Gordon Campbell on the US Financial Meltdown
Gordon Campbell on the US Financial Meltdown
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So, what impact is the world’s biggest financial crisis since the Great Depression having on the New Zealand election campaign ? Of course, this is nowhere near as crucial as what happens to Winston Peters but…. hello ? Apart from a few cracks by Michael Cullen about John Key’s work experience with Merrill Lynch - now swept away in a firesale to Bank of America - there has been nothing much so far beyond a lot of worried looks.
One reason being that National’s fiscal and economic policy is STILL a mystery. Also, the main shockwaves from the Wall Street carnage have yet to reach New Zealand, and no-one seems to know what will happen when they do.
A few things we do know. National’s extra round of tax cuts - to the extent they are premised on further government borrowing offshore - now look riskier, and will cost us more than seemed likely a month ago. Are they unaffordable ? We can’t know until National finally get around to telling us the size and structure of the tax cuts they have in mind. It would be helpful if the financial crisis now motivated both major parties – in the name of transparency – to put all their economic and fiscal policy cards on the table.
The crisis backdrop seems pretty clear, regardless. The cost of borrowing money from foreigners is going to rise. Banks will pass that on. That matters, given that New Zealand households are already up to their eyeballs in debt, and with more than $40 billion of housing related borrowing coming up for renewal over the next six months.
Over that time, the New Zealand economy looks likely to be hit by seesawing forces – mainly deflationary ones, some of them triggered by the US financial crisis. Commodity prices for our agricultural goods are expected to ease and the cost of borrowing and debt servicing will rise, as the lines of credit belatedly tighten up in the wake of the Nightmares on Wall Street, and ripple on through pension funds, and into the small regional banks in the global credit and investment chain.
Thankfully, oil is now below $100 a barrel. This will help remove some heat from the inflationary combo of imported energy costs and the first round of tax cuts that kick in on October 1st It is still unclear whether that will give the Reserve Bank much headspace for further interest rate cuts needed to fight both the deepening local recession, and the deflationary impact of the global tightening of credit. It is a situation that leaves little room for extravagance.
Trouble is, extravagance is what voters are expecting from National. The promise of bigger tax cuts – and more of them – has been bankrolling National’s lead in the polls, and the general mood for political change. National can’t back down now, even though stability is called for. Basically, National is hoping that voters will see the storm clouds on the horizon but still take the tax cut bait, and run. That’s a great way to win an election, but not a very good way to run an economy.
Over the next 18 months, the financial crisis will also put heat on National’s plans to finance infrastructural development via PPP's – large, heavily debt-financed projects that will now cost more to devise, and to service. On overseas experience, PPP's pose risks of budget blowouts because of deliberately under-pitched contracts. The safety net against those kind of rorts with PPP' - as with the crisis in the US financial sector – is greater regulation.
National however, stands for de-regulation. It is the ‘hands off’ party of economic management. That puts it out of step with the current angry and panicked mood in the US and within the wider global economy – which has good reason for feeling pissed off with the Bush administration’s ‘light handed’ approach to financial market management. The current financial crisis has been caused by a deadly double whammy hitting in succession - first the sub-prime mortgages going sour, then the rippling collapse of the speculation in derivatives, or so called credit default swaps. Across the political spectrum in the US, the blame for that has been laid on insufficient regulation.
That is not something that National - and many of its friends in business - want to hear. By and large, they remain locked in a 1980s mindset of liberalizing markets - where regulation is seen as a bureaucratic evil, and an unnecessary cost to business. Some times it can be. Yet such views also seem immune to empirical evidence from reality – which, as Stephen Colbert says, has a well-known liberal bias. No amount of BNZ and Air New Zealand bailouts, or Tranzrail and Telecom fiascos seem able to change the anti-regulatory mindset. It’s a cult.
On that score, the US political system seems a bit more flexible. In a rare example of quasi-unity, Barack Obama and John McCain have both been calling for greater regulation of financial markets Here’s Obama’s diagnosis :
Eight years of policies that have shredded consumer protections, loosened oversight and regulation, and encouraged outsized bonuses to CEOs while ignoring middle-class Americans, have brought us to the most serious financial crisis since the Great Depression.
Interestingly, Obama has homed in on the philosophy of unfettered markets : “ Certainly I don't fault Sen. McCain for these problems, but I do fault the economic philosophy he subscribes to." McCain has used a different language to promise much the same thing. While a self described –de-regulator in the past, McCain has committed himself in the wake of the current crisis, to increased regulation of financial markets :
"It is essential for us to make sure that the U.S. remains the pre-eminent financial market of the world … "The McCain-Palin administration will replace the outdated and ineffective patchwork quilt of regulatory oversight in Washington and bring transparency and accountability to Wall Street.”
