Secondat

Years back, when Raghuram Rajan was chief economist of the International Monetary Fund, I used to post about the fragility of the global economy.[1] I didn't write as an expert on the subject, but as a civilian struggling to understand a complicated situation that's too often discussed by economists and pretty much ignored by people like me.

Unlike almost all the others whose writings I attempted to master, Rajan wrote clearly and imparted a coherent and convincing point of view.[2] I was not the only one to feel this way and the blog posts I wrote gathered an unusually large number of hits. In 2007, when Rajan left the IMF, its press releases suddenly became much less useful from my point of view and, at about the same time, its influence was seen as waning. The world's economic condition was no less perilous, but I'd lost my primary source for understanding it.

Fortunately, I'd begun earmarking Steven Pearlstein's excellent columns in the Washington Post. The WaPo archive of his work, going back to July 5, 2006, can be found here.[3]

This week's column, The politics and economics of a falling dollar, is especially good.

He recognizes that people like me find it difficult to focus our attention on global financial matters, but, he says, "it turns out they are at the heart of most of the economic issues we're dealing with, from budget battles to the euro crisis to the rising price of gasoline." He explains how the US dollar became and continues to be the world's dominant currency, tells how this results in unimaginable quantities of dollars being held outside the United States, and predicts (as others have been doing) that America's debt problems are producing a devaluation of the dollar which will, in time, result in the decline of the dollar as dominant currency. He says "the global system is forced to rely on the currency of a once-dominant economy that has piled up too much debt and can't quite figure out how to deal with it."

He concludes:

There are two ways this dollar story can play out.

In the optimistic scenario, a credible budget deal is reached in Washington, the Fed manages to sop up all the excess liquidity it has created, and the long-term slide in the dollar remains gradual enough for the world to muddle through until a new order and a new architecture can emerge.

In the darker scenario, hinted at last week by the leading credit-rating agency, the failure to adopt a budget deal triggers a U.S. credit crisis that spawns a dollar crisis, which sets off another global financial crisis — one that makes the last one look like child’s play.

In the column, Pearlstein quotes Gordon Brown's speech at this year's Bretton Woods Conference. The speech is quite long, but admirably free of jargon and not difficult to understand. In it, Brown makes a persuasive call for a new set of international agreements for regulation of global finance. Here's a short summary of his talk by the New Yorker's John Cassidy.[4]

Gordon Brown, who was voted out of Downing Street last year, delivered a sweeping survey of global economic issues. Noting that he had recently enjoyed a “period of reflection, enforced reflection,” he argued that most of the problems facing the world—financial instability, recessions, trade disputes, environmental degradation — ”cannot be addressed on an individual basis and can only be resolved by global coördination.” In the area of financial regulation, Brown pointed out, coördination was sorely lacking, with some individual countries pursuing their own agendas and trying to cozy up to big financial institutions. “I believe we are going back to a race to the bottom,” Brown said.

Brown also pointed out that the old industrial nations of the North Atlantic would soon be surpassed in wealth by China and the other newer ones. It's virtually inevitable that the purchasing power of the Chinese population will dwarf that of the United States within the next two decades. Inhabitants of China will then be the world's greatest consumers; Americans may be able to export goods to feed this Chinese demand, but that's not a certainty. Careful oversight at the international level will be required to make likely a smooth transition from the past half century's American dominance to whatever is to follow it.

This graphic, from wikipedia, gives one economic projection for the next four decades. It estimates the ten largest economies in the world in 2050, measured in GDP nominal (millions of USD).


Here is the video of Gordon Brown's speech at this years Bretton Woods Conference.



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Notes:

[1] These posts, going back to 2006, are mostly on the global economy and are mostly drawn from the work of Rajan and the Washington Post's Steven Pearlstein.

• Travels of a T-Shirt
• kleptocratic cliques of looters and world trade
• China cuts back on financing US deficit
• something to think about (hard work & contentment)
• where does all the oil money go?
• a global monetary storm triggered by the Bank of Japan?
• a frightening prosperity
• the Japan carry trade, of all things
• sovereign wealth funds and US sovereignty
• whither China?
• economic inequality
• Rajan on resolving global imbalances
• a time for committed and credible American leadership
• Pearlstein on burst bubbles
• making nice to foreigners
• topsy-turvy economics
• credit and discredit, trust and mistrust
• who are we that this happened to us?
• I read the news today oh boy
• financial pundits of the FT
• easy living, not always easy to maintain
• a life that breathes its own breath

[2] The authors of the wikipedia article on Rajan say

In 2005, at a celebration honoring Alan Greenspan, who was about to retire as chairman of the U.S. Federal Reserve, Rajan delivered a controversial paper that was critical of the financial sector. In that paper, "Has Financial Development Made the World Riskier?", Rajan "argued that disaster might loom."Rajan argued that financial sector managers were encouraged to

(take) risks that generate severe adverse consequences with small probability but, in return, offer generous compensation the rest of the time. These risks are known as tail risks.[...] But perhaps the most important concern is whether banks will be able to provide liquidity to financial markets so that if the tail risk does materialize, financial positions can be unwound and losses allocated so that the consequences to the real economy are minimized.

Thus Rajan described the 2007-2008 collapse of the world's financial system.

The response to Rajan's paper at the time was negative. For example, former U.S. Treasury Secretary and former Harvard President Lawrence Summers called the warnings "misguided."

[3] Articles by Steven R. Pearlstein

[4] Cassidy is author of How Markets Fail: The Logic of Economic Calamities (which I recommend) and Dot.con: How America Lost Its Mind and Money in the Internet Era

Niall Ferguson's The ascent of money: a financial history of the world (2008) is one of my current reads. It's "big history," a broad overview of currency and other (many other) financial instruments. I wish he'd given more than a quick a once-over to the era which fascinates me: the financial revolution (so-called) that evolved from Renaissance Italy, to Reformation Holland, and Restoration England in the early modern period. But I find it interesting and fun to read all the same. The work makes plain that one of my cherished day dreams — a society based on the anarchic principles held dear by George Orwell, Ursula Le Guin, and others — is pretty much an impossible one. So too, the deep-ingrained faith of communists and socialists in the elimination of the cash nexus as a dominant measure of value.

This came to mind when my morning cruise across a small slice of the internet brought up a quotation from Henry David Thoreau: "The price of anything is the amount of life you exchange for it."

I like to search out the origins of inspirational quotes; they're often not what they seem. This one is pretty much the genuine article. It turns out Thoreau didn't actually write those exact words. If you search the sentence, you will find thousands of repetitions of it in blogs and websites, but close to zero actual references back to the man's works.

What he said, in both his Journal and the book Walden, was this sentence fragment: "the cost of a thing is the amount of what I will call life which is required to be exchanged for it, immediately or in the long run." It's not so pithy but its meaning is pretty much the same. Analyzing the differences would be an exercise, I believe, in pedantry.

Thoreau's argument in journal and book is much the same. It's the romantic notion that men lead dreary lives of toil which bring them no real satisfaction. They'd be happier if they could cast off the enslaving chains of obligation and live free. This is, of course, what he set out to do in removing himself to Walden Pond, but he never tells us how the world would run if everyone did the same (and he himself doesn't even try to live without receiving more material goods from well-wishers than he's able to exchange for them). I think we all have to agree that his experiment of life in the woods is like my Orwellian day dream: even with the best will in the world you must reluctantly conclude that it's a concept that doesn't scale up.

Here's some of the argument as developed in the Journal:

... Are we not reminded in our better moments that we have been needlessly husbanding somewhat, perchance our little God-derived capital, or title to capital, guarding it by methods we know? But the most diffuse prodigality a better wisdom teaches, — that we hold nothing. We are not what we were. By usurers' craft, by Jewish methods, we strive to retain and increase the divinity in us, when infinitely the greater part of divinity is out of us. ... [You must] roam far, grasp life and conquer it, learn much and live. ... Be unwise and daring. ... Men come home at night only from the next field or street, where their household echoes haunt, and their life pines and is sickly because it breathes its own breath. Their shadows morning and evening reach farther than their daily steps. But [so much better to] come home from far, from ventures and perils, from enterprise and discovery and crusading, with faith. ...

