europeans, faced with Asian competition, do not want a stronger euro. Moreover, the real question is not the currency in which oil is billed but whether foreigners find it desirable to continue to accumulate and to hold dollar-denominated assets—stocks, real estate, bonds, and U.S. companies. America’s oil bill is dwarfed by the size of the U.S. trade and current account deficits. If the United States continues to run budget and trade deficits, foreigners’ investment portfolios can become so loaded with dollar-based assets that they cease to acquire them. That is what would lead to a sharp fall in the dollar’s value and, perhaps, to the end of the dollar’s role as world reserve currency.

I am not saying that a move by Iran and other oil producers to euros would have no effect on the dollar. Such a development would result in a lower transaction demand for dollars as a means of payment. But the real question is: what do oil producers and the rest of the world do with the dollars associated with America’s large trade and budget deficits?

The deficit in our trade imbalance due to mineral fuels is small compared to the deficit due to our imports of manufactured goods. In 2005, the U.S. trade deficit in manufactured goods was $506 billion, almost twice as large as the $260 billion deficit for mineral fuels. Those speculating about the currency of oil bills could paint a darker picture by worrying about the currency used to pay bills for manufactured goods.

The fundamental point overlooked by worries about an Iranian oil bourse is that oil is billed in dollars because the dollar is the reserve currency and, thereby, is acceptable as the means of international settlements. What is likely to dethrone the dollar is not Iran but Washington. Reveling in neocon hubris, not even Republicans any longer worry about deficits.

Deficits have different causes, and not all are equally worrisome. But the U.S. trade deficit is problematic for a variety of reasons. From 1990 through the first quarter of 2006, the U.S. trade deficit has accumulated to $4.7 trillion. For just the first quarter of 2006, the deficit is $208.7 billion—about twice the cost of one year’s worth of war in Iraq. The trade deficit measures U.S. consumption that is not matched by U.S. production. In other words, Americans together are consuming $2.3 billion more per day or $1,610,000 more per minute than they are producing.

Free-trade economists, who seem to specialize in apologizing for red ink, say that our trade deficit is a very positive thing. It represents, they assert, the rest of the world’s confidence in America’s economic future. These economists say that the American trade deficit is the necessary offset to the capital surplus caused by foreign investment rushing into the U.S.

There are circumstances in which this explanation of a trade deficit would be correct. However, it is not a correct interpretation of the present case. The current crop of deficit apologists misinterpret the U.S. capital surplus as real net foreign investment that is increasing America’s ability to produce and to grow. In actual fact, the majority of this foreign investment is merely a change of ownership of existing U.S. assets from Americans to foreigners. The United States is paying for its excess consumption of $2.3 billion per day by handing over the ownership of its existing wealth to foreigners. This worsens the current account deficit as the earnings on these assets now belong to overseas interests.

Another reason that our trade deficit is serious is that it has been growing faster than the economy—further evidence that foreign investment in the U.S. is primarily a change of ownership in existing assets and not new plants and equipment. In 1996, in real terms, the U.S. trade deficit was 1.0 percent of GDP. In 2005, it was 5.7 percent of GDP. In the first quarter of 2006, it was 5.9 percent of GDP. These are unprecedented percentages. When I was assistant secretary of the Treasury in the Reagan administration during 1981-82, the U.S. balance of trade varied between a surplus of 0.2 percent and a deficit of 0.2 percent.

One of the reasons for the unprecedented trade deficit is the offshoring of manufacturing and jobs. When U.S. corporations move production for American markets offshore and hire people in other countries to provide engineering and other services via high-speed Internet, goods and services that were produced in the U.S. are turned into imports. Free-trade economists who tout the benefits of Wal-Mart’s low-priced Chinese goods do not tell you that the price you pay at the counter is only part of the full price. The other parts of the price are the American jobs that are transferred to China and the ownership of American assets that is transferred to the Chinese in order to cover our large trade deficit.

The important question neglected by American policymakers is: at what point does the rest of the world decide that the accumulation of additional dollars is folly? Can the U.S. run a trade deficit of 10 percent of GDP and still remain the reserve currency?

The answer to the question depends in part on whether those accumulating U.S. assets see some means by which the United States can balance its trade. American economists, such as Fred Bergston, believe the U.S. can bring its trade into balance by reducing consumption, that is, by undergoing a recession that puts people out of work and reduces their ability to consume. However, Charles McMillion of MBG Information Services points out that this strategy ceased to work in the 2001 recession when the trade deficit actually increased. Why did Americans import more during recession? Do we see here the impact of offshoring and growing dependency on foreign-made goods?

Another way of reducing the trade deficit is to export more. But how does a country that is offshoring its production of goods and services export more? (By more I don’t mean in absolute terms but relative to imports.) It is possible that offshoring has permanently affected the tax base, the incentives of young people to enter the high-productivity and formerly high-paid occupations that are now offshored or filled with foreigners on work visas, and the ability of American industry to mass produce advanced technology products.

A third way of reducing the trade deficit is through dollar devaluation or the appreciation of the currencies of countries with whom we run trade deficits. But what magnitude of dollar depreciation is required to wipe out an annual trade deficit of $800 billion, and what impact would such a large decline in real purchasing power have on our living standards? Devaluation is like inflation. It raises the prices of everything with foreign-made components, which today is almost everything. Just imagine what a significant dollar devaluation would do to U.S. gasoline prices.

These serious questions are given short shrift by free-trade economists who answer with mantras.

Today Americans, whether or not they are aware of it, are under the control of a government determined to achieve U.S. hegemony over the world. Neocons in the Bush administration advocate military attacks on Iran, Syria, Pakistan, and Saudi Arabia. They threaten a pre-emptive nuclear attack on North Korea. Neocons worry that China might attain military parity with the U.S. by 2020 and advocate policies designed to wreck the Chinese advance. Writing in The Nation, Stephen F. Cohen documents the neocons’ drive to marginalize Russia and to assert U.S. hegemony in Russia’s legitimate sphere of influence. These aspirations are inordinate, as well as criminal, and they will bring America to ruin.

Neocons are ignorant and disdainful of economics. They assume that hegemony derives from military power and the will to use it ruthlessly. They do not understand that America’s supremacy derives from two rapidly diminishing resources—manufacturing supremacy and the dollar as world reserve currency.

America alone emerged from World War II with manufacturing capability. It is easy to dominate world trade when no one else can produce anything. The benefits that free-trade economists attribute to America’s postwar experience were due to the impairment of every other country’s ability to produce. Great Britain was impoverished by two world wars and overwhelmed with war debts. The Breton Woods agreement dethroned the British pound sterling and established the U.S. dollar as reserve currency. This has been the source of America’s strength.

It is a strength that is close to exhausted by chronic budget and trade deficits that have sorely abused the reserve currency role, while the neocons’ grand designs for hegemonic power completely ignore the diminished economic basis on which U.S. power rests. Today Asia, or even individual countries such as Japan or China, could easily topple American hegemony simply by dumping their holdings of U.S. Treasury bonds and abandoning the use of the dollar as reserve currency.

Tough-talking neocons who are creating conflict with our major bankers, such as China, and with energy-rich countries, such as Russia, are leading America into ruinous conflict that serves no sane purpose. Indeed, the U.S. could not even wage war in Iraq if the Chinese were not lending us the money. What Gordon Prather calls the “neocon-crazies” are likely to discover that the U.S. is about as hegemonic as Hitler was at Stalingrad—and the consequences of their will to power can be just as destructive for America.

http://www.asianews.it/view.php?l=en&art=6900

7 August, 2006
IRAN – ISRAELE – MIDDLE EAST
War scenarios: Iran, oil embargo and the collapse of the world’s financial system
by Maurizio d'Orlando

Fears are growing that the confrontation between Israel and Iran might escalate. An oil embargo might lead to the collapse of the world’s financial system.


Milan (AsiaNews) – As the intensity of the war between Israel and Hezbollah grows, so does the number of victims on both sides. Syria and Iran are de facto in the conflict. The latter is under scrutiny for its nuclear programme so much so that various economic observers are wondering whether the Mideast conflict might not spread and lead to the destruction of Iran’s nuclear plants.

Faced with pressures and criticism from the international community against its nuclear programme Iran has not hesitated from warning the world that if it is attacked it won’t shy away from using oil as a weapon.

At first glance such threats appear unrealistic and with little deterrence value. Iran’s share in oil exports is in fact relatively modest compared to total production and consumption in the world. Yet, if we take into consideration some issues that might cause mass mobilisation in the Islamic world there are risks that must be considered.

Oil at 200 dollars a barrel

If the Muhammad cartoons affair showed anything, it was the potential to mobilise Muslim masses on short notice. That controversy I think was probably a rehearsal, not unexpectedly carried out as the decision by the UN International Atomic Energy Agency to defer Iran’s uranium enrichment programme to the UN Security Council got nearer.

Should the current Israel-Lebanon crisis involve others, there are people in Tehran who do not lack ideas and imagination to find some reason for mass mobilisation, especially in Muslim countries.

With strong internal public pressures, Muslim leaders are likely to be forced to join an eventual Iranian oil embargo. With the sudden loss of a third of all oil supplies, crude prices would probably jump by 3-400 per cent from the current long term average of US$ 60 a barrel.

Even at the historic heights of US$ 75-77, oil prices have so far remained within reasonable limits given today’s political risks.

One reason may be that technical reasons have induced oil companies to trade in slightly lower prices and make money on the difference. But this small-scale trend might not survive serious jolts, i.e. Iran’s use of oil as weapon. Should this happen, oil prices might shoot up to US$ 180-200 a barrel.

This would push up the prices of other raw materials, including food staples like grains. Agricultural prices could go through the roof, especially if people started to hoard ahead of a possible, even limited, nuclear confrontation. In turn this might result in harvests being affected by nuclear winter.

Financial system in crisis

The impact on the world’s financial system would also be devastating. Rising prices for raw materials would inevitably generate inflation. The money supply or M3 (i.e. the quantity of money in the economy to purchase goods, services, and securities) levels are already at historic heights.

The US Federal Reserve has ceased publication of the US M3 monetary aggregate. The European central Bank is no longer paying attention to this parameter to prevent the US dollar from dropping too much vis-à-vis the euro. In Japan, the level of monetary supply has reached 260 per cent of GDP.

This suggests that the world economy might not be able to avoid Weimar-style hyperinflation or stratospheric interest rates that would snuff out the life of the real economy.

Manufacturing companies with listed shares might see their profitability drop like a stone as a result of the rapidly rising prices of raw material, pulling down stock values with them. The stability of the world’s financial and monetary system would be jeopardised.

Several studies have already pointed to the structural weaknesses of the existing financial and monetary system. In the last few years we have witnessed the meltdown of the Russian, Asian and Argentine economies, the ‘New Economy’ bubble burst, and major corporations like Enron and Parmalat as well as smaller ones like Swissair go belly up.

In case of the Mideast confrontation escalating, what would happen to financial derivatives (described by some as the bubble of bubbles)? ‘Derivates’ are financial contracts whose value is derived from the performance of assets (such as commodities, shares or bonds), interest rates, exchange rates, or indices to hedge against extreme or long-term events.

Under normal circumstances, hedging against risks covered by derivatives carries little risk, so much so that some small Italian municipalities have invested in such atypical contracts. However, should the Mideast conflict widen, what is usually considered improbable by financial analysts might become real. The entire system might be put at risk if this happens, especially if we consider that according to the Basle-based Bank for International Settlements (or BIS), which operates as an international organisation of central banks, the total value of ‘financial derivatives’ is 50 times the world GDP.

A war against the West

Each war is different from the last one. Nowadays we need not think about nuclear war in terms of the adversary’s total destruction as envisaged by cold war ‘Doomsday’ or ‘Judgement Day’ scenarios. A feasible war aim today might be undermining the financial and economic system of the West.

In the current crisis, the two contenders, Israel and Iran, seem certain that they are going to prevail over the other; Israel through US support, and Iran by mobilising Muslim public opinion as well harnessing support from countries like Venezuela but also China and perhaps India which have reservations about the existing system or want to replace it with their own.

For this reason, Israel used the understandable indignation over the abduction of its two soldiers and then enemy rocket attacks, which are routine along the border, to carry out a pre-planned invasion.

For the same reason, Iran has taken advantage of every opportunity to provoke with its statements on the Holocaust and Israel’s creation, or by financing the Iraqi insurgency and Hezbollah.

Both contenders seemingly want to precipitate things now. Israel knows that if it now loses the ‘legitimacy’ of its nuclear monopoly in the region, it would never regain it. Iran knows that only now it can wield the oil weapon and profit from the weakness of the financial system of the West. Above all, only now can Muslim masses be mobilised for nothing is certain about what the future has in store since Muslim countries are also changing.

Meanwhile oil traders are talking sotto voce about a hot confrontation between mid-September and early December, one that might even go nuclear. Let us hope that it is all barnyard chatter. Let us hope the world heeds the words of the pope. Let us hope, if nothing else, that the world will look out for its own self-interest.

http://www.economyincrisis.org/showarticle.asp?ID=1046

America And The Dollar Illusion

By Gabor Steingart

The two things investors crave most are high yields and high security. Since you can never have both at the same time, the moods of investors are like an emotional roller coaster. They shift constantly from fear to greed and back -- although major investors, like corporations and states, clearly prefer security over fancy returns. Their fear is stronger than their greed. They'll freely relinquish the really fat profits as long as the stability of their billions is guaranteed. They're afraid of political unrest, they loathe overly dramatic changes in currency value and the mere thought of creeping inflation sends them into a state of panic.

Few countries are able to provide the greatest possible security in the face of these dangers. They include the United States and Switzerland. Indeed, this security is why the dollar isn't just used in trading and investment, but also functions as the world's reserve currency. Almost every country in the world distrusts its own currency to the extent that it prefers to invest the money from its treasury in the United States.

One can almost completely rule out the possibility of political unrest in the United States. Inflation is combated by the Federal Reserve Bank. Given the size of the currency's spread and the quantity of dollars circulating worldwide, speculators have no cause to get overly anxious about the dollar.

Thus, those who have money prefer to keep it in dollars. The United States disposes of a virtual monopoly on the commodity called security. For many investors, purchasing a US government bond is nothing other than a way of preserving their money. In 2005, only 20 percent of all currency reserves in the world were held in euros, whereas more than 60 percent were held in dollars. The introduction of the euro was a considerable success, and one should not downplay it. Nevertheless, the dollar has remained the world's currency anchor. As long as this anchor rests firmly on the ocean floor, stability is guaranteed for the national economies that invest in the dollar.

But if that anchor should tear itself loose and begin to drift freely in the ocean of global finance, the chaos that ensues would result in trouble for more than just exchange rates.

Buying to avoid selling

But why are the same traders who used to purchase products now so mad about dollar bills? Why do they rely on the good called security -- a commodity whose quantity cannot be increased at all? Doesn't every business student learn that the currency of a country is only as stable -- and hence as valuable -- as what the national economy of that country has to offer and produces? Does no one see that the tension between the dream and the reality is increasing and that this tension will snap, leading to suffering for millions?

Of course they see it! Investors can see what is happening. They wonder about it and shake their heads. It even scares them a little, sending chills down their spine. But they keep buying dollars as though possessed. The greater their doubts, the more greedily they order dollars. Indeed, that's exactly what is so crazy about these investors and their behavior: The client isn't just a client. He creates the security he's purchasing by the very act of purchasing it. If he were to stop buying dollars tomorrow, suspicion about the currency would spread and insecurity would grow. Then the dream would end. The dollar would start to falter and all the wealth held in dollars would lose its value. Of course, that's not something investors want to see happen.

The only way to fight a weak dollar is to strengthen it. Many people no longer care whether the US currency still justifies the faith people seem to have in it. The new game, which amounts to playing with fire, works exactly the other way around: The dollar deserves the faith it gets because otherwise it loses that faith. Dollars are bought so they don't have to be sold. The dollar is strong because that's the only thing that can prevent it from growing weak. Reality is ignored because only by ignoring it can the dream come true. Or, to put it still more clearly: Behaving irrationally has become rational behavior.

Everyone knows the danger

Of course, those playing this game know that, in the long term, currencies can't be stronger than the national economies from which they derive. Consumption without production, imports without exports, growth on credit -- these are all things that can't last in this world. Ken Rogoff, the former chief economist of the International Monetary Fund (IMF) and a man who thinks as clearly as he speaks brashly, recently criticized US economic policy even as he seemed to be praising it: Rogoff said the current boom in the United States is "the best economic recovery money can buy.

But if things have become that obvious, why aren't investors recoiling in fear? Why do foreigners, US presidents of all stripes and even Federal Reserve presidents known for their seriousness allow themselves to get involved in such a risky game, when the risk is that of destroying everything? Why aren't those mechanisms of market regulation functioning that are supposed to represent the advantage of the capitalist system over planned economies?

The answer is terrifyingly simple: Everyone knows how dangerous the game is, but continuing to play it strikes them as less dangerous than quitting. After all, what's to be gained from overreacting? Investors allowed themselves to get caught in the dollar trap years ago, and there's no easy way out. If they start taking their dollar bills and government bonds to the market themselves, they would lose money -- either gradually or all at once. They would like to avoid both scenarios, at least for a time. A president who does no more than recognize the situation as an important issue may lose his position as public discontent looks for a vent. Though the governors of the Federal Reserve Bank are under the strongest obligation to tell the truth, they have let the right moment for effective intervention slip by.

Waiting for the signal

Alan Greenspan, the legendary former chairman of the US Federal Reserve, did much to feed the dollar illusion. Whenever skepticism increased, he raised the key interest rate. Any rise in the key interest rate also serves as a sort of risk premium for those who took their chances by investing in the dollar. When doubts about the sustainability of US economic growth were heard, Greenspan set out to dispel them immediately. For a man better known for his mumbling and preference to keep people in the dark about the financial world, he spoke with remarkable precision. "Overall, the household sector seems to be in good shape," he said in October of 2004. If the global financial market's managers worship Greenspan, then it's at least partly because he's given their dream a lease on life of several more years.

His successor has no other option but to do the same thing. He knows that every piece of advice issued by someone in his position will have consequences. If he issues a warning about the skewed state of the economy, the warning itself instantly becomes a self-fulfilling prophecy. Even if he chooses a subtle formulation, the financial market will perfectly understand what he's saying. Everyone is waiting for the sign that the trend has reversed. No one is hoping for that sign, but no one can afford to miss it either.

At this point, a legitimate objection could be formulated: namely, that financial markets don't normally obey politicians. So why aren't the markets correcting themselves in this instance as they normally do? Who or what is preventing investors from behaving differently towards the dollar than they behaved towards New Economy stocks?

They're going to do it. The only question is when. Financial investors aren't tax collectors or accountants: Their job isn't that of a meticulous overseer. They love excess, and they regularly cause markets to overheat. After all, speculation is the business they're in, and being in that business involves living with the risk of going too far. Their professional attitude resembles that of race car drivers whose goal is victory and not avoiding accidents at all costs. What remains unclear is just how dramatic the crash will be. Experts have often forecast the effects of a dollar meltdown. If the downward trend were to begin, interest on credit would rise step by step in an attempt to curb devaluation. That way, the dollar crisis would spread from the world of currencies to the real world of factories, businesses and household accounts within days.

Major and minor private investments yield lower returns when interest rates climb. People would start to save, the economy would falter and eventually shrink. The first mass layoffs would arrive soon afterwards. US citizens would have to once more drastically reduce their level of consumption, as unemployment and waves of bankruptcy would shake up the country. Millions of households would become unable to pay back their bank loans. Then real estate prices and share values would begin to drop, having been overpriced for years and used as mortgages for consumer credit. When the real estate bubble bursts, consumption inevitably dwindles even further. The hunger for imports would fade, causing problems for exporting countries as well. It would only be a matter of days before newspapers would once more feature a term that seemed to have disappeared decades ago: world economic crisis.

Steroids for the giant

Last century, the United States already suffered from one deep economic crisis that gradually spread to the rest of the world. The Great Depression lasted 10 years and brought mass unemployment and starvation to the United States. The country's economic power sank by one-third. The crisis virus wrought havoc all over the West. Six million people were unemployed in Germany when the economic fever was at its peak.

Today's investors face a difficult choice, one they're not to be envied for. They can see the relative weakness of the US economy and they're registering the tectonic shifts in the world economy. They know that a great statistical effort is being made to prolong the American dream. For some time now, government statistics have announced sensational productivity leaps for the US economy -- productivity leaps that, strange as it may seem, haven't led to any rise in wages for years. This is in fact genuinely bizarre: Either capitalists are reaping the fruits of increased productivity all by themselves -- which would be a political scandal even in capitalism's heartland -- or the productivity leaps exist only on paper. There is much to suggest that the second hypothesis is correct.

Half the world is impressed by the low levels of unemployment in the United States. The other half knows that these statistics aren't official, but the result of a voluntary telephone survey. Many of those who declare themselves employed are assistants and day workers. Working just one hour a week is enough for one to be classified as "employed." Given that it's considered antisocial to declare yourself unemployed, the US statistics may well say more about American society's dominant norms than about its actual condition.

The US economy's high growth rates aren't to be completely trusted either. They are the result of high public and private debt. In no way do they express an increased output of domestically produced goods and services that the United States has achieved by its own strength. They say more about the successful sales ventures of Asians and Europeans. New loans taken by the US government were responsible for fully one-third of US economic growth in 2001. In 2003 they were responsible for a quarter. The United States is an economic giant on steroids -- doped so its decline in performance doesn't become too apparent.

Trust in God, market style

For capital market investors, reality isn't reality until the majority of investors are convinced it is reality and have begun reacting accordingly. Right now, everyone is watching everyone else closely. Everyone knows the dream of the stable economic superpower has ended, but everyone is keeping his eyes shut just a little longer.

Government bonds and shares don't have any objective value -- nothing you can see, weigh, taste or even eat. Their value is measured by investors' faith that the purchasing power of $1 million will still be $1 million 10 years from now, rather than having been reduced by half. This faith is measured on the markets almost every second -- and the measure used is nothing but the faith of other investors. As long as the faithful outnumber the skeptics, everything works out fine for the dollar (and the world economy). The trouble starts the day the scale begins to tip.

The process is complicated by the fact that investors aren't driven by blind faith alone. In part, it seems, hard facts also push them to extend their credit of trust a little longer. US economic growth -- an impressive figure on paper -- is an important benchmark. When it is high, investors feel reassured in their faith in the power of the US domestic economy to perform well. True, the trade balance deficit has skyrocketed since it first appeared in the mid-1970s. But the economy is growing steadily anyway, as the dreamers note with growing self-confidence. It may not be growing as rapidly as the Chinese economy, but it is growing twice as fast as the European economy.

And yet this benchmark is not as reliable as it seems. The faith investors have in the figure has actually helped create it. After all, the purchasing price of a government bond feeds almost directly into state consumption, just as the purchasing price of a share makes companies more inclined to consume. It also extends the credit basis of millions of private households -- which in turn boosts consumption. In this way, the expectations of investors -- including the expectation that the United States will continue to grow -- transform into certainties almost all by themselves.

In other words, the capital of trust creates the very growth rates it needs in order to justify itself. US economic growth, in fact, is fueled by ever-increasing consumer spending -- puzzling given that American wages are dropping as is industrial output. Still, everyone knows the answer to this riddle. The rise in consumption isn't based on an expansion of production, a rise in wages or even an increase in exports. To a large extent, it's based on the growing debt. But why do banks keep issuing credit? Because they accept the ever-increasing prices of stocks and real estate as a kind of collateral. A closed circuit of miraculous money minting has been created.

