Foreign Policy

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3
Aug 11

The Meal Was Great; Our Outlook, Not As Good

I had dinner the other day with two close friends, both former colleagues.  We are, in parlance, “men of a certain age:”   baby boomers, children of the sixties, sons of World War II veterans.  We all began our work lives in our twenties, worked for giant corporations, and turned jobs into long-term careers.  When first hired by our companies, we planned to stay just a couple of years and then move on to another company.  With the benefit of hindsight now, and the need for false humility ended, we can each gratefully admit that we enjoyed significant professional success, although none of us thought we would rise to the senior executive levels that we did.

We now occasionally get together for dinner and discuss our families, our current pursuits, how our former employer is doing and the general state of things.   Last time, we discussed what went wrong with America generally, why our children will not have long careers with large companies, and why they likely will not be as financially successful as we were.

We spoke about our fathers and the norms of their generation.  They fought in the War, returned and worked hard, and had few expectations about success or wealth.   They kept their noses to the grindstone and rarely complained.

We discussed the landscape of the corporations we went to work for.   When I was hired as a junior attorney, the General Counsel barely made five times my salary.  Bonuses were stingy and a modest number of stock options (in the hundreds of shares) were offered to a handful of our most senior executives.  Interestingly, it was generally a harmonious and engaging work environment. In contrast, by the time I retired, the Chairman and CEO made more than 400 times what an average employee made.  Employees were not nearly as engaged or happy.

The immediate catalyst for our wondering what has gone wrong with America was the current debate over the US debt ceiling.  I started to think back to the blogs I had written and tried to put together some hypotheses.  I caution the reader this is not a rigorous, but rather an impressionistic view of sociological, political and economic trends which shape the current state of affairs.   If it is insightful, I give tribute to good dinner conversation and fine friendship:

  • Loss of Shared Sacrifice – Perhaps it was the “Me Generation” of the 1960’s, but America has lost its sense of shared sacrifice; that is, the notion that we are all in this together and we rise or fall as one nation.   Instead we have an ethic of greed:   I want what I want and I want it now, everyone else be damned.
  • Out of Control Military Spending – Too much of America’s resources are spent in our defense budget.  Compounding this problem is a series of seemingly endless wars.  While we deploy hundreds of thousands of troops to Iraq and Afghanistan, our allies deploy hundreds.  Note that the German, Canadian, and Australian economies boomed, while ours stagnated.
  • The Volunteer Army – A volunteer army allows wars to be fought by other people’s children.  Thus, the popular outcry against wars or military spending is diminished because our own (privileged) sons and daughters are less likely to be involved.
  • Too Many Laws – The Wall Street Journal highlighted the growth in federal criminal law.  We over-criminalize too many areas of society.  One commentator archly noted that someone violates some law each day, often unaware of his lawbreaking conduct. See As Criminal Laws Proliferate, More are Ensnared
  • Unequal Enforcement of the Law – Perhaps since the OJ Simpson trial, our citizens cynically believe that if one hires a good enough lawyer, one literally can get away with murder.  This carries over to the belief if a corporation is big enough, especially a “too big to fail” financial institution, it will never be prosecuted.
  • Socialism for the Rich, Capitalism for the Poor – When the “too big to fail” institutions became insolvent, the Bush Administration, Congress and the Federal Reserve rushed in with a comprehensive program of TARP and zero interest rate lending.  The Obama Administration has continued these policies from the beginning.  Insolvent homeowners have been evicted from their homes, and many unemployed workers have exhausted their unemployment benefits.
  • Reckless Lending and Borrowing – The Federal Reserve was a major culprit in the growth of both public and private credit.  Instead of accepting the economic consequences of the internet bubble crash, Alan Greenspan reduced interest rates to below market levels to encourage real estate lending.   Subprime lending further inflated the housing bubble. Based on an inflated residential and commercial real estate market the economy boomed.  Assuming that this was permanent prosperity, debt was taken on at all levels: states and municipalities, corporations, homeowners and the federal government.  Now we cannot repay that debt.

While my dinner with friends continued all in one evening, Part Two will continue this discussion.

 

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13
Feb 11

Restoring Federal Reserve Accountability

In We Cannot Separate Politics and Economics. And Those Who Speak Out Against Bad Policy are Helping the Economy…And Our Individual Investments; Washington’s blog makes an important point about the poor state of economic analysis.  Modern economists naively analyze the economy without regard to the interplay of politics:

Some people criticize the injection of politics into economic discussions.