And this from Walden:

... [Civilized men] have designs on us for our benefit, in making the life of a civilized people an institution, in which the life of the individual is to a great extent absorbed, in order to preserve and perfect that of the race. But I wish to show at what a sacrifice this advantage is at present obtained, and to suggest that we may possibly so live as to secure all the advantage without suffering any of the disadvantage. ... While civilization has been improving our houses, it has not equally improved the men who are to inhabit them. It has created palaces, but it was not so easy to create noblemen and kings. ... We now no longer camp as for a night, but have settled down on earth and forgotten heaven. ... Though we are not so degenerate but that we might possibly live in a cave or a wigwam or wear skins to-day, it certainly is better to accept the advantages, though so dearly bought, which the invention and industry of mankind offer. In such a neighborhood as this, boards and shingles, lime and bricks, are cheaper and more easily obtained than suitable caves, or whole logs, or bark in sufficient quantities, or even well-tempered clay or flat stones. I speak understandingly on this subject, for I have made myself acquainted with it both theoretically and practically. With a little more wit we might use these materials so as to become richer than the richest now are, and make our civilization a blessing. The civilized man is a more experienced and wiser savage. But to make haste to my own experiment. ...

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Here is the full context of the quote from the Journal:

Though the race is not so degenerated but a man might possibly live in a cave to-day and keep himself warm by furs, yet, as caves and wild beasts are not plenty enough to accommodate all at the present day, it were certainly better to accept the advantages which the invention and industry of mankind offer. In thickly settled civilized communities, boards and shingles, lime and brick, are cheaper and more easily come by than suitable caves, or the whole logs, or bark in sufficient quantity, or even well-tempered clay or flat stones. A tolerable house for a rude and hardy race that lived much out of doors was once made here without any of these last materials. According to the testimony of the first settlers of Boston, an Indian wigwam was as comfortable in winter as an English house with all its wainscotting, and they had advanced so far as to regulate the effect of the wind by a mat suspended over the hole in the roof, which was moved by a string. Such a lodge was, in the first instance, constructed in a day or two and taken down and put up again in a few hours, and every family had one.

Thus, to try our civilization by a fair test, in the ruder states of society every family owns a shelter as good as the best, and sufficient for its ruder and simpler wants; but in modern civilized society, though the birds of the air have their nests, and woodchucks and foxes their holes, though each one is commonly the owner of his coat and hat though never so poor, yet not more than one man in a thousand owns a shelter, but the nine hundred and ninety-nine pay an annual tax for this outside garment of all, indispensable summer and winter, which would buy a village of Indian wigwams and contributes to keep them poor as long as they live. But, answers one, by simply paying this annual tax the poorest man secures an abode which is a palace compared to the Indian's. An annual rent of from twenty to sixty or seventy dollars entitles him to the benefit of all the improvements of centuries, — Rumford fireplace, back plastering, Venetian blinds, copper pump, spring lock, etc., etc. But while civilization has been improving our houses, she has not equally improved the men who should occupy them. She has created palaces, but it was not so easy to create noblemen and kings. The mason who finishes the cornice of the palace returns at night, perchance, to a hut no better than a wigwam. If she claims to have made a real advance in the welfare of man, she must show how she has produced better dwellings without making them more costly. And the cost of a thing, it will be remembered, is the amount of life it requires to be exchanged for it, immediately or in the long run. An average house costs perhaps from one thousand to fifteen hundred dollars, and to earn — this sum will require from fifteen to twenty years of the day laborer's life, even if he is not incumbered with a family; so that he must spend more than half his life before a wigwam can be earned; and if we suppose he pays a rent instead, this is but a doubtful choice of evils. Would the savage have been wise to exchange his wigwam for a palace on these terms?

When I consider my neighbors, the farmers of Concord, for instance, who are at least as well off as the other classes, what are they about? For the most part I find that they have been toiling ten, twenty, or thirty years to pay for their farms, and we may set down one half of that toil to the cost of their houses; and commonly they have not yet paid for them. This is the reason they are poor; and for similar reasons we are all poor in respect to a thousand savage comforts, though surrounded by luxuries.

But most men do not know what a house is, and the mass are actually poor all their days because they think they must have such an one as their neighbor's. As if one were to wear any sort of coat the tailor might cut out for him, or, gradually leaving off palm-leaf hat and cap of woodchuck-skin, should complain of hard times because he could not buy him a crown!

-- The Writings of Henry David Thoreau: Journal, ed. by Bradford Torrey, 1837-1846, 1850-Nov. 3, 1861, Volume 7, edited by Bradford Torrey and Franklin Benjamin Sanborn (Houghton Mifflin, 1906)

Here is the full context of the quote from Walden:

In the savage state every family owns a shelter as good as the best, and sufficient for its coarser and simpler wants; but I think that I speak within bounds when I say that, though the birds of the air have their nests, and the foxes their holes, and the savages their wigwams, in modern civilized society not more than one half the families own a shelter. In the large towns and cities, where civilization especially prevails, the number of those who own a shelter is a very small fraction of the whole. The rest pay an annual tax for this outside garment of all, become indispensable summer and winter, which would buy a village of Indian wigwams, but now helps to keep them poor as long as they live. I do not mean to insist here on the disadvantage of hiring compared with owning, but it is evident that the savage owns his shelter because it costs so little, while the civilized man hires his commonly because he cannot afford to own it; nor can he, in the long run, any better afford to hire. But, answers one, by merely paying this tax the poor civilized man secures an abode which is a palace compared with the savage's. An annual rent of from twenty-five to a hundred dollars (these are the country rates) entitles him to the benefit of the improvements of centuries, spacious apartments, clean paint and paper, Rumford fireplace, back plastering, Venetian blinds, copper pump, spring lock, a commodious cellar, and many other things. But how happens it that he who is said to enjoy these things is so commonly a poor civilized man, while the savage, who has them not, is rich as a savage? If it is asserted that civilization is a real advance in the condition of man, — and I think that it is, though only the wise improve their advantages, — it must be shown that it has produced better dwellings without making them more costly; and the cost of a thing is the amount of what I will call life which is required to be exchanged for it, immediately or in the long run. An average house in this neighborhood costs perhaps eight hundred dollars, and to lay up this sum will take from ten to fifteen years of the laborer's life, even if he is not encumbered with a family, — estimating the pecuniary value of every man's labor at one dollar a day, for if some receive more, others receive less; — so that he must have spent more than half his life commonly before his wigwam will be earned. If we suppose him to pay a rent instead, this is but a doubtful choice of evils. Would the savage have been wise to exchange his wigwam for a palace on these terms?

It may be guessed that I reduce almost the whole advantage of holding this superfluous property as a fund in store against the future, so far as the individual is concerned, mainly to the defraying of funeral expenses. But perhaps a man is not required to bury himself. Nevertheless this points to an important distinction between the civilized man and the savage; and, no doubt, they have designs on us for our benefit, in making the life of a civilized people an institution, in which the life of the individual is to a great extent absorbed, in order to preserve and perfect that of the race. But I wish to show at what a sacrifice this advantage is at present obtained, and to suggest that we may possibly so live as to secure all the advantage without suffering any of the disadvantage. What mean ye by saying that the poor ye have always with you, or that the fathers have eaten sour grapes, and the children's teeth are set on edge?

" As I live, saith the Lord God, ye shall not have occasion any more to use this proverb in Israel."

"Behold all souls are mine; as the soul of the father, so also the soul of the son is mine: the soul that sinneth it shall die."