Self-delusion

The extent of this self-delusion can be read in the balance sheets of the banks: Almost no one is saving money in the United States today. The US foreign debt grows by about $1.5 billion every weekday and has now reached about $3 trillion. Private household debt, both at home and abroad, has reached $9 trillion -- and 40 percent of these debts has been incurred since 2001. The Americans are enjoying the present at the cost of selling off ever larger chunks of their future. Arguably, the imminent economic crisis is the most thoroughly predicted one in recent history. Rather than refuting the crisis, the current US economic boom merely heralds it.

Biologists have observed similar phenomena in plants contaminated by toxins. Before they wither, they produce one last batch of healthy shoots -- to the point that they can hardly be distinguished from healthy plants. Some speak of a panic bloom.

So who will be the first to destroy the dollar illusion? Aren't all investors bound together by an invisible link, since every attack on the key currency would lead to a loss of value for them, perhaps even destroying a large part of their financial assets? Why should the central banks of Japan or Beijing throw their dollars onto the market? What could make US pension funds wilfully destroy their wealth, held in dollars? What sense would it make to send the United States into a deep crisis when that crisis could drag all the other states along?

The underlying motive is the same as the one that once prompted investors to buy dollars -- fear. This time it is fear that someone else may be faster, fear that the dollar's strength won't last, fear that every day spent waiting may be one day too long. It's fear that the herd instinct of global financial markets will set in and overtake those who can't keep up.

Weaker than they say

These days, the dollar is making a lot of people uncomfortable. One morning many dollar-owners will wake up and look at the facts about the US economy without their rose-colored glasses -- just as private investors woke up one day and took an unflinching look at the New Economy, only to see companies whose market value couldn't be justified by even the most dramatic of profit increases. Some of the revenue forecasts that had been issued far exceeded the total value of the market. The Nasdaq presented the spectacle of a stock market whose added value increased by 1,000 percent in just a few years, when the nominal growth of the US economy during the same period was only 25 percent.

Greed triumphed over fear for a few years -- but then fear came back. The value of high-tech shares plummeted by more than 70 percent in just a few months, and they're still less than half as high as they were then. Even the Dow Jones, a stock market index based on the value of the largest US companies, was devalued by some 40 percent.

Much the same fate is in store for the dollar and for dollar loans. The United States has sold more security than it has to offer. The expectations traded will turn out to be valueless because they can't be met. Just as the New Economy was unable to provide investors with either the growth or the profits that had been predicted for investors, currency traders will one day have to admit that the economy backing the currency they sold is weaker than they claimed.

The crash can be deferred, but not stopped

The dependence of foreign central banks on the dollar will defer its crash, but it won't prevent it. Today's snowdrift will become tomorrow's avalanche. The masses of snow are already accumulating at breathtaking speed. The avalanche could happen tomorrow, in a few months or years from now. Much of what people today think is immortal will be buried by the global currency crisis -- perhaps even the leadership role of the United States.

Incidentally, the commission that former US President Bill Clinton created to investigate the negative balance of trade concluded in clear terms that the government has to do whatever it can to put an end to the growing disparity between imports and exports. It demanded that the public give up its optimism and return to realism, that people start saving again and that the state reduce its imports in order to prevent too hard a crash landing.

None of that has been done. In fact, what is being done is the opposite of everything the experts recommended. Debt is growing, imports are increasing and an optimism now lacking every basis in reality has become official state policy. Lester Thurow, a member of Clinton's commission, draws the sober conclusion that no one will believe the US balance of trade could produce a crisis "until it happens."


http://www.sphere.com/search?q=sphereit:ht...cquires-reddit/

http://www.vdare.com/roberts/061202_economic_problem.htm

December 02, 2006

America's New Economic Problem
By Paul Craig Roberts

Few economists have come to terms with the meaning that offshore production of goods and services has both for the US economy and for the operation of US economic policy.

One of the main reasons for the rapid expansion of the US trade imbalance is offshoring. When a company closes a plant in the US and moves its production for US markets offshore, domestic production is turned into imports. Some additional impacts of offshoring are rising foreign ownership of the US stock of capital, increased payments to foreigners that result from the growth in this ownership, and pressure on the US dollar's value and role as world reserve currency.

There is also impact on the efficacy of US economic policy tools. Traditional methods of stimulating consumer demand are now less effective. They might cause a rebound in sales, but the follow- through to domestic employment is diluted as the response to demand is met by foreign labor. There is now a large new "leakage," as increases in domestic demand are met by offshore production.

This leakage from offshore production is in addition to the traditional leakage from foreign trade. Economists have long understood that some part of rising consumer incomes during an economic recovery will be spent on imports and can result in leakage if the domestic economy is expanding more rapidly than the economies of trading partners, thus resulting in a trade deficit. With so many American brand name goods now produced offshore, a pickup in domestic demand immediately translates into jobs and wages for offshore workers. During the current economic recovery, three million US manufacturing jobs have been lost, hours worked have declined, and there has been no gain in real incomes for the vast majority of Americans.

Moreover, as US capital and technology are shifted to the employment of labor abroad, there is less boost to US consumer demand from productivity-based growth in real income. The effect, then, of offshoring production for US markets is to weaken the effectiveness of traditional economic policy tools.

As official US economic reports make clear, and as Charles McMillion at MBG Information Services has emphasized, the current economic expansion has been driven primarily by US household dis-savings and by government red ink. For the sixth consecutive quarter, consumer spending has exceeded total disposable income.

There are limits to a debt-based expansion. The housing boom, which stimulated consumer spending through refinancings, has come to an end, and more households have reached their limit on credit card debt.

As the high tax rates of the pre-Reagan era no longer exist, supply-side tax rate reductions cannot deliver the punch of a quarter century ago. Easy money can encourage more debt, but households have fewer assets and income streams to mortgage. New domestic investment spending by US business weakens as cheap foreign labor draws US capital, technology and business know-how abroad. The bulk of new foreign investment in the US consists primarily of the acquisition of existing assets rather than new investments in plant and equipment. Therefore, the move abroad of US capital and technology is not offset by foreign investment in the US.

The access of US corporations to low wage foreign labor has produced an effective divergence of interests between US shareholders and US labor. With stock prices and CEO remuneration closely tied to quarterly results, there is strong pressure to move jobs offshore in order to lower labor costs and improve reported earnings.

In the past unions and managements fought over the level of wages and benefits. However, most economists believed that wages were in keeping with labor productivity. With offshored production, the large excess supplies of labor in countries such as China and India keep wages associated with offshore production below the productivity of labor.

Consequently, the measures used in the US to determine the success and tenure of corporate management and boards result in a divergence between the interests of capital and labor that favors capital.

As the large excess supplies of Asian labor are unlikely to be absorbed except over the long-run, addressing the new American economic problem would seem to require a change in the criteria used to measure corporate success.

Economists refuse to acknowledge the problem, because they believe it has protectionist implications and that nothing can be worst than protectionism. Indeed, so many economists have emotional commitments to free trade and professional commitments to globalism, that they are incapable of acknowledging that there is a problem.

As Herman Daly and I have emphasized, offshoring is not a manifestation of free trade based on comparative advantage. Offshoring is labor arbitrage or capital's pursuit of absolute advantage in low cost labor.

Moreover, the classic case for free trade has troubles of its own. The case depends on two conditions that no longer exist: the relative immobility of capital internationally, and different relative cost ratios of producing tradable goods in different countries. Today capital is as internationally mobile as traded goods, and knowledge- based production functions are not affected by climate or geographical location. Their operation is the same regardless of location. New original work in trade theory by William Baumol and Ralph Gomory challenges the correctness of the classic case for free trade even when its two conditions are met.

The longer economists wait until they address the new economic problem, the more the ladders of upward mobility in the US will be dismantled and the more political stability will drain from the US. In the 21st century, US job growth as been restricted to domestic services. The longer the growth of new US jobs is restricted to domestic services, the more difficult it will be to restore job growth in export and import-competitive sectors of the economy and the more the US will come to resemble a third world economy.

I call on economists to get their heads out of the sand and to put on their thinking caps.

haha would have never expected a thread like this here.

used to work at a macro hedge fund... kind of miss it. only slightly tho, the stress is incredible.

i don't worry about the dollar as much as i used to. most of the free floating currency that is printed, a lot of it is being held down by treasuries and housing assets. its not out there floating around like many of these articles assume it is. inflation won't be a problem as long as central banks hold on to treasuries.

Dollar Dethroned By Red Ink

Will Congress allow President Bush to waste another year on his Iraq misadventure, while serious problems overwhelm the United States?

During 2006, while the U.S. government focused on the deteriorating situation in Iraq, the U.S. dollar declined sharply against many currencies. By December, China's central bank was expressing its concern that the massive U.S. trade deficit could lead to a run on the dollar and to an international financial crisis.

Since WW II, the U.S. dollar has been the world's reserve currency, the currency in which oil is billed and international trade accounts are settled.

The low U.S. saving rate means that Washington's budget deficits must be financed by foreign lenders, who are awash in U.S. Treasury bonds. The massive U.S. trade deficit means that foreigners acquire U.S. assets as payment for U.S. consumption of goods made abroad.

Foreigners are worried about their large dollar holdings because there is no indication that the United States can reduce either deficit. The war against Iraq has run up the U.S. budget deficit, and the practice of U.S. corporations of producing offshore for their U.S. markets has increased the U.S. trade deficit. Every time a U.S. company moves its production abroad, domestic output is turned into imports.

China has indicated that it will continue to accumulate dollars, but at a slower rate by trading some of the dollars for other currencies.

On Dec. 18, Iran announced that it will cease to use the U.S. dollar as reserve currency.

On Dec. 28, United Arab Emirates, a close U.S. ally, announced that the weakening U.S. dollar has caused its central bank to move some of its foreign exchange reserves from dollars to euros.

The decisions of foreign central banks to reduce the rate at which they acquire dollars implies higher U.S. interest rates at a time when the U.S. economy is slowing, making it difficult for the Federal Reserve to ease monetary policy and more expensive for the United States to borrow.

If foreigners take the next step and begin dumping their dollar holdings, there is nothing the U.S. government can do to avert the catastrophe. Washington must take steps before it is too late.

The only timely solution is to reduce the U.S. budget deficit. This requires Congress to cut spending or raise taxes, or both. Raising taxes on a weakening economy is not a good idea. As entitlements (Social Security and Medicare) comprise most of non-defense spending, the easiest step for Congress to take is to stop funding Bush's pointless war. With less red ink to be financed, there would be less pressure on the dollar.

It is possible that Washington has waited too long to address the dollar problem. If 2007 brings recession to the United States, the rise in the budget deficit from the loss of tax revenues could offset deficit reduction achieved by ending the war.

Many economists offer false solutions. We hear, for example, that a weaker dollar will lead to more exports and a reduction in the U.S. trade deficit. This "solution" overlooks the impact of offshoring. With so many U.S. brand-name manufactures now produced offshore, there is less for the United States to export. Some economists still believe that the gap can be filled by the export of services, but offshoring has also taken its toll on professional services. The United States cannot simultaneously offshore the production of goods and services and reduce its trade deficit.

Other economists still think that the Federal Reserve can rescue the dollar by raising interest rates, thus making U.S. Treasuries more attractive to foreigners. However, the U.S. economy shows many signs of weakening. By stifling growth or provoking recession, higher interest rates can simply generate more red ink that must be financed by foreign borrowing, thus increasing the pressure on the dollar.

The United States cannot afford the Iraq war, and it cannot afford the distraction from the serious economic problems that a war-obsessed government has permitted to accumulate. Offshoring is destroying the ladders of upward mobility that made America an opportunity society.

Economists, in their commitment to offshoring, offer "solutions" that conceal offshoring's real impact on Americans. For example, we are told that education is the solution to "America's competitiveness problem." People who advance the education solution are obviously unfamiliar with the character of U.S. job growth in the 21st century and with the Bureau of Labor Statistics' predictions of the areas of job growth over the next decade.

The problem America faces is not a lack of educated people, but a lack of jobs for educated people. In the 21st century, the U.S. economy has been able to create net new jobs only in domestic services, such as waitresses, bartenders, and health and social services. The vast majority of these jobs does not require a college education and does not produce tradable goods and services that could be exported or substituted for imports. Income inequality is worsening as CEO pay soars, while median income stagnates.

This new year will be the fifth that the American people will have let President Bush commit their country to an illegitimate war that cannot be won. Will the United States extract itself from Bush's misadventure and address its real problems, or will the dollar's decline bring new economic hardships?



This article can be found at:
http://www.economyincrisis.org/showarticle.asp?ID=1063

© 2003-2006 Concerned Citizens, LLC

wow. this is very long.

I am taking an International Relations course.
this might come in handy!! Thanks a ton!

How the Fed Lost Control of Money Supply
by Axel Merk

The world is awash in money. This money has flown into all asset classes, from stocks to bonds, from real estate to commodities. In a world priced for perfection, should we enjoy the boom or prepare for a bust? Let us listen to Wall Street's adage and "follow the money."

After the tech bubble burst in 2000, policy makers in the U.S. and Asia set a train in motion they have now lost control over. In an effort to preserve U.S. consumer spending, the Federal Reserve (Fed) lowered interest rates; the Administration lowered taxes; and Asian policymakers kept their currencies artificially weak to subsidize exports to American consumers.

These policies have lead to one of the longest booms in consumer spending ever - U.S. consumer growth has not been negative since the early 1990s. However, it was credit expansion, rather than increased purchasing power, that has fueled the growth. Until about a year ago, consumers took advantage of abnormally low interest rates to print their own money by taking equity out of their homes. This source of money is drying up as home prices no longer rise and sub-prime lenders (those providing loans to financially weak consumers) are facing difficulties. More prudent homeowners have not yet been affected as they buy their home based on longer-term interest rates; until December these interest rates have stayed abnormally low. In recent weeks, these rates have ticked up significantly, and we may see the next and more severe round of pressure being exerted on the housing market. In this phase, we will see monetary contraction: money that has subsidized not only the real estate market, but also consumer spending, stocks, bonds and commodities may dissipate.

Why is it that asset prices have continued to soar despite the stall in home prices? Consumers have not been the only source of money creation. Corporate America is creating its share of money as cash flow positive businesses are piling up cash; but corporate CEOs seem to prefer to invest abroad, providing only limited stimulus to domestic money supply.

A massive source of money supply growth is purely of financial nature, it is volatility, or better: the lack thereof. Volatility in major markets was at or near record lows last year. With volatility low, risk premiums are low; when risk premiums are low, investors have an incentive to employ more leverage and still be within their risk comfort zone. What may seem like an abstract concept has propelled financial markets to the stratosphere.

Two groups that have been most aggressive at taking advantage of this are hedge funds and the issuers of credit derivatives. Take as an example, a report from the Financial Times last December: the paper reported that Citadel Investment Group, a manager of hedge funds, had $5.5 billion in interest expense on assets of only $13 billion. The hedge fund group routinely borrows as much as $100 billion. Note that this is only the leverage visible on the financial reports; the instruments invested in may themselves carry yet further leverage.

The world of credit derivatives has also seen explosive growth. European Central Bank (ECB) president Trichet at the World Economic Forum in Davos warned that the explosion of credit derivatives are a risk to the stability of financial markets. Specifically, he complained that the market under-prices their inherent risks. With risk premiums at record lows, issuers of credit derivatives can borrow money at or near the Fed Funds rate. And that in turn means that we do not need the Fed to print money, anyone can. That is precisely what has been happening; however, the credit created is not without risks; more often than not, credit derivatives contain risks that only the issuer properly understands.

A year ago, the Fed stopped publishing M3, a broad measure of money supply. Just because you lose control of something doesn't mean you shouldn't monitor it anymore. Of the major central banks around the world, only the ECB takes an active interest in money supply.

Why is it that the Fed doesn't intervene and try to stem excesses in the credit industry? We find the answer by circling back to the consumer: if the Fed were to do something about the spiraling credit expansion in the derivatives markets, the imposed tightening would quite likely hurt the consumer. Typically, a recession would not scare the Fed, but globalization has put the fear of deflation on Fed chairman Bernanke's table. Tight credit could cause a collapse in the housing market and in consumer spending; what has been a great boom would turn into a great bust.

The fear also spills over to the U.S. dollar: as a result of the current account deficit foreigners must purchase in excess of over $2 billion U.S. dollar denominated assets every single day, just to keep the dollar from falling. As the U.S. economy slows, foreigners may be more inclined to invest some of their money elsewhere. The rising price of gold reflects that many investors believe that the Fed rather see a continuation of monetary expansion than allowing a severe contraction. Fed chairman Bernanke has also made it clear in his publications that he favors monetary stimulus at the expense of the dollar to mitigate hardship on the population at large.

Market forces will try to bring this credit expansion to a halt. While a crisis scenario with an imploding hedge fund causing ripple effects through the financial sector is possible and likely, we don't need a crisis for the party to end. What we need is increased volatility which we have already seen in the commodities and bond markets; the equity and currency markets have also indicated volatility may be on its way back. As volatility increases, speculators are likely to pare down their leverage. In our assessment, the economic slowdown induced merely by an increase in volatility may be sufficient to encourage the Fed to ease monetary policy once again. Any easing in this context will, in our assessment, have negative implications for the dollar.

Investors interested in taking some chips off the table to prepare for potential turbulence in the financial markets may want to evaluate whether gold or a basket of hard currencies are suitable ways to add diversification to their portfolios. We manage the Merk Hard Currency Fund, a fund that seeks to profit from a potential decline in the dollar. To learn more about the Fund, or to subscribe to our free newsletter, please visit www.merkfund.com.

Axel Merk

Editor's Note: Axel Merk is manager of the Merk Hard Currency Fund, http://www.merkfund.com.



The US as leading currency manipulator
By Henry C K Liu

U.S. Current-Account Deficit Deserves Some Noise: John M. Berry

By John M. Berry

Feb. 22 (Bloomberg) -- To read the annual Economic Report of the President, one would think the whopping U.S. current- account deficit is no more than a minor bookkeeping entry of little importance to the future of the U.S. economy.

Yes, in the fourth quarter of 2005 the current-account deficit jumped to 7 percent of gross domestic product because of a surge in oil imports, though it came down a bit last year, says the 2007 report released by the president's Council of Economic Advisers on Feb. 12.

And what did that mean? Apparently not very much.

``Current-account deficits mean that domestic investment continues to exceed domestic saving, with foreigners financing the gap between the two,'' the report explains.

Harvard University economist Kenneth Rogoff, who is also a former chief economist of the International Monetary Fund, says he believes the current-account deficit is worth a good deal more comment than that. For one thing, it could lead to a plunge in the dollar, he warned recently.

``Many people have been asking why the dollar hasn't crashed yet,'' Rogoff said in a commentary posted Feb. 7 on a Web site of the U.K. newspaper, the Guardian.

``Will the United States ever face a bill for the string of massive trade deficits that it has been running for more than a decade? Including interest payments on past deficits, the tab for 2006 alone was over $800 billion dollars -- roughly 6.5 percent of U.S. gross national product,'' he said.

Dollar's Value

The need to finance the deficit means that ``U.S. borrowing now soaks up more than two-thirds of the combined excess savings of all the surplus countries in the world, including China, Japan, Germany and the OPEC states,'' Rogoff said.

According to the Federal Reserve's inflation-adjusted index of the dollar's value, compared to a broad trade weighted group of currencies, the U.S. currency has declined about 13 percent from a peak in early 2002. However, that slow depreciation hasn't had nearly enough impact on the price of exports to this country or to the price of U.S. goods and services sold abroad to reduce U.S. trade deficits.

The Commerce Department reported on Feb. 13 that the 2006 trade deficit was $763.6 billion, $46.9 billion higher than in 2005.

Details of the 2006 current-account deficit -- which includes the balance on goods and services plus more than $80 billion in remittances sent home by immigrants working in the U.S. and a growing deficit on net income flows -- will be released on March 13.

Negative Saving

As the Economic Report of the President says, the current- account deficit, in national income accounting terms, is also equal to the inadequacy of U.S. saving to finance investment in this country.

Last year, personal saving by Americans out of their disposable income was negative. That is, they spent about 1 percent more than their after-tax income. The federal government also ``dissaved'' by running a large budget deficit. In contrast, the business sector, which is normally a net borrower, was a net saver.

As Rogoff put it in his commentary, ``America's government and consumers have been engaged in a never-ending consumption binge.''

``Overall, after almost 25 years of stunning prosperity, punctuated by only two mild recessions, most Americans feel pretty confident about their economic situation,'' he said. ``So it is not surprising that private consumption continues to hold up even as U.S. economic growth has shifted into lower gear.

Parking Money

``People have enjoyed such huge capital gains over the past decade that most feel like gamblers on a long winning streak. By now, they see themselves as playing with the house's (or their houses') money,'' Rogoff said.

``It is less easy to rationalize why the U.S. government is continuing to run budget deficits despite a cyclical boom,'' he added.

Rogoff said surplus countries are willing to keep pouring money into U.S. coffers because they aren't able to use all their own savings. ``The net result is that money is being parked temporarily in low-yield investments in the U.S., although this cannot be the long-run trend.''

Nevertheless, the status-quo might last for some time -- at least as long as world economic growth remains strong and there are no major recessions or financial crises, he said.

Under those circumstances, the dollar could decline very slowly. On the other hand, ``it is not hard to imagine scenarios in which the dollar collapses,'' Rogoff said. ``Nuclear terrorism, a slowdown in China, or a sharp escalation of violence in the Middle East could all blow the lid off the current economic dynamic.''

Ending the Binge

Plenty of economists predicted several years ago that rising current-account deficits wouldn't and couldn't continue. Yet they have, and that fact, not unreasonably, has made most economists extremely wary about predicting when the U.S. current-account deficit will begin to shrink or what that would mean for the U.S. and the world economies.

Still the large current-account deficit represents such a enormous imbalance that at some point it must stabilize and probably begin to reverse itself. At that point, consumption, investment and the federal budget deficit, in some combination, will be affected. In other words, the 25-year binge will end.

Yes, one would think that prospect would have been worth more than a couple of paragraphs in the Economic Report of the President.

(John M. Berry is a Bloomberg News columnist. The opinions expressed are his own.)

http://www.atimes.com/atimes/Global_Economy/IB27Dj02.html
Feb 27, 2007

The US, the world's hedge fund
By Max Fraad Wolff

There are some strange facts about the asset and trade positions of the US economy in the globalizing economy. The United States runs massive and growing trade deficits, is borrowing at a clip that would arouse the suspicions of a casino pit boss, and has been selling its assets to anyone who will buy. In the past 24 months, the US balance on goods and services comes in just shy of negative-$1.5 trillion. Across the same period, the US has sunk further into debt to the rest of the world.

For 2006, exports of US$1.4378 trillion and imports of $2.2014 trillion resulted in a goods and services deficit of $763.6 billion, $46.9 billion more than the 2005 deficit of $716.7 billion. For goods, exports were $1.0237 trillion and imports were $1.8598 trillion, resulting in a goods deficit of $836.1 billion, $53.3 billion more than the 2005 deficit of $782.7 billion.

As a result of that shortfall the US has been selling assets and borrowing. The net international investment position (NIIP) is the Bureau of Economic Analysis's broadest measure of US-owned foreign assets less foreign-owned US assets.

There has been a dramatic and sustained deterioration in the US NIIP over the past several decades. Between 1986 and 1988, the US transformed itself from creditor to the world to debtor extraordinaire. It has never looked back, nor has it been forced to.

The US has enjoyed positive net income from its increasingly larger negative total holding of foreign assets. This has partially insulated the US from instability, dollar plunges and rising interest rates. Declines in the US currency get help from those most hurt - foreign owners of US assets. As greenbacks fall, the US increases its positive income stream because the value of it assets rises and the value of the United States' liabilities falls.

