chorafas - sovereign debt crisis; the new normal and the newly poor (2011)

Otto Hieronymi editorGLOBALIZATION AND THE REFORM OF THE INTERNATIONAL BANKING AND MONETARY SYSTEM Sven Janssen BRITISH AND GERMAN BANKING STRATEGIES Alexandros-Andreas Kyrtsis editor FI

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CONSOLIDATION IN THE EUROPEAN FINANCIAL INDUSTRY

Dimitris N Chorafas

SOVEREIGN DEBT CRISIS

The New Normal and the Newly Poor

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Dimitris N Chorafas

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Sovereign Debt Crisis

The New Normal and the Newly Poor

Dimitris N Chorafas

© Dimitris N Chorafas 2011All rights reserved No reproduction, copy or transmission of thispublication may be made without written permission.

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A slave is he who cannot speak his thought.

Euripides

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PART I FINANCIAL RISKS WHICH KEPT PILING UP

A historical precedent: the new normal at the end of World War I 12

Property-owning democracies versus debt-laden democracies 24

Wealth in western nations dropped like a bribed boxer 38

PART II LOOSE MONETARY AND FISCAL POLICIES LEAD TO

THE DESTRUCTION OF WEALTH

Japanification’s after-effect: precarious public finances 64

Money thrown at the problem brings nearer the next big crisis 67

Governments, central banks and the 2010 Jackson Hole

Symposium 72

Contents

5 Conventional and Unconventional Weapons in a

The government takes its money out of its citizens’ pockets 99

Sovereign debt and its consequences for the banking industry 111

PART III EUROLAND’S FINANCIAL INTEGRATION AND

SOVEREIGN RISK

One-size-fits-all monetary policies are a dangerous game 142

The message by credit default swaps should not be ignored 151

Textbook economics have no prescription for the current crisis 160

As with swallows, EU money alone will not bring spring 168

viii Contents

The British economy 177

PART IV THE NEW NORMAL’S EFFECT ON

THE WESTERN ECONOMY

What went wrong with monetary policy and the

American middle class and missing employment opportunities 205

The Dodd–Frank Wall Street Reform and Consumer

Ultimately economies advance because their

Banks do not know the risks they take with derivatives

Stress tests permit crossing the river while feeling the stones 221

How different experts evaluated the stress tests by the

November 2010: four months after the test results

Not only the economy, but also democracy is at a crossroads 232

European banks, American banks and the fight for

The former ‘poor’ are better off than the former ‘rich’ 245

Financial seismology and the slow-motion train wreck 248

Contents ix

1.1 Expected events and unexpected events are characterized by

10.1 German industrial output rebounded leaving other western

12.1 The unbearable truth of a thermonuclear option with

12.2 The normal distribution is a proxy valid only in connection

with low-impact events – the distribution of high-impact

Preface

The history of economics and finance is littered with the debris of

once-sacred theories The ‘new economy’, whose promise of wealth and

prosper-ity was supposed to be the only possible course, is now in shambles The belief that theoreticians know so well how to manage the economy that crises are banned forever is another fallen idol And the hypothesis that leveraging rescues people, companies and states from an existence of limited dimensions proved to be an unmitigated disaster:

This book is about sovereign debt, fiscal deficits, the newly poor and the deceit

of the ‘State Supermarket’, with its endowments and cradle-to-grave care The

issues confronting the global economy – and most particularly America, Europe and Japan – are inseparable from the current lack of social and politi-

cal leadership as well as of a credible plan to deal with the mountains of debt amassed by sovereigns, households and companies, particularly banks

The text is written for people who need to know what the problem is with the mountains of public debt, families’ deep indebtedness and finan-

cial institutions superleverage It is not written for economists, analysts and other technicians of the ‘dismal science’, to use John Maynard Keynes’ words The many practical examples which it includes expose the situation

by which western society has cornered itself Its constructive criticism gives advice on how to come up from under, even if this means slaughtering:

unaffordable endowments,

unwarranted government rescues, and

other proliferating but unsustainable big-spending projects

Largely due to weak governance, the United States and European Union fell on parlous days Public confidence is lost Breaking trust can be done very quickly; re-establishing it can take a long time The aim of this book

is to provide an adult conversation on the risks of losing sight of past failures and our society’s ability to solve its problems, with debt heading the list

Nowadays, with all liabilities taken into account, for every $1 of assets there is $4 of debt It is pure folly to think that such a huge amount of debt will disappear on its own, or even be partially repaid if current policies continue to prevail Liabilities have the nasty habit of increasing with time, particularly when people and companies have lost their individual initiative and put all their hopes for the future in rescues by leviathan sovereigns

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Western sovereigns are struggling with colossal debt Peacetime edents are lacking, the difficulties are so great and the debt hydra so fertile that those supposed to know better are approaching the most vital issues in ignorance Certainty about the right thing to do in this most challenging economic and financial situation is only expressed by people who either dwell in a world of fantasy or do anything that hits their fancy, while the economy around them falls apart.

prec-‘We are living with an unsustainable hangout between our ments and our resources,’ said Timothy Geithner, US Treasury secretary on October 13, 2010 in a Charlie Rose interview broadcast by Bloomberg News Geithner evidently knows what he is talking about because, together with the Federal Reserve, the Treasury has become the big banks’ safety net and universal fire brigade

commit-This is by no means a US phenomenon Signs of distress are easily seen all over the global economic landscape, but most particularly in the western countries From entitlements to the salvage of bankrupt institutions, the State Supermarket – a creation of infantile leftism – has taken on respon-sibilities which are unaffordable Critics are right when they say that the biggest deficit the West has is in the fact that there is not enough leadership around, and also those who govern either don’t know how or don’t care to help the common citizen understand what the issues are

Yet, in a democracy the people have the right to know why the economic and financial conditions are so grim, what has engineered the most recent deterioration and what kind of measures are needed to prune the system and put it on a growth course; also, why the sovereign debt is on an explosive path and what the next act of the drama will be if nothing radical is done

to bend the curve Which leads to three other questions: what lies behind

the evolving economic environment known as the ‘new normal’ (Chapter 1)

and who are the ‘new poor’ (Chapter 2), and how can this trend be stopped before it becomes irresponsible?

The book the reader has to hand examines these issues and explains why nothing has changed so far – in spite of the deep economic and financial crisis created by big banks through gambling with novel (and little under-stood) novel financial instruments The gamblers continue their good work; the regulators are timid; and this means that conflicts of interest have not stopped running down the state’s finances

On June 25, 2010 CNBC, the financial network, revealed that derivatives trades by American banks alone stood at 90 times the level of US gross domestic product (GDP) This was no number picked out of a hat A couple

of weeks earlier, a combined estimate of exposure by the US Senate and House of Representatives had put the market valuation of existing deriva-tives contracts at $1.2 quadrillion

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xii Preface

Unprecedented sovereign debt in peacetime and a quadrillion in derivatives

is bad news for the economy of the USA, the EU and the global economy

as well Ultimately economies advance because their institutions are strong Today they are on the sick list while governments are running after the facts, doing what Montagu Norman, the governor of the Bank of England in the 1920s and 1930s said about the central bank action which preceded the First Great Depression: ‘We collected money from a lot of poor devils and gave

it to the four winds.’