When I consider my neighbors, the farmers of Concord, who are at least as well off as the other classes, I find that for the most part they have been toiling twenty, thirty, or forty years, that they may become the real owners of their farms, which commonly they have inherited with encumbrances, or else bought with hired money, — and we may regard one third of that toil as the cost of their houses, — but commonly they have not paid for them yet. It is true, the encumbrances sometimes outweigh the value of the farm, so that the farm itself becomes one great encumbrance, and still a man is found to inherit it, being well acquainted with it, as he says. On applying to the assessors, I am surprised to learn that they cannot at once name a dozen in the town who own their farms free and clear. If you would know the history of these homesteads, inquire at the bank where they are mortgaged. The man who has actually paid for his farm with labor on it is so rare that every neighbor can point to him. I doubt if there are three such men in Concord. What has been said of the merchants, that a very large majority, even ninety-seven in a hundred, are sure to fail, is equally true of the farmers. With regard to the merchants, however, one of them says pertinently that a great part of their failures are not genuine pecuniary failures, but merely failures to fulfil their engagements, because it is inconvenient; that is, it is the moral character that breaks down. But this puts an infinitely worse face on the matter, and suggests, beside, that probably not even the other three succeed in saving their souls, but are perchance bankrupt in a worse sense than they who fail honestly. Bankruptcy and repudiation are the springboards from which much of our civilization vaults and turns its somersets, but the savage stands on the unelastic plank of famine. Yet the Middlesex Cattle Show goes off here with eclat annually, as if all the joints of the agricultural machine were suent.

-- The Writings of Henry David Thoreau: Walden, Volume 2, edited by Franklin Benjamin Sanborn and Bradford Torrey (Houghton Mifflin Co., 1906)

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It's irrelevant but (I think) interesting that a Google search of the Thoreau quote turns up a web page called Leatherman's Loop about a 10k trail race held each spring n Cross River, NY. I've previously written about the history of the Leatherman, and this page gives a good short account of the man and his doings: The Legend of The Leatherman.

That's interesting, but it's also interesting that the Thoreau quote does not actually appear on the web page. You have to look at page source to figure out that the person who put together the page used the quote as a meta title at one time (though no longer), why I could not say.

Golf in communist Cuba, migrant workers in Depression-era California, these are precursors to today's post on the impact of current recession in the US on what we used to call the country club set.

The editors of yesterday's Washington Post decided that an article on the financial hardships of wealthy suburbanites deserved front-page placement above the fold. The article, Squeaking by on $300,000, gives information about the inhabitants of "Birch Hill," a $2.5 million house which the author calls "a majestic property of tender grasses and low stone walls and a whimsical sculpture next to the swimming pool." Maintaining this place is expensive: the house requires $8,000 to $10,000 a month in outlays and other costs pile up: the live-in nanny, for example, at $40,000, as well as pricey schools, shops, and services. Kids expect, and get, clothes and possessions to match the prevailing standard of living. And — these days — the income of the owner, divorced mother of three, is not quite commensurate:

As a vice president at MasterCard's corporate office in Purchase, N.Y., she earns a base pay of $150,000 plus a bonus. This year she'll take home 10 percent less because of a smaller bonus. She receives $75,000 a year in child support from her ex-husband. She figures she will pull an additional $50,000 from a personal investment account to "pick up the slack."

The author of the piece profiles the nanny alongside the employer:

"I hit my recession 15 years ago in the Catskills," the 55-year-old nanny says one morning after everyone is gone. , and her words tumble out with a loose honesty. Plugging a leak under the sink, she stands up and gestures toward the pipe and says, "I fix things, too. Being as how once I had a house."

In 1994, Shellogg was working at a cement plant in Upstate New York as a chemical analyst earning $40,000 a year with a union card. "I had everything in that job," she says. When the plant shut down, she lost her position and then her home. A help-wanted ad for a nanny lured her to Rye, and now, three families later, she has the hang of Westchester County.

Steins wears a dark Armani suit and take-charge heels; has blue eyes that are lustrous and skin that is golden. "Even with wet hair and no makeup, she radiates confidence." Shellogg is also tan and blond, but has a chunker figure, less patrician face; wears comfy sweats (view images 6 and 7 in the Post's gallery accompanying the article). "Yet," the author concludes, "they can also seem like two exhausted blondes trying to keep a house going."

The Post article includes a photo of the house (no. 9 in the gallery). And it's pretty easy to find others like it, with its pool, gardens, and quarter-mile long driveway. For example, the New York Times did a real-estate background article on Harrion a few years ago: A Lovely Stretch of Suburban Opulence. It gives this photo:


Also, a page called Harrison Real Estate shows what's currently on the market in the range of six down to a mere one million dollars.

I've some small experience of the environment. The last reunion of my high school graduating class took place close to a Harrison-like suburb and a classmate invited some of us to lunch at her home, one very much like Laura Steins's Birch Hill. She was recently widowed and, with grown kids, was planning to sell out. I was very happy to be a visitor there: large, traditional house set on sloping hillside with floral and vegetable gardens, groves of fruit tress, a pool with pool house, lawns and old trees.

Addendum:

I was raised in a suburb near Harrison but not too much like it. It possessed lots of open space, a quiet village atmosphere, and an exceptionally good public school system. Though pretty much homogeneous as to ethnic origins (as in northern European), it wasn't an enclave of rich bourgeois; there were lots of little houses on small lots, like the one in which I grew up. I now live in a close-in, small-lot suburb which is coping with a "mansionization" problem but still has many small homes (again like mine). It too isn't much like Harrison. There's lots of wealth and power here, but also lots of neighborliness — no vast expanses of lawn or quarter-mile driveways.

Margaret Atwood was born a few years earlier than me and somewhat northward. She's also of the other sex and is one of the best writers in the world. These differences between the two of us suggest we have little in common. All the same some of her memories tally fairly closely with mine. They're in excerpts from her new book: Payback in FT: Forgive us our debts. Her topics are things that are on my mind these days: debt and debtors; banks and interest; revenge and forgiveness; and what can happen when you let your reptilian brain control the somewhat more rational one upstairs. But she leads with the reminiscences and they are what resonated sympathetically this bright Sunday morning.

She remembers the allowance she got (a nickel for her, a quarter for me) and how its spending -- in those primitive days -- led to much tooth decay. She remembers the tactics we used for accumulating wealth in comic books, glass marbles, and cards. (She recalls cigarette cards while mine mostly came from bubble gum packs.) She remembers the bank where she deposited money earned on her first paying job -- the fear of the tellers behind their high counters and the mystery of money "earning" more money in interest that showed up in the little savings book with its dark blue cover and light blue pages. About bank interest she asks "How could a fiction generate real objects? I knew from Peter Pan that if you ceased to believe in fairies they would drop dead: if I stopped believing in banks, would they too expire? The adult view was that fairies were unreal and banks were real. But was that true?" I never asked myself that question. But -- although I couldn't slake my addiction to candy or discipline myself to frequent and thorough tooth brushing, my first experience of banking did lead me to understand that you could save and, much later, buy things much more expensive than a ten-cent ice cream cone.

My first real job was a paper route. It was 1956 and I was 14-15. The route was long: out-and-back, about 4 mi. each way. It took me over the biggest hills our village possessed and it passed through none of the new housing "developments" with their closely-set newspaper customers. It must have been one of the least desirable I think now, but then it just was what it was. I was proud to learn the ways of shouldering the loaded bag on my Rudge Whitworth and was mostly conscientious -- in my own shy way -- in making my weekday afternoon round. I plagued my mom to drive me (in snow, ice, or pouring rain) as little as might be.





I earned money and remembered who paid up on time and who didn't, who tipped in coins and who in candy bars. I banked much of my take. And I observed.

I knew the mom's, some of the kids, and all of the dogs. And, because it was in the blood of boys my age at the time, I knew every car in every driveway.