US imports are linked closely to or pegged to the dollar and US export markets are less so. Thus falling dollars impose massive costs on asset holders and trading partners, reducing the regularity and severity of episodes. At least that has been true thus far. Spiking interest rates and falling dollars have neither regularly nor painfully recurred. There has been no forced rebalancing as economic theory suggests. Herein lies the source of much trouble, and many sound forecasts have gone awry.

Many have seen the growing negativity of net assets and predicted a coming dollar downdraft and violent rebalancing. Dollar slides have occurred - sometimes rapidly and to destabilizing effect. There have been episodes of rebalancing, but they are few and the trend is still clearly away from balance. The US NIIP has continued down, beyond the targets advertised as hard constraints. The US has avoided the forecast costs. How? Why?

There are many and complex answers to this question. Key among the factors is the United States' persistent ability to attract copious capital - at fairly low interest rates and with no risk premium associated with rising indebtedness. The US trade deficit's net outflow of dollars comes back as purchases of US assets and loans to US borrowers. The world buys US debt, at low yields and across maturities. They don't just buy, they hold. [1] They hold come hell or high water. The United States' foreign friends also undertake direct investment in the US.

Their returns, even unadjusted for currency, are terrible. US returns on foreign investment are much, much higher. It is estimated that US assets overseas outperformed foreign assets invested in the US by 210 basis points between 1952 and 2004 and by just shy of 300 basis points between 1973 and 2004. [2] Thus the United States' dwindling net assets are more than offset by vastly superior yields. It has helped the US that it tends to acquire riskier assets, equities and foreign direct investment (FDI), while they snap up debt. Rather amazingly, over past decades, the return to US FDI is more than 400 basis points higher than the return to foreign FDI in the US. [3]

The US is also allowed to borrow in dollars. US foreign assets are more than 75% non-dollar-denominated. This means the United States' assets grow and its liabilities shrink in value as the dollar falls. [4] Most important, the US has managed to earn more with fewer and fewer net foreign assets than foreigners have managed to earn with more and more net US assets.

In other times and places, such arrangements have been referred to as tribute, and were not handled through global "free" asset markets. Today they are. It might be worthy of note that the more unstable floating-exchange-rate period has been very kind to the US. Money comes to the US for safety and to fund the world's consumer demand. Thus the US invests according to portfolio theory, getting maximum cash returns, and they maximize across a broad range of non-cash-return considerations.

The net capital the US has deployed abroad is ever smaller relative to the net capital foreigners have deployed in the US. Both are rising fast in absolute terms. It is more than $2.6 trillion less as of the writing of this article. It was not until the fourth quarter of 2005 that US income receipts fell below US payments, despite trillions more in assets held by foreigners. There it has stayed for the last three quarters for which final data are available. The net income outflow remains tiny given the difference in size of net capital. The income shortfall was $3.8 billion in the third quarter of 2006, up from $2.2 billion in the second quarter of 2006. How can this be explained? What does it mean for it to end?

There are a few leading "explanations" for the superior returns of US assets abroad. The least interesting is called the "dark matter" theory and basically explains away the size of US NIIP as a failure to measure accurately complex and non-quantitative US assets held abroad. This merits little comment and recalls the classic line from Young Frankenstein, when the hunchback responds to the obvious question with, "What hump?"

On the more plausible side are explanations focused on the privileged and unique position of the US as the guarantor of liquidity and the printer of the global reserve currency. The US is able to borrow cheaply and lend dear with lower risk premiums attached to her debt. This allows the US to act as banker to the world, skimming off an "intermediation" fee that allows positive returns on portfolio maturity and quality composition. This has some explanatory power. However, it would seem the US is doing everything possible to cancel this advantage without appearing to lose the returns associated. A more rigorous and complex version of the history and measure of this oddity is well told with supporting data in "From World Banker to World Venture Capitalist" by Pierre-Olivier Gourinchas and Helene Rey. [2]

Gourinchas and Rey divide the reasons for persistent positive returns on declining US-owned assets abroad into two broad categories. The first source of positive returns has to do with the relative composition of US- versus foreign-held assets. The second has to do with the returns on these assets. Here we discover that the US has a preference for equity and FDI, while the rest of the world has accumulated trillions in US government debt securities.

The US holds riskier assets as a much larger portion of its portfolio. In addition, US FDI investment abroad earns much higher returns than foreign FDI in the US. The US runs much more leverage. Higher risk earns higher returns. The US even enjoys superior returns on its FDI compared with foreigners' FDI in the US.

The US functions like a leverage-loving hedge fund, hunting down and eating alpha. What this says about the others in the global portfolio allocation game, I leave to you to decide. All are acting in self-interest and all are aware of what they are doing. None seem to see a palatable alternative.

Others have added valuable elements to our understanding of NIIP anomalies. Some suggest that profits are reported outside the US where taxes are lower, artificially reducing the reported returns here. Many hold that foreign firms buy in the US for political reasons or to gain access to the US market. I would add funding the United States' trade shortfall as a leading motivation. Many who buy and hold do so to defend favorable exchange rates, curry favor and provide credit to the US state and consumer. This is a payment to continue the world economic and political order.

Before leaving you to ponder all this, we need to address what it means that the US is no longer above water in terms of the income from its negative net assets. It likely means building pressure on the dollar. If and when this occurs, it means pain to foreign creditors and possible political risk.

The sheer size of the US negative NIIP is flirting with offsetting the past advantage of positive net income. Rebalance will occur, US relative returns will rise further, or this former support will stay a drag. This signals the end of a support for the United States' over-indebtedness, although that may take time to manifest.

It raises a bigger question for the rest of the world. Why is it so vital for them to subsidize the US so much and for so long? What will happen to their swollen positions in low-yielding dollar assets? Last but not least, if the US is a leveraged hedge fund among nations, should Uncle Sam really be casting stones at the private firms mirroring US macroeconomic strategy?

Notes
1. Recently a troubling thing has been happening. Official holdings of US Treasuries have not been growing so rapidly and private holdings have taken their place. This may signal less stability of ownership at a future point.
2. Pierre-Olivier Gourinchas and Helen Rey, From World Banker to World Venture Capitalist. Presented 2005, National Bureau of Economic Research Conference on G7 Current Account Imbalances. Appendix Table 1.
3. Alexandra Heath, "What Explains the US Net Income Balance?" BIS Working Paper 223. January 2007.
4. If we were interested in scaring the rest of the world, particularly the big holders of dollar assets in Japan and China, we would repeat that line again and ask, "Are we all in this thing together?"


Max Fraad Wolff is a doctoral candidate in economics at the University of Massachusetts, Amherst and editor of the website GlobalMacroScope.

http://www.atimes.com/atimes/others/naked-hegemon.html
The Naked Hegemon, by Andre Gunder Frank

PART 1: Why the emperor has no clothes
With its unique privilege of being able to print the world's reserve currency at will and at a cost of nothing but the paper and ink it is printed on, the US would seem to be in a can't-lose position economically. But even the mighty dollar is not invulnerable to the massive debt caused by over-consumption, under-production and the Pentagon's global adventures. (Jan 5, '05)

PART 2: The center of the doughnut
There is no doubt that a collapse of the US dollar would have far-reaching effects, even as some are abandoning Uncle Sam's formerly safe haven for euros, yen and even yuan. But while the US-dominated economy gets hollowed out like a doughnut, Uncle Sam marches forward with his global vision. (Jan 6, '05)

Rep. Ron Paul, The End of Dollar Hegemony

Dollar Collapse

http://www.dailyreckoning.com/Featured/Ash032907.html

Mistrusting Money Whatever the Price


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"In the end, it took the Presidential executive order of April 5, 1933 to force U.S. citizens back into the dollar. President Roosevelt made gold ownership illegal, punishable by $10,000 fines and/or imprisonment."


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by Adrian Ash

"…Raising interest rates is supposed to restore confidence in a currency. But what if it fails like it failed in Mexico '94…Britain '92…and the U.S. in 1933…?"

On the morning of Wednesday, September 16, 1992, the Bank of England in London hiked U.K. interest rates from 10% to 12% - the biggest jump in more than eight years.

The Old Lady promised a further hike to 15% for later that same day, too.

Why the surge in borrowing costs? The Old Lady wasn't trying to kill inflation. She was trying instead to defend the pound sterling. Somebody had to.

Speculators across the world, most famously George Soros, had got it into their heads that Europe's exchange rate mechanism (ERM) - the precursor of today's Eurozone currency system - was about to collapse.

Britain was three years into a house-price collapse, and the ensuing recession had put more than a million people out of work. Both sterling and the Italian lira looked horribly over-valued inside the ERM's "trading bands" set two years earlier…or so the speculators thought.

And, as it turned out, the speculators were right. The Bank of England was wrong. By the close of trade on that autumn day in 1992, the United Kingdom had abandoned the ERM. It had also spent the equivalent of $1.6 billion, trying to prop up the pound.

George Soros, on the other hand, was $1 billion richer. And sterling interest rates were cut back to 10.5% the very next day.

Two years later, higher interest rates failed to defend the Mexican peso. The government in D.F. had squandered more than 80% of its foreign reserves in 1994 trying to prop up the currency. Its devaluation in December scared foreign investors so much that they deserted Mexican bond auctions despite interest rates topping 40%.

Yet again, the markets were right and the government was wrong. The Mexican peso had already lost half its value against the U.S. dollar in just 12 months. Over the next five years, it halved again.

This same mistrust of money at any price also whacked the U.S. dollar in the early 1930s…even as deflation hit and the value of money seemed to be rising.

The Great Depression led American citizens to hoard gold before cash. "During 1932 the U.S. Federal Reserve raised its discount rate to defend the dollar," as Sam Hewitt noted for Sun Valley Gold in a paper, 10 years ago. But fearing an imminent devaluation of the dollar, "the American public continued to hoard non-interest bearing gold."

The American public was right to fear devaluation - just as the sterling raiders and foreign investors fleeing the peso were right to mistrust rising interest rates, too.

In the end, it took the Presidential executive order of April 5, 1933 to force U.S. citizens back into the dollar. President Roosevelt made gold ownership illegal, punishable by $10,000 fines and/or imprisonment.

He also devalued the dollar by 40% at a stroke.

Fast forward to March 2007. Investors, householders, businesses and governments right across the developed world now refuse to hold cash. They'd rather spend it, gear it up for investment, lend it out or swap it for financial assets - any financial assets - rather than hoard it.

But no one's refusing to accept money in payment, not yet. So the issue of what it would take to restore confidence in official currency - including the dollar, sterling, euros, pesos and all the rest - looks purely academic. Today's disdain for paper currency remains a long way from loathing.

Right?

"Gold is a depletable resource," wrote David Ranson of H.C.Wainwright & Co. for a World Gold Council research paper in 2005, "and large discoveries are becoming increasingly rare. Thus gold's purchasing power will remain stable, and its role as a measuring rod will become still more secure."

Ranson's study found that changes in the price of gold bear a 0.50 correlation with consumer price inflation 12 months down the road. Oil prices, on the other hand, have only a 0.23 correlation with the cost of living one year later. That conclusion might be at odds with the received wisdom of CNBC and Bloomberg pundits. But rather than gold acting as "an inflation hedge", the metal in fact gives us a lead indicator of inflation in the cost of living.

Put it another way, and that means gold signals the forthcoming devaluation of paper money.

"Inflation is a monetary phenomenon," Ranson went on, "by which we mean it is governed by the purchasing power of a currency in terms of 'hard money' benchmarks. How to tell whether government actions are combating or accommodating inflation? Watch gold, not oil."

The U.S. Fed once knew this, too. And it might still today, according to the debate that rages over illegal manipulation of the gold price in the open market. But under Paul Volcker, the famously tall chairman from 1979-87, the Fed clearly saw gold as a barometer of inflationary expectations.

At one policy meeting in late '79, the Fed committee noted that "speculative activity" in the gold market was spilling over into other commodity markets. An official at the U.S. Treasury called the gold rush "a symptom of growing concern about world-wide inflation."

"There was a kind of great speculative pressure," said Volcker in a PBS interview of Sept. 2000. "We had to deal with inflation."

"It was the years when everybody wanted to buy collectibles from New York. The market was booming, and other markets of real things were booming - because people had got the feeling that things were inflating and there was no way you could stop it."

Volcker hit on one way of stopping inflationary expectations, however. He took U.S. interest rates to 19% and stopped the great gold speculation dead in its tracks.

His strong medicine also took real U.S. interest rates - above and beyond increases in the cost of living - to more than 9%. That destroyed long-dated bond prices, but no one wanted them anymore anyway. Treasury bonds had become known as "certificates of confiscation". Only high real returns, guaranteed by the U.S. government, could entice fresh finance via the bond market once again.

So far, no one's prescribing the same kind of strong medicine for paper money today. But how might this slow-motion destruction of confidence in government-issued currency be resolved in the long run?

It might take more than a few 0.25% hikes in interest rates. But if Washington were to make owning gold illegal once again - just as it did to defend the dollar in 1933 - at least U.S. investors now have the option of hoarding physical gold offshore…beyond the reach of their government's caprice and diktat.

Editor's Note: Adrian Ash is the City correspondent for The Daily Reckoning in London and is formerly the head of editorials at Fleet Street Publications Ltd. He has been studying and writing about the investment markets for the last 9 years, and is now head of research at BullionVault.com - giving you direct access to investment gold, vaulted in Zurich, on $3 spreads and 0.8% dealing fees.

Warning: Recession ahead
by Ron Cooke

http://www.dailyreckoning.com/Issues/2007/DR040507.html

THE NEXT GOLD STANDARD
by Nate Lewis

It appears that we are slowly drifting into a period of monetary turmoil. Turmoil leads to change, and ideally the result of a widespread desire for change will be the establishment of a new gold standard. Indeed, there are some indications that this may be achieved by the end of this year, although it may seem unlikely at this moment.

A necessary condition of a new gold standard is that at least a small group of people must understand what a gold standard is. So let's start with that.

Humans have used gold (and its adjunct silver) as money since prehistory because it is the one item best suited for this role. The primary reason being that gold's monetary value is stable, or at least more stable, than the alternatives.

It follows that anything whose value is linked to that of gold must, by definition, be as stable in value as gold. It is not particularly a stretch to link the value of a paper currency to gold. In fact, the world's first gold-linked "paper money" was made of clay, during Sumerian times, around 3500 BC. Clay tablets were used as warehouse receipts for gold, and traded among third parties.

It is not difficult to link the value of a paper currency to gold, even if the issuers of currency own no gold whatsoever. This is accomplished via the adjustment of the supply of currency, much like a currency board operates. Currency boards, such as those in use in Hong Kong or Estonia today, can just as easily and reliably link to gold instead of another currency.

One of the most straightforward ways to link the value of a currency to gold is to, quite simply, make the currency out of gold. In the past, when economies and currencies collapsed, people sometimes just started doing their business in gold and silver coins. Most of the dollar bills in the world today are actually being used outside the United States, and it appears that most of them are being used in under-the-table or even illegal activities of one sort or another. The popularity of the dollar outside the United States has been in steep decline in recent years, and many people that had used the dollar for their business have been transitioning to euros or other currencies. Apparently, some of these underworld elements have even begun to do their business in gold coins.

However, there really isn't enough gold in the world today to run today's economy with gold coins. And since all of the existing gold is already owned, the question is: what is everyone else going to use? Unless we are going to have a worldwide collapse of the most dramatic proportions, which would make the Great Depression look like a hiccup, it will be necessary to establish a paper currency linked to gold. A few governments have indicated a willingness to step up to the plate, including a number from the Islamic world who share the tradition of the gold dinar. Russia has also shown some interest. These incipient attempts have generally foundered on a lack of confidence in the technical ability to actually get the job done right - a conclusion which appears to be correct. It is better to have no gold standard than one that soon collapses due to incompetence. Operating a proper gold standard is easy, but it does take more than simply declaring a hope and crossing fingers.

That said it is also necessary to know how to create and maintain a viable gold standard. That is a subject rather more complicated than we can deal with in these pages, but at least we can now identify the steps along path from the present state of worsening chaos to the land of monetary milk and honey. If the man-in-the-street has the knowledge of why and how to operate a gold standard, governments will likely follow along. People get the government they deserve, it is said, and by increasing the average person's understanding they will come to deserve a better monetary system as well.

Another crucial stage will be to sweep away the encrustations of generations of misunderstanding of what a gold standard is supposed to accomplish. Many of today's gold standard advocates cling to the most implausible notions decade after decade, just as today's lovers of floating fiat currencies spout their own brand of ridiculous nonsense.

Here are some fallacies debunked:

A gold standard does not prevent a government from running a budget deficit. For example, the British government piled up impressive amounts of debt in the 18th and 19th centuries under a gold standard. A gold standard does not prevent a current account deficit, which is another term for the importation of capital. The United States ran a current account deficit in every single year of the 19th century, with a gold standard, as European capital flowed to the New World. In fact, a gold standard makes both government deficit financing and capital importation easier, because it tends to lead to lower interest rates and currency stability. As governments and other economic actors are forever engaged in all sorts of reprehensible behavior, and it is foolish to expect a gold standard to solve all those problems - just as it is foolish for the floating-currency advocates to think that the Fed can make any economic difficulty disappear by waving its magic wand over interest rates.

What can you do today? Imagine that a world of gold-linked money already exists. Things are considered politically impossible, but when they happen, and the historians call them inevitable. In this alternate universe, you can't even remember when Europe was a grab bag of over a dozen currencies. Now the euro is more commonly used in the world than even the U.S. dollar.

In this hypothetical world, the euro may be in turn replaced by the gold dinar, which got its start in Dubai in the autumn of 2007. The gold dinar was equivalent to one gram of gold. The Dubai Commerce Bank - it was supported by the government, which provided deposit insurance on amounts less than 5 kilograms - offered certificates of deposit in gold dinars, which proved popular as they paid 1% interest and were redeemable in gold bullion. (Exchange-traded funds based on these CDs almost immediately appeared worldwide. After deducting management fees, they paid a 0.80% dividend.) The bank then lent at 4.5%, in gold dinars. The gold dinar was quickly adopted as payment for oil exports throughout the Middle East, especially since the oil futures exchange in Dubai priced its crude oil contract in gold dinars. Soon the Middle Easterners were anxious to reinvest their oil revenues, leading them to make loans to governments and corporations around the world - loans (and bonds) denominated in gold dinars, of course.

Consequentially, governments and corporations were eager to borrow in gold dinars because they bore interest rates of only 3.5% for a ten-year bond for governments, and 4.5% for corporates, rates that were common in the 19th century. This was far better than borrowing in dollars or other local fiat currencies, which bore rates in excess of 15% due to worsening inflation. The trade-dependent countries such as Korea or Malaysia, which had always linked their currencies to those used in international trade, soon gravitated towards the gold dinar (local corporations were doing more and more of their financing in dinars), and eventually finalized their links via currency boards. China's sheer size and international ambitions were too great for that country to become a monetary vassal of Dubai, so China established an independent gold-linked currency. The gold yuan soon became popular in Africa, where it was received in payment for commodities exports. Because both the gold dinar and the gold yuan were linked to gold, their exchange rates were effectively fixed. Russia followed soon thereafter, with an independent gold ruble. Japan and Switzerland were next.

The Federal Reserve eventually raised its interest rate target to 85% in an attempt to support the dollar, but that policy was not able to counteract the dollar's worldwide rejection. Cindy Sheehan camped out in front of the Federal Reserve building, asking for a meeting with Chairman Bernanke. "I just want him to explain what 'In God We Trust' is supposed to mean," she told the media. She was soon joined by over two hundred others.

Despite becoming the first Chairman of the Federal Reserve to win a Nobel Prize in economics only six months earlier, Chairman Bernanke stepped down in disgrace, in the middle of his term. He then became president of the World Bank, replacing Paul Wolfowitz. Hyperinflation in the United States eventually led to a new political party, formed by dissatisfied Congresspeople from both the Republican and Democratic parties, which took a strictly Constitutionalist approach to monetary affairs. The unused Federal Reserve building in Washington DC was eventually converted into a museum of Native American art.

Regards,

Nate Lewis
for The Daily Reckoning

http://www.smirkingchimp.com/thread/7205
Post Mortem for the Stock Market
by Mike Whitney | May 2 2007 - 11:11am |

yeah we're probably standing on the edge or at the beginings of a global financial melt down

its gonna be a john teshed up ride

the latest from Henry CK Liu:

A Mute Strategic Economic Dialogue
Liquidity Boom Decouples US Equity Markets from the US Economy

[ur=http://www.prudentbear.com/articles/show/2044]Featured Commentary, by Ed McCarthy[/url]

Prosperity today at the cost of tomorrow's growth
June 18, 2007
Edmund M. McCarthy is President and CEO of Financial Risk Management Advisors Company. This piece was originally published in his newsletter.

Five Years Of Supposed Prosperity! Cost? Possibly The End Of About A Century Of Hegemony Inducing Growth?

China buys a piece of Blackstone, a company being perhaps the ultimate in capitalistic finance. When the Yellow Peril/Communists start buying the private equity players, something has certainly changed. Not too long after the gang in Beijing joined the rush to have their investments complemented by participation in leveraged buyout players, global interest rates started a significant climb. Coincidence? Time will tell but there has to be a suspicion that there is some congruity.

If you are a Kudlow and Co. disciple, the natural reaction is to continue to embrace “goldilocks” and utter or mutter, the old Mad comic’s character, Alfred E. Neuman’s” phrase, “What! Me Worry?”

If ridiculously Big numbers, comprising monstrous aggregations of capital/liquidity alarm you, the new acronym, SWF or Sovereign Wealth Funds comes very much to mind. Global reserve assets, including the pitiful $78 billion in the U.S., now total (Another Monstrous number), about $5.4 TRILLION. Of that total, approximately $2.5 Trillion are in or headed for one of these SWF creations. The purpose of having such an instrument for the sovereign creator is to enhance return on the pile. This isn’t done by continuing to sit in U.S. Treasuries where the return has been denuded by the crowded trade already in there with you.

We had the dotcom/telecom etc. bubble succeeded by the GSE induced residential bubble, succeeded by the structured finance/financial engineering residential bubble, succeeded by the CRE/financial engineering bubble, succeeded by the private equity/leveraged buyout/return of the conglomerateurs/no covenant, no guarantee bubble, and they were all looking a bit exhausted. Are we now to witness the SWF buys all of the foregoing bubble? Since the total amount of reserves available for growth and movement into these SWF’s is more or less the annual amount of the United States Current Account Deficit of $1 Trillion, on top of the aforementioned $2.5 Trillion approximately already thrown in, this could be an incredible self-sustaining bubble if only viewed from the aspect of resources and liquidity. In some of the more obscure financial publications, there has recently been some cognizance of this possibility. All this in aid of finding the next bubble since our past thoughts that we would run out of big enough new bubbles to keep the game humming have obviously been in error. It is also worthy of note that a requisite of a successor bubble is to have resource and leverage sufficient to equal or exceed its fading predecessor. Also, for the last five years or so, beneficent interest rates globally have been, at a minimum, a strong aid, perhaps an inherent necessity to this leverage addicted wealth creation methodology.

Most of the liquidity/inflation generated by the massive $1 Trillion+ U.S. annual foreign deficit has, so far, been channeled into: first, U.S. Treasuries and Agencies, and then corporate or other debt, with the local currency generated to purchase the $ going, until recently, into residential or commercial real estate and/or local equity markets. Neither the ROW (Rest of the World as it is called in the Federal Reserve Z1 report), nor the bubble blower (The United States) has had terribly painful domestic inflation at the consumer level. In fact, asset inflation in houses and investment indexes has been a pleasant trend for all of these nations.

