Global Economic Crisis

A few weeks before these antics a more sober assessment of America’s banking health was delivered at the National Press Club in Washington by Dr. Martin D. Weiss, the head of Weiss Research, a global investment research firm. Previously, Weiss had accurately forecast the demise of Bear Stearns and the implosion of the U.S. investment-banking sector. However, at the National Press Club he offered a more chilling prediction: 1,568 U.S. banks and thrifts risk failure. Included in that number are several of the largest American banks, including J.P. Morgan Chase, Goldman Sachs, Citigroup, Wells Fargo, Sun Trust Bank and HSBC Bank USA. The numbers and depth of the banking problem highlighted by Dr. Weiss are far larger and much more ominous than has been portrayed by the Federal Reserve, Treasury Department and FDIC. He backed up his dire analysis with documentation and precise mathematical modeling. For example, he refers to the government’s justification for a hideously expensive taxpayer bailout of AIG, based on the firm’s exposure to the fragile investment vehicles known as Credit Default Swaps, or CDS. The policymakers maintain that AIG’s $2 trillion in CDS exposure represented an unacceptable systemic risk, meaning AIG was “too big to fail.” However, Weiss points out that Citigroup alone holds a portfolio of $2.9 trillion in Credit Default Swaps, while J.P. Morgan Chase possesses a staggering $9.2 trillion of these toxic instruments, about five times the exposure that led AIG to demand that the government rescue it, or see the global financial system implode.

The essential point Dr. Weiss made at his press conference is that the degree of exposure U.S. banks have to a variety of toxic assets is beyond what the U.S. government and, by extension, the American taxpayer is financially capable of rescuing. Continued bailouts of insolvent banking institutions will not repair a broken financial order, but may very well cripple the overall economy.

Earlier, NYU economics professor Nouriel Roubini had already gone on record as declaring that much of the U.S. banking sector was functionally insolvent, and that bailing out zombie financial institutions would only replicate the Japanese “lost decade” of the 1990s, when Tokyo’s preference for keeping alive insolvent banks instead of closing them down led to a prolonged L-shaped recession. Roubini and other critics of both Bush and Obama administration policies on bank bailouts have looked to the Swedish model for resolving a profound banking crisis, which involved temporary short-term nationalization, closing down insolvent banks, while those banks that can be salvaged are cleaned up of their toxic assets, recapitalized and then sold back to the private sector. “You have to take them over and you have to split them up into three or four national banks, rather than having a humongous monster that is too big to fail,” Nouriel Roubini has argued.

According to the International Monetary Fund, the global financial and economic crisis has already created more than $4 trillion in credit losses due to toxic assets. If nothing else, the IMF estimate on the scale of the economic and financial disaster thus far should compel the Washington political establishment to face the painful yet necessary truths regarding America’s precarious situation. However, it appears that fantasy is preferred over reality within the corridors of power.

The procrastination of policymakers in Washington in facing dark reality, and preference to avoid any public takeover of troubled banking institutions while simultaneously subsidizing these financial dead men walking with almost unlimited taxpayer funds, at the same time maintaining the fiction, as Timothy Geithner has just done, that all is basically fine with the “vast majority” of U.S. banks, is to insure the inevitability of a systemic banking collapse in the United States. The conglomeration of reckless, greed-induced banking practices by the oligarchs of finance and inept, reality-denying policymakers is sending much of the American banking sector on a Wagnerian death ride into a financial apocalypse. Many of the U.S. banks are in fact doomed to fail, and no contrived stress test or Geithner speech can alter that outcome. And that isn’t even the worst part. For when mass banking failures occur in the United States and overseas, a global economic depression will be an irreversible outcome.

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Now we are in 2009, with the subprime mortgage securities debacle having been the underlying cause of the state of insolvency afflicting America’s largest banks. The U.S. government, including Congress, Treasury and the Fed, have injected or issued backstop guarantees to the tune of $13 trillion, in a frantic effort aimed at keeping these zombie financial institutions artificially alive. Yet, in this truly global economic and financial crisis, events in other parts of the world may render mute and futile all the trillions of dollars the U.S. is borrowing to save the American and global financial system. As in 1931, it may well be the Austrian banking sector that is the final nail in the coffin of the current globalized financial order.

With the fall of communism, former East Bloc European states were encouraged to borrow heavily by their Western brethren, with Austrian banks leading the way. Governments in Eastern Europe borrowed massively to finance the modernization of their industries, with the goal of providing lower-cost industrial goods and commodities to consumers throughout Western Europe. In addition, consumers in Eastern Europe were encouraged to borrow money in Euro currency at low interest rates for homes and consumer durables. When the Global Economic Crisis hit Europe, demand destruction afflicted the highly leveraged new industrial plants in Eastern Europe. In addition, the consumers who unwisely borrowed money from Western banks in Euros were devastated by the collapse of their home currencies. A new housing crisis has arisen in lands as diverse as Hungary, Bulgaria and Romania.

The non-performing assets on the balance sheets of European banks are enormous, and have affected many countries throughout the Eurozone. However, in terms of percentage of toxic assets to GDP, no European state is in as precarious a state as Austria. More than $250 billion in bad assets are poisoning the balance sheets of Austrian banks, a sum equal to more than 62% of the nation’s GDP. By way of comparison, if the admittedly shaky U.S. banks held toxic assets in the same ratio to GDP, this would equal $8.7 trillion dollars in bad assets. If America’s banking disaster was on the same scale as Austria’s, it would require a dozen TARP programs to cover the holes on the balance sheets.