As the case of Ireland and of its ‘Anglo-Toxic’ Bank (Anglo-Irish)

docu-ments, the mismanagement of credit institutions and poor governance of sovereigns strongly correlate High risk, descent into the abyss and a fire brigade approach is the course typically taken by the ‘unable’, who have been asked by other incapables to do the unnecessary

Like the First Great Depression, the economic and financial crisis in which

we are living – probably on our way to the Second Great Depression – has not been an act of God It is the direct outcome of dismal governance by chiefs of state, monetary policy-makers, investment bankers and the com-

mon man in the street In terms of cause and effect, some of the worst

deci-sions date back to the 1990s, while others saw the light in the first decade

of this century The people who took these decisions:

were singularly unqualified to be at the helm of great nations and of their central banks,

could not decide by themselves on what to do and therefore consulted others who had conflicts of interest, and

giving in to social pressure, they crash-landed the western economies through high leverage and unpayable debt

Against all logic, large and complex banking groups (LCBGs) have been offered, since late 2008, an unlimited line of credit by sovereigns, at tax-

payers’ expense But the LCBGs’ wounds, due to their high gearing and misdirected decisions, have been so deep that their financial performance did not strengthen Whatever money they got from central banks they used

to bolster their capital rather than lend

In spite of trillions thrown at the problem, the American, British, euroland and Japanese economies remained anemic The result of throwing trillions

to the four winds was a disaster Credit is the oxygen of business activity, but sovereigns did not oblige banks that benefited from public money to extend credit Without credit companies cannot function, and this has become also

true of households If banks cannot or will not lend, then the economy is

falling off a cliff

It is wrong to believe that central banks can continue forever

accumulat-ing useless collateral while printaccumulat-ing money non-stop The Federal Reserve, Bank of England and the European Central Bank (ECB) have been doing

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Preface xiii

so for more than a couple of years, but it cannot become permanent November 2010 the ECB indicated that there were limits to the short-term assistance it could give to Ireland’s banks, which account for around a quarter of the total liquidity offered by the ECB to all eurozone banks The same applies to Portuguese, Spanish and other banks.

Mid-Things got out of hand because there is a symbiosis in debt characterizing

relations between big banks and sovereigns This is creating serious risks for the longer-term sustainability of public finances Together with entitle-ments, it sees to it that efforts associated to the reduction of government debt are half-baked Tightening the belt has been always unpopular, and politicians think of their re-election when deciding about measures that need to be taken, forgetting that when the crisis becomes longer term tough-ness is required as well as competence, and that the party that deserves to win must craft a narrative and policy that creates opportunity out of disap-pointment and chaos

* * *The book divides into four parts Part I brings to the reader’s attention the financial risks which have been piling up for nearly 30 years, as well as their aftermath It outlines the succession of errors which has lead to a situation

known as the new normal, the economic, financial and social conditions

which (by all likelihood) will characterize the next two decades

The text brings the reader’s attention to the fact that western societies are no more the globe’s wealthy inhabitants Their overleveraging and poor growth

prospects have turned them into new poor, while less developing economies

are moving up the ladder at a fast pace – aiming to be the new rich

Part II provides documentation on the loose monetary and fiscal policies

in the West, those followed over too many years on both sides of the North Atlantic In recent times, such misdirected decisions were first made by Japan in the early 1990s, and they brought the former industrial dynamo to

a state of coma Hence, the term ‘Japanification’, describing where America, Britain and continental Europe are heading

This thesis is supported by both qualitative and quantitative evidence It is proper to inform the reader that in using statistics to document statements being made emphasis has been placed on accuracy and not on precision It has been a deliberate choice to employ only the two or three most significant digits of numbers and ratios (depending on the issue) with emphasis placed

on trend and on order of magnitude

The theme of Part III is case studies in economic failure, starting with euroland’s lack of success in financial integration, as well as its reasons This is followed by a discussion on what went wrong in the case of Greece Germany, France, Britain, Ireland and the so-called ‘Club Med’ provide

xiv Preface

some other interesting examples on how economies are being managed by sovereigns.

By way of conclusion, Part IV brings to the reader’s attention the new

normal’s effect on the western economies – including the one which used to

be the most vibrant: the United States Several financial analysts said that Greece is like Bear Stearns, the investment bank whose failure preceded Lehman Brothers’ bankruptcy By late November 2010 Ireland became Bear Stearns ‘bis’ In search of a candidate for the Lehman role, some experts mentioned America, while others said Britain

* * *What we forget today is to learn lessons from history – economic, financial,

political and social If we don’t understand what has been behind the

suc-cesses and failures of our predecessors, then we condemn ourselves to repeat

the same mistakes Decisions leading to misdirected risks are often taken as

a result of misquoting and misinterpreting what people of better knowledge have said or done

John Maynard Keynes, for example, is often used by leftist economists as the patriarch of big-spending policies by the State Supermarket Apart from the fact that this is less than half true, Keynes had the power to express his opinions without compromises, and he is quoted as having said: ‘When the capital development of a country becomes the byproduct of the activities of

a casino, the job is likely to be ill-done.’

Let me take this opportunity to thank Lisa von Fircks, for suggesting this project, Renee Takken, for seeing it all the way to publication, and Keith Povey and Joy Tucker for editing the manuscript To Eva-Maria Binder goes the credit for compiling the research results, typing the text, compiling the index and making valuable suggestions

DIMITRIS N CHORAFAS

Valmer and Entlebuch

Preface xv

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Part I

Financial Risks Which Kept

Piling Up

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1

The World’s New Normal Economic

System

Five forces promoting the next economic landscape

In the ‘go-go’ years which followed the 1994 crisis of debt instruments, Alan Greenspan, then chairman of the Federal Reserve, coined the term

‘New Economy’ This he defined as defying the laws of gravity by producing more and more wealth, practically forever We now know that such talk was

a chimera, while the tandem of bubbles it produced in 2000 and 2007 were real Their origin was not difficult to detect:

a highly accommodating monetary policy,

free reign to leverage and other excesses, and

scant attention by supervisory authorities paid to watch over systemic risk

These causes of economic and financial troubles tend to correlate among themselves, amplifying their impact Therefore, the disaster which followed was not totally unexpected One of the outstanding consequences

of the major global downturn, which started in 2007 and whose effects are still widely seen, has been the enormous increase in government debt

in western countries Spending by sovereigns rose very rapidly to both keep alive big banks and other ‘strategic’ companies, some of which were zombies, and offset the contraction in private sector spending, as millions

of households confronted unemployment as well as uncertainty about the future.1

In the USA the public deficit jumped from 2.8 per cent in 2007, first year

of the most recent economic and banking crisis, to 11.2 per cent in 2009 In the EU government deficits varied widely: from over 14 per cent in Greece to

a little less than that in Ireland, 11 per cent in Britain, 9 per cent in France and 6 per cent in Germany The big spenders at the governments’ ivory towers have had a ball – and that’s anathema to public confidence