As the ability to extend asset inflation bubbles reaches or exceeds market possibility, the inflation increasingly spills over into the more visible parts of the consumption economy. Central banks are increasingly forced to recognize the Hydra-headed monster they have accommodated, and raise rates/tighten liquidity. Some such as Kuwait and Syria have been so extreme as to sever their link to the $. New Zealand shocked the markets with an 8% short term rate. Euro rates and other global rates are up and/or rising and, it can be argued, are pushing up U.S. rates concomitantly. This is the counter force that we would argue will constrain the potential glee in the markets in anticipation of the Petro states, and The BRIC (Brazil, Russia, India and China) nations, as well as reserve rich others, such as Korea, Taiwan, maybe even Japan, from all buying their very own Blackstones. Obviously, should they be such buyers, with the leverage the Blackstone’s can employ, the limits to an SWF bubble are imponderable but truly immense.

Another restraint to this emerging new global bubble is the question of to whom do these reserve rich players sell their enormous holdings of U.S.$ Treasuries and Agencies, purchased, at the best, at breakeven yields today, with much of the portfolio surely underwater with Greenspan rates in effect for many of the last five years.

With the U.S creating well over a $Trillion of new sovereign paper in recent years, obligating the buyers thereof to create the equivalent in local currency and find a home for the dollars bought, the merry-go-round has been continuously working with the recycling of those dollars back into the sovereign or near sovereign (Agencies) debt of the U.S. There was thus a natural purchaser as the dollars issued by the U.S. Treasury. The SWF’s can be a disturbance on the merry-go-round as they look for Yale Endowment yields.

Yet another potential problem for those embracing “goldilocks” (Particularly for those surveying the global scene from behind the diaphanous blur of the United States knowledge screen) is the perhaps invidious state of the longstanding global reserve currency, the United States $. For going on a century, Seigneurage privileges (globally accepted) have enabled the U.S. to print money to pay global debts. This is a rare historic privilege accorded few sovereign entities. Even more rare is the status accorded the currency on emergence from World War II; that of sole hegemonic issuer. More rare still was continuing global acceptance when “Guns and Butter” Nixonian policies severed the currency’s last link to outside control of issuance, the supposed redemption availability in bullion. Basically, at that point, the global reserve currency stands on “The full faith and credit” of the U.S. Government. We forswear politics in these ramblings but would not be surprised if “some of the people, some of the time” are not as completely convinced of the value of such full faith and credit.

After a series of successes from the 1987 dip onward at thwarting any economic downturn with lowered rates and tsunami’s of liquidity, the Fedheads really went to an extreme with their 1% interest rates more than 5 years ago, ushering in the most massive global debt bubble, arguably, in the history of mankind. This crescendo of debt permits the globe to have simultaneously expanding economies virtually everywhere, a couple of exceptions such as Lebanon and Zimbabwe out there to be noticed by the few still thinking that a debt culture must eventually be constrained. As noted above, deluging liquidity everywhere has enabled simultaneous global expansion, unusual phenomena in the history of mankind.

A couple of thoughts here. The U.S. expansion, driven by the Fed cuts, and largely centered in 1.Real estate of all varieties 2. Buy-out/M&A/Leveraged lending. 3. Financial Engineering/Structured Finance creation, distribution and fee administration and investment and 4. The massive expenditures on Defense related and Security related to prosecute the ever-expanding utilization of militant activities. The cuts of interest rates by the Fed got this going. (Oh, we have forgotten the “saving” temporarily of such industries as “auto” with low interest rates.) There are signs of satiation and aggravating credit risk in the credit sensitive areas of these sectors. Oh, by the way, do any readers actually give credence to the Commerce Dept. consumer inflation statistics (If so, read John Williams’ “Shadow Government Statistics” to find the 10.2% REAL consumer inflation rate in the U.S.) In any event, the reported (not the nonsensical core) rates last week were demonstrating that lifestyle is being negatively impacted in the U.S. by dripover inflation.

The foreign central banks largely followed ours into the trough of rates. And their expansion started a little later. Asset inflation, as in the U.S., took over first. The two culprits in the U.S. stand out in the foreign markets: residential real estate and equity markets.

Nevertheless, the inevitable occurs; housing bubbles, affordability problems, equity bubbles that produce P/E’s that are untoward and, finally, lifestyle inflation that impinges on the central banks. As an example, the ECB, a central bank that actually has an inflation containment mandate in its constitution, is raising rates and warning of probable necessity to do more. A rising rate currency looks attractive to a stable one, possibly accounting for some $ defection in the recent past.

I met a young entrepreneur who opened and expanded a bikini factory in Brazil some years ago. The enterprise was/is a success, however, the climbing real is rendering him non-competitive. His solution: sell out to one or another of the private equity guys currently soliciting and go into the wealth management business. Such examples and the potential consequences are seldom seen in the U.S. media.

The Belief In Our Own Worldview Is Our Own Most Powerful Intellectual Imperative!

Here we hearken back to what we believe to be the consensus “worldview” in the U.S.; most particularly in the financial sectors thereof. Obviously not universal and imbued with the author’s prejudices, a construct thereof follows:

The U.S. economy is emerging from a “soft” landing. Although occasioned by the residential bubble in significant part, particularly sub-prime, that area is contained without widespread contagion and employment, production, efficiencies through privatization, growing exports and technological breakthroughs will lead to a new, burgeoning expansion.

Accompanying this renewal of “Goldilocks” seems to be a guiding belief that once out of the trough, another expansion similar to the pleasant 2002-2006 will follow as night follows day as has occurred for approximately 20 years.

This worldview, predicated on the Universal Empire the U. S. was at the beginning of the new millennia, is not a worldview shared by the ROW!
1. This 5-year period of prosperity, kicked off by the massively excessive Fed rate cuts and ensuing global liquidity started from a pitiful foreign reserve assets number globally (Much of which had been accumulated by Japan as it sought to recover from the bubble we taught them). The budget surpluses in the U.S. more than offset the then midget trade deficit, and the currency stood on a pinnacle. With the aforementioned exception of Japan and the inscrutable Swiss, the reserves and currencies of most of the rest of the world ranged from pitiful to disastrous. Argentina went on to a sovereign default and theft from creditors, Brazil devalued, Russia defaulted etc.,etc.

Five years later, the players have the aforementioned $5.4 Trillion in reserves and the U.S. currency is held aloft on generosity after an average fall in the 30% range. The domestic economy, driven by the afore-mentioned continuous bubble machines, has exhausted a debt laden U. S. consumer to continue to propel the machine. Foreclosures and defaults are hitting new records, not at the bottom of a recession but with record low unemployment rates. The only game still running at breakneck speed is the leveraged private equity play, still battening on low relative rates and tax advantages. The press of ROW, by and large, see and present this worldview in contrast to Bubblevision and Goldilocks.
2. We normally eschew the “It’s Different this time” approach as an exegesis for a thesis but find it necessary when confronted by the unprecedented.

Five years ago, the financial sector, both within the U.S. and globally, while having small entries into some of the following fields of risk and finance, was struggling to recover from the blows of the Asian debacle, the Russian default, 9/11 (although it actually served as an economic expansion ignition.), the 2000/2001 U.S. Recession and the afore-mentioned Latin imbroglios. True, the U.S. banking system had been hit by some, many or all of these, depending on the institution. Frankly, this opened the door for the previously intermediary giant Broker and Universal banks to vault into the new world of Financial Engineering/Structured Finance on a global basis.

Five years later, world finance has significantly and nearly totally changed. As an example, Fed NY Governor Corrigan only had to hit the rolodex for a dozen and a half names to suck up $4 Billion to stop the panic about LTCM. Today he admits that the number affected by a systemic event could go into very large numbers.

There really is no infrastructure in place to deal with a contagional systemic financial crisis! One has not yet occurred in the era of RMBS’S, ABS’S, CDO’S, CLO’S, SYNTHETIC CDO’, ‘S’S and the legions of forms of CDS’S and their progeny, CPDO’S, CPPS’S etc.

I recently looked at an 190 page report on this “market” which has enough other gibberish in it to confound any but the math ph’d’s who create, manipulate sell, buy and, occasionally run from this stuff. It is mindboggling. In previous efforts, we have described how BBB- securities can be transformed into 80% AAA. The weekend WSJ described how a fund of some of this stuff is coming unglued. One of the players, Merrill, has seized and is auctioning some of the collateral, impolitely screwing up “rescue” loans and other attempts to salvage. Mixed in will be some of the insurers, in front of the pension funds, endowments, foundations etc. presumably the ultimate owners of this smoldering wreck. Remember, we are at the beginning of the problem in residential real estate with still record employment! There is only some $7 Billion directly and peripherally mixed up in this Bear Stern’s directed vehicle, but it could serve as a eye-opening lesson as it burns on the way to sinking.

3. We mentioned the insurers above. At the beginning of the decade and in the early stages of the post 2000 downturn, these two entities guaranteed and/or absorbed into portfolios hundreds of billions per year in mortgages and mortgage-backed securities. Then it became apparent that the Financial results reported by these entities were suspect, that Management possessed less integrity and they were clueless as to the risks they were assuming. Investigations, Resignations and ability to provide limitless buying strength for the mortgage origination world disappeared!

The world of Financial Engineering/Structured Finance has largely operated without the two prior foremost liquidity providers, Fannie and Freddie, as they languished in Congressional hearings on their fraudulent or incompetent doings. They have recently re-emerged as large players as investigations came to a close, reparations were determined and some semblance of financial reporting was re-instated. The recent return of the yield curve to a positive slope has also been a tremendous help to these inveterate players of this type of curve with their Congress-given subsidy and their willingness to make noises about the alleviation of the Brokers sub-prime default and foreclosure-laden results to years of Financial Engineering/Structured Finance garbage.

In order to perform the legerdemain necessary to take less than investment grade and other slightly unsavory assets to the public type buyers described above, they had to throw in some sauce. This came, in the absence of the GSE’s from the private world of insurance, the AMBAC’s, MBIA’s, MGIC’s, RADIAN’s etc. Functioning in a not dissimilar way to the rating Agencies, these worthies would look a prospective issue over and then insure the higher rated tranches. Much like a GSE guarantee, such insurance would serve to make the issue palatable to the institutional buyer as all the due diligence necessary.

We were recently privileged to read an in depth credit review of the Insurer group with particular emphasis on the Ambac and MBIA numbers. We remember a scholarly look at MBIA a couple of years ago which would have given pause to thoughtful analysts except for coincidence with the Greenspan rush to Zero rate structure. The insurers have responded to slow times in the low rate environment by diving headlong into the Structured Finance world. The thing about insuring munis is that you either have taxing power (full faith and credit) or revenue generating capability (toll roads, airports) etc. It is not clear that these worthies fully understood that, in the absence of the appreciation which appeared to happen inevitably to houses in the immediate period in which they leapt headlong into insuring CDO’s composed of BBB- or equivalent to get them to AAA, that houses don’t mystically create debt service revenue, they eat it!

The leverage these critters have taken on historically may have been speculative when they were playing muni’s but it is outright outlandish in the game of Structured Finance. 900 to 1 leverage makes LTCM look cautious. Equity and Reserves are infinitesimal and not growing in proportion to the non-muni game they are playing.

The afore-mentioned analysis asks: “Who is holding the bag? In the game," and points to the insurers. Since a 10% drop in house prices wipes out their equity, we agree with the analysis that they are too slender a reed to support the ratings they carry and that there is going to be tremendous disillusionment when the axe falls. We would then repeat the question, Who is holding the bag? The ultimate buyers of these things are the ultimate bag holders, pension funds, the equivalent of Orange Counties all over the country, university endowments trying to emulate Yale, maybe the Gates Foundation but certainly the foundation industry and others seeking the yield in alternative investments that will pay for their commitments.

Not to be forgotten are the latter day monopolists, the rating agencies, Moody’s S&P, Fitch etc. Their revenue streams went ballistic when Wall Street created the Age Of Structured Finance. They get paid for rating. Isn’t there a conflict in here somewhere? In my days as a practicing credit guy, the watchword was that the rating agencies were a lagging indicator. I will never forget classifying a then fabled Texas bank substandard after a merger in the ‘80’s, only to have a giant argument with headquarters when Moody’s gave them a AA rating. They failed. Put all of this together and maybe this time it Is Different! Only not the kind of different I want to be a creditor of!

4. What else has happened while the United States happily built houses, bought cars and remodeled for the last five years as the Financial sector, particularly Wall Street, emerged as the most significant earnings stream in the S&P? Well, going back to that word used before, “worldview,” the U.S. convinced itself that the most important problem internationally was something called “The War on Terror." Hey, I’m against terror too. I just think it’s necessary to know and be sure who it is we need to go to war with. We don’t seem to have done too good a job on that front. It has been expensive but not effective. In a different “worldview”, the costs might have been ascertained in advance. The swing from a Federal surplus to a deficit, the curtailment of a current account deficit before it headed into dangerous territory, the maintenance of a sound currency, the maintenance of world/global respect and, at least, reasonably cordial relations with sovereign states all have a value to be measured, before lost, in pursuit of consumption and the War On Terror.


During this semi decade, the ROW, on its proverbial back when we began this crusade, reinvigorated. A possible “worldview” NOW must encompass a China with $1.3 Trillion in reserves and an industrial/manufacturing base of unbelievable proportions. Courtesy of Chian Kai Shek, their WW2 leader, they sit on the Security Council and are in a position to permit Iran to become what it wishes. Five years ago would have been a more propitious time for being bellicose about Iran. On the same Council is a Russia with $400 Billion in reserves, risen from the defaulting dead.

I don’t know a thing about Putin’s “soul” but I do know he and his Administration are ex-KGB, jingoistic about their nation, loaded with petroleum and still a powerhouse in terms of weaponry. We probably could have bought the weapons five years ago with a fraction of the funds since gone in the aforementioned War and its counterpart, the War on Drugs.

Net net, in the opinion of the writer, there is a very real danger that our worldview for the last five years has risked a century long hegemony as the reserve currency nation as well as creating a Credit Bubble, largely Unregulated, that has expanded far beyond the worst nightmares of the writer. It is also our opinion, as a long time credit troglodyte, that this bubble is leaking air and is in danger of bursting. With no infrastructure to deal with the first truly global bubble, we have an interesting time in front of us.

For the markets, global chill
It is no longer accurate to blame the current world equity-market selloff on the "subprimes", as if it were the case that if only that problem went away, everything would be fine. Rather, it's fear of the unknown that's driving the stampede - nobody knows how much bad debt the banks and brokerages have on their portfolios, or to what extent the ocean of easy money that propelled the recent boom has frozen over. - Julian Delasantellis (Jul 30, '07)

CHAN AKYA
Asia and the vicious cycle of bank bailouts
As with every market crisis, recent upheavals in global markets have claimed a host of victims in both US and European banking. The penchant of central banks to bail out their constituents undoubtedly predicates future crises for such banks as well as their countries. Asians can help end this vicious cycle by cutting their holdings of US and European bonds, and focusing on investments with high total returns. (Aug 10, '07)

Via Drudge:
Hedge funds braced for more pain

By Anuj Gangahar in New York and Kate Burgess in London

Published: August 12 2007 18:30 | Last updated: August 12 2007 18:30

The much-heralded financial rocket scientists responsible for the explosion in complex mathematical trading strategies are bracing themselves for fresh pain after what one team of analysts called “the perfect storm” last week.

Quantitative strategists, or “quants” as they are known, attempt to profit from pricing inefficiencies identified through mathematical models. These send buy and sell signals on small variations in price between different securities.

One hedge funds manager said the average quantitative fund manager was down about 15 per cent in the first few days of August.

“Nothing seems to be working. Previously uncorrelated factors have recently been falling with the same pace, leaving investors with very few places to hide,” said Citigroup analysts in a report to clients last week.

Hedge fund managers who have suffered in the first few days of August and late July include James Simons, long acknowledged as the “king of quants”, at Renaissance Technologies and Clifford Asness of AQR Capital Management. Quantitative managers at Goldman Sachs and Highbridge Capital Management have also experienced difficulties.

Statistical arbitrage funds have run into particular problems. Their mathematical models rely on past trading patterns to predict how particular securities will perform in the future if other securities, say, fall in price. But their models are unlikely to take into account current trading conditions where investors, desperate to raise cash, are selling everything they can.

They are also unwinding short positions, which means buying back stock they sold earlier. Thus, companies with poor prospects have seen shares rise and vice versa, undermining the logic of “stat arb” models. Compounding the problem is that many stat arb managers have borrowed heavily to buy shares.

One hedge fund manager estimated that statistical arbitrage funds with more than $100bn (€73bn, £49bn) in assets had on average borrowed four times their actual assets. These borrowings magnify significantly any moves they may make in the market.

It is these more heavily indebted statistical arbitrage funds that have proved most attractive for pension funds seeking supposedly lower risk hedge fund strategies.

It is also these funds that ran into problems at the end of July when volatility began to rock the market.

As volatility rose, they began to cut back their risk. They did this by selling out of their positions to reduce leverage.

But the wave of selling only exacerbated the problem by pushing down prices. As asset values fell, the ratio of debt to assets rose. This forced them to sell yet more assets.

One hedge fund manager said: “Nobody is happy with their credit position and everyone wants to de-risk and de-leverage. And it is global. The market has gone freaky”.

Analysts at Lehman Brothers said the problem was that investors’ models, its own included, were behaving in the opposite way to tried and tested predictions.

Central bank action calms investor nerves

By FT reporters

Published: August 12 2007 22:04 | Last updated: August 13 2007 07:00

Market jitters appeared to ease on Monday after the Bank of Japan injected a further Y600bn ($5.07bn, €3.7bn) in a concerted attempt by the world’s central banks to restore confidence in the global financial system.

On the Tokyo Stock Exchange the benchmark Nikkei 225 rose 0.5 per cent to 16,844.59 at the end of the morning session.

In Europe too confidence appeared to be returning after a harrowing week ended on Friday with billions wiped off the value of shares in the US and in Europe.

Financial bookmakers, or spread betters, in London were calling Britain’s FTSE 100, which had its worst day for four years on Friday, to open up as much as 1.4 per cent. Germany’s DAX is expected to open up as much as 1.3 per cent and France’s CAC 40 could gain up to 1.5 per cent at the open.

A sense of calm had begun to return to the markets in New York before Friday’s close after the Federal Reserve pumped an additional $38bn. The S&P 500 index closed up for the day and the week. The Dow Jones Industrial Average also finished higher for the week despite suffering losses on Friday. It closed down 0.2 per cent at 13,239.54. The Nasdaq also closed up on the week at 2,544.89.

Elsewhere in Asia, markets recovered from last week’s lows on Monday. A rebound in property stocks led the Hang Seng back from six week lows hit at the end of last week.

In South Korea, the key KOSPI, which was one of teh hardest hit markets at the end of last week, inched up 0.2 percent as market heavyweight Samsung Electronics and Kookmin Bank made small gains.

Australia’s S&P/ASX 200 index also rose. A 1.2 per cent advance was boosted by a rebound in the big four local banks including Commonwealth Bank. Top investment bank Macquarie Bank gained1.9 per cent.

The dollar, which made tentative gains last week on the back of interest in for US treasuries, slipped 0.1 percent from late US trade to 118.25 yen, holding off the four-month low of 117.19 yen hit on electronic trading platform EBS last week.

However, investors will be keen to keep an eye on the next move by the European Central Bank for clues on the direction of future interest rates.

Billions in dollar-denominated borrowing by European banks comes due in the next few days amid fears that US banks are unwilling to extend short-term credit to some of their European counterparts perceived to be vulnerable to the market turmoil.

One banker said: “The attitude is ‘don’t show me anything east of a [New York] 212-area code’. If youlendto [those banks],it could be a career-ending experience.”

Central bankers made it clear last week that they would step in to ensure funds were available to hold short-term interest rates close to their target levels.

In spite of market speculation that interest rates will soon be cut, they have given no indication that they will need to take such drastic action and see the current crunch partly as a welcome repricing of risk.

The Fed is likely to be sympathetic to an ECB request for a currency swap since it would be seen as a helpful way of dealing with pressure on the overnight federal funds rate caused by European banks’ thirst for dollars. It would be the first such arrangement between the world’s two biggest central banks since 2001.

Chris Furness, of 4Cast, the economic consultancy, said a swap would be “a market calming measure and would be logical in current situation”.

Conditions in the money markets are likely to remain extremely difficult in the coming days as there will be no let-up in the uncertainty over the scale and location of losses in derivatives markets, initially triggered by high default rates in US sub-prime mortgages.

Investors fear that some hedge funds and other institutions will soon have no option but to start a fire sale of their assets to cover losses on their portfolios. Any rapid liquidation of trading positions would exacerbate the volatility in financial markets.

Reporting by Krishna Guha in Washington, Michael Mackenzie and Anuj Gangahar in New York and Norma Cohen, Jennifer Hughes and Gillian Tett in London

U.S. Homeowner Woes Felt Around World

Aug 12, 4:45 PM (ET)

By MATT MOORE

FRANKFURT, Germany (AP) - The latest crisis in financial markets has once again served as a reminder of how vital and interconnected the health of the U.S. economy is to that of the rest of the world.

From New York to Frankfurt to Tokyo, markets were jolted in the past week by fears that Americans are failing to keep up with their mortgage payments and the ripple effects that could have on the global banking and financial system.

The fallout could further depress U.S. housing prices by making it harder to find buyers for a glut of foreclosed homes. That, coupled with a drop in the value of investments, could leave U.S. consumers feeling poorer and less likely to spend on domestic and imported goods.

"The sharp falls in global stock markets obviously affect consumer wealth, which again could dampen spending," said Howard Archer, chief British and European economist at Global Insight.

The most immediate effect for the half of all American households who own mutual funds and other individual investors worldwide is a decline in the value of their investments, which may or may not be short-lived.

Around the globe, small-time investors are taking a beating. Stock prices have slid in recent days as fears of the market crisis infected markets worldwide. Worried investors sold stocks but finding buyers was hard, which caused share prices to dip even lower.

"We all feel threatened, problems on the stock exchange have consequences for the economy of America and of the world" said Gabriella Savarini, a 69-year-old shopkeeper in Rome. "America influences all, for good or for bad."

The distress in the markets makes it harder and more expensive for businesses and consumers to get loans and cash, Archer said. If companies cannot get loans, they cannot expand and may have to cut expenses, typically through layoffs.

America faced a crisis similar to the current mortgage fiasco when hundreds of savings and loan companies went belly-up in the 1980s. Back then, the fallout did not spread dramatically to foreign shores because the U.S. government stepped in to bail out the banks and repay depositors.

But the past two decades have seen a quantum leap in globalization and outsourcing, crumbling trade barriers, and a revolution in financial markets have knit the world tightly together.

A steep sell-off in global markets on Thursday and Friday was triggered by distress signals from France's biggest bank, BNP Paribas, which had to freeze billions of dollars in assets in three mutual funds because of the falling value of securities linked to high-risk mortgages taken out by U.S. borrowers.

"I'm sitting here in Brazil and Brazilian markets have gotten crushed by this. ... It's hit all the emerging markets," said Kenneth Rogoff, a former director of research at the International Monetary Fund and now a professor at Harvard University. "If this were to snowball next week, it would affect markets in Turkey, Indonesia."

Global interdependency isn't a recent phenomenon: The Wall Street stock market crash of 1929 and the Great Depression affected the entire world, and helped create the conditions for the rise of fascism in Europe.

But with faster communications and real-time trading, market jitters in New York race around the world almost instantly today.

At the center of the concerns are high-risk loans to individuals or businesses made by banks globally.

More Americans are failing to keep up with their home mortgage payments, and there are concerns that this could ripple around the globe because much of the debt from mortgages has been packaged into securities sold to pension funds, banks and other investors who were hungry for high returns on investments.

