Moscow Memories of 1997

The last trip I had to Moscow was in the spring of 1997 as the ruble crisis was getting seriously underway towards the Russian debt default in August 1998.

US dollars were king, and you could buy almost anything except diamonds and gold with them as the public was beginning to panic out of the ruble and even basic commodities were in incredibly short supply. Our driver would take the windshield wipers off his car at night so that they would not be stolen.

The black market was alive and well. The city had the flavor of the Wild West as the Russkaya Mafiya was out in force in trademark long black woolen overcoats. A shipment of the coats had arrived the previous year at a local flea market and were impressively sinister, amenable to concealment, yet effective against the cold, thereby creating the signature gangsta look.

On that trip I had a driver/bodyguard, and an interpreter as I had no Russian, just a smattering of loosely related slavic languages from childhood. The Japanese immersion course just completed in Princeton for another long term project was not particularly useful. French was in slight demand, but it might have been more useful in Leningrad. I was able to read some instruction for a video camera that used SECAM, but that was about it.

The interpreter was a lady who mildly resembled Tatiana Romanova in From Russia with Love, but with the disposition of Odd Job. She was serious and highly professional, but did have a weakness for Dunhill cigarettes and the curious two tone bloody Mary's they serve there. Her boss was an Italian ex-pat who was a real character.

One should always treat the local associates well and with respect, because not only will they keep you out of trouble, but they will often slip you a bit of valuable information, even during an active translation. They take pride in their work, and are not servants. It is not only a matter of good manners but also good business sense. The way in which the average American businessman behaves is too often clumsily embarrassing, vacillating between boorish and aloof.

We switched hotels at the last minute as there was an unscheduled execution in the lobby of our intended lodgings the week before our arrival. The hotel we did have was nice, foreign owned out of Belgium as I recall, but the staff was a bit stiff if you know what I mean. It was more like a minimum security prison than a hotel. I'm sure our drivers and guards were getting kickbacks. Everyone was getting paid one way or the other.

That last trip was the culmination of a series of business trips in which we were opening up higher speed data and video communications to Moscow from the domestic US via reliable non-satellite connections. Keeping a lock on Sputnik from the US was a challenge given the inclination and its tendency to wobble somewhat erratically.

The 'last mile' in Moscow was a challenge given Moscow Telephone's tradition of non-attention to quality planning and somewhat eccentric layout of their central offices, as in the basement of an old house with a propensity for periodic flooding, generally during key events for ABC News or the State Department.

It may sound like a serious problem, but my team tended to take this sort of thing in stride, since it was a walk in the park, relatively speaking, compared to dropping satellite dishes into a simmering theater of war which we had often done before.

We teamed with another company named Sovintel instead, and chose to go with direct microwave shots from their tower to the multinational business and government locations who were the prime customers as they were the only ones who could still pay for premium services.

I liked Moscow and the people in particular. A walk in Red Square on a crisp night with falling snow, with St. Basil's ahead and GUM department store lit up on the left is very picturesqe. The Kremlin looks like the entrance to the kingdom of Mordor.

The Red Army guards were young and annoying, probably cranky because they were not getting paid. I remember walking through Lenin's tomb, which was utterly deserted, and being yelled at constantly to 'move along' by a young Russian soldier who looked like he had an urge to plant his jackboot on my face.

Ex-patriates in Moscow had an interesting time, living in $5000 per month apartments that were more indicative of their non-resident status than the amenities of their accommodations. We visited an apartment in one of the seven "Woolworth buildings" from the Stalin era that had a door which would have served for a very secure bank vault.

The ex-pats telex messages to us in the planning phase were concise: "Bring Western toilet paper." They tended to meet us every morning at the hotel, to take the toilet paper and soap out of our rooms and eat with us as our guests at the hotel breakfast buffet. It was a nice spread, and offered a more extensive fare than the grocery store we visited which offered only cabbages and big garishly orange boxes of Uncle Ben's rice.

We attended a performance at the Bolshoi Theater sponsored by some multinationals. Most notably, as a friend so slyly put it, the expats may be living poorly but it was nice to see them bring their attractive young daughters to the event. I don't think any of them were married, and we came away with the impression that people took assignments there to escape bad debts or bad marriages in the West.

There were a remarkable series of conversations with an interesting local acquaintances including one I called "Casper the Ghost," because of the promotional movie cap he always wore. From the way he spoke I became convinced that the primary occupation of those with savings was to convert it into hard currencies, gold and diamonds, and if possible get it out of the country.