But economic historians tell us that economists used to understand and accept that economics is wholly interrelated with politics, and that politics affects our economy. They note that modern economists have artificially tried to somehow separate the two, like Descartes tried to separate the mind from the body.

Indeed, the father of modern economics – Adam Smith – talked a lot about politics in relation to economics. Washington’s Blog

Recognizing the inter-connectedness of politics and economics, the discipline was originally referred to as “political economy.”  In fact Georgetown University has a political economy major.

The blog goes on to criticize the multi-trillion dollar expenditures on the Iraq and Afghanistan wars and the consequent deleterious effect on the economy.  Moreover, for the last ten years we have undermined any semblance of a free market by living under a state of economic emergency.   We have massively lost trust in government.  With the financial crisis and lack of prosecutions the public has also lost trust in our financial institutions, the SEC and the Justice Department.  But what is missing from this excellent analysis is the role of the Federal Reserve.

The Federal Reserve: Earnest Technocrats or Politicians in Disguise?

The Federal Reserve has a limited statutory mandate: maintain full employment and price stability.  Under Ben Bernanke the Federal Reserve has gone far afield from that mandate:

We now have a fourth branch, the imperial Federal Reserve.  Without our permission, this rogue branch is dictating economic policy for the United States.  Mission creep is taking the Fed from its dual mandates of employment and stable prices to its own self-proclaimed mandate: economic stimulation (in direct contravention of the views of the newly elected Congress and the American public) and dollar devaluation.   In QE2 it also has taken on the role of guardian of stock market prices. See Who Elected Ben Bernanke?

Bernanke has crossed into the realm of political decision making:

  • Ultra low short-term interest rates have fattened bank profits at the expense of retirees, pension funds and insurance companies.
  • QE2 money printing has set off a speculative binge in commodities hurting consumers.
  • QE2 has hurt the value of the dollar, favoring US exporters over foreign importers.
  • Higher import prices have hurt consumers since we have de-industrialized America.  Consequently, we are dependent on cheap foreign-made goods.
  • QE2 has exported inflation to foreign countries. Revolutions in the governments of our allies, Egypt and Tunisia, are not a coincidence.  Higher food prices in impoverished economies are a breeding ground for unrest. See A Perfect Storm in Egypt
  • QE2 has set off currency wars and raised global tensions with China, the EU countries, Brazil, and emerging economies.
  • QE2 permits the Federal Reserve to purchase a major portion of newly issued Treasury debt.  This permits continuance of unprecedented federal budget deficits.  Thus, Congress avoids making the necessary tough budget cutting decisions.
  • QE2 has also perversely raised the all important 10-year Treasury note yield by 1.25%, thus increasing mortgage rates and retarding any housing recovery.

Holding the Federal Reserve Accountable

The Federal Reserve cherishes its vaunted independence.  This independence was predicated on adhering to a technocratic, apolitical agenda of controlling money supply to provide a background for economic growth.  The Federal Reserve is now overtly operating in a political role: it determines winners and losers in the economy (banks favored over savers), the value of the dollar (exporters favored over importers and consumers), and financial speculators (the wealthy over the middle class and Wall Street over Main Street).  It is also interfering in foreign policy, exporting inflation in key commodities to foreign countries (many of which are our allies) and triggering a potential currency war and protectionism.  Finally, Dr. Bernanke recently lectured Congress about deficits: a topic far afield from the role of the Federal Reserve. See Bernanke Makes Sure Fed Reminds Congress Deficits Bigger Than QE2

Let me repeat: Ben Bernanke was not elected and he is not a benign technocrat.  Politics and economics are intertwined.   He was wrong about the housing crisis, the financial crisis and QE1.  Our politicians must rein him in and restore economic policy control to elected officials.

Some would argue that encroaching on Federal Reserve independence would undermine the institution hurting economic policy.  The military is under the control of civilian political leadership and there is no uproar over “military independence.”  If the military can be under political control then the Fed can be too.  The real issue is accountability and the Federal Reserve has little, if any accountability.  Conversely, it will also make our profligate elected officials equally accountable for economic policy.