The same mortgage securities in the U.S. that are crumbling in value are a part of bigger holdings that banks from Japan to Germany bought into because of low U.S. interest rates and a good returns. That is, until the mortgage holders started defaulting.

Meanwhile, the ability of banks to convert assets to cash quickly was in doubt because some were unable to track how much money they poured into now worthless securities backed by sub-prime U.S. mortgages, or loans made to high credit-risk individuals.

Those bad loans raised fears of broader credit troubles that could affect the entire banking and financial system - concerns that caused stock markets to plummet and threatened pensions.

The slide started innocuously in April after New Century Financial, a U.S. mortgage lender whose principle borrowers were Americans with less-than-stellar credit, filed for bankruptcy protection. Its customers were people who may have been late on credit card payments, maybe even filed bankruptcy in previous years, but still wanted a shot at buying their own home.

Lenders were only too happy to oblige - flush with cash and eager to exploit new markets so they could, in turn, lend more money and increase their profits.

Hedge funds and banks worldwide saw a market with opportunity and bought up mortgage-backed securities.

A month later, USB AG, the giant financial company, said its hedge fund business had lost $125 million in the first quarter largely on the back of investments in the U.S. sub-prime mortgage field. Then in July, Wall Street's Bear Stearns closed a pair of hedge funds after it lost more than $20 billion on mortgage-backed investments.

In early August, concerns mounted that those mortgage securities may not have been as solid as people thought.

Those fears were capped by the Aug. 6 bankruptcy by Melville, N.Y.-based American Home Mortgage Investment Corp. (AHM) American Home, once a major U.S. mortgage lender, said it fell victim to "extraordinary disruptions" that effectively cut off the funding it needed to make new loans.

On Thursday, France's biggest bank, BNP Paribas, froze $2.2 billion held in three funds because their exposure to sub-prime mortgages in the U.S. That intensified fears that risk was spreading worldwide.

With cash reserves running low, the interest rates that banks charge each other for overnight loans rose so steeply that central banks in the U.S., Europe and Asia poured tens of billions of dollars into the market to make sure enough cash was available to meet demand.

Such large-scale central bank interventions are rare - that last major injection came immediately after the Sept. 11 attacks in 2001.

---_

Associated Press writers John Leicester in Paris, Hiroko Tabuchi in Tokyo, Romina Spina in London, Teodora Teani in Rome, and Alan Zibel in Washington contributed to this report.

http://www.counterpunch.org/moses08112007.html

Weekend Edition
August 11 / 12, 2007
Behind the Banking Crisis is a Worker in Pain
SubPrime People

By GREG MOSES

Now that bankers of the world have been knocked sideways by American workers in pain – a phenomenon that goes by the name of the “subprime lending crisis” — will the bankers try to fix living conditions for people who make up the subprime base of the global economy? The answer of course is fat chance.

Having once again subprimed the pump of the global economy upon the backs of the most marginalized classes, the banker-driven conversation these days would have us forget the people whose feet are sliding and focus instead on questions of monetary policy. This is globalization as ideology, a mind-framing game that squeezes all it can from flesh and blood workers while denying their basic human value.

Asia Times economist Chan Akya, for example, admits that globalization has allowed bankers from Beijing, Geneva, and Los Angeles to simultaneously milk the labor of Mexican migrant workers in the USA. And he concurs with global consensus that hard times among subprime workers in the USA is the effective trigger for global market tremors. But with a cynical conclusion, he isolates the real pain of “subprime” humanity as a costly political problem to be laid at the feet of the USA administration, and encourages Asian-sphere financiers to turn their investments inward.

Akya’s conclusion is cynical because what remains untouched is the presumption that globalization should continue with top-down arrogance. He gives us no reason to believe, for example, that the increased bargaining power of newly withdrawn Asian financiers will be put to work on anyone’s behalf but bankers who are now able to throw pretty lights upon Tiananmen Square.

And Akya fails to make plain how much Asian bankers owe to American subprime workers who this past decade have been trading with China on a daily basis at Wal-Mart. In sum, Akya’s economics is seedling to the next world war, which is what happens when financiers draw lines between each other on a map.

A lot can be learned about the “subprime” crisis by browsing the abstracts of the Fannie Mae Foundation’s Housing Policy Debates (HPD). There we learn that subprime lending is shorthand for new racism in banking. Instead of “redlining” neighborhoods filled with struggling workers of color, bankers have for the past decade “subprimed” them — giving credit to these working poor at predatory rates (cf: Wyly HPD 15.3).

At the turn of the century, 16.8 percent of households in the USA lived in “housing induced poverty” – the kind of poverty that can be caused by predatory mortgage rates (Kutty HPD 16.1). At any point in time, social investment into these households could have slightly relieved the pain of inequality through housing-allowance entitlements, job improvements, or human rights (cf: Priemus HPD 16.3,4).

In fact, affordable housing helps to grow healthier children (Newman HPD 16.2), which is another way of saying that today’s predatory lending is already replicating tomorrow’s john teshed-over class. Is it any wonder therefore that subprime borrowers tend to be disenchanted with the home-owning experience?

The global lesson to be drawn from the subprime crisis is that bankers should be made to take interest in human development, not simply be allowed to extract interest from it, as they build their houses of cards. Or to put it another way, in a globalized world, banking policy is public policy. And public policy has no business taking lessons from predatory economic theories.

Bank bailouts, says Akya, can only damage the image of government. But bank bailouts in the form of mortgage vouchers given to “subprime” working peoples would surely bring us one step closer to globalization with a human heart.

Issuing housing allowances as entitlements has been tried in the Netherlands, and apparently it works well there (Priemus HPD 16.3,4). People who are secure in their housing are people who can afford to dream of better days to come, and such hope does good things for workers, their children, and — do we have to say it? — their employers, too.

Whether you belong to a Party that calls itself Republican, Democrat, or Communist, you could find some way to honestly repay subprime workers for carrying your whole world on their backs these past few years.

http://www.dailyreckoning.com/Issues/2007/DR081307.html

Superbanks to the Rescue

The Daily Reckoning
Courtomer, France
Monday, August 13, 2007

Keeping it real, dear reader…keeping it real…

Now we are going to see what a big mess central banks can make of things.

"Central banks seek to unblock markets," says a Financial Times report.

On Thursday and Friday of last week, the Bank of Japan, the European Central Bank, the Bank of Canada and the Fed all began to rise to the challenge. We saw one report that said the ECB had "injected" $215 billion into the system. Others said the Fed had put either $38 billion or $58 billion at work. And a Bloomberg item this morning says that Japan ponied-up $5 billion, which is already having a "calming effect" on Asian markets. Whatever the final numbers turn out to be, it is a lot of new liquidity in a short period of time - more than at any time since the days immediately following 9/11 in 2001. Lending by the New York Fed was so vigorous that the fed funds rate fell to just 1% - the lowest rate since 2004.

Alert Daily Reckoning readers may already be suspicious.

"Now wait a minute," they may be saying to themselves. "Wasn't this whole problem caused by too much liquidity in the first place? Isn't more liquidity going to make the situation worse?"

Bingo!

Oh, dear reader, what a joy it is to watch central bankers at work! What a spectacle! They are charged with keeping this great modern, capitalist economy going. In practice, that means keeping the bubble in speculative finance from deflating too fast. Of course, the bubble is largely of their own making - a direct consequence of the liquidity they injected after 9/11…and the subsequent EZ credit conditions throughout the world economy. And now, Ben Bernanke and the whole company of central bankers from Tokyo to London to New York is hard at work making sure that the bubble gets enough hot air.

Over the last few weeks, serious leaks have developed. First, there was the hole punctured by subprime lending. Bernanke and U.S. Treasury Secretary Hank Paulson immediately announced that this problem was "contained." But then, the gap just kept getting bigger. Builders tumbled. Mortgage companies went broke. Not only were the subprime homeowners going into default…but so were the big packages of subprime loans. And a few hedge funds that owned the stuff were closing their doors.

The hole itself was in the U.S. mortgage market, but major rips seemed to be appearing all over the place. France's largest bank, BNP Paribas, let it be known that it had a few subprime CDOs among the $2.2 billion in assets in three of its funds. It refused to give investors back their money, on the grounds that it could not properly price its assets, and therefore could not give its clients their share of their losses.

This revelation was expected. Nevertheless, it was important.

Many of the most sophisticated investments - such as the Bear Stearns (NYSE:BSC) "enhanced leveraged credit" fund - are now created by teams of mathematicians who presume to develop safer and higher yielding instruments by crunching the numbers in a better way. The resulting portfolios are not marked to market - because there is no ready market for these complicated confections. Instead, they are "marked to model"; that is, they are given values based on the mathematicians' own formulae.

"Value at Risk," or VAR, is the key phrase. But like so much else in modern finance, VAR is one part fancy modern arithmetic and two parts old-fashioned tomfoolery. Risk is not something that can be reduced to numbers, for the simple reason that you can't know what risks the future will throw at you. The mathematicians simply swept aside this fundamental insight and replaced risk with numbers they could work with. They just looked back to see the numbers of the past and assumed that they would be more or less the same numbers in the future…and that markets would keep the numbers coming more or less when they were needed. They knew things didn't always happen as neatly as planned, but they simply dismissed the unknown and unexpected as "anomalous."

What happens when markets seize up is that the numbers stop. You can't get a bid. What's more, the numbers that made sense in the '80s and '90s will not fully reveal the risks in the market in 2007; even 10 years ago was before the rise of the $500 trillion derivative market, the huge, global carry trade and the invention of the neg-am, no-doc ARM. In other words, the innovations of the financial market themselves make their history-based risk assessments obsolete.

Since July 13th, investors have been reluctant to buy CDO tranches, or to finance LBOs, or to take Wall Street's slick products at face value. Most recently, they've been worried about the real value of their stocks, too. This reticence has practically frozen the pipeline that pumps liquidity into the marketplace.

Of course, that is the way real capitalism works. It goes from crisis to crisis…from creative boom to creative destruction. From fully functioning, liquid markets…to markets as frozen solid as the polar ice cap in the days before global warming. From boom to bust…from profit to loss…from wealth to poverty…

But now, in step the central banks. The boom is fine, they say…but we'll put a stop to those nasty busts. How? By providing more credit! The Fed intervened on Friday, buying up the securities that free market players didn't want - including subprime backed mortgages.

We can't wait to see what happens. Will this new liquidity convince lenders and speculators to stay in the game…and thus make the inevitable correction both later and bigger than ever? Or is the bubble already leaking air from so many places that the holes cannot be plugged? We'll see…dear reader…we will see.

*** Goldman's (NYSE:GS) Alpha fund is thought to have lost 26% so far in '07. Citigroup is expected to announce $700 million in credit losses.

*** China's stock markets are now worth more then China's GDP. Bad sign.

*** "Keeping it real," says Jules, "is what it's all about. It's a favorite expression in America right now. It means rising to the challenge, or something like that. There was a skit on Chapelle's Show called, 'When keeping it real goes wrong.' It was very funny. People respond to some sort of challenge and get themselves beat up or put in jail."

We see from the news that America's imperial politicos are keeping it real. Presidential hopefuls Barack Obama and Rudy Giuliani said they would invade Pakistan, and Colorado Republican Congressman Tom Tancredo said that, if elected president, he would respond to terrorism on U.S. soil by bombing the Muslim holy cities of Mecca and Medina.

*** "I'm glad we're moving to Florida," said Maria.

"What are you talking about?" Jules replied. "We're not really moving to Florida. We're just changing our tax home in the United States."

"I know, but I just like the idea of moving to Florida. I always wanted to live in Florida. It's so warm. And I hate this cold, gray climate here. Give me sand, sun and palm trees. It will be nice to live in Florida, even if we don't live there. I can always think that someday we'll go back there, even though we've never actually been there. It's nice to have a home to go to in a warm, sunny place. In London, I think it's essential. I know a lot of people in London who dream of going to their houses in Spain, for example. They don't actually go very often but the thought of the warm, sunny place helps keep them in a good mood. In helps them get through the cold, wet winter. And now, I'll have a warm place to go to too."

"What are you talking about…we won't go there."

"That doesn't matter. It's just the idea of it. And since it's only an idea…I can imagine our home in Florida anyway I want. I think I'll imagine a beautiful house in Palm Beach. I drove through there once. It was really stunning…those nice, elegant old houses on the beach. I'd love to live there. Right next to Donald Trump. So, I think I'll imagine our house in Palm Beach."

Bill Bonner
The Daily Reckoning

And now…

*** The Democratic presidential hopefuls have taken on the mortgage meltdown, and are attempting to offer their solutions.

Across the board, the candidates mainly focused on mortgage brokers as the villains in the subprime mess.

Senator Clinton revealed her plan to "crack down on unscrupulous brokers" last week. In response, the National Association of Mortgage Brokers replied to Clinton by pointing out, "The entire mortgage system needs to be examined from stem to stern, from the home shopping phase, bankers, brokers, and lenders, all the way to Wall Street and the ratings agencies."

They might want to swing by Washington too, during this examination of the real estate industry. Don't forget that the excess liquidity and low, low interest rates created by the Fed made all of this possible.

CNNMoney.com quotes Brad Inman, publisher of Inman News (an on-line chronicler of the real estate industry) as saying, "I find it odd that the mortgage brokers would carry the weight of blame for this entire web of sins."

Oh, what a tangled web we've woven…

*** "You could almost hear the collective exhale of relief from Wall Street on Friday, as the market dodged another red day full of distressed selling. A lot of people who needed a drink probably had one. Or two," writes Dan Denning in today's guest essay.

"In Latin, delirium tremens means 'trembling madness.' The dictionary defines it this way, 'A serious alcohol-withdrawal syndrome observed in persons who stop drinking alcohol following continuous and heavy consumption. It involves profound confusion, hallucinations, and severe nervous system over-activity, typically beginning between 48 and 96 hours after the last drink.'

"The Fed has given the market a stiff drink to off-set the symptoms of credit withdrawal. As any good drunk will tell you, a drunk is always a drunk, even if he stops drinking. There is no cure for addiction, just a replacement of bad habits with better habits. Below the surface, what exactly has the Fed done and what does it mean for the weeks ahead?"

Keep reading today's guest essay here.

*** "Market watchers and history buffs will recognize the recent move by the Fed for what it really is: Moral hazard writ large," writes Addison.

"In his 1978 classic, Manias, Panics and Crashes, Charles Kindleberger suggested that in a world where the U.S. dollar is the universally accepted currency, the Fed has a duty to serve as 'the lender of last resort'. But they shouldn't appear to do it willingly, lest they encourage 'moral hazard' - the idea that no matter what dunderheaded lending mistakes bankers make, the Fed will always step in with a 'free lunch' program of easy terms and free cash.

"Last Tuesday, Bernanke and company stuck to the script. They announced they wouldn't change rates in response to market volatility caused by subprime revelations. But by Friday, the temptation was too great… and the liquidity spigots were opened wide. Friday's record $38 billion injection was second only to the $81 billion the Fed gave away following the September 11 attacks in 2001.

"Our question now: what happens if we face a real crisis? Another terrorist attack? During this era, when the United States is supposedly at the highest economic apogee in its history, why does it take so much credit to keep the dog afloat?"

*** Blackstone President and COO Tony James is keeping an eye out for debt that has been oversold in the market…

The end of EZ credit is surely going to cut down on the amount of "megadeals" in the market, says James, but that won't deter him. "The return of opportunities we see in private equity are at least the best we've seen in two years."

Tony James isn't the only one sniffing out overlooked opportunities right now…

"I think things could get worse in the market," says Capital & Crisis' Chris Mayer. "I can tell you, from watching some of the action closely over this past week that it just feels like a bad market. There is lots of panic selling that seems to sort of snowball. It's as if the market has many weak players, people on borrowed money or who are just not sure of what they are doing. When the market starts selling everything off indiscriminately, there are bound to be opportunities in the aftermath."

Short Fuse
The Daily Reckoning

P.S. "I think that in the still-warm ashes of a market sell-off there are goodies to be found. I'm committed to finding them," says Chris. He also says his watch list is looking more and more interesting…find out more here.

http://energybulletin.net/33603.html

originally published at Archdruid Report

Scrabbling around for plan B

by John Michael Greer

Those of my readers who have been paying attention to the financial news over the last couple of weeks may have noticed a certain weakening of the ebullient smile Wall Street likes to paste on the world. Pundits and financiers who were announcing vast profits and crowing over new stock market records a month ago are adopting a noticeably different style as they try to explain why many billions of dollars invested in hedge funds and the like aren’t there any more. The baroque financial architecture of yet another economic new era has turned out to consist mostly of bubbles rather less tiny than the ones that Don Ho used to sing about, and the results, to put things charitably, have not been good.

The carnage began with mortgage companies, not so long ago the darlings of the financial press. Eighty-odd of them have imploded in the last few months as they discovered that if you loan money to people who can’t pay it back – who’d have thought? – they can’t pay it back. Next it was the turn of hedge funds that speculated in mortgage debt, with two Bear Sterns funds leading the rush to insolvency. In the last few days, problems have surfaced in the commercial paper market, as it turned out that several firms in that end of the financial industry also have a good deal of dubious mortgage debt on their books, and in quant funds –funds that speculate in stocks using computer programs – that got slammed to the mat when the stock market didn’t behave the way their models said it would.

Meanwhile, other sectors of the credit market are looking nervously over their shoulders at their own equivalents of what the mortgage industry has uncharitably but accurately termed “toxic waste” – huge volumes of loans made with little attention to their prospects for repayment, and then offloaded onto buyers around the world whose greed for an extra percentage point of interest kept them from noticing that gamblers don’t always win their bets. Short term credit tightened up so drastically last week that central banks around the world had to dump more than $200 billion into financial markets to stave off a credit panic. Where this is going is anyone’s guess, but at this point the chance of a serious recession is hard to dismiss.

All this is interesting enough in its own right. As J.K.Galbraith pointed out in his wry classic The Great Crash 1929 – required reading for anybody interested in the vagaries of economics, not to mention the funniest work of serious economic history ever written – economic panics offer an unequaled glimpse at the gaping chasm between expectation and reality that opens up when people think they can get something for nothing. It also has real implications for the future of industrial society, since resources flushed down the ratholes of subprime mortgages, speculative hedge funds, and the like will not be available to deal with the pressing needs of an oil-dependent civilization slowly discovering that it’s already on the far side of Hubbert’s peak. All these are relevant, but the spectacle of empty air opening up beneath yesterday’s speculative boom also does a fine job of pointing out one of the most pervasive bad habits of contemporary thought.

The subprime mortgage mess is a good place to start. For many years it’s been customary in the banking industry to justify giving mortgages to people who wouldn’t normally qualify for a home loan by charging them a higher interest rate than usual. The extra income from the interest compensated the bank for the losses from those borrowers who defaulted on their loans. So far, so good, but this extra fillip of interest attracted money from outside the banking industry, and banks found that they could package mortgages into “collateralized debt obligations” – CDOs, for short – and sell them for cash, offloading risk while pocketing the proceeds of the sales.

In a time of record low interest rates, the return on subprime CDOs looked good, so long as you didn’t think too hard about the risk of default. Banks soon figured out how to hide that risk even further by slicing up packages of mortgages into multiple “tranches” that, at least on paper, had different levels of risk. The process was pushed further along when companies bought tranches of different CDOs and reassembled them into new CDOs, with their own multiple tranches, which could then be bought and reassembled ad infinitum.

Beneath all these bells and whistles, though, was the same pool of mortgage loans to people who couldn’t qualify for an ordinary mortgage – a pool that became increasingly risky as profits from the CDO market lured banks and mortgage companies into handing out mortgages with less and less attention to the borrowers’ ability to pay. The bottom of the barrel was reached with what were called NINJA loans – no income, no job or assets – which combined a hefty interest rate on paper with a fair certainty that not one cent of the interest or principal would ever be repaid.

In effect, the idea of risk had evaporated from the minds of the speculators. It’s understandable that banks and mortgage companies would stop worrying about risk once they learned to package their mortgages and sell them to other people. It’s less understandable that people who wanted to buy houses, to live in or (more and more often as the boom went on) to sell at a profit in a few months, lost track of the fact that if things went wrong they could be left with debts far beyond their ability to pay. It’s still less understandable that investors around the world would lose track of the fact that a high interest rate that never gets paid isn’t actually worth anything at all.

Still, the same myopia has appeared on cue in every previous speculative frenzy, too. Purchasers of subprime toxic waste can now join the long line of self-deluded gulls that reaches from the people in 1999 who bought stock in fly-by-night dotcom firms, all the way back to the people in 17th century Holland who spent hundreds of guilders buying single tulip bulbs on the assumption that they’d be able to sell them for even more in a few weeks. It’s an affliction endemic to market capitalism throughout its history, but it became pandemic in the last years of the 20th century and remains so today – and not just in the world of economic speculation.

It’s worth suggesting, in fact, that blindness to risk has become one of the most widespread mental habits in contemporary society. Plenty of examples could be cited, but one discussed many times in this blog – peak oil – belongs high on the list. All through the controversies about how much petroleum the world still has, how rapidly it’s being depleted, and whether or not it can be replaced by some other set of energy resources, one constant theme has been the refusal of most people outside the extreme “doomer” end of the peak community to notice that industrial civilization could end up in deep trouble if things go badly.

Those who argue that the world still contains ample supplies of oil that just haven’t been found yet, like those who insist that innovation will take care of the problem by pulling some currently unknown technological rabbit out of a hat just in time, tend to respond to such questions as “but what if you’re wrong?” in the same tone of irritated superiority as a Wall Street financier might have done a few months ago if asked what would happen if subprime defaults got out of hand. There’s an oddly incantatory quality to this nothing-can-go-wrong rhetoric, as though it will all work out fine just as long as everybody agrees it will.

As the long and sordid history of economic crises shows all too well, though, optimism is not always justified, and things that seem too good to be true generally are. Right now the world economy is reeling and shuddering because a great many otherwise intelligent people jumped to the conclusion that nothing could go wrong with a new set of moneymaking schemes that promised something for nothing. The similarities between this bit of delusion and the even more widespread faith that humanity can pump infinite amounts of cheap energy out of a finite planet leaves me wondering if the exponential expansion of industrial society over the last two centuries or so might be seen, in a certain sense, as the biggest speculative bubble of them all.

Speculative bubbles, after all, always launch themselves from a basis of fact. It was true in the 1990s that huge new fortunes were made on the Internet, and investments in computer firms during those years paid off spectacularly. It was true earlier in the present decade that a lot of Americans wanted homes of their own, and low interest rates and abundant capital from overseas made it possible for that desire to be met. Equally, it was true that the exploitation of coal, oil, and natural gas by way of an ever more sophisticated suite of technologies enabled the industrial societies of the West to enjoy the great-grandmother of all economic booms.

Just as every speculative binge eventually trips itself up on its own excessive optimism, in turn, industrial society ignored the well-timed warnings of oncoming resource depletion in the 1970s. The small but steady declines in oil production that have taken place over the last two years, despite sky-high oil prices and a flurry of well-drilling that has driven rig costs to record levels, may just turn out to be the equivalent of the rising default rates in subprime mortgages that started today’s economic landslide on its way. At the moment, industrial civilization is poised somewhere in the same period of eerie calm between the beginning of decline and the arrival of panic that comes late in the history of every speculative binge. In the example now unwinding around us, that period of calm ended a few weeks ago when Bear Sterns admitted that two of its billion-dollar hedge funds were no longer worth a cent. What will end the equivalent period in the trajectory of our civilization is still anybody’s guess, and it may still be years in the future.