Those were the years when performance and efficiency mattered little, style much. Cars were V8 powered, chromed, finned, and huge. I appreciated the cars of that time though never thought to own one. (My first car, bought 3 years later for $50, was a '50 Chev, all black with rusted out floorboards.)

Observing the newer models on my paper route, I noticed the three-tone jobs and in particular the three-tone Desoto. It's now hard to find images of this car. Here's one:




Here is a shot of the much-finned 1956 Fireflite, two-tone:



(If you care, there's a A Full History of DeSoto.)

Though I didn't really aspire to own a Desoto, I did have plans for my paper route savings. For $110 I bought a kit to make a 10-foot racing pram much like this.
"

Typically, I researched the purchase, carefully made the boat, and then didn't find much use for it. The river wasn't all that close to home and I couldn't drive myself there. I had no local friends with boats. So it sat down on Kemey's Cove while I found other things to do with my adolescent life and later became an embarrassment to my parents while I stored it in our next door neighbor's garage.

You'd think there was a lesson for me in this -- one about spending as wisely as you save, but I think I got all I really wished for in saving for, purchasing, and building the kit into a seaworthy racer.

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* I found it:

Representative government -- so awfully frustrating. It's as Churchill said

Many forms of Government have been tried, and will be tried in this world of sin and woe. No one pretends that democracy is perfect or all-wise. Indeed, it has been said that democracy is the worst form of Government except all those other forms that have been tried from time to time.

Citizens complained about the cost of the financial rescue bill, its failure to punish wrongdoers, and the new powers it gave the Treasury Secretary. In consequence the House of Representatives voted it down. The Senate took it up and passed much more expensive package.

Here are some links:

• From the Washington Post: Explainer: How the Senate Rescue Bill Is Different, by Ben Pershing, Oct. 2, 2008
• From Politico: Senate bailout bill keeps growing, by DAVID ROGERS | 10/1/08
• From the Financial Times: Republicans cannot spend their way out of crisis, by Grover Norquist, October 1 2008
• From Steven Pearlstein, who explains some of the complex financial aspects: No Silver Bullets Here, October 2, 2008

Who knows what our Representatives will do now?

• Despite sweetening, measure faces stiff fight in House, Baltimore Sun
• Bail-out bill: Still a bitter pill?, BBC News
• House members being sweet-talked into passing financial rescue bill, WTTE, OH
• Texas House members see opposition to bailout bill weakening, Dallas Morning News

When the bill is taken up in the House there surely will be lots of hold-outs. For some, the legislation is simply unthinkable. During House debate, Jeb Hensarling of Texas said it was "the slippery slope to socialism." Thaddeus McCotter of Michigan said "It was no mistake that, during the 1917 Bolshevik revolution, the slogan was, 'Peace, land, and bread.' Today, you are being asked to choose between bread and freedom." Paul Broun of Georgia said "Madam Speaker, this is a huge cow patty with a piece of marshmallow stuck in the middle of it, and I'm not going to eat that cow patty." And John Boehner, the Republican minority leader himself, referred to the bill as a "crap sandwich."

Read this opinion piece in the Guardian. It's good.

The US democratic-capitalist model is on trial. No schadenfreude, please, This week the demands of American democracy clashed with those of American capitalism. And China's premier smiled, by Timothy Garton Ash, October 2 2008

Excerpts: A quarter-century ago, near the beginning of what came to be known as the Reagan revolution, the American Catholic social theorist Michael Novak published an influential book, The Spirit of Democratic Capitalism. It argued that capitalism is "compatible only with democracy". "While bastard forms of capitalism do seem able for a time to endure without democracy," wrote Novak, "the natural logic of capitalism leads to democracy." And true capitalism requires moral virtues such as "temperance and prudence, fortitude and justice".

To adapt Churchill, democratic capitalism is the worst possible system, apart from all the others that have been tried from time to time.

The challenge to American democracy today is nothing less than to prove it can reform its whole model of democratic capitalism, and make it better.

Pray that it can.

I've got myself a free subscription to the Financial Times courtesy my UK student status. FT is considered to be right-of-center so its comments on the US election might be thought to slant toward the Republican candidate. But as with conservative columnist George Will this does not seem to be the case.

Before last night's debate the FT leader writer assessed the candidates on the financial crisis and gave Obama the edge: "Ordinary economic competence, which Mr McCain particularly appears to lack, may be less important than grace under pressure. Readiness to take charge and ability to inspire some confidence will be the real test. In this, Mr Obama has done better than his rival. Mr McCain’s instinct for decisive action has led him astray: his initial interventions were ill-judged and poorly received. Mr Obama’s tendency to intellectual detachment has been much criticised hitherto, including by many Democrats, but has now come into its own. Whereas Mr McCain has seemed rattled, Mr Obama has seemed calm and methodical. The Democrat’s impeccable taste in advisers – men such as Paul Volcker, whom voters are inclined to trust in an economic emergency – has also served him well."

This morning two FT columnists tip the same way.

Gideon Rachman says McCain showed his age while rambling about the economy but seemed more on top of things when the subject turned to "stuff he actually cares and knows about." He says Obama wasn't much better on the crisis but did have four succinct points to make at the beginning; contrast McCain who "gave the impression that he thought that the source of the problem is excessive spending in Congress."

Clive Crook liked Obama's performance much better than McCain's: "After the last couple of days, McCain badly needed to win Friday’s debate. My immediate feeling was that he didn’t even manage a draw. Obama was on fine form. He did not meander. His responses were calm and focused. He never looked rattled. He seemed comfortable with the issues and unthreatened by his opponent — sufficiently unthreatened to be generous to McCain now and then, an effective Clintonian (Bill) touch. McCain was prickly, rarely looking in Obama’s direction, repeatedly accusing him of failing to understand the issues — a difficult charge to make stick with Obama looking so assured. McCain’s aggression seemed to me at times to betray a lack of confidence. He had his moments; still, I thought it was a comfortable win on points for Obama."

Pearlstein says some things that have been on my mind lately. His column today -- Gut Check -- says:

1. It's not a good time for vindictiveness, for revenge, for playing the blame game. He says: "You can try to prevent a financial meltdown or you can teach Wall Street a lesson, but you can't do both at the same time."

2. The US is really close to a massive cascade of bank failures. He says: "All it would take is one more hit to trigger the modern-day equivalent of a nationwide bank run. Financial institutions would fail, part of your savings would be wiped out, jobs would be lost and a lot of economic activity would grind to a halt. Such a debacle would cost us a lot more than $700 billion."

3. The bailout involves sales as well as purchases. He says: "The latest proposal hammered out between the Treasury and Democratic leaders won't cost anywhere near $700 billion unless we get a 1930s-like Depression, in which case we'll have much bigger problems to worry about."

4. Legislators should not pretend they are members of the executive branch. Nor should they use legislative oversight and the power of legislation to hamstring executive branch specialists. He says: "It is important to give the Treasury secretary and the people he hires a good deal of flexibility in designing and experimenting with the mechanics of this rescue."

The head of Bank of America gives weight to point 2. He says banks are hoarding cash, refusing to extend credit, and credit is what makes the economy run. His bank is sound and will benefit from the failure of weak banks (by buying up assets cheaply). Nonetheless he doesn't want banks to fail. There's a serious risk that the current economic pessimism will escalate into panic. He says: "Right now, the flow of funds that makes our economy run is threatened by a lack of confidence in the value of financial assets, particularly mortgage assets. Financial institutions are extremely hesitant to purchase assets or lend money to one another to fund the system. Just as optimism in times of growth encourages an upward trend, pessimism in uncertain times can feed a downward trend. Allowing such a trend to gain strength is our great risk." (Main Street Needs the Treasury Plan)

A Wall Street Journal blog says the political posturing of Southern Republicans in congress -- a populist melange of vindictiveness combined with grasping for a share in the payout -- is being quietly supported by McCain: "McCain didn’t create the House rebellion, but at least temporarily, we are seeing an interesting partnership between House Republicans and John McCain. When I asked one GOP Hill staffer whether McCain was serving as a proxy for House Republicans, I was told that such a claim would be too strong but that McCain is, at the very least, trying to give voice to House Republicans skeptical of the bailout. And if that’s true, McCain will have an opportunity to bring them along–or some of them–to get a deal.” (Political Wisdom: A Wild Day Spawns Questions About McCain)

Who's to blame for the financial crisis that the US Treasury is now trying to mitigate? Its seriousness is obvious enough. How else explain the restraint our politicians are struggling to achieve? How even comprehend the quantities of money involved -- a trillion dollars or more in Federal payments and guarantees?