Casper was busy amassing enough gold, while facilitating the efforts of others, in order to get out of Russia and move to the western US. He cynically wore the mafia signature black coat to scare off small time competition. "I go to same flea market and buy. Its no hard to do." He was a good source of information for a few drinks and the promise of a contact in Colorado. I think his real name was "Ben." That is how he answered the phone when I called him back from the States.

That, and multinationals with a local presence like McDonalds trying to figure out ways to work around currency controls or do something productive with their profits. I had the chance to visit the largest McDonald's in the world at that time, at the request again of the expats, and it was indeed impressive with 32 checkouts, but no customers.

They were desperate times, and you could see that there was a climactic crisis coming. It is easy to talk about this sort of thing, a thousand to one devaluation of your home currency, but harder to understand the impact. Imagine that you have $500,000 in savings for your retirement. Now imagine that within two years it is effectively reduced to $500 or less, and you will understand how disconcerting a currency crisis can be.

If you don't think a financial panic is possible here in the US, just take a look at the negative returns on short term T bills, and you will get a taste of the leading edge.

One of the best descriptions of the Weimar experience I have ever read was by Adam Fergusson titled "When Money Dies: The Nightmare of the Weimar Collapse." It is notoriously difficult to obtain, but it does the best job in describing how a currency collapse can come on like a lightning strike, although in retrospect everyone could have seen it coming. Denial is a strong narcotic. People believe in their institutions and ignore history until they are staring off the edge of the abyss.

But in Moscow as in everywhere life does go on. I left with pocketfuls of 1000 ruble notes which I *bought* along with the requisite matroyshka dolls and military medals, all for the kids to play with. Things became worse, much worse, and then eventually they became better.

I have often wondered if 'Casper' ever achieved his dream of taking his diamonds and gold and relocating to Colorado. I hope he did. If he is there, I wonder if he is thinking of moving again.

Bloomberg
Russians Buy Jewelry, Hoard Dollars as Ruble Plunges
By Emma O’Brien and William Mauldin

Dec. 11 (Bloomberg) -- ...Russians are shifting their cash into foreign currencies and buying things they don’t need as the economy stalls and the central bank weakens its defense of the ruble, signaling a larger devaluation may be on the way. The currency has fallen 16 percent against the dollar since August, when Russia’s invasion of neighboring Georgia helped spur investors to pull almost $200 billion out of the country, according to BNP Paribas SA.

The central bank today expanded the ruble’s trading band against a basket of dollars and euros, allowing it to drop 0.8 percent, said a spokesman who declined to be identified on bank policy.

With the specter of the 1998 debt default and devaluation in mind, Russians withdrew 355 billion rubles ($13 billion), or 6 percent of all savings, from their accounts in October, the most since the central bank started posting the data two years ago. Foreign-currency deposits rose 11 percent.

Oligarchs Pinched

Those withdrawals are increasing pressure for the ruble’s devaluation, according to Basil Issa, an emerging- markets analyst at BNP Paribas in London.

Property is now a protective investment, not just a status symbol, said Sergei Polonsky, founder of real estate developer Mirax Group, which is building Moscow’s tallest skyscraper.

“Lately our clients are mostly those who buy real estate not to live in but to secure their investments,” Polonsky said. “No one wants to be left with pieces of paper.”

The 25 wealthiest Russians on Forbes magazine’s list of billionaires, including Oleg Deripaska and Roman Abramovich, lost a combined $230 billion from May to October as asset values plummeted, according to Bloomberg calculations.

‘Feel Happy’

For the burgeoning middle class, investments of choice range from electronics to gold jewelry. Evroset, Russia’s largest mobile-phone chain, is telling people to buy anything they can.

“It’s better to feel happy that you own something than to fear losing the money you have earned,” Chairman Yevgeny Chichvarkin says in a letter posted at 5,200 Evroset stores. “If you need a car, buy a car! If you need an apartment, buy an apartment! If you need a fur coat, buy a fur coat!”

Sales at Technosila, the third-biggest consumer electronics chain, have doubled since September as customers rush to swap rubles for flat-screen TVs and laptops, spokeswoman Nadezhda Senyuk said by phone from Moscow, where the company is based.

Jewelry sales are also accelerating, particularly items made of gold and diamonds, said Vladimir Stankevich, advertising director at Adamas, Russia’s third-largest jewelry retailer.