Whenever it comes, though, the central problem that will have to be faced then is the same problem that banks, mortgage companies, and the global economy are having to face right now. By ignoring the reality of risk, the money managers of the last few years left themselves with very few options once the economic situation changed in a way they hadn’t anticipated. In the same way, by ignoring the possibility that we may be running out of cheap abundant energy, modern industrial civilization could well be backing itself into a corner. Without preparations in place, or even a sense of what the options might be, we could all find ourselves desperately scrabbling around for a Plan B when the illusion of endless energy supplies pops around us like a bubble – speculative or otherwise.

http://www.telegraph.co.uk/money/main.jhtm.../ccbanks121.xml

Capitalism not to blame for debacle

Last Updated: 12:12am BST 22/08/2007

Ambrose Evans-Pritchard points the finger at the central banks that created the credit bubble

The witch hunt has begun. French president Nicolas Sarkozy has vowed to hunt down the "speculators". Germany's Angela Merkel is eyeing laws to curtail hedge funds.Brussels has launched a probe of the rating agencies, suspected of sticking "AAA" and "AA" grades on sub-prime debt for venal motives. The US Congress is orchestrating a show trial of "predatory lenders".
# Blog: Has Bear Stearns finally popped the great world bubble?
# Watch: Money markets are at the heart of the crisis
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The blame-game was ever thus. Wall Street bankers were hounded after the 1929 crash: some went to prison. But if you track down the root cause of this credit bubble - now popped - the "blame" lies with Asian, European and Anglo Saxon central banks.

They created this mess, if that is what we now face. It was they - in effect governments - who intervened in countless complex ways to push down the price of global credit to levels that warped behaviour, as the Bank for International Settlements (BIS) has repeatedly noted. By setting the price of money too low, they encouraged debt and punished savings.

The markets have merely responded with their usual exuberance to this distorted signal. Private equity was tempted to launch a takeover blitz at a debt-to-cashflow ratio of 5.4 because debt was made so cheap. The US savings rate turned negative because interest rates were held below inflation.

Untangling the varied causes of this credit debacle is not easy but the central banks of Asia and the developing world have surely played a key role by hoarding reserves. Their motive is either to hold down currencies or to ensure that they need never again suffer bitter medicine from the IMF.

The sums are staggering: China $1,330bn (£670bn), Japan $924bn, Russia $414bn, South Korea $251bn, Taiwan $266bn, India $229bn, Brazil $147bn, Singapore $144bn, Malaysia $98bn, Thailand $73bn. Compare this to US insouciance, $67bn.

These reserves have risen from $3,000bn in 2003 to $6,700bn today. The vast bulk has been invested in G10 government bonds or agency debt - although some countries are switching to sovereign wealth funds able to invest in equities and property.

The effect has been to drive down global bond yields, with effects spilling into the M&A market, Latin American debt and, of course, US property. It is why the spreads on corporate bonds reached the lowest ever recorded in February this year. The iTraxx Crossover index of low-grade debt reached 162, while the spread on Brazil's bonds fell to 138 - a wafer-thin margin over "AAA" benchmarks. Pension funds and insurers are often compelled to buy "AAA" bonds, yet the yields on offer have not been enough to meet their long-term liabilities. So when the alchemists hawked tranches of "senior" US sub-prime debt - and car loans, etc - that had been packaged into securities (collateralized debt obligations, or CDOs) with an "AAA" or "AA" rating and a bumper yield, they could hardly resist. Some $470bn of CDOs and $524bn of "synthetic" CDOs were issued last year, BIS data shows.

So while the investment boutiques - Bear Stearns, Morgan Stanley, Deutsche Bank, Lehman Brothers - may have pushed a toxic product (a rash of lawsuits will decide), this occurred in a context where policy error had bent incentives.

In parallel, the Bank of Japan held interest rates at zero for six years until July 2006 to stave off deflation. Even now, rates are still just 0.5pc. It also injected some $12bn liquidity every month by printing money to buy bonds. The net effect has been a massive leakage of money into the global economy. Faced with a pitiful yield at home, Japan's funds and thrifty grannies shovelled savings abroad. Banks, hedge funds, and the proverbial Mrs Watanabe, were all able to borrow for near nothing in Tokyo to snap up assets across the globe. BNP Paribas estimates this "carry trade" to be $1,200bn.

Faced with an asset shock coming from Asia, the Federal Reserve and the European Central Bank could have taken counter-action. They did not do so. Nor did they tighten much to offset liquidity being "created" by the new-fangled credit instruments. The Fed held rates at 1pc until June 2004, when the economy was growing at 5pc. The ECB kept rates at 2pc until December 2005. It takes 18 months - or so - for monetary policy to exert its full effects. The bubble peaked in early 2007.

The central banks have said their task is to fight inflation, not to police asset prices. Critics retort that the US asset bubble in the 1920s and Japan's bubble in the 1980s both occurred at a time of low inflation. Belatedly the Bank of Japan, the ECB, the Swiss, the Scandies and the Bank of England are questioning the wisdom of ignoring asset prices, deeming it wise to "lean into the wind" to slow excesses. But it is very late in the day. The credit bubble is already with us.

PAUL B. FARRELL
If we are Rome, Wall Street's our Coliseum
Comptroller General warns (again), we're 'bankrupting America'

The Fed’s Subprime Solution

By JAMES GRANT
Published: August 26, 2007

http://www.dailyreckoning.com/Writers/Moga...s/MG091307.html

Money won't supply your soup spoon
By The Mogambo Guru

If you want to know the kind of news that makes my heart lurch with an audible "Urk!", it is perhaps best exemplified by the knowledge that the money supply is rising at a rate of over 14% per year.

If you are innocently asking, "Whose money supply is rising so alarmingly that inflation in consumer prices will destroy that country, and therefore a terrific strategic plan would be to set up



underworld contacts and smuggling routes now, in preparation of making a fortune in the arms and contraband smuggling racket, as the future becomes a bitter class struggle between the government and desperate, rebellious citizens?"

I begin my enlightening answer with a joke to lighten (get it? Lighten and enlightening? Well, screw you, too, then!) the mood, in contrast to the heartbreak of raw reality. So, I say, "It don't make no damned bit of difference whose money supply! Somebody is freaking doomed! Hahahaha!"

My lonely laughter echoes across the auditorium, and I see that I got no laughs with my lame attempt at humor. I make a mental note that the audience is either a bunch of stupid chumps who wouldn't know real comedy if it came up, lifted its leg, and peed on their damned shoes, or they are so smart that they understand the frightening inflationary implications of a rapidly expanding money supply and are unable to laugh at the horror of it.

Either way, I immediately reveal that it is, alas, the US money supply that is growing so fast! Gaaaaah!

So if you never had the pleasure of hearing me say, "We're freaking doomed!", prepare yourself for a real treat, as I will now use a famous line from Marlon Brando's portrayal of Fletcher Christian in Mutiny on the Bounty as I bellow, "We're freaking dooooOOooommmmmed!" in your stupid face and urge you to pray to "whatever pig-god you pray to" to be somehow magically spared the inflationary horror.

I know that you don't believe me, and I would have no respect for you if you did, so instead I will turn to Addison Wiggin of the 5-Minute Forecast, who cleverly reveals the truth with some adroit juxtaposition, and first presents Bernanke as soothingly saying, "It is not the responsibility of the Federal Reserve - nor would it be appropriate - to protect lenders and investors from the consequences of their financial decisions", and then immediately qualifying that remark, "But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy." Hahahaha!

I love this! Now, the next time one of those snotty little social workers comes over here, knock, knock, knocking on my door, complaining about my stupid kids acting like the destructive little juvenile delinquent morons that they are, and always coming up with the same tired conclusion; the father is at fault! (me! it's always my fault!), I will ask them, "My fault? How in the hell can it be my fault when I keep them locked in their rooms so that I never have to even see them or their faces at all, ya stupid government morons?" And they will just push past me like I'm not standing in the doorway and proceed to "rescue" everybody!

Now, thanks to Ben Bernanke, I can proudly fling open the door and say, my eyes flashing and my voice dripping with smarmy contempt, "I know that it is the responsibility of a parent to teach their children not to be worthless, criminal trash, but now so many people make their living from them, such as law enforcement personnel, bail bondsmen, bartenders, lawyers, jailers, graffiti removers, streetlamp repairers, beer can picker-uppers, automobile recovery and repair industries, whole swaths of unemployable social deviants who make a living selling drugs and contraband, social worker morons like you wallowing around in the mess and blaming innocent fathers, and many other people 'outside their sphere of influence' that all now have to be taken into account when determining Proper Parental Policy Response (PPPR). So why don't you take your little forms, and take your little court orders, and take your big, nasty butts off my property? Hahaha!"

And this new legal maneuver of being mindful of "broad effects" is going to be sooOOOooo sweet at work, too! So sweet!

And the effects of the Fed "considering the broad economic effects" is going to be equally as bad, which brings up the perennial question "And just what in the hell is that supposed to mean?" For an answer, I turn to Junior Mogambo Ranger (JMR) Michael, who writes of his "90-year-old parents" watching the "goings on in the world and stock market" through the eyes of direct experience. He goes on to say that "they thoroughly believe that their generation has failed to convey the proper morals to the B-Boomer generation, and even less to the generation following. They say the result is that we have to replay the 1930s all over again, except much worse."

The good news is that they "offered a few more suggestions" about lessons they learned the last time the Federal Reserve acted like a bunch of buttheads and created the Great Depression by creating too much money and credit:

"1. We hope you can sell that foreign car you spent too much money for.

"2. Get a good pair of shoes as you will need them to walk from place to place while begging for the jobs you sent overseas.

"3. Obtain good negotiating skills, as you will have to go low enough to displace foreigners you have let in to our country illegally because everyone wanted to profit from under-priced labor.

"4. Eat right. You don't think a hospital will waste resources on anyone over 50 do you? They did not back then!"

The funniest and most practical advice was:

"5. Obtain a favorite cup and spoon, because even at the soup kitchens of the 1930s, you had to bring your own."

Richard Daughty is general partner and COO for Smith Consultant Group, serving the financial and medical communities, and the editor of The Mogambo Guru economic newsletter - an avocational exercise to heap disrespect on those who desperately deserve it.

http://www.dailyreckoning.com/Issues/2007/DR091407.html

Just Like Japanese Bailout Buckets

The Daily Reckoning
London, England
Friday, September 14, 2007

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*** The temporary 17-year pull-back…a prediction made too early…bailing out as fast as the buckets allow…

*** Respecting the confusing Dow Theory…finding themselves a little short…a sentimental Irish poet…

*** A friendly reminder from Kevin Kerr…everybody Loves Greenspan…and more!

---------------------

Do you remember what practically everyone said after the Japanese stock market began falling apart in January 1990?

"Don't worry," they said. "Japan has the most dynamic economy in the world…it's just a temporary pull-back."

Well, that was 17 years ago. Japanese stocks pulled back…and kept pulling back for more than a decade. Only recently have they begun to move forward again…and they're still far cheaper than they were at the end of the Reagan years.

And do you remember how American economists and pundits criticized the Japanese? They refused to let their big banks fail, said the critics…and thus stretched out the pain of a correction.

"We wouldn't do something that stupid," they seemed to say.

And do you remember how here at The Daily Reckoning we predicted that the United States would follow Japan into a long, deflationary slump? You do? Well, forget it…we were obviously wrong. Or, at least seven years too early…because we made that prediction back in 1999!

Still, we were right in predicting that when the water started coming over the gunwales, English-speaking financial authorities would race to the pumps at least as fast as their Japanese counterparts.

Today comes word that the feds are bailing out the big banks as fast as their buckets allow. It is the biggest bailout in five years, say the reports…with big banks averaging about $2.7 billion per day in loans from the Fed. These injections of cash are said to be 'forced' by the Fed itself…rather that the result of desperation on the part of member banks. Still, recent estimates put the increase in U.S. money at nearly 50%, annualized.

The Bank of Britain took the high road on these bailouts - until yesterday.

Mark Gilbert explains:

"The Bank of England, by contrast, has been adamant that it won't rescue the money markets by accepting low-grade collateral, or by offering three-month cash. Indeed, the Fed and the ECB were rebuked yesterday, albeit obliquely, by U.K. central bank Governor Mervyn King for bailing out commercial banks.

"'The provision of such liquidity support undermines the efficient pricing of risk by providing ex post insurance for risky behavior,' King said in a copy of testimony he plans to deliver to the U.K. Parliament's Treasury Committee on Sept. 20. 'That encourages excessive risk-taking, and sows the seeds of a future financial crisis.'

"Victoria Mortgage Funding Ltd., a U.K. company that lent about 300 million pounds ($609 million) in subprime mortgages to British borrowers, was placed into administration earlier this week, the U.K. equivalent of Chapter 11. Victoria couldn't secure enough funding to stay in business."

But then came the news that house prices in Britain fell in August - for the first time in two years. Practically in the same flurry of news reports we found the BOE offering to prop up Northern Rock, a major source of funds for UK property speculators. (More below…)

But at least there are still a few voices of rectitude and probity. Out comes that sly fox, Alan Greenspan, announcing that he doesn't approve of such rescue efforts and opposes an emergency rate cut!

Could this be the same Alan "Bubbles" Greenspan who allowed, encouraged and facilitated history's largest credit bubble ever? We haven't checked the fingerprints, but we believe it is.

And it makes sense. The man is a scoundrel but not a fool. He sees trouble coming…and he's getting as far away from it as possible. Since a real rescue is probably impossible at this stage, he will begin criticizing the rescuers…laying the blame squarely where it does not belong - on his successors.

Of course, the rescuers are bound to make the situation worse - just as they did in Japan…and just as they always do. Capitalism functions best without bailouts. Leaky, overloaded, lost vessels sink; the sea-lanes and ports are opened to new ships and better captains.

But tomorrow's captains don't vote, make campaign contributions, work in the big banks, or have lunch with Fed governors. It's today's captains who get the favors…and money - whether they speak Japanese…or English.

We've been reading Richard Russell, one of the greatest stock market observers in the country, for at least 10 years. Now in his mid-80s, Russell has seen it all. And he thinks we're in a bull market.

Though we've been reading for a long time, we have never figured out how Dow Theory (his system) works. There are a lot of indicators and technical enhancements involved, but it appears to us to come down to this:

When prices are moving up, we are in a bull market. When prices are going down, we are in a bear market. When we are in a bull market - as Russell believes we are now - how long will it continue? Until prices go down!

After the epic high of 2000, Russell maintained that the Dow would probably remain in a bear market until an epic low was reached. This made sense to us. At least in broad outline. We buy when prices are low. So, we'll wait for another epic low. What the heck…we know it is coming sooner or later. In the meantime, taking the long view, everything is going downhill.

But now, Russell says stocks are in a bull market…with another big burst of gains coming. How long will it last? Until it comes to an end, says Russell. How high will it go? Until it reaches its peak, he explains.

The Dow only went down only about 20%, after January 2000, so it never got to an epic low; it never even reverted to the mean. Instead, stocks have been expensive since the mid-'90s. From here, maybe they'll go higher. Maybe they won't.

We don't know what to make of Russell's system, but we have a deep respect for the man's experience and intuition. When he says stocks are headed higher…we pay attention.

Why would stocks go up from here? Could it be just the final stage of a credit bubble…could it be the bailout cash will float them up…

…or, could it be that stocks' earnings will rise?

Colleague Chris Mayer ruminates:

"You know the big debate about profit margins. They are near all-time highs. The mean-reversion guys (Granthan, et al) say they will come back to trend. Others (GaveKal) believe the economy is fundamentally different now.

"But what if the high profit margins (and high return on assets) are due to understated book values (because of the cost accounting assumptions) and that the actual cost to replace these assets - because of inflation - is actually much much higher?

"Then, what happens is that as companies replace plant and equipment or expand, capex expenses should rise. This won't show up in earnings right away, because of the delay between capex and when they start hitting the P&L in the form of depreciation charges.

"But is becomes a stiff headwind against earnings after a while. Earnings fall as they reflect more truly the cost of the assets used, and profit margins fall, book values rise, returns on equity fall…stuff starts to move back to trend…

"Obviously, this doesn't affect all industries equally…but it could be a contributing factor to a potential decline in earnings…

"And, of course, it would mean the market price has to come down some. Bad for stocks generally."

We suspect Chris is right. American companies have borrowed heavily. But much of the money has gone into bonuses, fees, buybacks and other non-capital investments. When they actually have to replace plant and equipment, to keep up with foreign competitors, they're going to find themselves a little short.

You can read more insights from Chris Mayer here:

The Next Forever Stock

"What's the matter?" we asked.

We have been working with a group from Ireland. Last night, late, after a good meal, well lavaged with liquor, a few of them had tears in their eyes.

"Liam has been telling us about his dead pets…" one young woman explained.

A tall young man, his dark hair swept back, making him look a little like Yeats himself, continued:

"Yes, I remember Fluffy…and Hammy…they were such good dogs. Followed me around. They slept on my bed…though Hammy moved around so much at night I had to keep him out of the bedroom. He would follow me to school when I was about 6 or 7. I had to take him back to the house and lock him inside, and then go back to school.

"All seven of my pets…4 dogs…and 3 cats…all dead now…

"…it's overwhelming really…even now, I can barely stand to talk about them."

"Liam is a poet, you know. And like all the Irish, he gets very sentimental when he drinks."

Have a nice weekend,

Bill Bonner
The Daily Reckoning

Now, over to today's guest essay…

September 18, 2007

U.S. Banks Brace for Storm Surge as Dollar and Credit System Reel
By MIKE WHITNEY

By now, you’ve probably seen the photos of the angry customers queued up outside of Northern Rock Bank waiting to withdraw their money. This is the first big run on a British bank in over a century. It’s lost an eighth of its deposits in three days. The pictures are headline news in the U.K. but have been stuck on the back pages of U.S. newspapers. The reason for this is obvious. The same Force 5 economic-hurricane that just touched ground in Great Britain is headed for America and gaining strength on the way.

On Monday night, desperately trying to stave off a wider panic, the British government issued an emergency pledge to Northern Rock savers that their money was safe. The government is trying to find a buyer for Northern Rock.

This is what a good old fashioned bank run looks like. And, as in 1929, the bank owners and the government are frantically trying to calm down their customers by reassuring them that their money is safe. But human nature being what it is, people are not so easily pacified when they think their savings are at risk. The bottom line is this: The people want their money, not excuses.

But Northern Rock doesn’t have their money and, surprisingly, it is not because the bank was dabbling in risky subprime loans. Rather, NR had unwisely adopted the model of “borrowing short to go long” in financing their mortgages just like many of the major banks in the U.S. In other words, they depended on wholesale financing of their mortgages from eager investors in the market, instead of the traditional method of maintaining sufficient capital to back up the loans on their books.

It seemed like a nifty idea at the time and most of the big banks in the US were doing the same thing. It was a great way to avoid bothersome reserve requirements and the loan origination fees were profitable as well. Northern Rock’s business soared. Now they carry a mortgage book totaling $200 billion dollars.

$200 billion! So why can’t they pay out a paltry $4 or $5 billion to their customers without a government bailout?

It’s because they don’t have the reserves and because the bank’s business model is hopelessly flawed and no longer viable. Their assets are illiquid and (presumably) “marked to model”, which means they have no discernible market value. They might as well have been “marked to fantasy”,it amounts to the same thing. Investors don’t want them. So Northern Rock is stuck with a $200 billion albatross that’s dragging them under.

A more powerful tsunami is about to descend on the United States where many of the banks have been engaged in the same practices and are using the same business model as Northern Rock. Investors are no longer buying CDOs, MBSs, or anything else related to real estate. No one wants them, whether they’re subprime or not. That means that US banks will soon undergo the same type of economic gale that is battering the U.K right now. The only difference is that the U.S. economy is already listing from the downturn in housing and an increasingly jittery stock market.
That’s why Treasury Secretary Henry Paulson rushed off to England yesterday to see if he could figure out a way to keep the contagion from spreading.

Good luck, Hank.

It would interesting to know if Paulson still believes that “This is far and away the strongest global economy I’ve seen in my business lifetime”, or if he has adjusted his thinking as troubles in subprime, commercial paper, private equity, and credit continue to mount?

For weeks we’ve been saying that the banks are in trouble and do not have the reserves to cover their losses. This notion was originally pooh-poohed by nearly everyone. But it’s becoming more and more apparent that it is true. We expect to see many bank failures in the months to come. Prepare yourself. The banking system is mired in fraud and chicanery. Now the schemes and swindles are unwinding and the bodies will soon be floating to the surface.

“Structured finance” is touted as the “new architecture of financial markets”. It is designed to distribute capital more efficiently by allowing other market participants to fill a role which used to be left exclusively to the banks. In practice, however, structured finance is a hoax; and undoubtedly the most expensive hoax of all time. The transformation of liabilities (dodgy mortgage loans) into assets (securities) through the magic of securitization is the biggest boondoggle of all time. It is the moral equivalent of mortgage laundering. The system relies on the variable support of investors to provide the funding for pools of mortgage loans that are chopped-up into tranches and duct-taped together as CDOs (collateralized debt obligations). It’s madness; but no one seemed to realize how crazy it was until Bear Stearns blew up and they couldn’t find bidders for their remaining CDOs. It’s been downhill ever since.
The problems with structured finance are not simply the result of shabby lending and low interest rates. The model itself is defective.

John R. Ing provides a great synopsis of structured finance in his article, “Gold: The Collapse of the Vanities”:

"The origin of the debt crisis lies with the evolution of America's financial markets using financial engineering and leverage to finance the credit expansion…. Financial institutions created a Frankenstein with the change from simply lending money and taking fees to securitizing and selling trillions of loans in every market from Iowa to Germany. Credit risk was replaced by the "slicing and dicing" of risk, enabling the banks to act as principals, spreading that risk among various financial institutions….. Securitization allowed a vast array of long term liabilities once parked away with collateral to be resold along side more traditional forms of short term assets. Wall Street created an illusion that risk was somehow disseminated among the masses. Private equity too used piles of this debt to launch ever bigger buyouts. And, awash in liquidity and very sophisticated algorithms, investment bankers found willing hedge funds around the world seeking higher yielding assets. Risk was piled upon risk. We believe that the subprime crisis is not a one off event but the beginning of a significant sea change in the modern-day financial markets.”

The investment sharks who conjured up “structured finance” knew exactly what they were doing. They were in bed with the ratings agencies----off-loading trillions of dollars of garbage-bonds to pension funds, hedge funds, insurance companies and foreign financial giants. It’s a swindle of epic proportions and it never would have taken place in a sufficiently regulated market.

When crowds of angry people are huddled outside the banks to get their money, the system is in real peril. Credibility must be restored quickly. This is no time for Bush’s “free market” nostrums or Paulson’s soothing bromides (he thinks the problem is “contained”) or Bernanke’s feeble rate cuts. This requires real leadership.

The first thing to do is take charge, alert the public to what is going on and get Congress to work on substantive changes to the system. Concrete steps must be taken to build public confidence in the markets. And there must be a presidential announcement that all bank deposits will be fully covered by government insurance.

The lights should be blinking red at all the related government agencies including the Fed, the SEC, and the Treasury Dept. They need to get ahead of the curve and stop thinking they can minimize a potential catastrophe with their usual public relations mumbo jumbo.
Last week, an article appeared in the Wall Street Journal, “Banks Flock to Discount Window”. (9-14-07) The article chronicled the sudden up-tick in borrowing by the struggling banks via the Fed’s emergency bailout program, the “Discount Window”:

“Discount borrowing under the Fed’s primary credit program for banks surged to more than $7.1 billion outstanding as of Wednesday, up from $1 billion a week before.”
Again we see the same pattern developing; the banks borrowing money from the Fed because they cannot meet their minimum reserve requirements.
WSJ: “The Fed in its weekly release said average daily borrowing through Wednesday rose to $2.93 billion.”
$3 billion.

