Carey Center for Democratic Capitalism
Feb 25, 2005
1000 Massachusetts Ave.
Washington, D.C. 20001
I hope that this letter can add focus for further discussions. My proposition is that our country’s economy is in the middle stages of a “financialization” in which financial services dominate the job growth economy rather than support it. The threat that this presents to free markets is huge, complex, and fast moving. Cato is one of the few organizations with the free market mission and the sophistication to turn back this tide, if not tsunami.
Concentrated wealth is at record levels and has provoked the usual outrage from the “have nots” and their representatives, along with the usual nonsense from the “trickle down” representatives of the “ haves.” This concentration, with visible evidence of individual greed, has helped change our international image from the beacon towards freedom to an arrogant bully trying to run the world. Less attention is paid, however, to broad wealth distribution, as a critical principle in Smith’s economic dynamic to spread wealth around the world. Free markets work when additional volume reduces costs and prices that then allow more people to buy if they have spendable income. (Democratic Capitalism, 278-284)1 Henry Ford figured this out in 1915 and raised wages to $5 a day so his workers could buy the model T’s. Globalization is now managed on the mercantilist philosophy in which profits are presumably maximized by suppressing wages and benefits. (p.182, 193). This cannot work in the long-term because people need money for reciprocal purchases in order to energize the economic perpetual motion machine that can eliminate material scarcity in the world.
Kevin Phillips in Boiling Point called attention to what financialization can do to great nations: first Spain in the 16th century, Netherlands in the 18th, Great Britain in the 20th, and now our turn? The manifestations are a shifting of taxes from capital to the middle class, shrinking of manufacturing, an explosive growth of financial services, and record concentration of wealth. (p. 258). Profits are now so good in financial services that they seem insulated from the big cash settlements required by so many cases of wrong doing.
In your mission to support free markets you properly identify the ideologues of the American Empire who push a strong government agenda that is in contradiction to the proper role of America, which is to spread the benefits of economic freedom around the world. I regard, however, the ideologues of the liberalization of capital markets as an equal threat to America’s future. The two in combination are truly scary. Apparently the ideologues of the liberalization of capital markets quit studying Smith before they got to the part about neutral money, and control of the speculators. Financial services have grown from 4% to 40% of total corporate profits with the share of total S&P market capitalization up to 25%. GM and Ford make 125% and 157% of their profits from financial services, that is, they are losing money on cars. Imagine what the overall numbers would look like if we followed Smith’s advice and treated financial services as administrative expenses to be subtracted from the wealth of nations
The financialization threat to our long-term economic success is the result of mistakes caused by the lobbying of Wall Street and the inability of Congress to dig deep and get it right. These mistakes are in fiscal and monetary matters that few have the financial sophistication to examine and challenge. The two big mistakes were Nixon floating the dollar without an alternative stabilizing mechanism, and ERISA pumping $100 billion a year into Wall Street with no examination of whether the money went into investment in the job growth economy or only into pushing up stock prices. There was similar lack of examination of how much it cost to get from savings to investment. The mutual funds, for example, contradicted the laws of supply and demand by raising their prices at the same time that the volume of their business was growing strongly. (p. 204) These two mistakes caused the excessive liquidity and volatility that provoked the financialization of the economy. Inattention to the fundamentals of this savings-investment equation continues in the discussion of privatizing social security, that is, where does the money go, and how much does it cost to get there?
Greedy CEOs are a popular target as many were seduced by ultra-capitalism with millions of stock options. (pp.118-123) All CEOs, however, were pressured to choose short-term earnings over long-term growth. The short-term choice gave some the high P/E to acquire other companies. Others were forced to sacrifice long-term plans because they knew that if they did not protect their high P/E they were easy targets for the take-over artists. (Chapter 8) M&A activity is heating up again but with a new twist, the presence of the hedge funds including lots of wage earners’ pension money. They will do new damage with their large war chests, unregulated status, and knowledge of how to play games with derivatives.
In Democratic Capitalism I examine the rise of ultra-capitalism in detail but only after a full examination of democratic capitalism, its philosophy and protocols. (Chapters 4&5) Despite the clarity and comprehensive treatment of democratic capitalism by Adam Smith, Karl Marx and John Stuart Mill, and the experimental verification by Robert Owen, (chapter 3) it has never been presented as a coherent whole for student examination in Business or Law schools or, for that matter, in the liberal arts despite their mission to improve the human condition. There has been a massive intellectual default during the whole industrial revolution by those who could have presented the good capitalism but have preferred to stay with their contempt for commerce that has persisted from the time of Plato. The result is that democratic managers must continue to reinvent democratic capitalism.