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4 Financial Risks Which Kept Piling Up

As Demosthenes, the ancient Greek orator, said: Business is built on

confidence Any waning of it, particularly at the time economic fortunes seem

to start timidly rising, is counterproductive Consumer confidence is crucial

to western economies as it represents up to 70 per cent of spending; a figure amplified by industrial production which nearly always cruises along ‘The real devils today are the states not the bankers,’ says Dr Heinrich Steinmann,

a former vice chairman of UBS

Scared of the long-lasting effect on the economy of these deep red numbers, by the second quarter of 2010 several western governments – including Britain, France, Germany, Italy, Spain and Greece but not the USA – announced rather significant austerity measures to reign in their dete-riorating fiscal situation This led some economists to express concern that an austerity policy amid an ongoing recession will make matters worse, warning how fragile the early signs of an upturn still are (see also Chapters 5 and 7)

Other economists, however, have taken precisely the opposite stand, pointing out that the unprecedented 2008–11 economic easing – which went

in full swing with the Lehman Brothers’ bankruptcy and near bankruptcies

of AIG, Fannie Mae, Freddie Mac – has turned western economic history

on its head by creating an unsustainable flood of money (see Chapter 4

on the many heads of the debt hydra) These economists also emphasized

that business confidence will wane if the market sees no signs of restraint in

keeping the printing presses busy

While the two aforementioned economic theories are diametrically opposed

to one another, they also share the same basic weakness No economist,

on either side of this gulf of opinions, has come up with a clear and documented definition of the cause and effect that characterized the ongoing crisis (see the next section) Which is the primary cause? Is the salient issue:

well-1 the accumulated huge amount of debt per se?

2 or, is debt the consequence of the current structure of world finance and its institutions?

3 or, is the structure of world finance the consequence of entitlements and globalization, and therefore of unsustainable policies?

4 or, is it the classically poor regulation at government levels, which allows greed and irrationality to carry the day?

5 or, are these reasons closely intertwined, and therefore acting on one of them affects all the others with dismal results?

In my opinion, the most likely fundamental reason for the current malaise

is the fifth alternative which integrates all others, making both the problem and any serious approach to its solution tremendously complex Yet, our efforts must be focused Searching for a holistic approach which simultaneously attacks every cause will be like trying to unscramble scrambled eggs

The World’s New Normal Economic System 5

We might, but only might, have a better chance by establishing priorities and subsequently attacking these causes indidually – provided we don’t lose sight of the total picture, or forget the underlying interdependencies among the causes of the current state of world affairs and their effects (see below)

In addition, to untie the threads of this knot we would need to use

practica-ble rules like those we employ to organize our lives, promote our businesses and confront our obligations

Talking of priorities, the overriding obligation at this moment is to control

the exploding debt at all levels of society And because it is famously hard to govern debt, this is going to be the issue to which the present book addresses

itself It is not normal that every $1 in production corresponds to $4 in debt Such an ‘unstoppable’ debt inflation has to stop before it becomes irreversible

But the other causes should not be forgotten Looking at them in reverse order to that presented in the preceding list, there has been, indeed, a huge amount of greed which amplified the economic and financial debacle of

2007 and the ensuing years significantly In a Charlie Rose interview

broad-cast by Bloomberg News on April 26, 2010, Michael Lewis, the author, put the blame on both the market players and the instruments they have been using, stating that:

Real corruption is behind new financial instrument design

This problem is widespread; Goldman Sachs cannot be the only bank which designs debt-based securities aimed to fail

All sorts of tricks embedded in instruments have been accompanied by misrepresentation to clients – which under current laws is illegal

Regarding the structure of international finance and its contribution to the crisis we have been going through, its reorganization and control was thought to be the mission of the G-20 heads of state But international tour-

ism aside, the G-20 meetings have so far been met with no real success and

it is a deliberate decision not to dwell on their remit in this book

Allow me also to add that, as if to make matters worse, within each

jurisdiction the prospects for a significant and deep-rooted regulatory initiative are not good The slimmed-down Dodd-Frank Act in the USA is a lightweight (see Chapter 12) In his deposition to Congress, Paul Volcker, the respected former chairman of the Federal Reserve, insisted that the essential flaw in regulatory proposals and measures being adopted is that

they leave the structure of banking unchanged This is a pity, because

if culture and structure remain the same, then so does the ultimate systemic risk

Risk-taking is a basic ingredient of progress but it must be matched by risk control Watching one’s exposure is not an option; it is a requirement

of sound governance of a person’s, company’s or state’s fortunes – while

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6 Financial Risks Which Kept Piling Up

paternalism towards the homegrown banking industry is a most serious error

Cause and effect

Virgil, the Roman poet, said: ‘You must know the causes, to draw the right conclusions.’ What are the causes of the crisis we are going through in 2007–11? The answers most often heard in my research have been lax lend-ing practices, the real estate bubble and subprime mortgages While these have been, indeed, important factors, they were the triggers of the debacle rather than fundamental reasons The real causes are:

massive increase in debt, at all levels of society,

excessive risk appetite, amplified by exposures risk-takers don’t stand,

under-a shunder-adow bunder-anking system, with its dubious debt instruments, still ing risks,

fund-limitations of financial engineering and serious mistakes in model-based estimates, and

totally substandard risk management at all levels, totally inappropriate

in a world where derivatives are the most popular and lucrative trading instrument.2

Largely engineered through leverage, and therefore by ‘funny money’, this

massive increase in debt has become a western culture By no means a random event, it is the culture of ‘borrow now, pay later (maybe)’ which pervades all levels of western society – and which must now change to: save now, so as not to starve later on, for an improvement in fortunes of peo-ples and states There have been many false prophets who prompted public spending through misplaced statements, and helped in creating this attitude

to spending

‘The future appears brilliant,’ wrote Thomas Lamont of JPMorgan a short while prior to the ‘Black Tuesday’ of late October 1929, moreover assuring that ‘air holes’ due to a ‘technical condition’ had developed in the market but that the situation was ‘susceptible to betterment’.3 With hindsight we do know what followed in the decade after the First Great Depression

Clear minds expressed the opposite opinion ‘We have involved selves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand,’ John Maynard Keynes wrote in December 1930 in his article ‘The Great Slump of 1930’ The same words can be used today without changing a syllable in regard

our-to what the Federal Reserve, Bank of England and (our-to a slightly lesser extent) European Central Bank have done to the western economies in the 2008–11 timeframe

The World’s New Normal Economic System 7

Other warnings, too, were unheeded and relegated to the wastebasket of economic history, even if they came from people who could see further than most Friedrich Engels (1820–1895) – whose work and foresight extended beyond economics – identified in the mid-nineteenth century certain social happenings that lead to a dismal future:

people tending to live beyond their means,4

rapid urbanization under stressful conditions, and

short-term policies of governments, adopted because of their lack of

cour-age to lead in shaping society’s future

Engels wrote, in 1844, that the centralization of the population in great cities (the cause) exercises of itself an unfavorable influence (the effect):

‘All putrefying vegetable and animal substances give off gases decidedly injurious to health, and if these gases have no free way of escape, they inevitably poison the atmosphere.’5

Urban dwellings in crowded cities, which are rapidly replacing rural life for large chunks of the world’s population, may range from palaces to shanty towns, but what they have in common is the strained way of life – full of

uncertainty and anguish This is the new normal, in social terms, and Engels

described it in a prophetic way nearly 17 decades ago (The definition of the

new normal in terms of the economy is given in the next section.)