Traditionally, the “Discount Window” has only been used by banks in distress, but the Fed is trying to convince people that it’s really not a sign of distress at all. It’s “a sign of strength”. Baloney. Banks don’t borrow $3 billio unless they need it. They don’t have the reserves. Period.

The real condition of the banks will be revealed sometime in the next few weeks when they report earnings and account for their massive losses in “down-graded” CDOs and MBSs.
Market analyst Jon Markman offered these words of advice to the financial giants

"Before they (the financial industry) take down the entire market this fall by shocking Wall Street with unexpected losses, I suggest that they brush aside their attorneys and media handlers and come clean. They need to tell the world about the reality of their home lending and loan securitization teams' failures of the past four years -- and the truth about the toxic paper that they've flushed into the world economic system, or stuffed into Enron-like off-balance sheet entities -- before the markets make them walk the plank.”….” Since government regulators and Congress have flinched from their responsibility to administer "tough love" with rules forcing financial institutions to detail the creation, securitization and disposition of every ill-conceived subprime loan, off-balance sheet "structured investment vehicle," secretive money-market "conduit" and commercial-paper-financing vehicle, the market will do it with a vengeance."

Good advice. We’ll have to wait and see if anyone is listening. The investment banks may be waiting until Tuesday hoping that Fed-chief Ken Bernanke announces a cut to the Fed’s fund rate that could send the stock market roaring back into positive territory.
But interest rate cuts do not address the underlying problems of insolvency among homeowners, mortgage lenders, hedge funds and (potentially) banks. As market-analyst John R. Ing said, “A cut in rates will not solve the problem. This crisis was caused by excess liquidity and a deterioration of credit standards….A cut in the Fed Fund rate is simply heroin for credit junkies.”

The cuts merely add more cheap credit to a market that that is already over-inflated from the ocean of liquidity produced by former-Fed chief Alan Greenspan. The housing bubble and the credit bubble are largely the result of Greenspan’s misguided monetary policies. (For which he now blames Bush!) The Fed’s job is to ensure price stability and the smooth operation of the markets, not to reflate equity bubbles and reward over-exposed market participants.

It’s better to let cash-strapped borrowers default than slash interest rates and trigger a global run on the dollar. Financial analyst Richard Bove says that lower interest rates will do nothing to bring money back into the markets. Instead, lower interest rates will send the dollar into a tailspin and wreak havoc on the job market.
“There is no liquidity problem, but a serious crisis of confidence," Bove said:

"In a financial system where there is ample liquidity and a desire for higher rates to compensate for risk, the solution is not to create more liquidity and lower the rates that are available to compensate for risk. ... (The Fed) cannot reduce fear by stimulating inflation…

"It is illogical to assume that holders of cash will have a strong desire to lend money at low rates in a currency that is declining in value when they can take these same funds and lend them at high rates in a currency that is gaining in value. By lowering interest rates the Federal Reserve will not stimulate economic growth or create jobs. It will crash the currency, stimulate inflation, and weaken the economy and the job markets".

Bove is right. The people and businesses that cannot repay their debts should be allowed to fail. Further weakening the dollar only adds to our collective risk by feeding inflation and increasing the likelihood of capital flight from American markets. If that happens; we’re toast.

Consider this: In 2000, when Bush took office, gold was $273 per ounce, oil was $22 per barrel and the euro was worth $.87 per dollar. Currently, gold is over $700 per ounce, oil is over $80 per barrel, and the euro is nearly $1.40 per dollar. If Bernanke cuts rates, we’re likely to see oil at $125 per barrel by next spring.

Inflation is soaring. The government statistics are thoroughly bogus. Gold, oil and the euro don’t lie. According to economist Martin Feldstein, “The falling dollar and rising food prices caused market-based consumer prices to rise by 4.6 per cent in the most recent quarter.” (WSJ)

That’s 18.4 per cent a year, and yet Bernanke is still considering cutting interest rates and further fueling inflation.

What about the American worker whose wages have stagnated for the last six years? Inflation is the same as a pay-cut for him. And how about the pensioner on a fixed income? Same thing. Inflation is just a hidden tax progressively eroding his standard of living. .
Bernanke’s rate cut may be boon to the “cheap credit” addicts on Wall Street, but it’s the death-knell for the average worker who is already struggling just to make ends meet.

No bailouts. No rate cuts. Let the banks and hedge funds sink or swim like everyone else. The message to Bernanke is simple: “It’s time to take away the punch bowl”.
The inflation in the stock market is just as evident as it is in the price of gold, oil or real estate. Economist and author Henry Liu demonstrates this in his article “Liquidity Boom and the Looming Crisis”:

"The conventional value paradigm is unable to explain why the market capitalization of all US stocks grew from $5.3 trillion at the end of 1994 to $17.7 trillion at the end of 1999 to $35 trillion at the end of 2006, generating a geometric increase in price earnings ratios and the like. Liquidity analysis provides a ready answer".(Asia Times)

Market capitalization zoomed from $5.3 trillion to $35 trillion in 12 years? Why?Was it due to growth in market-share, business expansion or productivity?
No. It was because there were more dollars chasing the same number of securities; hence, inflation.

If that is the case, then we can expect the stock market to fall sharply before it reaches a sustainable level. As Liu says, “It is not possible to preserve the abnormal market prices of assets driven up by a liquidity boom if normal liquidity is to be restored.” Eventually, stock prices will return to a normal range.

Bernanke should not even be contemplating a rate cut. The market needs more discipline not less. And workers need a stable dollar. Besides, another rate cut would further jeopardize the greenback’s increasingly shaky position as the world’s “reserve currency”. That could destabilize the global economy by rapidly unwinding the U.S. massive current account deficit.

The International Herald Tribune summed up the dollar’s problems in a recent article, "Dollar's Retreat Raises Fear of Collapse."

"Finance ministers and central bankers have long fretted that at some point, the rest of the world would lose its willingness to finance the United States' proclivity to consume far more than it produces - and that a potentially disastrous free-fall in the dollar's value would result.

"The latest turmoil in mortgage markets has, in a single stroke, shaken faith in the resilience of American finance to a greater degree than even the bursting of the technology bubble in 2000 or the terror attacks of Sept. 11, 2001, analysts said. It has also raised prospect of a recession in the wider economy.

"This is all pointing to a greatly increased risk of a fast unwinding of the U.S. current account deficit and a serious decline of the dollar".

Other experts and currency traders have expressed similar sentiments. The dollar is at historic lows in relation to the basket of currencies against which it is weighted. Bernanke can’t take a chance that his effort to rescue the markets will cause a sudden sell-off of the dollar.

The Fed chief’s hands are tied. Bernanke simply doesn’t have the tools to fix the problems before him. Insolvency cannot be fixed with liquidity injections nor can the deeply-rooted “systemic” problems in “structured finance” be corrected by slashing interest rates. These require fiscal solutions, congressional involvement, and fundamental economic policy changes.

Rate cuts won’t help to rekindle the spending spree in the housing market either. That charade is over. The banks have already tightened lending standards and inventory is larger than anytime since they began keeping records. The slowdown in housing is irreversible as is the steady decline in real estate prices. Trillions in market capitalization will be wiped out. Home equity is already shrinking as is consumer spending connected to home-equity withdrawals.

The bubble has popped regardless of what Bernanke does. The same is true in the clogged Commercial Paper market where hundreds of billions of dollars in short-term debt is due to expire in the next few weeks. The banks and corporate borrowers are expected to struggle to refinance their debts but, of course, much of the debt will not roll over. There will be substantial losses and, very likely, more defaults.

Bernanke can either be a statesman---and tell the country the truth about our dysfunctional financial system which is breaking down from years of corruption, deregulation and manipulation---or he can take the cowards-route and buy some time by flooding the system with liquidity, stimulating more destructive consumerism, and condemning the nation to an avoidable cycle of double-digit inflation.

We’ll know his decision soon enough.

Mike Whitney lives in Washington state. He can be reached at: fergiewhitney@msn.com

http://counterpunch.org/whitney09182007.html

http://www.atimes.com/atimes/Global_Economy/II20Dj01.html

Sep 20, 2007

US rate cuts: Like a blow to the head
By Julian Delasantellis

Zhou Xiaochuan, the governor of the Bank of China, must sympathize with the plight of poor Raoul, the waiter whose good service is rewarded with a brick to the back of his head.

In a 2004 episode of the US cable network series The Sopranos , New Jersey mafia boss Tony Soprano takes the senior leadership of his crime family to an expensive dinner at a casino restaurant in Atlantic City, New Jersey.

There they enjoy multiple rounds of the best cuts of steak, lobster and the finest beverages; it is Tony's nephew and heir apparent, the sobriety-, impulse-control-, fidelity- and literary-talent-



challenged would-be part-time Hollywood screenwriter and full-time thug Christopher Moltisanti who gets stuck with the US$1,184 check.

Christopher is none too happy with this situation; he is particularly enraged that his fellow goomba Paulie "Walnuts" Gualtieri sent over an expensive bottle of Cristal to two young ladies he classified as "skanks" at an adjoining table. He leaves a $16 tip, for an even $1,200. The waiter, Raoul, is none too pleased with this, and he comes out to the parking lot to complain to Christopher about his stinginess.

There was no problem with his service; he feels he deserves more. Standard American tipping protocol calls for gratuities to amount to about 15% of the check, which, in this case, would have called for a $177.60 tip.

Christopher is in no mood for interlocution. As in most scenes in The Sopranos up to and including solemn religious observations, the situation rapidly descends to exchanges of rank obscenities. As Raoul turns away to return to work, Christopher throws a brick that hits the waiter in the head. As Raoul writhes on the ground, unconscious in an epileptic-type fit, for good measure, Paulie comes over, shoots and kills him.

I bet that, in the middle of the night Beijing time, after he became aware of the results of Tuesday's meetings of the US Federal Reserve Board, Zhou Xiaochuan, the man in charge of China's one and a half trillion dollars of foreign exchange reserves, sympathized with the plight of poor Raoul. After all, in deploying its foreign exchange reserves to buy US Treasury securities to keep US interest rates low, and by not converting its US dollar export proceeds into other currencies, China has served the US well.

And the thanks he gets is Fed chief Ben Bernanke hitting him on the head with a brick.

In an extraordinary meeting of the United States Federal Reserve on Tuesday, the board shocked the financial world (very much including me) by announcing interest rate cuts far more extensive than previously expected. The expectation was that the cuts would have been limited to just a single 0.25-percentage-point (25 basis point) cut in the benchmark Federal Funds target rate; instead, the Fed reduced the target rate 50 basis points, along with a second 50 basis point cut (the first was on August 17) in a less commonly reported but possibly more important rate that the Federal Reserve also controls, the Federal Reserve discount rate.

This is a complete rejection of the policy of former Fed chief Alan Greenspan of slow and gradual interest rate changes so as to assure the markets that they will not be continually surprised by unexpected Federal Reserve actions, a policy that Bernanke had been maintaining during the previous 19 months of his tenure.

The contrast between Tuesday's meeting result and the sunny optimism of the previous Fed meeting on August 7 is breathtaking; it is far and away the most ominous portent of the future prospects of the US economy since the current "subprime crisis" broke into the market's consciousness earlier this year. Comparing the results of the August meeting with Tuesday's is like going to the doctor wanting to have a hangnail removed and having the physician start his conversation by asking how you feel about cremation.

Clearly, this is an indication that the Fed feels that the surface calm that has returned to world equity markets since the discount rate cut is illusory. Contributing to this must be the actions by the Bank of England to once again bail out the troubled Newcastle-based Northern Rock bank. A crisis that began in the overheated condominium markets of southern California and Florida has spread across the globe.

The fact that the Fed chose to lower both the funds and discount rates is indicative of the uniquely serious nature of this crisis.

As I explained in my August 21 Asia Times Online article, When the big guns fail, call in China, the discount rate and the Federal Funds rate are two very separate monetary policy instruments. The funds rate (lowered on Tuesday, for the first time in four years, to 4.75%) is customarily the lower of the two; it governs the interest paid by big banks when they initiate short-term lending and borrowing between each other.

The Federal Reserve sets a "target" point for this rate; when they think that the economy is growing too fast, threatening inflation, they raise the target, as they did 17 times between 2004 and 2006. Likewise, when they are fearful of an economic slowdown, they lower the target, as they did on Tuesday. The Fed effects these target rate changes through either buying or selling Treasury securities in its portfolio, to either provide or drain sufficient liquidity from the system to move the market rate to the target rate.

The discount rate is always meant to be higher than the funds rate. This is the rate at which the Federal Reserve will directly lend to banks shut out of the private Federal funds market due to concerns about their soundness; it is higher than the Federal Funds rate because the Fed wants to be available, but not easy. Lowering the Fed Funds rate is the preferred policy choice when the problem the Fed wants to address is feeling that there is generalized economic weakness.

Discount window borrowing is considered the most effective tool for times such as now, when certain banks and other financial institutions are being denied access to Federal funds loans because of fears of their connection with the subprime market. However, the Fed had already lowered the discount rate 50 basis points on August 17, to 5.75%. If they had lowered it another 50 basis points without lowering the funds target, the funds target would have been even with the discount rate, at 5.25%. So what we really saw on Tuesday was another discount rate cut masked by a Federal Funds target rate cut.

To me, the most remarkable thing about these events is that they demonstrate the breathtaking disregard that US economic policy makers have regarding the value and fate of their own national currency. Richard Nixon-era secretary of the treasury John Connolly, speaking to European economic officials, once said that the US dollar was "our currency, but your problem". The country could get away with that back in the early 1970s, when the US was the world's biggest lender; now that this situation is reversed, and the country must borrow $2-3 billion from foreigners each and every day just to feed its overconsumption addiction.

The market reaction to this Fed move was about as expected as the day's sunrise - a sharp fall in the US dollar. The greenback finally breached the record 1.4 level versus the euro; it has now fallen 15% against the euro since early 2006, 63% since early 2001.

Still, none of this had any effect on the drunken bacchanalia that erupted on Wall Street following the announcement. The Dow Jones Industrial Average soared 336 points, 2.51%, to 13,739;

CNBC's Maria Bartiromo was so gushingly giddy in her coverage of the rally that you would have thought that Starbucks had opened a coffee stand in her electroshock therapy suite.

Shares of broker/dealer industry companies had a particularly fine afternoon; Goldman Sachs rose 7%. If you accept the thesis from my article of this past Monday, September 17, A rate cut with a shoeshine and a smile that Federal Reserve chiefs are, in reality, nothing but glorified salesman for the US financial services



industry, then Tuesday saw a particularly glowing employee evaluation placed in Bernanke's file.

Very few other countries have ever been able to make such whoopee as their national currencies are being debased. In 1981, newly elected French socialist president Francois Mitterrand had to abandon his campaign promises for an ambitious social equality program when currency traders started to sell the franc hard against the West German mark.

In 1993, when US labor secretary Robert Reich urged an expansive social welfare/jobs reflationary fiscal program; newly elected president Bill Clinton nixed this idea when treasury secretary Robert Rubin advised the president that this would cause both the US dollar and bond prices to fall. When their currencies were hit by speculative attacks, the countries most affected by the 1997 East Asian financial crisis, primarily Thailand, Indonesia and South Korea, were forced to make painful cuts in their national social welfare spending.

But it seems that the US is never forced to face such dolorous consequences as its currency weakens. Its policymakers initiate policies that they know full well will weaken the US dollar, and they just don't care. It's almost as if the nation can pay for goods with checks it knows the other party will never cash; if you could do this, you'd probably be living pretty large too.

This is particularly true in the case of China. China's foreign exchange reserves are now approaching the trillion and a half dollar level, and this massive wad of cash is mostly kept as US dollars. China has earned this treasure through being the gleaming supermall for the shop-till-you-drop obsession that has swept the US, and to a lesser extent the rest of the Western world, this decade.

What Ben Bernanke is saying with his sharp interest rate cuts, and what the nation is affirming its approval of with the orgiastic stock market response that followed, is that it continues to hold no other value higher than the pleasure to be attained through its own excess consumption. In depreciating the value of the currency it uses to pay China for its goods, the US is telling China that it has no intention of paying China the full value for what it buys from it; that would be unacceptable, it would mean that there would be less money to buy even more stuff.

Of course, China does not have to continue to put up with this. It could stop accepting the funny money dollars, the depreciating greenbacks with Mickey Mouse's picture on the face instead of George Washington's. China could convert its foreign exchange reserves into other currencies by selling its dollars. As this would severely reduce the demand for US Treasuries in which China parks its reserves, US interest rates would have to rise sharply to re-attract the securities demand lost from China, and there would be little or nothing that Bernanke, Treasury Secretary Henry Paulson, President George W Bush, or even the US's first infallible-by-decree army general staff officer, the Blessed Holy Father General St David Petraeus, could do about it.

This would not be an easy thing for China to do, so the US feels China will not do it. If China actually did try to publicly sell all or a large part of its dollar portfolio the prices of the dollar assets remaining in the portfolio would undoubtedly fall sharply; China could lose a lot more than it gained. Still, Bernanke has just told China that, come hell or high water, he fully intends to filch away the value of their reserves. Maybe China could decide that it's a choice between losing a lot of money, fast, by selling its dollars, or losing a lot more, slowly, by keeping its dollars.

Like pulling off a Band-Aid, it probably hurts less to do it fast. Or, China could do it smart, slow and gradual; that's the way China likes to manage change. There are some indications that this is exactly what is happening. From a level of over $160 billion a year in 2006, Tuesday's US Treasury Department's Treasury International Capital (TIC) report, released a few hours before the Fed meeting and so thus totally ignored, showed that foreign (like the Chinese central bank) buying of US government securities actually turned negative in July. (I wrote about the implications of TIC data in my March 24, 2006 ATol article, US living on borrowed time - and money).

China probably is already diversifying away from the US dollar, but among all the cacophonous noise of the glorious roiling tsunami of inanity that is US public life, the actual signal information is being missed.

There were a few disquieting responses to the Fed move. Crude oil continued its recent record breaking rise, topping $82 a barrel. This market knows that, unlike China, the members of the Organization of Petroleum Exporting Countries (OPEC) long ago made clear that they would not accept depreciating dollars in exchange for their non-renewable export assets; oil prices go up as the US dollar goes down. China seems to be learning from OPEC's example.

The most interesting aspect of Tuesday's market responses to the Fed cuts may be the most massively under-reported - the fact that the only one of the Dow 30 stocks that did not rally on the news was, curiously enough, Boeing. Boeing got some bad news on Tuesday with some press questions regarding the potential crash survivability of its new 787 Dreamliner, but, in a market move like Tuesday's, even that type of report is usually ignored. The market wisdom for rally days like Tuesday is that these are times when "even the [scatological term] floats to the top".

I see the Boeing stock price divergence as more of an indication that, with Boeing so dependent on Chinese airline demand, the company may be in big trouble if China really does act to reduce its economic relationship and dependence on the US.

On an episode of the old 1970s CBS-TV situation comedy The Mary Tyler Moore Show, it once was suggested in the fictional television newsroom where the show was set that, since the previous night's newscast had done so well in the ratings, they should get out the script and broadcast it again - why mess with success?

In that spirit, since this Federal Reserve move has apparently gone over so well, (with the only constituency that really matters in the US, upper and upper middle class investors) there will probably be more cuts at the next Fed meeting in late October should there be further bad subprime or economic news, which there undoubtedly will be.

How long will the nation get away with the debasement of its own currency and the defrauding of its lenders? I have no idea. I find it most amazing that, in its actions, the nation is ignoring the very principle at the heart of the subprime crisis the Federal Reserve's actions are trying to remedy. To their own misery, the subprime borrowers have learnt the lesson that the nation has yet to learn. You can't forever live in a house, or in a consumer lifestyle, that you cannot afford.

Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.

(Copyright 2007 Asia Times Online Ltd. All rights reserved. Please contact us about sales, syndication and republishing.)

Not so benign neglect
For a top US central banker to claim today that the dollar's ongoing five-year devaluation is "inexplicable" is simply hard to swallow. There are major costs associated with the Fed's neglect of the dollar, and it had better at least start sounding like it has thought through some of the issues.
Doug Noland wraps up the previous week's developments each Monday. (Oct 15, '07)

Henry CK Liu:
Super Capitalsism, Super Imperialism and Monetary Imperialism
Part I: A Structural Link
Part II: Deregulation: Global War on Labor

Unemployment and Credit Crisis

Dinner roll model of Yale economics
A famous-yet-laughable Yale economist bonehead thinks the Fed can "mitigate" the US housing bust by taking "aggressive actions". This guy is saying that there IS such a thing as a free lunch! Hahaha! Bigshot Yale economist!

Road to ruin
The week saw the credit crisis engulf the epicenter of the US credit system. Not surprisingly, the Fed rate cut only seemed to exacerbate market tension, with oil, gold and commodities spiking and the dollar faltering. Those arguing that the Fed needs to cut rates aggressively to avoid recession are disregarding the much higher stakes involved.
Doug Noland wraps up the previous week's developments each Monday. (Nov 5, '07)

http://www.counterpunch.org/farago11032007.html

November 3 / 4, 2007
From AAA to Junk
The Housing Crash, Suburban Sprawl and the Crisis of the American Middle Class

By ALAN FARAGO

Congress and the White House, state governments, local legislatures and lobbyists are vested to the hilt in denial: that the downgrade by Moody's of at least $50 billion in collateralized debt from AAA to junk is a verdict on an economic model-suburban sprawl-that is torpedoing America's middle class.

At the heart of sprawl is securitization: that is to say, the packaging of mortgages by Wall Street indifferent to locale so long as the shape, size, and purpose of its components is more or less the same.

The catalogue of horrors is not exclusive to the middle class, of course. In places like Miami, the housing bubble had the collateral effect of diverting attention from the needs of the poor. While local legislatures did the bidding of the growth machine, the county housing agency was looted to a fare-thee-well.

But it is suburbia is where the financial avalanche in debt markets started-in states like Florida where a sophisticated economic elite, tied to the interests of production homebuilders, primed the pump of the growth machine.

Today, the stock market remains near historic highs but it is increasingly irrelevant to the middle class. The Wall Street press is filled with hope for another interest rate cut by the Federal Reserve. There is James Cramer (who even appeared on NBC Nightly News! as a reporter from the trenches) hyperventilating over the Fed "doing something", but when it can turn its TV set off long enough to pay attention, the middle class is like a boxer looking at its face in the mirror for the first time.

Round after round of promises: low inflation, steady job growth, health care, bridges, highways, the promise of public education, social security, the environment: what stares back at the middle class is an almost unrecognizable result.

The phenomenon was noted in the Sunday New York Times Magazine, "End Times for Evangelicals?" The report explored the profound change as Christian conservatives abandon the Republican party.

Some evangelical leaders are apparently concerned how closely tied the religious right has become to corporate America.

Another aspect, scarcely noted by the Times, is how the religious right organized in megachurches located in suburbia and rose exactly in proportion to the false prosperity of a housing bubble.

The constituents of suburban sprawl need constant spiritual renourishment even as discomfort spreads of its strip mall culture. The megachurches are a welcome relief for wage-earners pinned by long commutes from home to work and especially for latch-key children otherwise languishing in homes without mom or dad.

The bursting housing bubble is fragmenting the religious right. It's not a matter of evangelical convictions faltering. It's a matter of home economics ruining families as lines of credit and home equity make fools of believers. It's not just about church on Sunday. It's about the middle class coming to a boil over manifest inflation despite government assurances, good news papering over rampant fraud, it's about vanishing home equity, and it's about the middle class realizing that it has been left behind by arks of privilege.

It's in this context to consider two pieces of news: first, that Stanley O'Neal-the CEO of Merrill Lynch-has been held accountable for the worst loss in Mother Merrill's history, some $8.4 billion and yet will retire, according to press reports, with a payday that could reach $200 million.