The democratic capitalist proposition has not changed: investing in people in a moral environment maximizes profits. Owen demonstrated this synergy of quality of life, moral values, and profits in practice. Mill later connected the dots among these crucial components but few paid attention then and now. (p.49) If democratic capitalism is not examined in the university, and is rarely mentioned in the popular media, as Bill Greider asked in one of his books: Who Will Tell the People? I hope that Cato will examine this opportunity.
Fortunately the problems are susceptible to simple solutions that are detailed in my book: they include tax-free dividends for low-and-middle income wage earners, (pp.183, 193) a change in measurement of corporate performance from quarterly and annual e.p.s. to a three year running average of sales, cash flow, and profits, measured against predictions (p. 395) and a steady reduction of the borrowing leverage for speculation. These actions would activate the trillions of dollars of 401(k) and pension money that are now subsidizing Wall Street, move the stock market away from its casino function back to being a source of equity capital for growth, and regulate speculation with borrowed money, the persistent impediment to capitalism functioning at full potential. There are other actions needed in support of democratic capitalism including reform of the U.N. but they are not relevant unless lives are being improved and the world is uniting in economic common purpose. (pp.482-493) The intention of our Founders to harmonize democracy and capitalism was partially accomplished and the concept is still attractive to a huge democratic majority—if properly presented. They now have little influence on the political process but represent the potential voting power to support reform once an agenda is defined.
I appreciate that you find my book of interest and hope that others at Cato have read it. It is the product of 30 years of running companies, including 18 as Chairman and CEO of ADT, and then almost 20 years of intensive study about what free markets need to function at full potential. Full potential meaning feeding, sheltering, clothing, educating, and providing good health for over 6 billion humans, and meaning the substitution of economic common purpose for violence in a world now trapped by reciprocal atrocities. Chapter 10 includes ten hypotheses in a logic trail that leads, according to my analysis, to a world of peace and plenty. Please study hypothesis # 1 that requires validation before proceeding to the other hypotheses. It argues that Marx was right when he rearranged the economic system, culture, and political structure to give priority to economics to be assimilated by the culture with government then restructured in its support. Acceptance of this hypothesis has profound implications.
Cato concentrates on the pathologies of collectivism, which you do very well. You do not, however, in your examination of the role of government in the free market, emphasize acceptance of Adam Smith’s qualifications for the free market to function. The “peace, easy taxes, and a tolerable administration of justice” is understood by most, but the specification for neutral money and control of the speculators, (prodigals and projectors as Smith called them) does not seem to register with many. Neutral money was highlighted by our Founders as the responsibility to “control currency and credit for the general welfare” The importance of neutral money has also been emphasized by 20th century free market philosophers such as Friedrich Hayek who identified the worst sin of government as non-democratic privileges that result in money having a dominating influence in the commercial process. We are in the grip of the Great American Contradiction that frees what should be controlled, and controls what should be freed. The government tells companies what shoes to wear and ladders to use while simultaneously deregulating monetary matters and suspending market disciplines. (pp 263-265)
From the time of Hamilton the wealthy and powerful have enjoyed privileges to speculate with borrowed money resulting in economic panics from 1818 to 1929. In the past quarter century, however, this impediment to free markets has escalated into a dominance that threatens permanent damage to our economy. Imperial overstretch, budgets deficits, and current account deficits puts America into uncharted and dangerous territory. Reform must begin by purging ultra-capitalism (chapter 7) and moving to democratic capitalism in the domestic economy followed by leadership of the world to the benefits of free markets. How did the most successful free market economy in history give up economic leadership for the use of military power to run the world?
Please consider that Collectivism with all of its micromanagement waste and inefficiencies is the Democratic response to concentrated wealth from privilege. In a vague way the Collectivist thinks that they are justified to tax and spend because they see the enormous concentrated wealth and know that much of it is the product of government privilege. Our government is polarized between those protecting privilege to concentrate wealth and those trying to redistribute it. This grid lock can be broken only by discovering that democratic capitalism is the superior free market system, based on traditional values, that improves the human condition thus satisfying the missions of the left and the right. The problem is that no one, except those enjoying the feast, understands the fiscal and monetary policies that provide the privileges and consequently the free market continues to be corrupted. This is where I believe that Cato has a unique capability. You have the mission to support free markets, the financial sophistication to understand the corruptions and solutions, and the infrastructure to promote real reform.