Press coverage is, understandably, vast. I note only three: two by a Washington Post business columnist and one by a hedge fund operator. Reading them I wonder what's happened to us? What's happened to US citizens, we who once prided ourselves on thrift and now are overwhelmed with mortgage and credit card debt? What happened between the Depression generation of tightwads and those intervening generations of more and more laid back consumers?

The press writes as if Americans who spend the earnings tomorrow may never bring are simply victims. What does that say about our collective intelligence and integrity, our collective power as voters in this democracy? Many of us seem to have caved in, given up, stopped t_h_i_n_k_i_n_g.

I also wonder about the rest of the world, so intertwined with the US economy that they suffer with us, some even more than us. And the rest of the world, too, who sustain our outrageous debt -- our government, household, and and corporate debt that cannot be funded without this foreign support. Have they become so dependent on the US as the world engine of prosperity that they cannot do otherwise?

I wonder but am unable to predict what will happen.

After my comments on the three commentators, I've put some info on Charles MacKay's old and interesting book.

In the first article, commentator Steven Pearlstein says that "when you strip away all the complexity and trappings from the magnificent new global infrastructure, finance is still a confidence game." But he says the bankers wouldn't have been able to work their con if the US economy hadn't been artificially buoyed up by low interest rates over the last decade. And he says Greenspan and the Fed were able to keep interest rates so low because foreigners remained willing to buy American debt instruments, American securities, American real estate and other assets of all sorts. Low interest rates provided Americans with cheap money. Households borrowed heavily "to buy houses, cars and college educations, along with more health care, extra vacations and all manner of consumer goods and governments used the cheap money to pay for services and benefits that citizens were not willing to pay for with higher taxes." When this credit bubble began to frighten foreign investors, the big New York banks found a way to keep these investors happy by inventing new credit instruments and working their con to keep the bubble growing. That meant that the inevitable bursting was a much more serious event than almost any previous meltdown (it's being compared to the 1929 crash of course).

Pearlstein says that the financial restructuring that we're now seeing should "force some financial discipline on the majority of U.S. households that relied on borrowed money to maintain their lifestyles," but he says it probably won't.

In the second article Pearlstein says the scale of the event is mind boggling but not so great that it can't be controlled. This week should show us life being lived normally in most US households and most companies outside Wall Street. The securities markets should return to normal. The main effect will prove to be a new way of looking at free market ideology: "There is little doubt we are witnessing a once-in-a-generation sea change. It will no longer be an easy applause line for a politician to declare that government is the problem and that markets always know better than regulators and politicians. Debates about the competitiveness of U.S. financial markets will focus less on how little regulated they are and more on how much protection and transparency they offer to investors. It will be harder to deny essential government agencies the talent, money and respect they need to do the job right."

He closes by addressing the confidence of foreign investors in the US economy: "No doubt there will be those who see in this crisis further proof of the inevitable decline of the United States as a world economic power. In fact, it may be just the opposite. The wild swings over the past week in financial markets from Moscow to Mumbai, were only the most recent reminder of the increasingly global nature of capital flows and the risks of financial contagion. They also were a reminder that, in times of stress, global investors still seek refuge in the safety of the U.S. dollar, U.S. Treasuries and the skillful crisis management of U.S. policy makers."

The opinion piece by the hedge fund operator is Calling Out the Culprits Who Caused the Crisis, by Eric D. Hovde. He's an interesting character. A financier who's wealthy enough to own both an investment bank and commercial banks, and also runs a hedge fund, he's not a sleazy character, but rather one who strongly supports charitable activity here and abroad. It's also obvious from this article that he's one who is blunt in his criticisms of his own industry.

Like Pearlstein he says the historically low interest rates put in place by the Greenspan Fed created a toxic environment for the US economy. The New York bankers who took advantage of this environment simple threw away all the internal checks that traditionally kept the banking business sound. He say the price of all this greed is an estimated $1 trillion and more in losses. While giving Greenspan much of the blame, he also says "One has to wonder why Treasury secretaries under Presidents Clinton and Bush -- Robert Rubin and Hank Paulson, respectively -- took no action to curb these abuses."

He says we might have gotten some help from congressional oversight if the financial industry hadn't corrupted congress: "The Wall Street investment banking firms, their executives, their families and their political action committees contribute more to U.S. Senate and House campaigns than any other industry in America. By sprinkling some of its massive gains into the pockets of our elected officials, Wall Street bought itself protection from any tough government enforcement."

He leaves us with no prognosis but only a wish: "there has not been a time since the 1920s when Wall Street has enjoyed as much influence over Washington as it has for the last 12 years. Let's hope that this influence fades rapidly -- and that this financial crisis doesn't end the same way as the one of nearly 80 years ago."

Here's the old and ever-popular book I mentioned at top. MacKay was one of the first to notice how easily people get carried away and how dreadful the results can be.

Memoirs of Extraordinary Popular Delusions and the Madness of Crowds

Prefaces

1. Money Mania.—The Mississippi Scheme

2. The South Sea Bubble

3. The Tulipomania

4. The Alchymists (file a.) 4. (cont.) The Alchymists (file b.)

5. Modern Prophecies

6. Fortune-Telling

7. The Magnetisers

8. Influence of Politics and Religion on the Hair and Beard

9. The Crusades (file a.) 9. (cont.) The Crusades (file b.)

10. The Witch Mania

11. The Slow Poisoners

12. Haunted Houses

13. Popular Follies of Great Cities

14. Popular Admiration of Great Thieves

15. Duels and Ordeals

16. Relics

Footnotes

About the Book and Author

Illustrations

I apologize for the length of this. I'm too lazy to break it into bite-size pieces.

The thesis research I'm doing these days deals indirectly with the development of a credit-based economy in 17th century England. I'm studying ways of calculating interest received or paid and it's apparent that promises written out on pieces of paper served for money with growing frequency. Although shortages of coins, the dangers of carrying lots of coins, and the difficulties of calculating the true value of coins made credit transactions necessary, people were coming to see lots of other advantages.

At first the word "credit" carried all the weight of its multiple meanings. In particular it connoted trust, the assurance that both parties were committed and fully able to do exactly what they promised one another in the paper documents they signed. In time, merchants' courts evolved to enforce these promises making it unnecessary for one party to personally acquainted with the other. However, these courts came to have little influence over the speculative trading of some forms of credit transactions, in particular the buying and selling of securities -- the bonds that the government used to borrow from citizens and the stock issued by the East India Company and other trading ventures. Securities were a different form of credit, one much more subject to abuse than merchants' credit.

My research isn't concerned with the emerging stock exchanges in European cities of the time, but as it happens I'm reading a book that deals with the subject: David Liss's Conspiracy of Paper. It's an excellent amalgam of mystery story, historical novel, adventure tale, and exploration of chicanery on a huge scale. It is set in London at the time the South Sea Bubble and its hero takes us into the intricacies of that vast web of intrigue. Bit by bit the author unfolds the conspiracies, manipulations, and crimes of some of the wealthiest and most powerful men of the time -- men whose place in society and its institutions was one of public trust. The story thus concerns, in part, the abuse of trust.

If you know the story of the South Sea Bubble at all, you know that this massive abuse of trust led to the ruin of many English men and women from all walks of life.