It will not be easy or elegant, but it will begin to restore trust in our government and economy.

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3
Feb 11

A Perfect Storm in Egypt?

Much has been written about the Cairo demonstrations and the attempt to remove long-serving President Hosni Mubarak.  Pundits focus on rising democratic impulses, anti-Americanism and radical Islam.  In past blogs, I have pointed out a number of trends which create governmental instability, especially in the third world.   The confluence of these trends is at the center of the current turmoil in Tunisia, Yemen, Egypt and Jordan, and threatens to spread to other countries.

Before we begin, we must also remember the personal affront to their peoples perpetrated by the leaders of these countries.  In his thirty years in power the Mubarak family has accumulated a fortune estimated between $40b and $70b.  Contrast that with the average Egyptian family income of $2070 per year.  In Tunisia, the Ben Ali family was forced to flee the country for Saudi Arabia, but they took with them a family fortune estimated at 3.5 billion British Pounds.  So, on its face, a dictatorial power structure, which enriches a ruling family at the expense of an impoverished and disenfranchised citizenry, is an irrational structure doomed to fail.

Regime-Disrupting Technology

-          Costs of obtaining information have declined drastically.  Populations can widely and cheaply use the internet, computers and wireless communication.

-          Information now travels seamlessly between borders without central state control.

-          Social media such as Facebook and Twitter permit anti-government groups to organize quickly and outmaneuver government agents.

-          Wikileaks released documents showing cooperation between pro-Western Arab regimes and Israel.

-          Technology also permits the movement of work to the cheapest locations with the best-trained work force and developed infrastructure.  Thus, countries like Tunisia and Egypt are at a disadvantage in the game of global work force arbitrage. The small but vocal college educated middle class becomes more disaffected as they watch jobs migrate elsewhere.

-          Technology adds to structural unemployment.  As we have discussed in the past it  requires fewer people to operate a modern factory.  See Why This May be Worse than the Great Depression. Jobs available are highly specialized, eliminating much of the work force from hiring consideration.

-          As evidence of the above points, note that the first thing that the Egyptian government did was shut down cell phone and internet service.

All of these technologies operate in concert to fuse anti-government sentiment in autocratic, impoverished countries.

The Decline and Fall of the US Dollar

The US government’s response to the 2008 financial crisis has been to devalue the dollar.  This has been accomplished through a zero interest rate policy and money printing (quantitative easing).  The effect has been dramatic.  Basic food stuffs such as wheat, corn, rice, metals, cotton and energy have skyrocketed in price since the Jackson Hole, Wyoming, Federal Reserve Board announcement that QE2 would be instituted. See 1984 in 2010.  In countries such as Tunisia and Egypt these necessities constitute 40-50% of a family’s budget. A jump in inflation is felt immediately and triggers riots, protests and civil disobedience.

How ironic that in order to save the US economy we are exporting inflation and destabilizing long standing allies in the Arab world such as Egypt, Yemen, Jordan and Tunisia.

Anti-Americanism and Decline of Western Power

The Global Europe Anticipation Bulletin (GEAB) report (January 16, 2011) catalogues the decline of the international system and the diminishing power and influence of the West:

Just look at the inability of the international community to effectively help Haiti over the past year, the United States to rebuild New Orleans for six years, the United Nations to resolve the problems in Darfur, Côte d’Ivoire for a decade, the United States to progress peace in the Middle East, NATO to beat the Taliban in Afghanistan, the Security Council to control the Korean and Iranian issues, the West to stabilize Lebanon, the G20 to end the global crisis be it financial, food, economic, social, monetary, … to see that over the whole range of climatic and humanitarian disasters, like economic and social crises, the international system is now powerless. GEAB No.51 (subscription required)

The West (and especially the United States) lacks the vision or willingness to shape events.  The corollary result of this vacuum is the failure of Arab leadership amicable to the West:

Tunisia and Algeria were rocked by riots and Jordan, Egypt and Lebanon are experiencing serious problems. Beyond the reactions to higher prices for basic necessities, it is the first political shock of the “fall of the Dollar Wall”. The regimes in question are typically powers supported at arm’s length by Western money, that’s to say basically the US Dollar. The rapid erosion of Western credibility and financial resources especially US is already beginning to make itself felt, just like European impotence outside its borders. These countries’ elite are accustomed to feel “untouchable” thanks to their US and European protectors: their fall will be brutal as they realize only now that the “West” can’t really protect them. GEAB No.51 (subscription required)

The Rise of Radical Islam

We read all the time about Al Qaeda but pay less attention to the Muslim Brotherhood movement in Egypt.  I must believe that the rise of radical Islam, fanned by Al Jazeera attacks on the ‘corrupt,’ pro-Western Arab dictatorships, has had a major role in the civil disturbances in Tunisia, Egypt, Yemen and Jordan.