I argue that the best way to defeat collectivism is a move to democratic capitalism that not only distributes wealth broadly but before that creates more wealth. Once wage earners are enjoying a “capital wage” along with their labor wage they will pressure government to copy democratic capitalistic principles and restructure from rules based micromanagement to results based decentralization and empowerment. Conversely, the “starve the beast” Republican plan now being followed, in combination with the expected economic decline, can cause social tensions worse than the Great Depression that came close to destroying this great democratic experiment.
In my first letter to your President Ed Crane in 1989 I identified ERISA pension money as the reason that Wall Street was able to dominate Corporate America. At that time, you will remember, the world was a promising place with economic freedom spreading to Eastern Europe, South America, and Southeast Asia. I was convinced that the end of Communism was the beginning of the world of peace and plenty, and that the parts of the world still full of violence and misery would gradually be changed to economic freedom by the pressure of their people who could see the benefits of economic freedom on TV and the Internet. I used Singapore as the case study in how economic freedom can improve lives in an authoritarian government with political freedoms following once the freedom genie is out of the bottle. (pp. 449-451) Despite this encouraging progress the competing momentum from ultra-capitalism caused me to warn of an insidious development as our economy was becoming steadily more financialized.
Democratic Capitalism, in chapter 7, defines ultra-capitalism as the combination of old-fashioned mercantilism that treats the wage earner as a disposable cost commodity, and finance capitalism that is dominant over, not supportive of, the job-growth economy. Chapter 8 is a play that depicts the terrible choice facing CEOs, and chapter 9 is “Enron, the Poster boy for Ultra Capitalism.” It argues that while Enron may be about greedy executives it is, more importantly, about how the Wall Street-Washington nexus provides government privileges for the easy credit that allows an Enron to happen. Several chapters of my book are a textbook about democratic capitalism and promote a “capital wage” through tax-free dividends for low-and-middle income wage earners. Also presented are ways to create more wealth and spread it broadly through profit sharing and ownership plans like the Care and Share that I designed and put in place at ADT. These plans are the most motivational because the wage earner has to put up some of their own money. These plans will not work unless the culture is changed to participation through trust and cooperation. (pp. 45-47) (United Airlines gave worker ownership a bad name because they did not change the culture.) .
I have a tendency to concentrate on the evils of ultra-capitalism and not describe the wonders of democratic capitalism sufficiently. This is because ultra-capitalism is the bone in our economic throat that must be removed before the benefits of economic freedom can be released again. I hope to have the opportunity with CATO to present why democratic capitalism is the most profitable because it is moral. Not quite conventional wisdom about any type of capitalism, but I think it is a proposition that can be validated. Similarly, the conventional wisdom that the government and the culture must contain the “animal spirits” of a economic system that is amoral at best, and more likely immoral, is reversed because there is evidence that the moral environment of democratic capitalism actually spreads a benign infection to the contiguous community. This should not be surprising as trust and cooperation is the natural condition of humans and will be carried into the community from people in companies that encourage this culture. I also propose, contrary to conventional wisdom, that the Great Depression did not destroy the theory of free markets finding equilibrium. The cause of the Crash of ’29 and the Great Depression was speculation with borrowed money in contradiction to Smith’s classical economic theory, followed by three monstrous mistakes by Hoover. The free market will find equilibrium if currency and credit is, in fact, controlled for the general welfare. (pp 209-216).
Another case study that I believe is critical to understanding the economic threat is the damage done to the Asian “Tigers” in 1998. Rubin and Clinton jawboned emerging economies into taking down cross border capital controls so that “free capital could roam the world looking for the most efficient investment.” A good theory but in practice it became speculative capital rushing around the world looking for a quick chance to make money. The lack of controls of hot money (short-term loans) and currency speculation (or even the threat of it) drove the currency down as much as 70%. It had been clear since Soros defeated the British in 1992 that the speculators with borrowed money have more power than the central bankers. Basel I, written by the central bankers club, BIS, in Switzerland, did not find ways to monitor the quality of loans by requiring a matching component of long-term money and, in fact, wrote reserve rules that encouraged short-term loans. Neither did they have ways in a crisis to automatically convert short-term loans into long term. Hot money was able to rush in and out at great speed. BIS is now working on Basel II but these deliberations can take six years and there is no evidence of popular participation. The money tree is now $2 trillion a day in Forex, $1.2 trillion a day in derivatives. Soros warns of calamities ahead if we do not learn how to purge the instabilities. Who is representing the people in Basel II?