“More cash appeared on the market and there’s an opinion among shoppers that gold is a good investment in times of crisis,” Stankevich said.

Natalya Kulikova has a different approach. The 31-year-old sales manager said she’s opened accounts in rubles, euros and dollars at three different banks -- one foreign and two domestic -- to guard her savings.

“My main goal is to save money,” she said.

Putin Pledge

Those who don’t want to spend are keeping more money at home or in safe-deposit boxes because the government guarantee on bank accounts is limited to 700,000 rubles, said Yulia Tsepliaeva, chief economist in Moscow at Merrill Lynch & Co.

Alfa Bank, Russia’s biggest non-state lender, said demand for boxes has increased about 40 percent since October, and there are few available.

“The Russian experience with saving is not that good and people prefer to consume and enjoy rather than save in pre-crisis situations,” Tsepliaeva said. “Buy cash dollars and put them in mattresses or safe deposit boxes but not in accounts because most crises are accompanied by banking crises.”

A decade ago, many lost their life savings after the ruble plunged 71 percent against the dollar. Those fears prompted Prime Minister Vladimir Putin to pledge not to allow “sharp jumps” in the exchange rate, during a call-in television show Dec. 4.

‘Ideal Time’

Troika Dialog, Russia’s oldest investment bank, is betting the central bank will allow a one-time devaluation of the ruble of about 20 percent in January, following New Year’s and Orthodox Christmas celebrations.

“With the holidays at the beginning of January, companies won’t be fully working and people will be spending more money,” said Evgeny Gavrilenkov, Troika’s chief economist and a former acting head of the government’s Bureau of Economic Analysis. “That means demand for rubles will increase and that means it’s an ideal time to allow a devaluation.”

Russia has drained almost a quarter of its foreign-currency reserves, the world’s third-largest, since August as it tries to slow the ruble’s decline. The central bank has widened the trading band five times in the past month, effectively reducing its defense of the currency amid plunging oil prices.

Devaluation Skeptic

Urals crude, Russia’s main export earner, has slumped 72 percent since reaching a record $142.94 a barrel July 4. It fell below $40 for the first time in three years last week, compared with the $70 needed to balance the country’s budget.

The government will avoid a large, one-step devaluation because it wants to prevent a run on the banks and lure back foreign investors, said Chris Weafer, chief strategist in Moscow at UralSib Financial Corp.

“I’m skeptical a 10 to 15 percent devaluation will provide a significant boost for the economy because the sector that it will most benefit, manufacturing, is just too small,” he said.

The ruble will probably be allowed to drop in small steps to as low as 33 per dollar by the middle of 2009, from about 28 now, Weafer estimates. It will end next year at 26.8 because of a recovery in oil prices and a weaker U.S. currency, he said.

Svetlana Guseva isn’t taking any chances.

The 32-year-old mother of two from the southern city of Sochi plans to take her 8-year-old daughter, Dasha, to Moscow for the New Year’s holiday, a trip that will cost twice her family’s monthly income of about 30,000 rubles.

“This way at least we’ll have some memories,” she said.

Are Markets Naturally Efficient? Are All People Naturally Rational and Good?

There is a ideology that would like to believe that all people are naturally good and rational, and that markets are therefore naturally efficient and free if just left alone to themselves and allowed to function without regulation or management.

This line of argument is often pursued by certain faux conservatives when arguing that the police should be dismissed and the locks removed from the doors, in advance of a period of sustained looting of the common folk by the wealthy elite.

One thing almost all idealists have in common is that their work exists largely on paper, and is rarely to be found in practical implementations over any sustained period.

That is why there are so few farmers and women in this camp of free market idealists because their daily struggle with disorder and decay teaches them that nothing goes the way of order and productive results without plenty of hard work, repeated effort and at least occasional observation.

It is the man in his easy chair reading his books that believes that the dishes clean themselves, the clothes are self-folding and storing, and the children organize their rooms and personal hygiene willingly without 'interference.'

This romantic belief in natural goodness is a great fallacy underlying the Greenspan-Reagan doctrine of trickle down easy money and the prima facie good of boundless deregulation.

It is similar to the belief in the natural goodness of all men and the self-ordering of large societies towards justice and equality without effort. It sounds nice, but in practice it is just ridiculous and almost utterly without support except in the minds of its philosophical adherents. No one who has ever driven in a major metropolitan area can possible believe it.