The second piece of news is from the New York Times (Saturday, October 27, 2007), "As Housing in Florida Plummets, the Top Tier of the Market Just Dips."

"Despite a record number of foreclosures and a raft of public auctions of unwanted houses, the upper tier of the real estate market in Florida remains relatively immune to the spreading disaster As in other once-booming regions, in Florida the housing market seems to be not one market, but two. The lower end is littered with vacant houses and unfinished developments, and homeowners are struggling to meet their monthly payments as rates adjust upward. The luxury end has its unsold new condos and mansions lingering on the market, too, but as in New York, where the demand in pricey Manhattan is still strong, sales have fallen less. And Miami and other parts of Florida are continuing to attract interest among the wealthy."

At the same time, the stratification of housing markets in places like Manhattan or tony vacation retreats in Florida appear to the middle class to be supported by the kinds of financial fraud that turned dreams of wealth into bankruptcy on Main Street and turned AAA rated paper to junk on Wall Street.

But it does not pass unnoticed by Main Street that Wall Street can walk away from its failures with hundreds of millions, all taken down as fees and commissions and salaries in the creation of financial derivatives-or how speculators and bankers and developers in places like suburban Miami have squirreled away profits from developments at the edge of the Everglades foisted off as a public good-or, how the deal worked out by Wall Street banks whose off-book transactions shielded nearly $100 billion in losses will result in a further rain of commissions-as much as $1 billion worth according to recent financial reports.

These are the arks of privilege insulating the highest strata of society from the disintegration of the US dollar.

Today, homeowners in the millions-middle class Americans-are absorbed with the anxiety of foreclosure, of a home that can't be sold except at a loss, or, of personal debt tied to vanished gains of an unrealized asset. But there is more.

How much more remains to be seen. The total damage to financial institutions, measured in the hundreds of billions, may be absorbed by the wealth of nations, but the damage is so large, so global, no wonder most middle class Americans have no idea what hit them.

Here is what hit the middle class: wealth drained from the US economy by the forces of globalization-owned as equity now in low-cost labor or oil-producing nations-returned to the United States in the form of US government debt but also ownership of mortgage backed securities and other higher yielding financial derivatives. That they should be less than eager for a repeat performance should surprise no one.

And American voters think the biggest problem is tax dollars financing both sides of the "war on terror"? No. There's more.

If securitization defines suburban sprawl as a matter of scale (ie. more Targets, more Lowes, more McDonalds: can you really fit a hundred million people into Florida?), scale itself makes accountability vanish.

As accountability vanishes, uncertainty rises exponentially. There is a domestic analogue to the uncertainty plaguing world credit markets: for the American middle class, as accountability vanished in the financial sphere, so did the ideals of a civil society and representative democracy.

The middle class was promised the "ownership society", and while it was passively satiated by "American Idol" and "Dancing with the Stars" promising that anything is possible, its pockets were picked.

The middle class was robbed by liar loans and mortgage fraud, from toxic consumer debt to the wholesale conversion of local government to the purposes of the growth machine.

The biggest risk-one that the mainstream press and Wall Street, both, should take into account-is that the coming recession will trigger a backlash against the bankers and financiers whose engineering related to housing markets and mortgages did not, in fact, diversify risk (as securitization of mortgages was advertised to do,) but concentrated risk by raising the unquantifiable to exalted status.

America's political and economic elites have been perfectly happy with the arrangement, but in 2008, watch the "values voters". This time, the middle class, evangelical or not, will be pegged to the value of the dollar more than the morals so many candidates for political office wear on their lapel like laquered pins of the American flag.

Alan Farago of Coral Gables, who writes about the environment and the politics of South Florida, can be reached at alanfarago@yahoo.com.

papabear,

GREAT articles you have posted.

I'm wondering about what your economic predictions are for 2008. I see commodities heading higher, and the US middle class being reduced to buying cheap food and products in order to survive.

Gas prices should head higher towards $4 a gallon while housing values will hold. Since the Federal Reserve is pumping so much money into the system, I don't see housing values to drop. This will help to prop up the banks and lenders who will undoubtedly fail if housing prices fail.

Hrm, I wouldn't venture any predictions, though in general I'm inclined to think that things will become noticeably bad--that is to say it will become obvious to more Americans, as opposed to now, when people just have a "feeling".

What country would be least hurt by a severe dollar crash?

THE CORNERED RAT DEFENSE OF INFLATIONARY COLLAPSE
by The Mogambo Guru

There is a line of argument which says that because money will be literally disappearing as loans default and new loans are not taken out, inflation in the money supply will fall, which means that prices will fall, and thus this proves that we are going to suffer a deflationary collapse instead of an inflationary collapse, where prices go up and up.

You gotta admit; it seems to be a compelling argument; the money supply will fall as loans go bad, which means consumer prices will fall. And with loans going bad, nobody is going to either make a loan or take one, and so the money supply will not grow.

This presents a real difficulty for me, as it means that when people demand that I defend my thesis that we will, instead, see an inflationary collapse, I can't. The fall in the money supply seems so compelling!

So I nervously hem and haw, desperately looking for some plausible reason, and I can't think of one, and pretty soon I am resorting to personal attacks against the person questioning me ("Did your stupid kids dream up that question, or is that your own stupid question?) and all-in-all I get to feeling like a cornered rat, which usually leads to the Attack Without Mercy (AWM), which is, actually a "surprise attack" even if the enemy knows right where you are, is looking at you, and is actually laying in ambush for you! I get this little-known tactical nugget from General Armstrong Custer himself in the movie "Little Big Man", where he said, in this very "they know we're here!" circumstance, "Nothing is more surprising than the attack without mercy!"

So imagine my great relief to have an ally in Peter Schiff of Euro Pacific Capital, who writes, "Many mistakenly believe that when the U.S. economy falls into recession, reduced domestic demand will lead to falling consumer prices. However, what is often overlooked is the fact that as the dollar loses value, the rising relative values of foreign currencies will increase consumer demand abroad. As fewer foreign-made products are imported and more domestic-made products are exported, the result will be far fewer products available for Americans to consume. So even if the domestic money supply were to contract, the supply of goods for sale would contract even faster. Shrinking supply will be a major factor in pushing consumer prices higher in America."

Hey! I love it when math works in my favor for a change, instead of the bank showing me the math of where I had screwed up my checking account, and the math about how I owe them money for overdrafts and bounced checks. Now it would be the other way around, for a welcome and long overdue change! Now I would get right in THEIR stupid little faces and demand that THEY come up with some cash, you deadbeat losers, and right now, or I'm calling the cops! Oooh! I tingle at the anticipation!

I was enjoying this little tingle and almost missed the whole point, which is that, "The big problem politically is that hyper-inflation may superficially appear to be the lesser evil. If asset prices are allowed to collapse, ownership of those assets will pass to our creditors. If instead we repay our debts with debased currency, we retain ownership of our assets and shift the losses to our creditors."

That's the way it shapes up, and the deciding factor is, so he says, "Since American debtors can vote in U.S. elections and foreign creditors can not, the choice seems obvious. Of course there are some American creditors as well, but since they comprise such a small percentage of the electorate, my guess is that their losses will be seen as acceptable collateral damage."

Exactly so! That is the depth to which the American government has sunk; the "good of the majority" is paramount over the desires of the minority, which is proved when something like the bottom half of taxpayers ranked by income pay no income tax at all, while the top 1% pays more than half of all income taxes, and the fact that almost half of the people in the USA receive money directly, or indirectly, from the federal government each and every month! Hahaha! What a system! The "Good of the Majority" run amok! Ugh.

Until next time,

The Mogambo Guru
for The Daily Reckoning

Mogambo sez: With all the losses, the Dow Jones Industrial Average index is now sporting a price-to-earnings ratio of 47. You have probably concluded by the way my face is ashen and my breath comes in ragged gasps that something is wrong, because this means that the price of the Dow would have to fall to half to bring the P/E ratio back to 23, which is also unnaturally high, and due to fall some more!

And bonds? Hahaha! Bonds are so highly priced that they are literally yielding less than the rate of inflation as it is!

But this is all not just wrong, it is more than wrong; it is insane! Hahaha! Insane! Insane, I tells ya!

And that is why I cling to gold and silver with such force, measured in sheer firepower, which is the only sane thing left to do in a world gone mad! And that is not just me talking like I am such a smart guy who has figured out something new and exciting, but the sum total of all of the world's history, which proves over and over and over again that everyone always turns to gold at the end. Always. The smart ones first.

Editor's Note: Richard Daughty is general partner and COO for Smith Consultant Group, serving the financial and medical communities, and the editor of The Mogambo Guru economic newsletter - an avocational exercise to heap disrespect on those who desperately deserve it.



Michael Shedlock, Asymmetrical Unwind of the Credit Bubble

http://www.atimes.com/atimes/Global_Economy/JA08Dj02.html
Subprime disease a traded infection
By Thomas Palley

In recent months, the US subprime mortgage crisis has been rippling outward affecting other countries. British banks have made large loan-loss provisions and there has been a run on the Northern Rock bank. German lenders have incurred similar losses and Germany has suffered two large bank failures. European banks have also become leery about lending to each other, forcing the European Central Bank to infuse emergency liquidity. Now, Japan’s banks are feeling the heat.

These global spillovers have their origin in the huge US trade deficits of the past several years. Those deficits played a critical



role generating the distorted interest rate environment that created the subprime bubble, and they also explain how subprime loans have wound up in Tokyo portfolios. For policymakers everywhere there are lessons about the dangers of large trade deficits.

Over the last several years, the US trade deficit has persistently drained spending from the US economy. As a result, much of manufacturing failed to recover after the recession of 2001, making for a weaker than usual recovery. This weakness prompted the Federal Reserve to push interest rates to historic lows in 2003, keep them there for an extended period, and then only raise rates gradually for fear of undermining the economy.

The Fed’s ''easy money'' policy succeeded in avoiding a relapse into recession, but it came at the price of a housing bubble and a twisted expansion. The hallmarks of this twisted expansion were house price inflation, a construction boom, explosive growth of non-traditional subprime mortgages, a debt-financed consumer spending binge, and yet larger trade deficits.

The counterpart of these deficits was trade surpluses in the rest of the world, which provided the conduit for distributing subprime holdings globally. Moreover, these trade surpluses persisted because many countries actively pursue export-led growth, and they therefore blocked appreciation of their currencies against the dollar to maintain competitiveness in US markets.

These large surpluses in turn sought an investment home, which helps explain why long-term interest rates did not rise as predicted when the Fed eventually raised short-term interest rates after 2004. More importantly, artificially low short-term interest rates promoted a ''chase for yield'' among investors, who started lending at diminished risk premiums.

This chase affected both American and foreign lenders. In Japan, interest rates have been close to zero for a decade, while European interest rates have been below US rates since the end of 2004. Japanese and European investors therefore willingly bought subprime mortgage loans, which spread holdings around the world and also elicited additional supply.

Ironically, owing to bureaucratic inertia, China is the one country that did not get caught up in the frenzy. Instead, it has invested in Treasuries, while capital controls have limited individual Chinese investor access and exposure to US financial markets.

The vast scale of foreign accumulation of dollar assets means that other countries are now vulnerable to US credit market losses. Paradoxically, that may support the dollar. However, other countries are better placed in terms of economic fundamentals. Though they will bear financial losses, their households are in better financial shape - except in countries that have also had house price bubbles. Contrastingly, US households are burdened with debt, and there is a massive overhang of house supply that promises to drive down house prices, further erode financial wealth, and further undermine economic activity.

The sting in the tail is that a troubled US economy will likely come back to haunt other economies because of their reliance on export-led growth and investments aimed at supplying US consumers. And that sting may hurt China most owing to its heavy reliance on export-led growth and foreign direct investment.

From a policy perspective there are several big lessons. First, failure to address problems in one area (trade deficits) can trigger policy responses elsewhere (monetary policy) that ultimately create even bigger problems. Second, large trade deficits cause real distortions, the consequences of which are costly, albeit slow to emerge.

The consequences of the distortions caused by the US trade deficit will be worst for the US, but they will also affect surplus countries that have accepted dollar-denominated financial assets in payment. Moreover, many countries are vulnerable to the extent that they depend on the US market. That points to the urgency of global policy mechanisms preventing repeats of such trade imbalances, and for countries to shift from export-led growth to domestic demand-led growth.

Thomas Palley is founder of the Economics for Democratic and Open Societies Project.

(Copyright 2007 Thomas I Palley.)

http://www.atimes.com/atimes/Global_Economy/JA08Dj03.html
Tumult ahead
by Doug Noland

COMMENTARY

I'll cut to the chase somewhat and highlight three of the major themes for what will surely be a tumultuous and historic 2008: An ongoing bust in "Wall Street-backed" finance; mounting recessionary forces imperiling the US bubble economy; and worsening global monetary disorder.

It is a confluence of extraordinary developments that will keep policymakers discombobulated and impotent, with financial market participants increasingly aghast at what they perceive as ineffectual policymaking. This year will fundamentally change the



Greenspan/Bernanke Fed's (fallacious) doctrine that bubbles are to be ignored because of the confidence in the effectiveness of post-bubble "mopping up" measures. Going forward, an appropriate "risk management" approach to central banking will give much greater weight to restraining credit and speculative excess.

Last year was a watershed year for both US and global finance. Spectacular breakdowns in the gigantic markets for Wall Street's "private label" mortgage securitizations and mortgage-related derivatives fundamentally and profoundly altered the financial and economic landscape - for years to come. The loss of trust in structured credit products' ratings, pricing, leveraging, financial guarantees, counterparties and marketplace liquidity is an ongoing saga that will for some time significantly restrain both credit availability and marketplace liquidity.

US risk asset market (financing and speculating) dynamics have been altered and myriad bubbles are in now jeopardy. Resulting recessionary forces are so powerful I am confounded as to why the vast majority of analysts and strategists maintain ridiculously low probabilities for recession for 2008. It's on us. And a key economic Issue 2008 is how rapidly and deeply the bubble economy falters, a dynamic that will be greatly influenced by the performance of the financial markets.

As we begin 2008, I believe the US bubble economy is unusually susceptible to stock market weakness. Consumer confidence has waned right along with home prices, yet I'll suggest that equities market resiliency worked to support the general view that US economic fundamentals remained sound. Prolonging the equities market bubble also played a role in cushioning the Credit market crisis. Faltering stock prices will now batter fragile consumer and debt market sentiment, creating a spiral of market weakness begetting and reinforcing economic weakness. Moreover, I expect negative sentiment to be reinforced by what will soon be a steady stream of headline-grabbing job cuts, especially in the financial and retail sectors. I would argue that, in the case of both the stock market and corporate America, last year's disregard for the true ramifications of the bursting credit bubble will make for a more problematic 2008 in the markets and otherwise.

Consumer spirits are certainly not being heartened by headlines of US$100 crude oil. And while the bloated consumer sector of the economy will initially suffer the brunt of recessionary headwinds, other dimensions of economic activity (ie energy, alternative energy, agriculture, metal and mining, and exports in general) will be governed by powerful inflationary dynamics. Wall Street is keen to ridicule the Fed's (or at least a faction at the Fed Open Market Committee) attention to inflation risk. The reality of the situation is that global inflationary pressures have become the most robust in decades. In 2008, economies with weak currencies, huge trade deficits and large imported energy requirements will face outsized inflationary risks.

Attempting to illuminate dynamics associated with today's problematic Global Monetary Disorder, I'll use an analogy to the mortgage finance bubble. The GSEs (government-sponsored enterprises such as mortgage finance institutions Fannie Mai and Freddie Mac) with their quasi-government status, hence market perceptions of superior debt quality, were for years instrumental in nurturing market distortions and powerful inflationary biases throughout American housing markets (homes and mortgages).

By the time GSE accounting irregularities brought an abrupt halt to their ballooning credit expansion back in 2004, inflationary biases had become more than sufficiently powerful to accommodate the shift to massive issuance of Wall Street-backed "private-label" MBS (mortgage-backed securities). This credit onslaught was, at least for awhile, sufficient to sustain the bubble. I have discussed how Wall Street grabbed the mortgage finance bubble "baton" from the GSEs (and ran like crazed lunatics).

Well, US credit bubble excesses - manifesting into asset bubbles, unprecedented spending and "investment" distortions, massive current account deficits, and highly leveraged speculation - over a period of years nurtured increasingly robust global credit bubble dynamics. And just as mortgage/housing inflationary biases invited wild and destabilizing ("blow-off") credit excesses from an emboldened Wall Street, US bubble-induced global inflationary forces (ie securities markets, energy, commodities, and economies) have encouraged domestic credit systems around the globe to partake in an unparalleled global credit boom.

With few exceptions, double-digit credit growth has become the global norm, with "BRIC" (Brazil, Russia, India, and China) credit expansion likely in the 20% to 30% range. To be sure, "Wall Street" monetary disorder evolved into an even more unwieldy strain of global monetary disorder. Wall Street today wishes desperately that the Fed would completely disregard global issues and aggressively reflate. It is the nature of bubbles that such easy-money policies would work to exacerbate bubble excess, with minimal impact on those that had already burst.

There are today great - and apparently unappreciated - risks associated with aggressive Fed rates cuts further aggravating global liquidity, financial flows, and currency market excesses and instabilities. This is not 2001/02 or 1998, and the current backdrop is the antithesis of the early-nineties global "disinflationary" backdrop that provided the Greenspan Federal Reserve the flexibility to orchestrate a historic banking system recapitalization and economic reflation.

For one, the Fed today risks inciting a crisis of confidence for our degraded dollar and currency market dislocation more generally. Second, there are the enormous financial, economic and geopolitical risks associated with the continuation of rampant energy and commodities inflation. Third, aggressive Fed rate cuts risk exacerbating increasingly destabilizing financial flows (teaming with now rampant domestically induced excesses) to Asia and the emerging markets (Brazil, Russia, India and China - in particular). The last thing an increasingly unstable Chinese bubble needs is another year of massive financial inflows. Fourth, with monetary disorder and general inflationary pressures mounting rapidly across the globe, reflationary policies here at home today have a much greater propensity for feeding into traditional measures of consumer price inflation than they’ve had in decades.

Returning to my credit bubble baton analogy, it is instructive to contemplate how precarious it became when Wall Street-backed credit supplanted (quasi-govt) GSE credit at the ("terminal") blow-off phase of mortgage finance bubble excess. This period of acute monetary disorder was fueled by unfettered inflation (issuance) of Wall Street securitizations conjoining with manic speculative impulses. Inflating home prices, market euphoria and accompanying economic distortions masked the fundamental fragility of the underlying credit instruments, debt structures and asset prices.

Today, similar dynamics enshroud acute asset market, credit system and economic vulnerabilities on a global basis. The US credit system handed the global credit bubble baton to domestic financial systems in the likes of China, Russia, India, Brazil, the oil/commodity producing economies, and the emerging markets more generally. These immature and unsound "contemporary" financial systems are today perpetrating a credit fiasco paralleling US subprime but on a much grander scale.

Keep in mind that only deep-seated underlying US systemic weakness (manifesting into massive financial outflows and a depreciating currency) could have engendered the profligate backdrop where (fundamentally deficient) credit systems across the globe could inflate with such reckless abandon. The bottom line is that credit bubble and "Ponzi" dynamics are working their seductive and disastrous effects now on an unprecedented international scale.

To those arguing that aggressive Fed rates cuts pose inconsequential risk, I have the following retort: "Only if you exclude the risk of global financial and economic collapse."

Analysts of the bullish persuasion have been trumpeting the US economy's resilience in the face of the "subprime" crisis. As I have addressed over the past few months, our bubble economy has been bolstered by significant ongoing credit creation - even in the face of the bust in Wall Street-backed finance. Importantly, the liabilities of some key sectors have retained their "moneyness" throughout the crisis, spurring a rapid expansion of the thus far immune debt instruments. Bank credit has expanded at a 16.1% rate over the past 23 weeks and finished 2007 with one-year growth of a record US$964 billion, or 11.6% (2-yr growth of 23.4%!). Money fund assets ballooned at a 46% rate over this same 23-week period (to $3.1 trillion), with one-year growth of 30.2%. Fannie and Freddie’s combined books of business (BofB) expanded on average almost $55 billion monthly between March and November, in what will be a record year of BofB growth. The Federal Home Loan Bank System likely expanded credit at a 30% to 40% annualized rate during the second half, capping off what will also be record annual growth.

The ongoing bust in Wall Street-backed finance will undoubtedly be a major Issue for 2008. No amount of Fed rate cutting can reverse this spectacular debt collapse. The fallacies of so many aspects of ''contemporary finance'' have been exposed. Going forward, the viability of many firms involved in Wall Street risk intermediation will be in doubt. The financial guarantors are in serious trouble. The credit default marketplace will attempt to forestall implosion. Problems that will beset the colossal
leveraged speculating community have only begun to emerge.

What impact Fed "reflationary" policies have on the ballooning bubbles in the "money-like" credit sectors is a less obvious but major issue in 2008. With Wall Street risk intermediation now virtually out of the equation, the ballooning bank, GSE, and money fund complexes are left in a perilous position as the prominent risk intermediators (of last resort) for a US bubble economy at the precipice.

Delaying the inevitable (arduous) financial and economic adjustment period through aggressive Greenspan-style cuts only



exacerbates the unmanageable risks accumulating in institutions issuing enormous quantities of perceived safe and liquid liabilities ("money-like" debt instruments). The difference between a deep recession and a devastating depression hinges - as it has historically - on maintaining market faith and confidence in "money". A serious Issue 2008 has the perceived soundness of ''money'' today in the most serious jeopardy in almost 80 years.

It will be another year of fascinating tests for macro credit theory and analysis. Is it possible for our bubble economy to persevere through 2008 without ever increasing quantities of system credit growth? Assuming such massive credit creation is in the offing (a major assumption today), how does the credit system pull off such a feat and what will be the consequences? Well, it would certainly necessitate ongoing bubbles in "money" market instruments, including Treasuries, "repos", and agencies. It would also require a massive issuance of agency MBS, along with another year of double-digit (trillion plus!) bank credit expansion. And we must also hope that our foreign creditors will not completely back away from our risk markets.

Today, ongoing credit excess, current account deficits and financial outflows inundate the world with dollar balances - that are then recycled back to a limited supply of perceived safe Treasuries and (to a somewhat lesser extent) agencies. This resulting bubble has severely distorted the fixed income marketplace, creating one more facet to the unfolding financial crisis and dislocation. The first three trading sessions saw stocks in virtual freefall, Treasuries in melt-up mode, the yen rallying strongly, and many spreads widening meaningfully.

2008 has commenced with some key hallmarks of impending financial dislocation - not a huge surprise since we’ve for some time now been in the midst of an unfolding financial crisis. The stock market is in some serious trouble, and the US bubble economy is in serious jeopardy. Myriad global bubbles are accidents waiting to happen. Worse yet, we're now officially in what will be a decisively unbullish political campaign season. There’s also increased talk of Wall Street investigations - of which there will be plenty. Disconcertingly, the public mood is turning increasingly sour at home and the geopolitical backdrop more problematic abroad. Get ready for one of the consequence of bursting bubbles - a public less trusting in "capitalism", a world increasingly lured to "protectionism", and a federal government much more intrusive in our financial lives.

As for Issues 2008, there are obviously many and they are unusually varied - a wide spectrum of financial, economic, political, environmental and geopolitical risks. I really fear a major California bust has commenced. But what worries me most at the present is the possibility of a run on the leveraged speculating community, a circumstance that could potentially precipitate a seizing up of even the more money-like debt markets at home and abroad. I foresee chaotic markets. As always, I can only hope my fears prove unfounded.