Indonesia, the world’s largest Muslim nation, was the poster boy of how to improve the lives of people through economic freedom because it lowered the number of those under the poverty line from 40% to 10% in a few decades by standard free market moves. American led ultra-capitalism then drove the Indonesians living in poverty back under 50% in a matter of weeks. Another Muslim, the prime Minister of Malaysia, called currency speculation unnecessary, unproductive, and immoral at a speech at a World Bank meeting in Hong Kong. Footnotes to this tragedy: Indonesia became a location for terrorist training and funds; the popular media did not understand the economic causes and turned it into a political event easier to report; and finally the “Tigers’ did not even need more capital because of a high level of savings. The earlier opening up of Indonesia for foreign investment was real investment with real people working, not speculative money going into their stock market or excessively risky ventures. The Treasury Department and the IMF then treated a liquidity problem with standard cures and further slowed down growth. (pp 278-284). Joseph Stiglitz examined the confusion between a liquidity crisis and a capital crisis in Globalization and Its Discontents. (p. 280)
It is the ideologues of the liberalization of capital markets that I want to address in this letter, but before I leave the ideologues of the American Empire I want to call attention to Niall Ferguson’s 2004 book Colossus. Ferguson wishes that we were imperialists like Great Britain because he believes that Empires must stay and manage like the British did. In other words, we have the worst of both worlds in that we start actions like an Empire, but do not follow up with the requisite administration. Contrary to Ferguson’ sentimental and sanitized retrospection of British imperialism, Joseph Nye, former Dean of the Kennedy School of Government and former Secretary of Defense, positions America as a leader towards economic common purpose and a strong team player in containing the violence. The title of his book summarizes it well: The Paradox of American Power, Why the World’s Only Superpower Can’t Go It Alone. (p.486)
In FDR’s view World War II was fought for two reasons, certainly to defeat Fascism but also to end Empires in the world. Subsequently the British left India but unfortunately DeGaulle was repositioning France in the worst possible way and refused to leave Vietnam or Algiers until a lot more blood of young people was shed. Later America followed the French into Vietnam and 54,000 young Americans lost their lives.
Back in 1987 Prof Paul Kennedy of Yale called attention in The Rise and Fall of Great Powers (p. 170) to “imperial overstretch” that precedes the fall of great nations. America now represents about one-third of the world’s economy but one-half of all military spending. The share of the world’s economy is shrinking while the percentage of military spending grows. This spending, combined with the financialization of our economy, has put this great democratic experiments in jeopardy. According to Hegel, the humans’ move toward freedom is one of struggle and contradiction with three steps forward and two back. Is it possible that for the first time we are in serious danger of two forward, three back? If true, what a tragic, unnecessary failure.
Additional matters for discussion include:
- The savings investment equation, fundamental to the success of capitalism, was largely ignored in ERISA and is in danger of being ignored in the privatization of social security discussions. The assumption is that the stock market is an efficient way to move savings into productive investment. Not true, the stock market is a casino with a mission of making money on money with some of it flowing into the job growth economy. At the time of ERISA companies were putting cash away for only a fraction of their pension obligations. ERISA in effect took trillions of dividend or growth dollars out of companies and gave it to Wall Street where only a part of it ended in real investment. IPOs peaked at about $45 billion dollars but they became another scam. I have been unable to find out how much other equity capital comes out of the stock market each year, does Cato know? Most of the ERISA money goes into a hydraulic pressure to buy stock while M&As and stock buy-backs reduce the total stock. As demand goes up and supply goes down, the price has only one way to go, until fear takes over from greed.