What people forget is that it takes rules and referees and a great deal of hard work and repeated efforts to create and maintain a fair game and a level playing field for the many who may wish to play.

So too with the notion of a natural tendency to free markets. Its just not true. Markets tend to gravitate to oligopoly, insider dealing, fraud and utter inefficiency. Free market capitalists quickly come to hate competition with their success, and are always seeking to avoid the zero profit outcome through unfair market advantages and the stifling of competition.

Markets can be over-regulated by central planners, and it is always the road to ruin. But they can also be under-regulated and allowed to degenerate into the same awful excesses that governments and peoples fall into at various times in their history, periods of seemingly collective madness, disregard for the individual, and the rise of the will to power.

Government is best that governs least indeed, but with the appropriate level of government to uphold the principles under which people come together to interact in a society and avoid despotism and anarchy. There is a range of good and evil in people, and they join in society for their mutual protection, and the accomplishment of efforts requiring a broad participation.

It is no accident that Jefferson was one of the framers of the Constitution, which although remarkable in its simplicity is ingeniously complex in its design, and fine balances of powers that endure with the commitment and sacrifice for the greater good of each succeeding generation.

Five Critical Decisions Leading to Our Financial Crisis: Joe Stiglitz Presents His Analysis

This is a benchmark document, a starting point, for finding our way out of the wilderness.

It validates the points that quite a few economic bloggers have been making for some time, with great effect because of Joe Stiglitz' reputation and accomplishments in his field.

Here is a summation of the Five Major Causes of our financial crisis. As Joe so correctly observes:

"What were the critical decisions that led to the crisis? Mistakes were made at every fork in the road—we had what engineers call a “system failure,” when not a single decision but a cascade of decisions produce a tragic result. Let’s look at five key moments."

1. Reagan's nomination of Alan Greenspan to replace Paul Volcker as Fed Chairman
2. The Repeal of Glass-Steagall and the Cult of Self-Regulation
3. Bush Tax Cuts for Upper Income Individuals, Corporations, and Speculation
4. Failure to Address Rampant Accounting Fraud Driven by Excessive and Flawed Compensation Models
5. Providing Enormous Bailouts to the Banks without Engaging Systemic Reform for the Underlying Causes of the Failure

There are other points that might be added, some that are not strictly financial in nature.

An international monetary exchange system that facilitates manipulation to create de facto barriers and subsidies in support of industrial trade policies. This creates destabilizing surpluses and deficits which may be the source of the next stage of the financial crisis.

The concentration of the ownership of the mainstream media in a handful of corporations has had a chilling effect on the newsrooms and commentators.

The lack of Congressional courage in exercising its obligations with regard to the extra-Constitutional excesses of the Executive Office. Certain mechanisms and instruments that facilitate the unilateral exercise of presidential power are tipping the balance of powers.

The existing system of funding inordinately expensive political campaigns is a breeding ground for favors and corruption.

The undue influence on prices, particularly global commodity prices, that is exercised by a handful of US banks operating far outside of traditional banking charters. This is a dangerously destabilizing influence on the real world economy and industrial growth and investment. A significant step forward would be the imposition of position limits, greater and more timely transparency for those with more than 10% of any market's open interest, and an uptick rule with stronger enforcement against naked shorting and other forms of short term price manipulation.

Vanity Fair
The Economic Crisis:
Capitalist Fools
by Joseph E. Stiglitz
January 2009

Behind the debate over remaking U.S. financial policy will be a debate over who’s to blame. It’s crucial to get the history right, writes a Nobel-laureate economist, identifying five key mistakes—under Reagan, Clinton, and Bush II—and one national delusion.

There will come a moment when the most urgent threats posed by the credit crisis have eased and the larger task before us will be to chart a direction for the economic steps ahead. This will be a dangerous moment. Behind the debates over future policy is a debate over history—a debate over the causes of our current situation. The battle for the past will determine the battle for the present. So it’s crucial to get the history straight.

What were the critical decisions that led to the crisis? Mistakes were made at every fork in the road—we had what engineers call a “system failure,” when not a single decision but a cascade of decisions produce a tragic result. Let’s look at five key moments.

No. 1: Firing the Chairman

In 1987 the Reagan administration decided to remove Paul Volcker as chairman of the Federal Reserve Board and appoint Alan Greenspan in his place. Volcker had done what central bankers are supposed to do. On his watch, inflation had been brought down from more than 11 percent to under 4 percent. In the world of central banking, that should have earned him a grade of A+++ and assured his re-appointment. But Volcker also understood that financial markets need to be regulated. Reagan wanted someone who did not believe any such thing, and he found him in a devotee of the objectivist philosopher and free-market zealot Ayn Rand.