As it happens, too, we ate out last night at the New Deal Cafe in Greenbelt Maryland.


Greenbelt was created as part of the New Deal in the aftermath of the bursting of another financial bubble -- the the Wall Street Crash of 1929. It's cooperative approach to commerce and civic life has made it a conscious antidote to the greed and betrayals of trust that foment financial bubbles.

After the meal, we attended a performance of G. B. Shaw's play Mrs. Warren's Profession at the Greenbelt Arts Center


The play is about Mrs. Warren's profession, of course, but also about women's rights, the generational gap between a mother and daughter, the conflicting impulses of career and romance and of business and the arts. But it's also about people with wealth and social position who maintain an aura of probity while earning money in anti-social ways. In this sense, it compliments the Conspiracy of Paper and the betrayal of public trust. In fact, Shaw makes this connection fairly plain in speeches by two characters: the mother, Mrs. Warren herself, and her partner, Crofts. The latter, a Baronet, speaks of the financial dealings men of his class, including for example his brother the M.P. who "gets his 22 per cent out of a factory with 600 girls in it, and not one of them getting wages enough to live on." He says, "As long as you don't fly openly in the face of society, society doesn't ask any inconvenient questions; and it makes precious short work of the cads who do. There are no secrets better kept than the secrets everybody guesses." Later Mrs. Warren puts the matter a little more bluntly: "You think that people are what they pretend to be: that the way you were taught at school and college to think right and proper is the way things really are. But it's not: it's all only a pretense, to keep the cowardly slavish common run of people quiet. It's truth, gospel truth Vivie: the big people, the clever people, the managing people, all know it. They do as I do, and think what I think. I know plenty of them."

This tirade brought to mind this: A Con Game In Pinstripes

Extracts:

What is so telling about these stories [of financiers lying to their clients, regulators, and the public] -- and, rest assured, there will be many more before we're finished -- is that they come only a few years after these same companies reached similar settlements for defrauding many of the same investors during the telecom and dot-com boom. While the fraud back then had more to do with bogus research and accounting and manipulation of initial public offerings, it is clear that they sprang from the same slimy ethical culture that has produced the current credit crisis. Wall Street has become a fundamentally corrupt enterprise in which the motto is: "We'll do anything for a fee."

I refer not to the narrow legal definition of "corrupt," but to the general instinct to mislead clients, double-cross and collude with counterparties, and pull the wool over the eyes of investors. It is the kind of corruption grounded in the attitude that it's all just a game in which the only rules are "buyer beware" and "heads I win, tails you lose." In a corrupt business culture like that of modern-day Wall Street, cynicism is rampant, candor and accountability are first casualties, and a man is measured by the size of his bonus rather than the depth of his integrity. It's not so much immoral as amoral.

The tell-tale signs of this endemic corruption now litter the financial landscape.

To find it, look no farther than the televised bleatings of research directors and equity strategists who, until the last few weeks, were still talking about a stock market rebound in the second half of the year and have never once forecast a losing year for the S&P 500.

You can find it in the spectacularly misguided mergers and acquisitions that were conceived, negotiated, blessed and underwritten by investment bankers who are paid enormous fees no matter how things turn out for investors. Their latest bright idea: the merger of Fannie Mae and Freddie Mac.

It's right there in the Wall Street Journal, where it is reported without a trace of irony, that some master of the universe who was forced out of Citi for overseeing the loss of billions of dollars has been snatched up by Morgan Stanley while another is staked for a couple of billion dollars to start his own hedge fund.

Addendum:

I hadn't been to Greenbelt in years. Back then I would occasionally join in the Greenbelt National Park Training Race Series

This is brilliant. An editorial in the AARP Bulletin tells how much our economic well-being has deteriorated in the last 12 months: One Year Later, a New World.

The piece says the world is complex, fully interconnected, and volatile, enhancing the need for individuals to do what they can to ensure their own financial security. Here's the main graphic and excerpts:

In just 12 months, unemployment has risen from 4.5 percent with a growing workforce to 5.1 percent and a shrinking workforce as millions stopped seeking jobs. The average price of a gallon of gas has jumped 53 cents to $3.44, and crude oil has nearly doubled from $64 a barrel to

$115. Inflation is growing; medical costs are growing faster. Stock prices have dropped nearly 15 percent, and housing prices have plummeted more than 10 percent, part of a spiral of delayed payments, defaulted mortgages and home foreclosures. Banks and lenders around the world are in full retreat.

The U.S. trade deficit and the federal budget deficit continue to mushroom, and the national debt is $9.4 trillion—up 10 percent in a year. And the value of the dollar has fallen another 15 percent, driving the cost of imports ever higher and shaking the confidence of foreign investors.

If there is turmoil in the markets, there is chagrin and anxiety at home. Amid all the statistics, it is workers, home-owners, spouses, children and grandparents who feel the impact of this wrenching sequence of events—in lost jobs, postponed retirement, reduced wealth, delayed medication, lower confidence.

An article in the Washington Post makes a point that should be obvious, but wasn't to me. The falling value of the US dollar makes life easier for companies that have goods to sell foreigners (Harley Davidson Motor Cycles, I hope). It also makes more expensive the million things Americans buy from abroad. And it helps US tourism; visiting here becomes the thing for foreigners to do. Just as predictably it encourages European and other overseas buyers to pick up pieces of us -- our real estate, our companies; farms, factories, and franchises. Here's the citation: What Can They Buy? A Good Bit of Us., by Moisés Naím (Washington Post, Sunday, April 27, 2008; Page B04). The author says,

U.S. companies have rarely been so cheap. Five years ago, a German or Spanish company that coveted a U.S. competitor worth $500 million needed almost 550 million euros to purchase it. Today, it would take just 319 million euros. The U.S. marketplace will be altered by an infusion of new foreign competitors that will manufacture their own products in the United States. These firms will use their new American base both to export to the world -- including their own European markets -- and to serve the U.S. market from inside its borders.

Such a transatlantic shift will inevitably, ignite a political firestorm on both sides of the Atlantic. [But] it will be impossible for U.S. politicians to stop the Euroinvasion, and European politicians will prove equally helpless in preventing their companies from moving to the United States. While blocking a few large investments by foreign government-owned funds in U.S. ports, defense industries and oil companies may be possible, preventing thousands of private companies from investing in the United States is not. Although difficult economic times always create political opportunities for demagogues and populists, the United States is far from ready to repeal capitalism. And stopping the Euroinvasion will require nothing short of that.

An article from Agence France Presse adds a bit of spice to this thought. Although much of the foreign investment in the US is coming from individuals and private corporations, much is also coming from large financial concerns, among them the huge sovereign wealth funds that governments have set up to manage their budget surpluses. The article says these surpluses are large and growing. Here's the head and lede:
Sovereign wealth funds hit 3.5 trillion dlrs in 2007: US firm.

Sovereign wealth funds have mushroomed 24 percent annually over the past three years to hold a total of 3.5 trillion dollars in 2007, a US economic firm said Monday.

Global Insight said that projected on that annual growth pace, sovereign wealth funds (SWFs) would surpass the entire current economic output of the United States by 2015, and the European Union by 2016.

As always, there's concern that these government-run funds will be used for political not just economic purposes. Of course the unbelievably large US deficit makes this country vulnerable to blackmail by other governments simply because we rely so greatly on them to help cover our debt through purchase of US Treasuries and the like. The potentially inimical actions of sovereign wealth funds adds spice to the paranoiac mix. It's not just the uncomfortable feeling one gets on realizing that -- more and more -- foreigners "own" us; it's also the risk that they'll let it be known that they will do some destabilizing action, like a sudden shift in investment that puts thousands of Americans out of work, unless the US government takes a position that agrees with theirs (reduces or eliminates US subsidies for farm products for example).