- ERISA funding gave the market the clout to dominate companies through enormous rewards and punishments for quarterly and annual e.p.s. (pp. 254, 255). CEOs became Pavlov’s dogs and after receiving enough big juicy bones for beating quarterly e.p.s., or electric shocks for missing by a few cents, all became trained and some even learned how to cheat to get the big bones and avoid the shocks. This quarterly/annual measurement is not responsive to the normal dynamics of business and until we change the measurement to a three-year running average of cash flow, sales, and profits ultra-capitalism will continue to dominate and companies will continue to manage for the short term. Can it be that simple, just change the measurement and accountability to three components and a three-year average? Yes, and until we do the analysts will run the economy.
- The reforms coming out of Congress are, as usual, cosmetic “gotcha” oversight rules that will cost money and reform nothing. Every CEO I know feels responsible for the numbers in the annual report. Telling him or her that they will go to jail for 20 years for bad numbers is both insulting and silly. Predictions of cash flow could have prevented the Enron smash up as it would have demonstrated that they did not know how much cash they were burning every year from their many screwed up projects. A clever CFO can fake cash flow but not for long and not against predictions.
- Once Investment Bankers shifted to pricing their services on a percentage of the deal, the deals exploded most of them either bad or not very good in the long-term. (pp. 120, 121). Bankers, lawyers, accountants, serial CEO acquirers, and acquired CEOs, all feasted on billions of dollars with no risk and little accountability. Even CEOs responsible for making the models work insulated themselves with multi-million dollar severance agreements. Anti-trust is a delicate instrument in a free market but we have gone too far in the wrong direction. Serial acquirers like Sandy Weil and Dennis Koslowski must be constrained by reasonable percentage of market controls. In 2005 the M&A game is heating up again energized by the investment bankers salivating over the big fees and the CEOs who know that playing monopoly is easier than running a business and is sure to stick millions in the CEO’s pocket. The pattern will be the same: fire thousands, hype earnings, pump the stock, collect on options, and do not worry too much about how much red meat was cut in the process. It takes years to realize how dumb most of these deals are.
- The “ fairness opinion” is a joke. How many bankers are prepared to recommend or write an opposing opinion when a deal means millions of dollars and no deal means zero? Until investment bankers go back to pricing their services by time related advisory fees, deals will proliferate and stockholders will be exploited. A quaint idea now that they are all public companies with their motivation the price of their stock.
- Asset inflation: Speculation with borrowed money has caused every recession and depression in this country’s history from 1818 to 1929 to the recent bubble economy. (pp. 209-216). The Chairman of the Federal Reserve Board, however, does not think that preventing asset inflation is their job although vigorous action to prevent price inflation is. The latter protects the asset value of the wealthy and favors the creditor class while action to prevent asset inflation protects ordinary people. Contrary to Greenspan’s testimony to Congress asset inflation can be prevented by transaction taxes, higher short-term capital gains taxes, and bank reserve requirements that move up as stocks appreciate beyond corporate earnings growth, or real estate beyond inflation. (pp. 216-222; 271-274). ( Feb 2007 addendum: please read BIS paper # 205 April 2006 “Is Price Stability Enough?”)
- LTCM is a good case study in the extremes of leverage up to 98% of the bets. It is a good case study of how hedge funds raise the risk in order to feed the steady demand for increasing earnings as they moved from “market neutral” to “directional.” It is a good case study of how the government suspends market disciplines by bailing out private interests who have screwed up. (pp. 287-292). The argument that no public money was used in the bankers’ bail out does not pass scrutiny as the S&L debacle showed how fast the insurance money runs out leaving the taxpayer holding the bag.
- Glass Steagall and Citigroup: The lobby power of Wall Street was demonstrated by the repeal of Glass Steagall including Citigroup’s arrogance in putting together their various enterprises in anticipation of the repeal. (pp 298-300). It is a case study of why we need to protect the system from the conflict of interest of commercial bankers providing easy credit for bad loans, so that the investment bankers can get big fees for the bad deals. These banking functions were separated in the 1930s and Enron in 2001 showed why it was a good idea to prevent the damage from easy credit from government privileges. Greedy executives are a symptom not a cause. Volker’s purchase of Continental Illinois in 1984 ushered in the “too big to fail” era, a major violation of market disciplines.(pp. 264, 265). The repeal of Glass Steagall in 1999 ushers in the “really too big to fail” threat to market disciplines. Free of regulation, criminal actions by Citi bankers have become endemic from the U.S. to Japan, to Europe.