Greenspan played a double role. The Fed controls the money spigot, and in the early years of this decade, he turned it on full force. But the Fed is also a regulator. If you appoint an anti-regulator as your enforcer, you know what kind of enforcement you’ll get. A flood of liquidity combined with the failed levees of regulation proved disastrous.

Greenspan presided over not one but two financial bubbles. After the high-tech bubble popped, in 2000–2001, he helped inflate the housing bubble. The first responsibility of a central bank should be to maintain the stability of the financial system. If banks lend on the basis of artificially high asset prices, the result can be a meltdown—as we are seeing now, and as Greenspan should have known. He had many of the tools he needed to cope with the situation. To deal with the high-tech bubble, he could have increased margin requirements (the amount of cash people need to put down to buy stock). To deflate the housing bubble, he could have curbed predatory lending to low-income households and prohibited other insidious practices (the no-documentation—or “liar”—loans, the interest-only loans, and so on). This would have gone a long way toward protecting us. If he didn’t have the tools, he could have gone to Congress and asked for them.

Of course, the current problems with our financial system are not solely the result of bad lending. The banks have made mega-bets with one another through complicated instruments such as derivatives, credit-default swaps, and so forth. With these, one party pays another if certain events happen—for instance, if Bear Stearns goes bankrupt, or if the dollar soars. These instruments were originally created to help manage risk—but they can also be used to gamble. Thus, if you felt confident that the dollar was going to fall, you could make a big bet accordingly, and if the dollar indeed fell, your profits would soar. The problem is that, with this complicated intertwining of bets of great magnitude, no one could be sure of the financial position of anyone else—or even of one’s own position. Not surprisingly, the credit markets froze.

Here too Greenspan played a role. When I was chairman of the Council of Economic Advisers, during the Clinton administration, I served on a committee of all the major federal financial regulators, a group that included Greenspan and Treasury Secretary Robert Rubin. Even then, it was clear that derivatives posed a danger. We didn’t put it as memorably as Warren Buffett—who saw derivatives as “financial weapons of mass destruction”—but we took his point. And yet, for all the risk, the deregulators in charge of the financial system—at the Fed, at the Securities and Exchange Commission, and elsewhere—decided to do nothing, worried that any action might interfere with “innovation” in the financial system. But innovation, like “change,” has no inherent value. It can be bad (the “liar” loans are a good example) as well as good.

No. 2: Tearing Down the Walls

The deregulation philosophy would pay unwelcome dividends for years to come. In November 1999, Congress repealed the Glass-Steagall Act—the culmination of a $300 million lobbying effort by the banking and financial-services industries, and spearheaded in Congress by Senator Phil Gramm. Glass-Steagall had long separated commercial banks (which lend money) and investment banks (which organize the sale of bonds and equities); it had been enacted in the aftermath of the Great Depression and was meant to curb the excesses of that era, including grave conflicts of interest. For instance, without separation, if a company whose shares had been issued by an investment bank, with its strong endorsement, got into trouble, wouldn’t its commercial arm, if it had one, feel pressure to lend it money, perhaps unwisely? An ensuing spiral of bad judgment is not hard to foresee. I had opposed repeal of Glass-Steagall. The proponents said, in effect, Trust us: we will create Chinese walls to make sure that the problems of the past do not recur. As an economist, I certainly possessed a healthy degree of trust, trust in the power of economic incentives to bend human behavior toward self-interest—toward short-term self-interest, at any rate, rather than Tocqueville’s “self interest rightly understood.”

The most important consequence of the repeal of Glass-Steagall was indirect—it lay in the way repeal changed an entire culture. Commercial banks are not supposed to be high-risk ventures; they are supposed to manage other people’s money very conservatively. It is with this understanding that the government agrees to pick up the tab should they fail. Investment banks, on the other hand, have traditionally managed rich people’s money—people who can take bigger risks in order to get bigger returns. When repeal of Glass-Steagall brought investment and commercial banks together, the investment-bank culture came out on top. There was a demand for the kind of high returns that could be obtained only through high leverage and big risktaking.