In cause and effect, there are similarities between the social and economic definitions The way people live and work (the cause) has a great deal to do with economic after-effects because – from autos and house appliances to exotic vacations – the twenty-first century’s proletarians have been enjoying

an increasing standard of living paid through debt The mountains of leverage

were supposed to be taken care of by the ‘future generations’ but, as the deep crisis of 2007–11 has shown, they have already become unsupportable and unsustainable by this generation

The easy way for politicians is to promise what they know they cannot deliver and make the people pay for it George W Bush came to office in

2001 and engineered the largest ever US peacetime deficit (the cause) – promising security and plenty of other goodies in exchange In terms of security the effect has been practically nil Instead, what the American peo-

ple got is another layer of bureaucracy in Washington and an explosion of public deficit

Barack Obama compounded all of the Bush mistakes Among them, the two conceivably worst presidents in the history of the American Republic brought another calamity which will haunt the USA in the coming decades:

the new poor (Chapter 2).

For reasons quite similar to one another, two megarisk events are likely

to compete with one another during the coming years One is that the

economy implodes as sovereigns, companies and families restructure their

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8 Financial Risks Which Kept Piling Up

balance sheets The other megarisk is that the economy explodes as debt

reaches for the stars (Both the reasons and the consequences will be brought into perspective in the last chapter of this book.)

A preview of events to come would see the specter of horribly indebted countries which scare the hell out of their partners For all the brave talk about solidarity among euroland’s member states, their taxpayers don’t wish

to put on the table the money which might keep their badly behaved and undisciplined neighbors afloat Not without reason, they believe that this is

not their cause and that the nations which misbehaved should pay for the

effects by themselves

This has been behind an overwhelming 69 to two vote by the Slovakian parliament, in the week of August 8, 2010 A crashing majority of Slovak deputies rejected taking part in a European Union aid package for the trou-bled Greek economy (Chapter 9) – and they had good reasons not to care if both the Brussels-based European Commission and the German government criticized the Slovak parliament’s decision

‘All member states committed themselves politically to assistance for Greece,’ said a spokesman for Chancellor Angela Merkel ‘Every member relies on solidarity; solidarity is no one-way street.’6 That’s true, but the prerequisite to solidarity is self-discipline

The Slovaks, who said they would not pay for other peoples’ first-century lifestyle’, know that their country has a gross domestic product (GDP) per capita of $21,200 at purchasing power parity (PPP), while Greece has a per capita GDP of $32,000 – nearly one and a half times greater Slovak taxpayers have been asked to put a4.4 billion on the table ($5.9 billion) for something they say was not their fault Moreover:

‘twenty-Slovakia embarked on a bout of painful economic reforms in 1998, that transformed it into one of the EU’s top economic performers

By contrast, Greece, Spain, Portugal and other EU countries piled new debt over old debt, rather than taking the tough decisions necessary to restructure their economy and labor market

This cause and effect, the most significant cross-border difference in economic management, is another way of showing that the accumulated

huge amount of debt is, per se, a real and present danger The recent crisis

made it highly visible, and one cannot blame those people who don’t wish to pay for other peoples’ mistakes, even if they belong to the same community

The bigger countries in euroland had additional reasons for those of Slovakia, when they decided to salvage Greece.7 In fact, for these reasons, in June 2010 they put together a war chest of a750 billion (about $1 trillion), enhanced by a unique supply of liquidity from the ECB and aimed at arrest-ing the Damoclean sword of a reignited financial crisis

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The World’s New Normal Economic System 9

But, in the EU and the USA, the issue of too many entitlements having been granted without proper study of their effects is still dominant (Chapter 3) What speculators now do is to accumulate liquidity and bide their time With Greece’s financial crisis, they shook the euro and were ready to attack, first, euroland’s financial system and, next, that of the glo-

bal economy – if Greece had gone broke While they are waiting, powerful

forces are shaping the economy’s new normal.

The new normal defined

Two people are at the origin of the term ‘new normal’: Mohamed El-Erian,

Pimco’s8 CEO, and Bill Gross, its chief investment officer (CIO) According

to their judgment, while the markets may rise from their current depth, the next five years will not resemble those preceding the crisis Some of the changes brought by the financial earthquake we have been through may be reversed, but not all For the world economy, the ‘normal’ situation will be different than that we knew prior to this crisis

In the way El-Erian defines the future landscape, growth will be subdued, unemployment will remain high and the banking system will be a shadow

of its former self (more on this later) As for securitization markets, which buy and sell marketable bundles of debt, they will most likely be the shadow

of a shadow – while the stock of physical capital will erode

Another of the worries associated with the new business landscape

(according to this brief definition) is that state capitalism may become the

name of the game, with free enterprise in the decline In addition, as the financial system remains weak, its role of intermediation will wane, while the cost of capital will rise Consequently, companies will use less of it per unit of output (the cause), resulting in a lower ceiling on production, as well

as lower expected returns and higher implied volatility

Pimco is by no means alone in this projection on the after-effects of the deep economic and financial crisis which, in a way, resembles the First Great Depression of 1929–33 Plenty of other experts say that, in their opinion, we are set for a long period of slow growth, as a number of global imbalances are worked through That process will take time

Higher taxation will, in all likelihood, be the rule as governments (rather unsuccessfully) try to restructure their balance sheets But taxation will

also have an alter ego: austerity measures (Chapter 7), accompanied by an

increasingly deeper re-evaluation and downsizing of all sorts of entitlements (Chapter 3)

Business will be confronted by loss of power because its classical recovery drivers will no longer function the way they previously have As for the helping hand of central banks and governments, they will lack money for extravagances like quantitative easing (Chapter 5) and stimuluses Equities will

suffer because they are prospering in risk-on events, and (save for speculators)

10 Financial Risks Which Kept Piling Up

the new economic climate will be largely risk-off To confront this novel set of

challenges, investors will, most likely, place a much greater emphasis on:

diversification of assets, in the real sense of the term,

directed cash flows, cross-border and within markets, and

shifts in credit risks expressed by spread positions in corporate and sovereign debt, with the latter weaker than the former

According to expert opinion, another characteristic of the new normal will

be that sovereign risk will attract as much attention as that of banks, which have been known for decades to overleverage themselves and gamble with derivative financial instruments The way a news item on CNBC had it on July 23, 2010, a strong correlation exists between credit default swaps (CDSs)

of banks and sovereigns

To be taken seriously in their effort to change course from high leverage

to dependable balance sheets, sovereigns will have to come up with firm plans for a turnaround, not just with words and intentions Their quality of governance will be judged by whether the action being taken is convincing, and by how effective it proves to be in reducing the country’s huge public debt and current account deficits (Chapter 6)