- Enron, along with Freddie Mac, Fannie Mae, Goldman Sachs, and many others are case studies of the danger from derivatives. When they needed better quarterly earnings at Enron, they put out the call to “crank the dials,” meaning raise the risk on trading and even revalue certain future estimates. (Chapter 9). Goldman Sachs is now a public company motivated by the stock price, and as more than a quarter of their earnings are from “trading” they do the same type of pumping when their earnings are weak. Warren Buffett and his partner Charlie Munger called derivatives time bombs that will explode damaging both the players and the economy. (pp. 311-316). Greenspan, however, with his liquidity obsession, has consistently opposed regulation of derivatives and hedge funds and the game playing goes on. Both parties to a contract can change the future value taking the difference into current earnings free of audit or necessity to reconcile the two estimates. Derivatives are not only unregulated but are increasingly used to avoid regulation of basic banking. Balance sheets and traditional references like a debt-equity ratio have become meaningless. This zero-sum game will be reconciled only when the future contracts mature. How many bi-lateral self-serving estimates will do damage then no one knows. OFHEO is now requiring Fannie Mae to write off $9 billion of losses on derivatives. Why do we have so many agencies involved in monetary and fiscal matters?
- It is hard to find a single financial motivation on Wall Street that is consistent with the obligation to the customer, the wage earner. Specialists became technically obsolete over two decades ago but still manage to take their slice of the pie. There are more stockbrokers than steel workers now, most of them on commission. When Mr. Merrill founded Merrill Lynch he insisted that brokers be on salary to avoid the obvious conflict of interest, where did Mr. Merrill go?
- Big bang accounting. Under ultra-capitalism serial acquirers maintained earnings momentum by the acquire and fire method with write offs of future expenses guaranteeing a good following year. Once on the merry-go-round they had to keep acquiring or the music would stop. The big bang announcements were usually made with an estimate of how many would be fired which became the CEO manhood check by Wall Street and bumped the stock up. (p.109). Conversely, a CEO building a company who chooses to reduce manpower by attrition and retraining does not have the same benefit of the big bang and has to report lower earnings during the years of reduction. Tax laws consistently favor ultra-capitalism.
- Stock buy backs. Another example of tax laws favoring ultra-capitalism is the inducement to buy back stock instead of spending the money on growth programs or sending the money back into the economy through dividends. (pp. 123, 187, 212). Stock buy backs were defended as “tax efficient” which they were until taxes were relaxed on dividends for the wealthy. Hundreds of billions of dollars were wasted on stock buy backs to arithmetically improve the price of the stock.
- “Lightly regulated” Hedge funds have tripled in number in six years and now include smaller investors and the wage earners’ pension money. Their defenders describe their function as providing a “discipline” but most of their mission is to make money on money. (pp. 270,271). Derivatives and the influence of hedge funds are spreading through the economic system like a cancer and now infect Mergers and Acquisitions and specific events such as the run up in the price of oil. Speculators with borrowed money thrive on volatility, businesses hate it. The rules favor the speculators and protect them from regulation (pp. 300-304).
- Forms of worker ownership have been recognized for a long time as the way to motivate the wage earner to produce and innovate with an automatic broad distribution of wealth resulting. (Chapter 5). How can we continue to ignore the system that can create more wealth and distribute it broadly? Jeff Gates in Ownership Solution presents support for worker ownership as the long-sought “Middle Way,” including prominent Republicans and Democrats as well as Martin Luther King’s widow and Gorbachev, one of the 20th century’s visionaries. (pp 150, 151). When ERISA was passed into law Senator Russell Long’s committee down the hall was passing 15 laws that gave ESOP tax benefits for worker ownership.(p. 149). What a tragedy that the committees working on these laws were not introduced to each other. The greatest savings-investment opportunity in history was lost when they neglected to couple the ERISA’s trillions of dollars with some place to go with tax-free-dividends for a secure double digit return to the wage earner, their “capital wage.” In the immortal words of J.P. Morgan “Don’t tell to me about return on capital, tell me about return of capital!”