Along with these two somewhat scary stories comes one of a type that's becoming increasingly familiar. The price of the energy we use is likely to continue to rise. As Al Jolson said "You ain't seen nutt'n yet." From the Financial Times: Opec says oil could hit $200, by Carola Hoyos in London. The article says that oil continues to cost more partly because the US dollar is worth less and less. But, as we all know, the price is also manipulated by suppliers. There's no free market for oil. The wonderful discipline of oil producing nations enables them to screw the rest of the world if they wish, and apparently they do. There's nothing new about this state of affairs. For a long time we've been living in paranoia over the havoc that OPEC could wreak in the US economy. In fact our carefully maintained good relations with Saudi Arabia might be something of a bellwether for our life a world of cheap dollars where foreigners buy up America. I mean to say the huge diplomatic, commercial, and political efforts to stay on the good side of the Saudi ruling family may be a useful learning experience as we find ourselves required to make nice to many others who could do us harm.

Addendum:The Washington Post has an excellent article on the global escalation of food prices: The New Economics of Hunger, A brutal convergence of events has hit an unprepared global market, and grain prices are sky high. The world's poor suffer most. For the 1 billion people living on less than a dollar a day, the world's worst food crisis in a generation is a matter of survival. By Anthony Faiola, Washington Post Staff Writer, Sunday, April 27, 2008; Page A01

The article makes it plain that nations are interdependent and there's no policy that is purely domestic. We no long live in a world where any nation can act unilaterally to protect its citizens. For example, a country that fears the consequences of rising grain prices may wish to stockpile grain, but this stockpiling makes prices rise higher and faster and consequences are bad for all. Similarly, fears of dwindling supplies may cause grain producing nations to control exports. That action reduces world supply of course, driving prices higher, even within the nation that's trying to control exports. (And resorting to price controls to prevent price rises can destabilize the country's financial markets with further unfortunate consequences.)

It's another indication, for me, that the US habit of acting unilaterally has had its day. We're still the dominant world power, but our ability to influence affairs with selfish arrogance is growing weaker and weaker.

I've written before about how low interest rates have fueled consumption in the US and how, in turn, this consumption has helped countries that export to the US, notably the oil producing nations and China. I've been a little fuzzy about one aspect of this bilateral binge. The cycle of accelerating indebtedness and import frenzy has been accompanied by the purchase of huge chunks of US debt by foreigners (among them the oil producers and China). But with low interest rates these investors in American debt might have sought to put their money elsewhere, where it would earn a greater return.

Why have foreigners continued to invest in US debt when there has been more money to be made through investments elsewhere at higher return?

To some extent they put money into the US financial markets because that enabled Americans to continue buying from them. To some extent because the huge imbalance of trade between the US and other nations resulted in huge stores of US dollars that needed, one way or another, to be repatriated. To some extent since the US dollar is the defacto medium of exchange across the globe and, because of that, all nations have an interest in preventing its collapse. (A collapse that would probably result from failure of foreign nations to finance US deficits and its those foreigners financing US deficits enabled the US to keep interest rates low.)

But to some extent the put their money into the US financial markets because they see the US mainly as a customer for their output (whether oil or t-shirts). They see themselves as producers more than as investors. Their dollar hoards are more of a problem for them than an opportunity. Yes, they represent wealth, but -- such is their abundance -- these hoards need to be carefully managed to insure that the main business -- production -- continues to grow.

All this is long preamble to a link to a current article by Steven Pearlstein. He writes today about how the habit we Americans have of living beyond our means is a main source of the financial crisis we have created and the world now suffers from. In doing so he draws attention to the phenomenon I've just drawn attention to. I urge you to read the article.

Its upshot is what many have already said, global prosperity cannot be sustained simply by the huge amounts of over-consumption we've seen in the US over recent years. There has to be an international rebalancing. He says we Americans have been living way beyond our means, consuming more than we produce and investing more than we save. Other nations, such as China and Saudi Arabia have been willing to finance our trade deficit on easy terms because it allows them to peg their currencies to the dollar in a way that generated higher job creation and economic growth in their home markets. This mutually advantageous imbalance in trade and investment flows has created a huge supply of cheap dollar-denominated credit that virtually invited the bankers and brokers and rating agencies and private-equity firms in U.S. markets to throw caution to the wind and make ill-advised lending and investing decisions.

Some excerpts:

If this is the case -- if the story of the credit bubble and its bursting is more fundamentally about macroeconomic imbalances than microeconomic failures -- that has very different implications for where we go from here.

For what it means is that things won't be "fixed" simply by having the financial sector write off its losses and bad loans and promise to do a better job next time with risk management. Rather, it will require a reduction in the overall standard of living in the United States so that the country as a whole begins to live within its means.

What does that mean exactly?

In practical terms, it means that households will have to reduce consumption, increase savings and stop piling up credit card debt or using home equity as an ATM.

It means that the federal government stops running huge operating deficits by raising taxes or dramatically cutting national security and entitlement spending.

Such a broad reduction in wealth and living standards will take many forms. It will come in the form of higher unemployment and stagnant wages and falling income, which take statistical form in slower or even negative economic growth. It will come in the form of inflation and its first cousin, a lower value for the dollar. And it will manifest itself in lower values for pension funds, 401(k) accounts, university endowments and house prices.

You don't have to have a PhD in economics to see that this adjustment is underway. But it would be folly to assume that it is anywhere near completion. After all, it took many years for our collective standard of living to get out so far out of whack, and it's highly unlikely that we are somehow going to reverse things in a couple of quarters. And the bubbles in commodities and commercial real estate are still to pop.

What Pearstein doesn't say, because it's not his subject, is that the producing nations whose exports we have been consuming are becoming disenchanted with the US market and the US dominance in world finance. China is diversifying its manufacturing, finding a growing number of customers outside the US, and, by the growing prosperity of its citizens, making its own internal markets. Saudi Arabia and the other oil producers are finding other markets as well, notably within the newly-emerging economic powerhouse countries -- that is China, India, much of South-East Asia, and, eventually within Latin America as well. Along with this the decline in value of the US dollar is encouraging money men to think of international finance in terms of a market basket of currencies, including notably the euro as well as the dollar. The evolutionary impulse of these two shifts will reinforce the changes that Pearlstein predicts.

Newspapers are reporting that China's currency has appreciated against the US dollar to the highest point since 1994. This pleases US policy makers who maintain that the Yuan has been artificially low.

As the Yuan rises in value, Chinese exports become more costly to Americans. Americans who spend a lot of time in Wal-Mart and Target have benefited from the cheap Yuan. They'll regret the appreciation of the currency. American producers consider the cheap Yuan to be unfair competition. American politicians dislike the unequal trade balance that has resulted, as exports from America to China represent only a tiny offset to the enormous volume of American imports from China.*

Things are much more complicated than that.

China has been constrained from letting the Yuan rise in value because its factories provide employment to millions of its citizens. The nation set a fixed ratio of the Yuan to the dollar at least partly in order to stimulate exports and thus provide jobs to those who were barely surviving on subsistence agriculture. Chinese factories produced cheap clothing and other low-wage goods, Americans bought this output, and the Chinese economy grew at a rapid rate.

China sees that there are limits to this policy and has more recently begun to diversify its manufacturing. It has been purchasing high-tech production equipment and improving educational opportunities so that it can develop a better-trained workforce and produce more sophisticated goods and services.

It has been induced to make this change partly because its currency manipulation has stimulated inflation and partly because middle class Chinese people need better investment opportunities: it does not make sense for them to continue to invest in low-end manufacturing.

Chinese policy makers also realize that as Chinese people gain wealth (or at least reasonable incomes) from exports, their desire to consume high-end goods and services increases. The Chinese government would prefer to meet this need from within China rather than by way of imports.

Inflation is a world-wide concern. The price of oil continues to rise and now rises in the price of food are causing great concern. China has to worry about the rising price of rice as much as do its Asian neighbors. There's great risk that people who can't afford food will rebel against their governments.