These are, indeed, tall orders, and success is by no means a foregone conclusion since precise longer-term plans are missing For instance, in the opinion of British political analysts the ‘fiscal responsibility bill’ in the

2010 Queen’s Speech was a headline, not a plan Yet, with the new normal

it matters greatly that governments set clear, more longer-term objectives, have financial credibility and have the know-how to implement the plans they make

The same is true of central banks, which, by and large, are lacking a longer-term monetary and interest rates policy, which (in the majority of cases) is part of their charter Nearly zero interest rates have been a short-term game plan, before becoming a long-term drift (Chapter 5) Made to serve the self-harmed big banks, they penalized the common citizen For the weaker members of society this has been a triple whammy:

the interest households get for their savings is below inflation; hence their capital wanes, small as it might be,

their private pension plans find near zero interest rates as an excuse to speculate, since they earn nothing from money in the bank, and

the way to bet is that taxpayers, the common people, will eventually be asked to foot another king-size bill, while near zero interest rates feed the next bubble

As we will see in greater detail in Part II, the hidden costs of very low interest rates may well be greater than their visible benefits Authorities with a long

The World’s New Normal Economic System 11

tradition of speaking their minds say so In its 2009 Annual Report, the Bank for International Settlements (BIS, the central bank for central banks) brings

to attention plenty of ills connected with the too-low interest rates

prevail-ing in western countries:

excessive risk taking,

lop-sided balance sheets,

creation of delays in cleaning out bad debts,

surges in global cash flows which are destabilizing, and

distorted allocation of capital, as well as of the labor force

These are among the reasons propelling the new normal The question is:

When will its day really come? Current thought is that with the forthcoming new big bubble (Chapter 13), which for any practical purpose has been already programmed, the post-World War II party of greater and greater leverage will

be over As for the new economic situation, it will be characterized by what Ben Bernanke called an ‘unusually uncertain’ economy.9 There is no point

in denying that the western economy is weak and its players are uncertain about the future, because the measures taken so far have been poorly studied

in terms of after-effects and the jury is still out on whether they made

eco-nomic sense, even if unexpected consequences are not accounted for

What is more or less sure is the stress these measures inflicted on the economy, and the hits suffered by common people and businesses alike We all know that unstoppable leverage and speculation cannot last forever, but the medicine of trying to lower the huge indebtedness of the banking industry by creating mountains of debt at sovereign level may be worse than the disease

In the eye of the storm are the very expensive but ineffective stimuli and quantitative easing gimmicks (Chapter 5), respectively engineered by gov-

ernments and central banks Some economists involve Ricardian10

equiva-lence in trying to explain why the US economy does not take off in spite of the stimuluses This arises when:

consumers are forward-looking and save the proceeds from a

debt-financed fiscal stimulus, and

they are doing so in anticipation of future tax increases needed to repay the extra government debt

Plenty of factors impact on how the economy and its players react to

meas-ures taken by governments and central banks Costs head the list The IMF’s World Economic Outlook counted the cost of 88 banking crises over the past

40 years On average, seven years after a bust, an economy’s level of output has been almost 10 per cent lower than the level it would have attained without the crisis; that’s a big gap If replicated in the years to come, this 10 per cent difference would: make the public debt harder to sustain, offer little hope for

12 Financial Risks Which Kept Piling Up

higher unemployment, diminish the fortunes of those in work and create conditions leading to further financial breakdown

Even when the economy begins to expand, it may not regain the same pace

as before, therefore eroding national income In conclusion, the new normal

shapes up as the antimatter of the go-go environment of the 1990s and earlier years of this century Apart from the astronomical leverage found at all levels

of western society, the wounds created by huge financial losses require a tively long period in which to heal; healing is not doable at short notice

rela-A historical precedent: the new normal at the

end of World War I

Mayer Amschel Rothschild (1744–1812) is rumored to have said: ‘Let me issue and control a nation’s money and I care not who writes the laws.’ The dictum fits hand in glove with the statutes and policies of central banks By keeping the printing presses busy and spending money in quite inordinate amounts as compared with a nation’s productive capacity, they can destabi-lize the currency, penalize businesses and households and, eventually, lead

to the collapse of both the currency and the banking system

The creation of the Federal Reserve at end of the first decade of the eth century and the subsequent independence given to many central banks after World War II (the Bank of England got its independence under Tony Blair and Gordon Brown) were heralded as the start of a new epoch Developing countries were advised by westerners to do the same – but this ‘ independence’

twenti-proved to be fata morgana, as subsequent events demonstrated.

Near zero interest rates and quantitative easing were moves by minded people, in step with their governments They were not acts by inde-pendent central bankers, whose No 1 mission is monetary policy sustaining financial stability This has been a very dangerous deviation from primary duties, and there is no better example of cause and effect than the collapse

politically-of the British, French and German economies after World War I (This also applied following World War II, but the former example is the better.)

The World War I lesson sets the precedent for what currently happens with the mismanagement of monetary policy as well as currencies, and it is also very instructive because, among other events, it includes the run on the French franc and hyperinflation in Germany Another interesting incident

of that epoch was the rift between the United States and Britain, due to the controversy over repayment of wartime loans

One of the outstanding similarities between 1918–23 and 2007–11 is that both politicians and monetary policy leaders were running out of ideas on what to do with a mammoth debt; and they were in total disagreement about who, in the last analysis, should pay what to whom.11 They were also in a bind because they could understand that unsolved debt problems would destabilize currencies, lead to bank panics and create other serious financial problems

The World’s New Normal Economic System 13

‘Victory’ at the end of World War I was an illusion, since millions of soldiers and civilians had died for nothing, while economic disaster spread all over Europe As for the international financial system – which, prior to

1914, had brought prosperity to all the combatant nations, it was in a

sham-bles The unraveling had started with the panic liquidation of securities in London, on July 30, 1914, while stock exchanges in Berlin, Vienna and

St Petersburg were closed by the authorities The first days after the Great

War saw the first glimpses of what was then a new normal.