There were other important steps down the deregulatory path. One was the decision in April 2004 by the Securities and Exchange Commission, at a meeting attended by virtually no one and largely overlooked at the time, to allow big investment banks to increase their debt-to-capital ratio (from 12:1 to 30:1, or higher) so that they could buy more mortgage-backed securities, inflating the housing bubble in the process. In agreeing to this measure, the S.E.C. argued for the virtues of self-regulation: the peculiar notion that banks can effectively police themselves. Self-regulation is preposterous, as even Alan Greenspan now concedes, and as a practical matter it can’t, in any case, identify systemic risks—the kinds of risks that arise when, for instance, the models used by each of the banks to manage their portfolios tell all the banks to sell some security all at once.

As we stripped back the old regulations, we did nothing to address the new challenges posed by 21st-century markets. The most important challenge was that posed by derivatives. In 1998 the head of the Commodity Futures Trading Commission, Brooksley Born, had called for such regulation—a concern that took on urgency after the Fed, in that same year, engineered the bailout of Long-Term Capital Management, a hedge fund whose trillion-dollar-plus failure threatened global financial markets. But Secretary of the Treasury Robert Rubin, his deputy, Larry Summers, and Greenspan were adamant—and successful—in their opposition. Nothing was done.

No. 3: Applying the Leeches

Then along came the Bush tax cuts, enacted first on June 7, 2001, with a follow-on installment two years later. The president and his advisers seemed to believe that tax cuts, especially for upper-income Americans and corporations, were a cure-all for any economic disease—the modern-day equivalent of leeches. The tax cuts played a pivotal role in shaping the background conditions of the current crisis. Because they did very little to stimulate the economy, real stimulation was left to the Fed, which took up the task with unprecedented low-interest rates and liquidity. The war in Iraq made matters worse, because it led to soaring oil prices. With America so dependent on oil imports, we had to spend several hundred billion more to purchase oil—money that otherwise would have been spent on American goods. Normally this would have led to an economic slowdown, as it had in the 1970s. But the Fed met the challenge in the most myopic way imaginable. The flood of liquidity made money readily available in mortgage markets, even to those who would normally not be able to borrow. And, yes, this succeeded in forestalling an economic downturn; America’s household saving rate plummeted to zero. But it should have been clear that we were living on borrowed money and borrowed time.

The cut in the tax rate on capital gains contributed to the crisis in another way. It was a decision that turned on values: those who speculated (read: gambled) and won were taxed more lightly than wage earners who simply worked hard. But more than that, the decision encouraged leveraging, because interest was tax-deductible. If, for instance, you borrowed a million to buy a home or took a $100,000 home-equity loan to buy stock, the interest would be fully deductible every year. Any capital gains you made were taxed lightly—and at some possibly remote day in the future. The Bush administration was providing an open invitation to excessive borrowing and lending—not that American consumers needed any more encouragement.

No. 4: Faking the Numbers

Meanwhile, on July 30, 2002, in the wake of a series of major scandals—notably the collapse of WorldCom and Enron—Congress passed the Sarbanes-Oxley Act. The scandals had involved every major American accounting firm, most of our banks, and some of our premier companies, and made it clear that we had serious problems with our accounting system. Accounting is a sleep-inducing topic for most people, but if you can’t have faith in a company’s numbers, then you can’t have faith in anything about a company at all. Unfortunately, in the negotiations over what became Sarbanes-Oxley a decision was made not to deal with what many, including the respected former head of the S.E.C. Arthur Levitt, believed to be a fundamental underlying problem: stock options. Stock options have been defended as providing healthy incentives toward good management, but in fact they are “incentive pay” in name only. If a company does well, the C.E.O. gets great rewards in the form of stock options; if a company does poorly, the compensation is almost as substantial but is bestowed in other ways. This is bad enough. But a collateral problem with stock options is that they provide incentives for bad accounting: top management has every incentive to provide distorted information in order to pump up share prices.

The incentive structure of the rating agencies also proved perverse. Agencies such as Moody’s and Standard & Poor’s are paid by the very people they are supposed to grade. As a result, they’ve had every reason to give companies high ratings, in a financial version of what college professors know as grade inflation. The rating agencies, like the investment banks that were paying them, believed in financial alchemy—that F-rated toxic mortgages could be converted into products that were safe enough to be held by commercial banks and pension funds. We had seen this same failure of the rating agencies during the East Asia crisis of the 1990s: high ratings facilitated a rush of money into the region, and then a sudden reversal in the ratings brought devastation. But the financial overseers paid no attention.