One can readily see the need for a drastic response. The size of the toppling giants involved is staggering. At the time it went under, Lehman Brothers held assets worth $650 billion, making it the biggest bankruptcy in history. The AIG insurance group – currently the subject of an $85 billion temporary bailout from the US taxpayer – is the 17th biggest firm in the world, and is headed for liquidation. Looking ahead, Morgan Stanley is also teetering on the brink of collapse – or tottering towards a fire-sale merger with a major bank, along the lines of Merrill Lynch’s ‘rescue’ by Bank of America.
However, these massive disasters and re-alignments pale when put up against the slow disintegration of the credit default swaps market. Only ten years ago, this was an obscure neck of the financial woods, frequented by banks and bondholders. But as, Time reported last March, the CDS market had exploded to where it was worth $45 trillion by late 2007. That is twice the size of the entire US stock market, six times the size of the US mortgages market and roughly ten times the size of the US treasuries market. Out of control, in other words.
I can’t claim to fully understand credit default swaps – but from the outside, they look like financial chain letters where all the focus was on the risk to the guaranteed, without due attention to the risk involved for the guarantor. Famously. investor Warren Buffett once called credit default swaps “ financial weapons of mass destruction,” which still didn’t stop him from trading in them. As Time said in its March report :
Credit default swaps are insurance-like contracts that promise to cover losses on certain securities in the event of a default. They typically apply to municipal bonds, corporate debt and mortgage securities and are sold by banks, hedge funds and others. The buyer of the credit default insurance pays premiums over a period of time in return for peace of mind, knowing that losses will be covered if a default happens. It's supposed to work similarly to someone taking out home insurance to protect against losses from fire and theft.
Except that it doesn't. Banks and insurance companies are regulated; the credit swaps market is not. As a result, contracts can be traded — or swapped — from investor to investor without anyone overseeing the trades to ensure the buyer has the resources to cover the losses if the security defaults.
Unfortunately, commercial banks – you know, the ones that handle deposits and finance loans and that are supposed to be more heavily regulated than finance companies in order to protect the investor – got in on the CDS act. The top 25 banks in the US reportedly hold over $14 trillion in credit default swaps. That’s scary, now that they are also being hammered by the defaults on mortgage-related business, either directly or through their subsidiaries.
What began as a cheap way to earn more cash in a booming economy – when defaults were unlikely, and look like they’ll always be some else’s problem – are now coming back home to roost as the US economy heads into decline. It is this Merrill Lynch mindset – where you take the short term profits and assume you’ll always be able to wing your way out of trouble –that Cullen will use as a rationale for Key’ not being entrusted with the reins of government.
Who let the fox into the chickenhouse In the US? People looking for other prime causes for the current crisis are also pointing to the repeal of the Glass -Steagall Act in the late 1990s. For good reason, this Depression era legislation had created a firm division between traditional commercial banks (as mentioned, these were heavily regulated to protect depositors) and the freer, standalone finance houses. The speculative sins at the root of the current crisis owe a lot to the riotous blurring of those roles over the past decade. Of course, there is some grim consolation in seeing that the scrapping of this distinction has now enabled Bank of America to buy Merrill Lynch, and for Barclays to mop up the valuable bits of Lehman Brothers.
Longer term, the crisis will require John Key to adapt to a new, far more sober reality. To date, Key’s approach to economic management - so far as we know what it is – has shared some elements in common with McCain’s. In fact this recent Washington Post article by two McCain advisers
strongly echoes what we have seen to date from National. Cut taxes. Slow the growth of government spending. Abolish gratuitous government programmes, aka ear-marks. Here’s how the Key/McCain approach reads :
By maintaining strong control over the growth of government spending, Mr. McCain will bring the budget into balance. His long record of fighting against excessive government spending, his plans to veto earmarks and reverse the spending binge of the past few years, and his strong commitment to balancing the budget can make this goal a reality.
All very well, but hardly enough to balance a budget that has to incorporate major tax cuts as well. Labour has set the ball roiling in this respect. Both Cullen and Key now havesome explaining to do in the next few weeks, as to how they proposes to manage the government revenues – in the light of the cris, and the expectation National has aroused of extra, even bigger major tax cuts partly financed by extra borrowing. This is a terrible time to be planning to expose the country to greater debt.
Free financial markets regularly deliver the same message. Bereft of effective regulation, they operate in costly, socially damaging ways. Routinely, the firms involved need to be rescued by the taxpayer. It would be re-assuring if both major parties showed they’ve taken that lesson from the current crisis on board.