Another similarity between ‘then’ and ‘now’ is that chiefs of state,

includ-ing the central European royals, who in the early part of the twentieth century ran the political show, had shown a curious incapacity to distinguish between what they called a punitive action (against Serbia for the Sarajevo murders) and setting the world on fire Subsequently, historians found

it difficult to understand what World War I was all about and who really pushed whom into that gigantic hecatomb

By the end of World War I, the spotlight fell on economists, bankers and other financial experts who proved unable to put straight the ‘IOUs’ signed

by the British, French and Imperial Russian governments among themselves and (in the case of Britain and France), with the United States Both prior to America’s entry into the war and during its intervention, the USA had acted as banker and armaments factory for the Allies During World War I, the British government spent the equivalent of $43 billion, including $11 billion, in loans principally to France and Russia (but also to 15 other countries)

In counterpart, it owed the United States $5 billion, which took a long time to negotiate and settle after the war ended The deal was struck in 1923

by the then British finance minister, against the advice of John Maynard Keynes – who said it was better to hold out for better terms since time worked in the debtor’s favor London paid Washington 80 cents to the dollar For their part, the French chose to wait and by so doing they proved Keynes was right In 1926, they settled their American loans at 40 cents to the dollar.12

Three years later, the Italians settled their war loans by paying a mere

24 cents to the dollar, a better term than Argentina imposed on its debtors with its December 2001 (unjustified) bankruptcy Of course, it is not only

the loans which generated the condition for the economic and financial new

normal in the first quarter of the twentieth century The money the Bank of

England and Banque de France printed during the war overwhelmed the

mar-kets, distorted financial stability and had a strong negative effect on prices

In Britain the currency in circulation doubled, and prices made the same jump

In France it tripled, and prices also increased by 300 per cent

In Germany it quadrupled, and so did the prices initially,13 thereafter leading to hyperinflation

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•

14 Financial Risks Which Kept Piling Up

That’s a lesson central bankers (particularly Bernanke and King) have forgotten While the currency in circulation in all European countries rose

by leaps and bounds during the fights, the end of the war changed none

of the politicians’ bad habits No government altered the wrong policy of throwing money at the problem Instead, that unwise practice accelerated

In Germany, throughout 1919, the monetary base rose by 50 per cent, and

in 1920 by another 60 per cent The Reichsbank warned that the volume of short-term debt was a dangerous threat, but it still kept the presses running Germany faced, among other financial challenges, the huge and illogical reparations demanded by World War I victors, which were way beyond the ability of its ruined economy to pay, even if stretched over many years In

1921, the German government made the first reparations payment by ing marks for dollars, and this transaction contributed to a sharp decline in the mark’s value, while at home social unrest and strikes worsened

sell-Politicians, economists and central bankers are often fooled by the fact that the debt hydra takes some time to raise its heads In 1921, money

in circulation in the German republic rose by the ‘usual’ 50 per cent to

120 billion marks, but in 1922 the situation significantly worsened With paper money being printed round the clock, inflation ran at 1300 per cent The following year, 1923, was one of despair with newly minted Reichsmark flooding the market, as well as the mark’s decline against the dollar continu-ing relentlessly

By mid-1923, the Reichsbank was throwing cash at the market at the rate

of 60 trillion marks per day, much of it in big denominations By November

1923, the currency in circulation was heading for an astronomical 400,000,000 trillion Something significant had, however, changed The Reichsbank had a new boss, Hjalmar Schacht, who was a no-nonsense banker

With hyperinflation still carrying the day, on November 20, 1923 a new currency was introduced, the Rentenmark, to replace the old imperial Reichsmark The conversion rate to the new currency was set at one tril-lionth of a mark;14 at that time the exchange rate of the old currency to the dollar had hit 4.2 trillion, which made the rate of the Rentenmark to the dollar 4.2 This was the ratio prevailing before World War I between the German and American currencies.15

This 4.2 exchange rate was fine-tuned to affect the market’s psychology, but in itself the change of currency would have been pure cosmetics without fiscal discipline Schacht, the Reichsbank’s new president, insisted that the only way to financial salvation was through balanced budgets It was true then; it is true now

Living at the edge of chaos

The new normal which characterized post-World War I Europe did not

affect only economics and finance It also meant the disappearance of the

The World’s New Normal Economic System 15

old social order, a fact which preceded the major upheaval of populations

and economies because, for any practical purpose, a new normal

con-stitutes a major inflection point This change started during the World War I years and continued unabated.16 Then, as now, governments were not really in charge; they just drifted Or, alternatively, the challenges they were confronted with overwhelmed the second raters who were in charge

Yet, everyone knew that it would not be possible to turn back the clock People and organizations, including government bureaucracies, had to adapt to the new conditions Not the least among them was the need to gain citizens’ confidence by bringing all economic and financial excesses under control They failed in that mission then, as they fail in that mission now

What happened in 1923 in economic, financial and social terms is so interesting because of its striking similarities to what has taken place in recent years In the early 1920s in Germany, tax revenues accounted for

no more than 10 per cent of government expenditure The difference was covered by deficit financing

As far as western sovereigns are concerned, this 90 per cent deficit is not the case today,17 but even persistent deficits of 10 per cent or more can reek havoc Interviewed on August 18, 2010 by Bloomberg News, an American economist said that much when he commented that a US Treasury bubble

is building up rapidly One of the examples he gave was that the Obama Administration’s $1.4 trillion deficit in 2010, which is over 10 per cent of

US GDP (see also Chapter 12), may be the last drop which makes the glass overflow

Western economists must also cope with the continuing high leveraging

of the banking industry Unprecedented increases in the use of structured instruments and securitizations, across the globe but most particularly in the USA, have been a seemingly unstoppable trend, with the trading of credit risk at its core The tool is credit derivatives, which initially sup-

plemented then overtook traditional forms of transferring credit risk, like syndication of loans Lust and greed aside, factors which contributed to this development include the globalization of financial markets and information technology, especially networks and pricing models

These developments produced significant changes in the financial

struc-ture of western countries and in the role of banks therein, but they also had

a major effect on sovereign debt The changed role of banks developed from originating and holding to originating, repackaging and selling, thereby altering loan dynamics

The impact on sovereigns can be briefly described as the alchemy of their budgets, enacted by hiding the effect of ever-greater public deficits As the

‘help’ Goldman Sachs gave to different governments (the Greek among them) demonstrates, the use of novel derivative instruments produced a

16 Financial Risks Which Kept Piling Up

mystical transformation of state debt, much of it highly shaky, yet good enough for a prolonged denial of a red ink torrent

The 80th Annual Report by the Bank for International Settlements put this issue from a different perspective when it stated that: ‘By the end of

2011, public debt/GDP ratios in industrial countries are projected to be on average about 30 percentage points higher than in 2007 – a rise of about two fifths But the increase for countries that have been hit particularly hard by the crisis will be even greater.’ The United States, Britain, Ireland, Greece, Portugal and Spain are evident examples

Worst of all is the fact that the rapid increase in public debt in the wake of the 2007–11 economic and banking crisis is unlikely to be halted within the near future As was the case after World War I (as well as after World War II), sharp declines in tax revenues will be used as an excuse for more deficit financing In addition, nowadays sovereigns cover their lack of financial discipline behind expenditures such as income support and other entitle-ments (Chapter 3)

It is most instructive to note that, with the possible exception of the United States, fairly similar conditions of lack of fiscal discipline prevailed in the early 1920s for all former belligerents If anyone thinks that hyperinflation befell Germany because it had lost the war, then he or she is fairly misguided Neighboring France won the war but, in the early to mid-1920s, its currency was just as much the plaything of speculators and its recovery of economic wellbeing was just as tedious as Germany’s