- Greenspan did not want two Bushes to miss a second term and propped up the economy with artificially low interest rates resulting in an explosive housing market. The signs are now scary: since 2001 the economy has grown $1.3 trillion while debt has grown $4.2 trillion; our savings rate of 1% can be compared to Europe’s almost 10%; and home values have gone up $ 4 trillion. The financially sophisticated, however, are getting ready as the majority of the home refinancing is being converted to floating rate and over half of the $365 billion of corporate bonds issued last year were also on floating rates. Many were hedged with derivatives like rate swaps but many others were doing reverse swaps converting long-term interest rates into short term in order to reduce costs and hype earnings. I study the problem all the time but like most do not really understand all the other things going. At this writing, for example, there is confusion about the yield curve with short-term rates going up while long-term rates are going down. Derivatives encourage metaphors: are they time bombs, the tip of the iceberg, or “Alligators Lurking in the Swamp” as Carol Loomis of Fortune called then back in 1994? (pp. 268-271)?
- Citi had trouble making their quarterly estimate in the fourth quarter of 2004 so they took over $800 million out of their reserve for bad loans, 15 cents a share, and beat the analyst’s estimate by 1 cent! Back when the NY banks destroyed many South American countries’ economies by pushing too many petrodollars on them, they had a way to avoid writing off non-performing loans, they just loaned them more money so they could pay the interest and avoid being classified as non-performing. (pp. 258-261). Much more sophisticated game playing now goes on in banking stimulated as usual by stock options: SPEs, structured finance, off-balance-sheet debt, and many other artifices that make bank statements a work of fiction. $171.8 billion, or 15.7% of Citi’s total debt, cannot be found on the balance sheet; it had to be searched for in the footnotes. (p 369). For these reasons bankers should be on straight salary with five-year performance bonuses corrected for loan write offs and reserve increases. Chairman Greenspan regularly advises Congress that derivatives do not need regulation because they get their money from banks that are regulated, and he’s not kidding.
- The Fed has been between a rock and a hard place for many years because the efforts to prop up the economy has required zero cost money while the growing current account deficit (p. 196) normally needs higher bond yields to keep the Japanese and Chinese reasonably happy. The experts do not agree but it seems probable that when our foreign bankers have a better alternative we are in for big trouble. A couple of points higher on interest rates and imagine all those floating rate loans bankrupting homeowners, companies, and our government.
- Our position as the world’s reserve currency has many benefits but the Euro is making steady progress as an alternative with our share of the total shrinking from around 85% to 65% in a few years partly caused by its lower value. South Korea just dumped dollars provoking a strong negative stock market response. The more polite term is “diversification.” Is this another part of the gathering “Perfect Storm?”
- One aspect of our financialized economy is the ability of financial services companies to make money playing the interest-rate, “carry trade,” game. Hedge funds have borrowed lots of 2% money and have gone into junk bonds because as long as the leveraging opportunities exist, and the interest rate does not go up too high, it is a license to steal. If the government were controlling the currency and credit for the general welfare there would be an exit strategy for the taxpayer but only the unregulated hedge funds have an exit strategy- get out first.
- ERISA’s mission was to protect pensions, however, many pensions are now under-funded. During the 1990’s bubble economy companies were allowed to hype their earnings by using the fictitious stock price to lower their pension cash-funding obligation. Now many industries’ pension plans such as automobiles, airlines and steel, with big obligations under defined benefit plans, are broke to the tune of hundreds of billions of dollars. Again the only question is how long the insurance will hold up and when will the taxpayer take up the load.
In support of my call to Cato for help I resort to one of Cato’s Letters dated November 26, 1720:
National credit can never be supported by lending money without security, by raising stocks and commodities by artifice and fraud to unnatural and imaginary levels, and consequently delivering up helpless women and orphans, with the ignorant and unwary, but industrious subject, to be devoured by pickpockets and stock- jobbers, a sort of vermin that are bred and nourished in the corruption of the state.
I hope that we have learned from our misfortunes so that we may expect that no privileges and advantages be granted for which ready money might be got. I dare pronounce before-hand, that every scheme which they themselves propose to make their bubble and roguery thrive again, will be built upon the life and misery of this unhappy nation.
If our money be gone, thank God, our eyes are left. Sharpened by experience and adversity we can see through disguises, and will be no more amused by moon-shine.
Sharpened by experience and adversity these questions remain:
Are financial services progressively dominating the economy?
If so, is this a serious threat to the free market economy?
If so, will the Cato Institute analyze and recommend actions?
1 All references are to my book Democratic Capitalism , available on Amazon.com and n this website.