Implications

The United States and Europe have missed the opportunity to reform their own financial and political systems.  Instead, we have implemented only palliative solutions such as zero interest rates, “extend and pretend” accounting, stimulus programs, currency devaluation and meaningless reform such as Dodd-Frank.

American policy makers have not made the connection that our weak financial system has endangered our Arab allies.  Perhaps we are at a historic turning point where technology, irrational political structures, radical Islam, a weakened international system and a financially weak United States combine to effect revolutionary change.  Maybe these changes were inevitable, but maybe not.   Perhaps it is time that American leadership becomes more self-critical and globally focused, examines the unintended international consequences of our economic and political policies, and effects real reform before it is too late.

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7
Oct 10

You Say You Want a Revolution Part I

“You say you want a revolution
Well, you know
We all want to change the world
You tell me that it’s evolution
Well, you know
We all want to change the world” Revolution – The Beatles

“Revolution” is a term often thrown around in blogs and internet commentaries.  We discount thoughts of a revolution as the ravings of society’s fringe elements: the Tea Party movement, survivalists, states’ righters,  secessionists and other non-mainstream political movements.  As Americans we accept as fact that the last “revolution” on American soil took place in 1776 and that no more will take place in our lifetime.  We think in linear extrapolation:  that is, we give much weight to past experience and assume that the future will look just like it.  Paul B. Farrell writes a column for MarketWatch, a part of the Wall Street Journal Digital Network (which in turn is owned by the ultraconservative News Corporation).   Among other assignments, Mr. Farrell worked as a Morgan Stanley investment banker and executive vice president of the Financial News Network.  He has authored nine books on finance, economics and psychology.

Few writers and websites are more main stream than Mr. Farrell and MarketWatch.  Thus, when I went online on Tuesday, I was surprised that Mr. Farrell’s two most recent columns, The Fed is Dead, Maybe by 2012 and America on the Brink of a Second Revolution were ranked first and second “most read” columns on MarketWatch.  This is surprising and scary stuff.

The Brink of a Second American Revolution

Mr. Farrell focuses on the revolutionary characteristics of the Tea Party movement:

Tea-baggers are kicking the revolution into high gear. Debt is sinking America. Both parties are to blame. So vote out incumbents. Spare no one. We need new leadership, another Reagan or Truman. Congress better get the message: Cut that budget, or they’ll dump the rest of you in the coming Great Purge of 2012.

Unfortunately they’re tone deaf. Congress cannot see past the election. All that changes in November.

So thanks Tea Party, Vegas odds must favor a Second American Revolution.  See America on the Brink of a Second Revolution

The trigger for this revolution will be the breakdown of the Washington political process.   The Republicans will win the House, causing political gridlock, budget crises and even governmental shutdowns.  Obama will become a lame duck and be defeated in 2012.  A Republican President will kowtow to Wall Street.  Wall Street greed will trigger a second deeper financial crisis, then a currency crisis and a sovereign debt default.  Class warfare will break out in the US between the middle class and the financial elite. And voila!  Welcome to the Second American Revolution.

How We Got There

Mr. Farrell cites the “brilliant but bleak” study “Decadence of Election 2010” by Professor Peter Morici, former chief economist of the International Trade Commission.  The highlights:

  • Democrats, Republicans and even the Tea Party have no positive solutions to our problems.  Raising taxes, balancing budgets or deregulating everything will not fix the crisis.
  • Governance is impossible where the financial system has broken down.  He cites Wall Street pay and fraud, poor lending standards at Fannie Mae and Freddie Mac, huge trade deficits with China and the massive importing of oil.
  • Massive policy errors: admitting China into the World Trade Organization and handing it unfettered access to the US market without reciprocal access; blocking domestic oil and gas development and limiting off shore drilling, failing to raise automobile mileage requirements and others.
  • Bush’s failure to see the gathering storm on Wall Street and naming the clueless John Snow, then pro Wall Street Hank Paulson as Treasury Secretaries.
  • Obama’s two signature initiatives, health care and financial reform, do not solve the underlying problems.  For example, Americans will still pay 5% more for health care than under the “socialist” European programs.
  • Wall Street greed has returned with shoddy corporate and municipal bond financings.
  • The new Republican leadership will fail as deregulation will not fix health care and there is no credible plan to take $1 trillion of spending from the budget.
  • Americans need a messiah and a visionary such as Truman or Reagan.  We will never get one, as Wall Street is so greedy and corrupt that they will control all future “prophets” until there is a catastrophe.

Eventually, America will have to impose austerity affecting all classes including the financial elite.  Fed up with a failed political system the middle class will revolt and overthrow “the greedy wealth conspiracy” of Wall Street, Washington, CEOs and the Forbes 400.

Mr. Farrell predicts that the middle class will lose another 20% of their retirement savings over the next decade.   Given the potential for revolution, that looks like an optimistic prediction.

More on the demise of the Federal Reserve in Part II.

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27
Dec 09

Seven Black Swans a-Swimming

The holiday spirit lingers. With all due respect to the Twelve Days of Christmas, let’s see if we can predict seven potential black swan events for 2010.  But we have a conundrum. According to Nassim Taleb (author: The Black Swan: The Impact of the Highly Improbable), “black swan events” are high-impact, hard-to-predict and rare events that are beyond the realm of normal expectations, that is, statistical outliers. Thus, if we are able to predict them, they may not be true “black swan events.”

I will leave that issue for philosophers.  Let’s focus on possible “disturbances in the Force” which can render useless the carefully orchestrated Obama, Geithner, Bernanke engineered recovery.

Black Swan Event Gestation

The government and mainstream media have been extremely helpful in identifying “black swan events.”  These even have usually been hidden in plain sight and then reported by main stream media.  Then we have a noted academician or high government official contextualizing the event to make the public believe that the occurrence of the event is improbable or lunacy. Examples: Ben Bernanke reassures the public that sub-prime losses were well contained and no threat to the economy. Tim Geithner proclaims that the largest banks were well capitalized.

In the former Soviet Union the joke was that nothing was true until it was officially denied.

2010 Candidates for Black Swan Event of the Year

And now for an Academy Award moment, the nominees please:

  • The Dubai World default – We are again receiving governmental reassurance that the Dubai World is well contained. Hearing this has eerie echoes of the sub-prime crisis being well contained. Why? We live in a highly interdependent worldwide financial system: if a butterfly flaps its wings in Beijing… you know the rest.
  • The US defaults on its sovereign debt – The Obama administration provided financial guarantees to everyone from American Express to GE to money market funds to Citicorp.  More than 2 trillion dollars of new US Treasury debt will need to be financed in 2010.  Is there enough money in the world to fund these deficits? What if a Treasury auction fails; that is, there are not enough bids to cover the amount offered?  That is like having a garage sale and nobody coming by.
  • The FDIC runs out of money – One commentator believes that the FDIC ran out of money in October 2009.   The FDIC is trying to muddle through by not aggressively closing problem banks.  Yes, the Treasury could step in and loan the FDIC money, but review the second bullet above on the potential for sovereign debt default.  Also, modern day bank runs occur via the internet rather than through heartwarming scenes a la It’s a Wonderful Life.  There is no George Bailey and no honeymoon money to bail out the money center banks.
  • Commercial real estate implosion – Commercial real estate – office buildings, hotels, regional and strip malls and multi- family dwellings have had a price decline of 41% since 2007. Rents have declined in all categories. Commercial real estate heavily utilizes short-term financing which require frequent re-financing at three, five and seven year intervals.  Re-financing needs will double from 2009 to 2010. Already stressed regional banks financed much of the growth in commercial real estate. Next year could be the perfect storm as both public and private sectors tap a limited pool of capital.
  • State, county or municipal insolvency – Multiple states are nearly insolvent. The same problems exist at the county and city levels.  States cannot declare bankruptcy, but counties and municipalities can.  A cascade of these bankruptcies would tax state treasuries.  A series of state defaults would put pressure on the Federal government for another set of bailouts.  Municipal defaults would send shockwaves through all financial markets.
  • Pension Fund Failure – Public and private pension funds are massively underfunded.  See Underfunded Pension Plans: The Next Shoe to Drop. Next year could be the year of recognition.  PBGC has limited resources to bailout the private sector funds and there is no PBGC coverage for public pension funds.  Multiple pension fund failures loom on the horizon.
  • War in the Middle East – Iran has shown contempt for international efforts to stop its nuclear development program.  Israel or the United States may be forced to take military action.  Iran has threatened to retaliate by closing the Straits of Hormuz, the international oil shipment passage way for Gulf oil.  Oil prices could soar crippling the world economy.