As 1923 was coming to a close, a very short time after the German mark had turned to dust, the value of the French franc fell by about 50 per cent against the dollar In January 1924, the French Ministry of Finance asked for expert advice on how to redress the situation and salvage the franc Frank Altschul, the principal of Lazard Brothers New York office, came to Paris at the French government’s request

One of Altschul’s strengths was thinking out of the box He proposed to the French government what he called an ‘experiment,’18 which essentially was a way of teaching speculators a lesson – something missing today from the toolkit of sovereigns and central bankers ‘This would involve arranging credits for the government in the United States and perhaps England, in round amounts,’ he told the French.19

The new loan of $100 million (big money at the time) was provided by the Morgan Bank, which evidently required appropriate guarantees (At that point the French had not yet repaid their World War I loans to the USA.) Morgan was going to lend money to a government which, five years after World War I had ended was still borrowing $1 billion a year to close its budgetary holes The conditions for the loan included:

reduction of expenditures,

abstaining from asking for new loans,

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The World’s New Normal Economic System 17

concrete steps to balance the budget of the republic, and

a rumored secret clause that the French government bound itself to accepting whatever plan the Dawes Commission came up with.20

The members of the Dawes Commission were no novices.21 They were well aware that a large part of the projected fiscal deficit in the 1924–5 timeframe was likely to persist even in the event of recovery in output The financial crisis had permanently reduced the level of future potential output for Britain, France, Germany, Italy and other countries, and therefore the tax base Sound familiar?

In spite of these negatives, Altschul’s trick worked By taking on the speculators with the $100 million war chest, the French government bid the franc from nearly 30 to 18 to the dollar in a couple of weeks (The salvage of the French franc was, however, temporary Three years later, in 1926, the franc fell to a new low, then fluctuated while the Banque de France intervened to hold it at 25 to the dollar; an exchange rate which favored French industry.)

Up to a point, but only up to a point, this was the road taken in 2010 by euroland and the IMF to salvage Greece from bankruptcy If Greece had had the drachma and not the euro as a currency, it is quite likely that its value would have been halved against the dollar (Markezinis, the then finance minister, did just that in 1953) But with the euro, the country could not devalue In other words, its financial problems significantly weakened the euro against the dollar, and it had to pay over 9 per cent for short-term loans, 600 base points more than loans by Germany

Greece does not seem to have comprehended that, in the decision- making process of nations, forthcoming ‘battles’ will not be fought by tanks and super-

sonic jets but by financial instruments This will be a permanent feature – the outcome being decided by financial staying power Overindebted nations, and this reference includes the United States and Britain, would do well to notice that there is nothing new in the message conveyed by the preceding sentences (In the early eighteenth century, Louis XIV had said that the last Louis (the golden sovereign) wins the war – in other words, he who has the financial staying power.)

In conclusion, massively printed money represents unsupportable

govern-ment leverage, and therefore debt, which unsettles investors and makes them run for their money It was not for nothing that, in the 1920s, Hjalmar Schacht believed the real problem in post-World War I Europe (not just in Germany) was the prevalence of government debt – and this was bound to lead to a general European bankruptcy It was true in 1920s and it is true today, with the differ-

ence that, in the coming years, general bankruptcy might be truly global

The importance of knowing the ‘normal’ conditions

Let’s start with statisticians They love the normal curve of events and

meas-urements because it reflects the degree of calculability of an event occurring

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18 Financial Risks Which Kept Piling Up

Besides that, there exist excellent statistical tests and tables based on normal distribution The nasty fact is that many distributions of real-life events are not normal Some are skew, others have long legs – and the further a meas-urement falls from the bell-shaped curve, the higher is the degree of com-plexity of the problem, its interconnections and its aftermath The so-called

‘normal’ situation is easily calculable and presents a simple structure But, as Figure 1.1 shows, outliers alter these conditions and harbor great challenges, not the least being that they involve too many unknowns

As far as the ‘not normal’ distribution of events is concerned, a major contribution has been made by Benoit Mandelbrot, a mathematician,

who developed the fractals theory – which has interesting applications

in economics Mandelbrot believed that the market behavior of financial movements has fractal forms.22 It does not follow the familiar bell shape of the normal distribution Therefore, trading practices and financial models based on the assumption of a normal distribution are fundamentally wrong The 2007–11 economic and financial earthquake proved that Mandelbrot was right Plenty of models were written by people who were good at mathematics but knew little or nothing about finance, and the economy was turned on its head Banks using these models paid dearly for this error

The misconception derives from the fact that typically, though by no means always, the distribution of measurements associated with events which are ‘normal’ and understood tends to approximate the bell-shaped curve By contrast, with skew, leptokyrtotic, long-legged, fractal and other

Expected events based on known conditions

Unexpected events involving too many unknowns

Long leg

of distribution

A distribution approximating the normal curve

Figure 1.1 Expected events and unexpected events are characterized by two different

distributions

The World’s New Normal Economic System 19

distributions the area under the curve is never stable, and what are thought

to be outliers may become frequent daily occurrences Therefore, extreme events and their likelihood must always be taken into account and, while their cause is far from being clear, their effect may be significant

As different occurrences outside the bell-shaped curve multiply, the area under it changes its shape, or it translates itself to the left (or to the right)

As the frequency of what used to be extreme events increases, they become

a part of a new normal It needs no explaining that this is not only relevant

today It has been occurring all the time in both natural and man-made

sys-tems – as they move from stability to chaos and back to stability following

an inflection point

During the last quarter of a century there has been: the 1987 stock market crash (a 14.5 standard deviations event); descent to the abyss by Japanese banks and breaking of the British pound by Soros and Steinhart, both in early 1990s; the 1994 hecatomb of debt instruments; the 1997 East Asia crisis; the 1998 Russian bankruptcy and near bankruptcy of LTCM; the 2000 stock market crash (with dotcoms at the epicenter); and the 2007–11 deep economic crisis – which included the bankruptcy of Lehman Brothers, as well as near-bankruptcy of AIG, Fannie Mae, Freddie Mac, the Royal Bank of Scotland and plenty of other mismanaged mammoth institutions

The fact that these have been (unwisely) saved, through torrents of red

ink, by central banks and governments has ushered in the new normal It is

in this sense that El-Erian/Gross’s insight about coming events in finance and the economy, as well as their aftermath, should be interpreted Crises which used to be outliers are now becoming mainstream, and their impact weighs heavily on the daily lives of people, business activities and the global economy as a whole

For instance, according to Goldman Sachs, in just two years, from early 2008

to early 2010, the economic and financial crisis knocked $30 trillion off the value of global shares (owned by people and companies) and another $11 tril-

lion off the value of homes Another statistic to remember is that these losses amounted to over 0.75 per cent of the world’s GDP

Notice that this cumulative $41 trillion represents an amount of money in fairly popular markets – exchanges and housing – where players can win and

lose all at the same time If there is even a mild turnaround, as the new

nor-mal theory suggests, some (though probably not much) of this lost money

will be recovered and will help to start redressing balance sheets

What will not be recovered, at least by many of the players, is money lost with games involving derivative financial instruments To appreciate this statement, the reader should know that over 95 per cent of derivatives trading

is proprietary between financial institutions, particularly the big ones Trading transactions undertaken for clients represents a meager part of the total