No. 5: Letting It Bleed

The final turning point came with the passage of a bailout package on October 3, 2008—that is, with the administration’s response to the crisis itself. We will be feeling the consequences for years to come. Both the administration and the Fed had long been driven by wishful thinking, hoping that the bad news was just a blip, and that a return to growth was just around the corner. As America’s banks faced collapse, the administration veered from one course of action to another. Some institutions (Bear Stearns, A.I.G., Fannie Mae, Freddie Mac) were bailed out. Lehman Brothers was not. Some shareholders got something back. Others did not.

The original proposal by Treasury Secretary Henry Paulson, a three-page document that would have provided $700 billion for the secretary to spend at his sole discretion, without oversight or judicial review, was an act of extraordinary arrogance. He sold the program as necessary to restore confidence. But it didn’t address the underlying reasons for the loss of confidence. The banks had made too many bad loans. There were big holes in their balance sheets. No one knew what was truth and what was fiction. The bailout package was like a massive transfusion to a patient suffering from internal bleeding—and nothing was being done about the source of the problem, namely all those foreclosures. Valuable time was wasted as Paulson pushed his own plan, “cash for trash,” buying up the bad assets and putting the risk onto American taxpayers. When he finally abandoned it, providing banks with money they needed, he did it in a way that not only cheated America’s taxpayers but failed to ensure that the banks would use the money to re-start lending. He even allowed the banks to pour out money to their shareholders as taxpayers were pouring money into the banks.

The other problem not addressed involved the looming weaknesses in the economy. The economy had been sustained by excessive borrowing. That game was up. As consumption contracted, exports kept the economy going, but with the dollar strengthening and Europe and the rest of the world declining, it was hard to see how that could continue. Meanwhile, states faced massive drop-offs in revenues—they would have to cut back on expenditures. Without quick action by government, the economy faced a downturn. And even if banks had lent wisely—which they hadn’t—the downturn was sure to mean an increase in bad debts, further weakening the struggling financial sector.

The administration talked about confidence building, but what it delivered was actually a confidence trick. If the administration had really wanted to restore confidence in the financial system, it would have begun by addressing the underlying problems—the flawed incentive structures and the inadequate regulatory system.

Was there any single decision which, had it been reversed, would have changed the course of history? Every decision—including decisions not to do something, as many of our bad economic decisions have been—is a consequence of prior decisions, an interlinked web stretching from the distant past into the future. You’ll hear some on the right point to certain actions by the government itself—such as the Community Reinvestment Act, which requires banks to make mortgage money available in low-income neighborhoods. (Defaults on C.R.A. lending were actually much lower than on other lending.) There has been much finger-pointing at Fannie Mae and Freddie Mac, the two huge mortgage lenders, which were originally government-owned. But in fact they came late to the subprime game, and their problem was similar to that of the private sector: their C.E.O.’s had the same perverse incentive to indulge in gambling.

The truth is most of the individual mistakes boil down to just one: a belief that markets are self-adjusting and that the role of government should be minimal. Looking back at that belief during hearings this fall on Capitol Hill, Alan Greenspan said out loud, “I have found a flaw.” Congressman Henry Waxman pushed him, responding, “In other words, you found that your view of the world, your ideology, was not right; it was not working.” “Absolutely, precisely,” Greenspan said. The embrace by America—and much of the rest of the world—of this flawed economic philosophy made it inevitable that we would eventually arrive at the place we are today.

Is the Fed Taking the First Steps to Selective Default and Devaluation?

We have been looking for an out-of-the-box move from the Fed, but this was not what we had expected.

The obvious game changing move would have been for the Treasury and the Fed to make an arrangement in which the Fed is able to purchase Treasury debt directly without subjecting it to an auction in the public market first. This is known as 'a money machine' and is prohibited by statute.

But as usual the Fed surprises us all with their lack of transparency. They are asking Congress about permission to issue their own debt directly, not tied to Treasuries.

This is known in central banking circles as 'cutting out the middleman.' Not only does the Treasury no longer issue the currency, but they also no longer have any control over how much debt backed currency the Fed can now issue directly.

If the Fed were able to issue its own debt, which is currently limited to Federal Reserve Notes backed by Treasuries under the Federal Reserve Act, it would provide Bernanke the ability to present a different class of debt to the investing public and foreign central banks.

The question is whether it would be backed with the same force as Treasuries, or is subordinated, or superior.