The Sky is Clouded with Black Swans

Given the nature of black swan events, I cannot predict that any will land. It is even more difficult to determine whether or not they are even black swan events at all.  Other worthy candidates: dollar collapse, earthquakes and volcanoes, sovereign debt default in Portugal, Spain, Italy, Ireland, Greece, the United Kingdom (or all these countries), Euro collapse, depression in China, constitutional crisis in the United States.  The list is long and fraught with possibility.  Or the black swan event could be that nothing happens at all.

Still hope spring eternal, keep checking the skies and Happy New Year.

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23
Oct 09

Relying on the Kindness of Strangers

Whoever you are, I have always depended on the kindness of strangers.

Blanche DuBois  – A Streetcar Named Desire by Tennessee Williams

The United States has one of the world’s largest and most well-equipped militaries. A truism about military might: it requires a lot of money and a sound budget.  But we are unable to finance our trade deficits from domestic sources and have imperiled our international standing.  We now rely on the kindness of foreign financing and have created a self-defeating “Achilles Heel” in our US foreign and military power.

Projecting Power Throughout the World

Through its system of international bases, large annual military budgets and sophisticated weapons systems, the US projects global American power. These expenditures dwarf expenditures of other countries:

The 2009 U.S. military budget is almost as much as the rest of the world’s defense spending combined and is over nine times larger than the military budget of China (compared at the nominal US dollar/Renminbi rate, not the PPP rate). The United States and its close allies are responsible for about two-thirds of the world’s military spending (of which, in turn, the U.S. is responsible for the majority).

The Iraqi army learned that direct confrontation with American armed forces is a losing strategy.  Unfortunately, we are undermining this American military supremacy by owing massive amounts of money to foreign creditors.

Owing your Banker

There is a wise old shibboleth: “If you owe a bank thousands, you have a problem; owe a bank millions, the bank has a problem.”   Over the next ten years, new estimates project cumulative budget deficits of 9 trillion dollars. Health care proposals will swell even that projection.  Who is going to finance this deficit?  With traditional funding sources, pension funds and private investment under pressure, the answer has to be foreign investment.  Despite promises to the contrary, the US dollar has been in a controlled decline.  Our fiscal and monetary policy is punishing our foreign creditors by reducing the value of their dollar holdings.

The Intersection of Economics and Politics

Can we keep up our level of spending and direct military intervention in light of the ever-cheapening dollar?  More importantly, how will our foreign creditors react to American intervention?  If we embrace the realistic probability that countries like China and Russia do not wish us well, deficits have handed these antagonistic creditors a counterweight and serious threat to our military power.

Let’s assume you are the foreign minister of mainland China.  Taiwan has always been a thorn in the side of the Beijing government.  Assume also that you wish to minimize loss of Chinese lives and destruction of military hardware.  Why not reach an understanding with the US that your government will not dump its hoard of cheapening US treasury securities and for goodwill purposes China will buy even more.  The quid pro quo: no United States opposition to the peaceful reuniting of Taiwan and the mainland.  Such a diplomatic initiative in a Congressional or Presidential election year would present a quandary to both political parties.  Electoral political expediency would enable China to reunite.  In this scenario, the nukes remain in their silos, our expensive military hardware remains unused, and T-bills become more powerful than hydrogen bombs.

Bad Habits Always Catch Up With You

Bad economic habits weaken the global position of the United States. But where is the fiscal and monetary discipline in Washington?  While we focus on bailing out bankers and making JP Morgan and Goldman Sachs richer, our enemies are thinking about how to take advantage of our economic disarray.  Is it smart to continue to rely on the kindness of strangers?

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