Echoing many financial experts, a blogger says China should be more aggressive in revaluing its currency:

China's PMI Numbers Are Too Strong, by Michael Pettis.

Extracts:

China should have begun the appreciation of [its currency] much earlier than it did and it should have appreciated more aggressively. Unfortunately, perhaps because of the excess global liquidity of the past few years and especially of the past few months, China is now caught in a monetary trap in which the high trade surplus forces the central bank to buy large amounts of foreign exchange, which of course causes very rapid domestic money expansion. This money expansion feeds directly into excessively high levels of investment, which force up industrial production and so causes the trade surplus to rise or remain high. It will be extremely difficult for China to get out of this trap.

As China’s labor force, especially in the wealthy south and southeast, move out of low value-added assembly and into higher quality manufacturing and service jobs, companies that rely on cheap, unsophisticated labor will necessarily find conditions more difficult and may even go out of business.

Policies aimed at creating a higher quality manufacturing and service base in places like Guangdong are succeeding. As long as overall exports continue to grow it is hard to see how the rising RMB** has caused trouble for Chinese exporters in general.

In China, appreciation will not reduce inflationary pressures through the price impact on imported goods. It can only really reduce inflation if it reduces the amount of foreign exchange the central bank has to buy every month, and so reduce the growth of the domestic money supply. As long as China’s money supply keeps expanding at such a fast pace, it will be impossible to bring inflation down, and as long as the central bank is forced to purchase very high levels of foreign exchange every month, China’s money supply will keep growing too quickly. The recent appreciation has done nothing to slow the trade surplus but it may have increased speculative inflows, so it actually causes an even further increase in the money supply.

Chinese policy makers say this analysis overstates their ability to revalue the Yuan. There is a limit to how quickly the country can replace low-level manufacturing with manufacturing that requires a more educated workforce. Moving too fast could cause economic chaos world-wide.

The US and other western governments don't substantially disagree, but see it as in their interest to keep the pressure on China.

Coincidentally, the global concern with inflation and the rising price of food comes as China is attempting to show the best side of itself with the coming Olympic games. Its difficulty in answering critics of its civil rights policies in general and in particular of its policies toward Tibet is only one of many concerns connected with this aim to look good.

China thus has lots of reasons to allow its currency to continue to appreciate.

One final complication, however, is the expected recession in the US and (to a lesser extent) around the globe. That event will cause American imports to decline and the decline in imports from China will provide counter-pressure against appreciation of the Yuan. The logic is thus: appreciation increases the price of exports and reduces the expansion of the Chinese money supply through purchase of dollars. US recession reduces the volume of exports and this makes it less necessary to purchase dollars. The result is less need to purchase dollars and consequently less inflationary pressure on the economy.

If China succeeds in controlling the rise in prices of oil and food imports, the recession in the US and slowed growth throughout the world may give Chinese policy makers greater flexibility in transforming the country's industrial infrastructure from low-end toward high-end manufacturing. If they do get this flexibility and use it wisely, expected benefits should flow over from China to the global marketplace. That is to say, all of us stand to benefit from Chinese modernization. However, these benefits will not be evenly distributed (whenever are benefits evenly distributed?) and, in the long run, while the US may be able to increase exports to China, it will not be easy for Americans to make a transition from prosperity based on expanding consumption (driven by low interest rates and manifested substantially in an abundance of cheap imports from China) to one in which interest rates are more rational (i.e., higher) and prosperity is achieved by growth in production as much as by growth in consumption. Along the way, as I've said, there's a good chance that the US will lose its status as preeminent financial power.

One last quote. Here is the head of the IMF on the Chinese economic situation. Note that he mentions social inequality, energy efficiency, and social services as areas that the Chinese government should address in addition to more purely economic and financial ones. He doesn't say so outright, but it's implicit that carbon emissions and other forms of pollution are and should be a major concern. It's not his place to add that China needs to address the corruption of its political regime. Although China has immensely talented and well-educated bureaucrats and policy makers, Party hacks block needed economic, social, and political reforms, and -- to some extent -- permeate the government from top to bottom. And the Chinese judicial system is unable to insure due process either for the Chinese people or those who do business with them.

Statement by IMF Managing Director Dominique Strauss-Kahn at the Conclusion of his Visit to China.

Extract

The Chinese government is confronting several macroeconomic policy challenges, including preventing inflation—largely the result of food price increases in recent months—from becoming entrenched, and rebalancing growth away from heavy reliance on exports and investment toward consumption. Addressing social inequalities and improving energy efficiency are also priorities.

We agreed that continued tight monetary policy will be important in containing investment growth and inflationary pressures. The government's emphasis on reorienting the budget toward improving social services—including health and education programs—can also help both to reduce disparities and rebalance growth. In addition, we also see the government's focus on financial sector reforms as key for achieving these goals. On exchange rate policy, we welcome the authorities' objective of allowing greater flexibility over time. However, we encourage a faster pace of appreciation that would be helpful for addressing China's key economic challenges and would also contribute to preserving global economic stability.

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* The BEA reports that the Chinese trade surplus with the US was $20 billion in January and a little less in February. $20 billion is more than a quarter of the total January deficit in US import/export of goods.
**RMB: The renminbi (literally "people's currency") is the currency of the mainland of the People's Republic of China whose principal unit is the yuan. (Wikipedia)

In last Sunday's Outlook Section, a Washington Post columnist made some of the same arguments about international finance which I made in a recent post (a process of mutual understanding). The article is No Cushion Against Hubris, by Jim Hoagland. Here are a few extracts:

"The first panacea for a mismanaged nation is inflation of the currency; the second is war." -- Ernest Hemingway, Esquire magazine, September 1935

There is still time to covet and honor the American greenback as the strongest link of stability in the international financial system. [But] the "golden moment" that enveloped the global economy for most of this decade is fading -- at least psychologically if not materially -- as we reach the end of an era of hubris in global affairs.

[The moment is fading] not just because President Bush will leave the White House next year, although that will help. The brash Texan has personified the global zeitgeist of his time: one of audacity curdling into hubris. He was elected to pursue a powerful nation's impulses and ambitions to be stronger and richer than any country in history, and he and his compatriots have pursued those dreams into the ditch.

However necessary and skillfully managed, the rescue efforts [of the Federal Reserve] add devastating new pressure on the dollar's value as a traded currency (which then affects oil and other commodity prices) and on rising U.S. inflation rates. They also eat into the fixed-income investments of many retirees. Like so much that has happened on Bush's watch, the bill for today's maneuvers will come due after he has gone.

It is hard to see how the world's global trading and financial systems can be fixed or even rebalanced without committed and credible American leadership based on realism and not hubris. But it is even harder to see that leadership coming forth unless the United States can first put its own house in order.

Hoagland doesn't say so directly, but it's implicit in his argument that we're at risk of destroying the status of the dollar as the world's standard currency. This de-facto standard has given Americans the ability to set internal monetary policy without considering international repercussions. As this site points out:

Today over half of all dollar notes in circulation are held outside the borders of the US. Almost half of US Treasury securities are owned by foreigners, mainly held as reserves by foreign central banks. The dollar is the main currency in international capital flows, as well as the currency of invoice for commodities and for many manufactured goods and services. All countries that trade directly with the US invoice both imports and exports in US dollars. . . . The US can issue dollar-denominated claims to the rest of the world which may never have to be redeemed so long as it maintains the domestic purchasing power of the dollar. While this gives the US a unique advantage in terms of borrowing in its own currency, the existence of a safe reserve asset is a great convenience to other countries. Only a serious loss of confidence in the dollar could depose it as the primary medium of international exchange, such as might be due to a prolonged major inflation in the US.

It's the "loss of confidence" in the dollar that's now becoming a realistic possibility and the failure of Americans to recognize this fact is part of the hubris that Hoagland warns against.