There will not be any lack of new Treasury debt issuance upon which to base new Fed balance sheet expansion. The notion that there might be a debt generation lag out of Washington in comparison with what the Fed issues as currency is almost frightening in its hyperinflationary implications.

This makes little sense unless the Fed wishes to be able to set different rates for their debt, and make it a different class, and whore out our currency, the Federal Reserve notes, without impacting the sovereign Treasury debt itself, leaving the door open for the issuance of a New Dollar.

What an image. The NY Fed as a GSE, the new and improved Fannie and Freddie. Zimbabwe Ben can simply print a new class of Federal Reserve Notes with no backing from Treasuries. BenBucks. Federal Reserve Thingies.

Perhaps we're missing something, but this looks like a step in anticipation of an eventual partial default or devaluation of US debt and the dollar.


Wall Street Journal
Fed Weighs Debt Sales of Its Own
By JON HILSENRATH and DAMIAN PALETTA
DECEMBER 10, 2008

Move Presents Challenges: 'Very Close Cousins to Existing Treasury Bills'

The Federal Reserve is considering issuing its own debt for the first time, a move that would give the central bank additional flexibility as it tries to stabilize rocky financial markets.

Government debt issuance is largely the province of the Treasury Department, and the Fed already can print as much money as it wants. But as the credit crisis drags on and the economy suffers from recession, Fed officials are looking broadly for new financial tools.

The Federal Reserve drained $25 billion in temporary reserves from the banking system when it arranged overnight reverse repurchase agreements.

Fed officials have approached Congress about the concept, which could include issuing bills or some other form of debt, according to people familiar with the matter.

It isn't known whether these preliminary discussions will result in a formal proposal or Fed action. One hurdle: The Federal Reserve Act doesn't explicitly permit the Fed to issue notes beyond currency.

Just exploring the idea underscores many challenges the ongoing problems are creating for the Fed, as well as the lengths to which the central bank is going to come up with new ideas.

At the core of the deliberations is the Fed's balance sheet, which has grown from less than $900 billion to more than $2 trillion since August as it backstops new markets like commercial paper, money-market funds, mortgage-backed securities and ailing companies such as American International Group Inc.

The ballooning balance sheet is presenting complications for the Fed. In the early stages of the crisis, officials funded their programs by drawing down on holdings of Treasury bonds, using the proceeds to finance new programs. Officials don't want that stockpile to get too low. It now is about $476 billion, with some of that amount already tied up in other programs.

The Fed also has turned to the Treasury Department for cash. Treasury has issued debt, leaving the proceeds on deposit with the Fed for the central bank to use as it chose. But the Treasury said in November it was scaling back that effort. The Treasury is undertaking its own massive borrowing program and faces legal limits on how much it can borrow.

More recently, the Fed has funded programs by flooding the financial system with money it created itself -- known in central-banking circles as bank reserves -- and has used the money to make loans and purchase assets.

Some economists worry about the consequences of this approach. Fed officials could find it challenging to remove the cash from the system once markets stabilize and the economy improves. It's not a problem now, but if they're too slow to act later it can cause inflation.

Moreover, the flood of additional cash makes it harder for Fed officials to maintain interest rates at their desired level. The fed-funds rate, an overnight borrowing rate between banks, has fallen consistently below the Fed's 1% target. It is expected to reduce that target next week.

Louis Crandall, an economist with Wrightson ICAP LLC, a Wall Street money-market broker, says the Fed's interventions also have the potential to clog up the balance sheets of banks, its main intermediaries.

"Finding alternative funding vehicles that bypass the banking system would be a more effective way to support the U.S. credit system," he says.

Some private economists worry that Fed-issued bonds could create new problems. Marvin Goodfriend, an economist at Carnegie Mellon University's Tepper School of Business and a former senior staffer at the Federal Reserve Bank of Richmond, said that issuing debt could put the Fed at odds with the Treasury at a time when it is already issuing mountains of debt itself.

"It creates problems in coordinating the issuance of government debt," Mr. Goodfriend said. "These would be very close cousins to existing Treasury bills. They would be competing in the same market to federal debt."

With Treasury-bill rates now near zero, it seems unlikely that Fed debt would push Treasury rates much higher, but it could some day become an issue.

There are also questions about the Fed's authority.

"I had always worked under the assumption that the Federal Reserve couldn't issue debt," said Vincent Reinhart, a former senior Fed staffer who is now an economist at the American Enterprise Institute. He says it is an action better suited to the Treasury Department, which has clear congressional authority to borrow on behalf of the government.