To understand what this means in terms of ‘silly business’, it is as if

General Motors were to sell 95 per cent of its auto production to Ford, and

20 Financial Risks Which Kept Piling Up

Ford were to return the compliment by selling 95 per cent of the motor vehicles it manufactures to GM In addition, the large majority of these derivatives transactions contribute nothing to the national economy and involve ‘imaginary’ money, such as 30-year interest rate swaps

How a banker or trader can know what the interest rates will be three decades down the line mystifies me, and also those people to whom I posed that question To the contrary, what is not appreciated enough (by the gam-blers) is that one party is bound to lose and it will not recover its money, even if the economy returns to stellar performance

The only way the loser can try to get his money back is to get even deeper involved in gambling, going further into the red In a way, it is worse than

in a casino, because the players gamble against each other to total tion and they can all go bust because of their superleveraging Look at the fall not only of Lehman Brothers, but also of Citigroup, Bear Stearns, Merrill Lynch and plenty of others

destruc-While in the short term superleveraging might deliver fat profits, in the

medium term it leads straight to the precipice A message the new normal gives

to those who care to listen regards what happens after the day of financial reckoning has arrived When the gambling casino goes bust, people and com-panies discover that the so-called ‘assets’ (of most doubtful value) are accom-panied by vast debts, which are due with interest In a crisis, these ‘assets’ are shattered, but, short of outright bankruptcy, the liabilities always stand

As in the case of Japan and its ‘two lost decades’, from 1992 to 2011, western financial institutions and households confront a balance sheet recession And, because this is happening on a massive scale, nobody really has a clue about how to handle it, let alone how to get the economy out of the long tunnel which it has entered

The curious medicine of throwing massive amounts of money at the problem, first practised by the Japanese government and then followed blindly by the American, British and continental European governments,

is a medicine whose longer-term effects are anybody’s guess All sorts of portfolios have been left with liabilities that far exceed their assets

Some economists believe that the world’s economy will be pulled up from its crisis by the developing nations – which, relatively speaking, are in better shape, while demand in developed countries remains weak But other economists question the thesis that the emerging nations will be able to compensate There is an even more basic bifurcation in expert opinions:

Some economists say that many governments will have to keep their stimulus packages going for longer than expected, or face entrenched unemployment

To the contrary, others believe that public debt cannot rise any more without disastrous after-effects for everybody, common citizens companies and the state itself included

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The World’s New Normal Economic System 21

Last but not least, opinions are divided as to whether the current system of global currencies can continue functioning under the preposterous weight

of debt and liabilities on some countries and their currencies As it stands, the situation is attracting cruising sharks whose business is the blood of the mighty

There is, indeed, a currency puzzle which has found its way into the

new normal but which is still (by all likelihood) living on borrowed time

International transactions and central bank reserves are being denominated mainly by three currencies: the dollar, the euro and the yen, which is rather funny because none is supported by first-class fundamentals The Japanese economy has been in a coma for 20 years The finances of euroland resemble those of a traveling provincial circus And as for the US dollar, its investment bankers, mortgage ‘bodybuilders on steroids’,23 credit-rating agencies and big spenders at sovereign level have killed the goose that laid the golden egg

2

The Newly Poor

Poor people’s recipe: falling deeper into debt

In 1966, the Daily Express ran a competition in which one should select,

in order of importance, what one considered to be the essential attributes

to become a self-made millionaire Plenty of people participated in it According to Robina Lund, Paul Getty, one of the oil industry’s pioneers, assessed his own most important attributes as:

single-mindedness

ability to work long hours1

elastic use of time2

attention to detail

knowledge of a particular business

unpredictability3

ability to make good use of professional advice4

What Getty chose as the seven top characteristics of success are the sonality traits of men who make history in any profession – from politics

per-to business and science These qualities are rare, possessed by exceptional people, most of whom are self-made What the large majority of men and

women choose as their guiding light in planning their life (if they plan it at

all) is the exact antithesis of Paul Getty’s guidelines Quite surprisingly, this antithesis prevails even among so-called ‘experts’

The basic qualities characterizing the doers of society are not limited to the seven just discussed An eighth all-important characteristic of success, which Getty did not spell out explicitly but implicitly used throughout his life, is thriftiness and the avoidance of debt Costs matter Wealth provides economic freedom, gained by living within one’s assets, acquired through hard work, rather than amassing liabilities and becoming slave to them, and

The Newly Poor 23

The ninth principle guiding the life and work of people who are in charge of their destiny is their aversion to the welfare state – today’s State Supermarket Getty’s thesis was that those who deserve social support don’t get it By contrast, the lazy good-for-nothing scroungers who live on rent are encouraged in their idleness His motto was: ‘People only appreciate what they pay for If it’s free, they waste it.’ Look at the State Supermarket’s free medical care ‘for all’ to find the evidence

The tenth principle (which really belongs at the top of the list) is personal

responsibility Everybody has his or her duties and dues to society Forgetting

about them, or having them waived due to the pressure of the masses and being led by a lightheaded leadership, is the worst that can be done in terms of building up character ‘In a profession, waiving your dues may be a question of conscience; in a businessman it’s proof of weakness,’ Paul Getty pointed out.5

The disregard of personal responsibilities, so well described by these ten principles of behavior, has brought our society to the edge of social, ethical and economic bankruptcy.6 In the course of the last 50 years, whether we talk of Europe or of America, the absence of personal responsibilities has become proof of social organization’s weakness This is true all the way from the sovereign state to the smallest social unit It is also the most fundamen-

tal reason for déclinisme of the West.7

As we will see in the next section, the western countries that wrongly think themselves as ‘the rich world’ are becoming poorer and poorer – and this is

a self-inflicted wound Their sovereigns, their companies (particularly their banks) and their citizens are living on debt and, therefore, on borrowed time

The newly rich are the so-called BRICs (Brazil, Russia, India, China), the bigger countries of the developing world How far apart the newly rich and the newly poor are in terms of policy is dramatized by the annual meeting

of the International Monetary Fund and World Bank, held in Washington,

on October 8 to 10, 2010 – which was dominated by the Damocles sword of global currency wars hanging over the global monetary system

The newly poor countries, especially America, focused on China’s

unwill-ingness to allow the yuan to rise In response to this, China’s officials argued that the biggest distortion came from the (formerly) rich world’s extra-loose economic policies, particularly the expectation that the Federal Reserve would soon reactivate its deplorable strategy of massively printing money

to buy government bonds and to devalue the dollar (see Chapters 5 and 12

on quantitative easing (QE))

Steady current account and fiscal deficits reveal a roadmap to financial catastrophe Even worse than the doctrine is the thoughtless way in which it

was deployed The force behind the creation of newly poor nations, precisely

those who in the nineteenth century were the mighty world powers, have been the twentieth century’s devastating European wars