Is another Credit-Anstalt catastrophe in the works? The macroeconomic data emerging from Europe looks increasingly gloomy. In addition, the European Union is proving to be both disunited and uncoordinated in facing up to mounting evidence of a financial avalanche that may bury the Union and everything else with it, including the common currency. Policymakers throughout Europe are arguing over Eastern European stabilization funds, protectionism versus “free trade,” and other issues, both real and distractions, while the financial underpinning of the entire European economic system is ablaze.

Just as Iceland was the first nation to become nationally insolvent due to bank failures stemming from the Global Economic Crisis, Austria may be fated to endure a similar disastrous outcome. Should Austria’s banks fail as spectacularly as did the Credit-Anstalt back in 1931, the impact on the world’s financial and economic order will be at least as catastrophic and likely much worse. It is indeed timely for Paul Krugman to state the obvious regarding the looming Austrian banking crisis, irrespective of the indignation pouring out of Vienna.

Will 2009 prove to be 1931 redux? The indicators favor the pessimists far more than the optimists. Nobel Prize winning economist Paul Krugman has issued a sober warning, which hopefully will not be drowned out by the hyperbole of reality-denying European politicians.

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It was only back in January that the IMF had estimated that toxic assets tied to the United States stood at $2.2 billion, while NYU professor of economics Nouriel Roubini provided a more sobering analysis that placed a figure of $3.6 trillion regarding toxic garbage sitting on global balance sheets, half that figure being directly tied to U.S. financial institutions. The revised IMF numbers, in my view, tell us two things: 1. The erosion in asset values across the world is accelerating and 2. No

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There is not even a glimmer of optimism in the IMF forecast, except in the sense that some regions will contract at slower levels than others. Japan is projected to decline by 5.8 %, with lower but still shattering levels of economic contraction in the United States, the United Kingdom and Eurozone. Emerging markets, especially Eastern Europe, are assessed as being particularly vulnerable to the turbulence being unleashed by the Global Economic Crisis. “The risks are largest for emerging countries that rely on cross-border flows to finance current account deficits,” concludes the IMF in reference to the impact the global financial crisis and credit crunch have had on the debt-dependant economies of Eastern Europe.

Reading between the lines of the IMF forecast, it is clear that the contraction ratios would be even more severe, but are in effect being masked to a certain degree by so-called economic stimulus programs. In effect, future tax money is being borrowed to artificially create employment in the near term. However, the IMF report alludes to the challenges to be faced in 2010, when less stimulus spending is projected, especially in Europe. This is already a source of contention between the United States, which is currently projecting a deficit of 12% of her GDP, and the European Union where, in comparison, a much lower ratio is being allocated within the Eurozone. The UK, however, is forecast by the IMF to have attained a fiscal deficit in 2010 that will comprise 11% of her GDP, nearly the same percentage as is the case with the US federal budget.

With deficits soaring and projections of global economic contraction multiplying, the U.S. Federal Reserve has made its own unique contribution to the toxic brew being stirred in the midst of our worldwide economic catastrophe. As I have previously warned in my earlier blog comments regarding Ben Bernanke and quantitative easing, the Fed has now officially announced that it will fire up the printing presses and conjure out of thin air $1.2 trillion of freshly minted fiat currency, which it will utilize for purchasing Treasury bonds and mortgage-backed securities. This is an act of desperation, devoid of any long-term strategic framework. In a panic to achieve a short-term reversal of economic fortunes in the U.S., the all-powerful Federal Reserve has embarked upon an experiment in quantitative easing and government debt-monetization that will inevitably unleash the dangerous prospect of hyperinflation. Defenders of the Fed’s reckless gamble with America’s fiscal and monetary health will argue that currently deflation is a much greater danger than hyperinflation. This is accurate only in a very short-term time horizon. If anything, the Global Economic Crisis has shown how powerful financial and economic currents can be turned around on a dime. Last summer, the price of oil skyrocketed, reaching levels of nearly $150 per barrel, with serious financial analysts projecting a much higher price in the near future. Within a matter of weeks, the world witnessed a radical reversal in the price of oil and other commodities. I mention this as a warning that disastrous policy measures being enacted by the Fed can transform deflation into hyperinflation much more rapidly than can presently be envisioned.

Between news bulletins concerning the IMF and World Bank reports that are forecasting the most severe global economic contraction in 60 years, and the $1.2 trillion in make-believe money being manufactured by the Fed, it is inexplicable why major stock markets are undergoing a rally of sorts. Could this be the calm before the storm?

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As the major actors of the global economy gather in Davos for the World Economic Forum, they might shift their gaze from the landlocked enclave of Switzerland to another frigid enclave enveloped by the chilling waters of the Arctic Ocean and Denmark Strait; Iceland. For it is on this sparsely populated Island nation of 320,000 inhabitants that ground zero for what the Global Economic Crisis can unleash is being experienced. As a harbinger of the economic doom that the global financial disaster can inflict on human societies, Iceland should serve as a clinical laboratory for what much of the rest of the world is in store for, as the masters of the universe continue to feast on champagne and caviar at rarefied summits such as that occurring in Davos.

Iceland once had a reputation for hardworking fishermen, and financial thriftiness. Its budgets were usually balanced or in surplus, and its banking sector was responsibly regulated. Then came the ideology of the so-called “free market” in banking, bringing along a wave of financial deregulation. The financial engineers that populated Iceland’s banking sector dreamed up a new way to make money; have Iceland’s banks borrow heavily via short-term debt, while offering above-market interest rates to recruit bank depositors overseas. Iceland’s banks actually had more depositors outside of Iceland, especially the United Kingdom, when the global financial crisis exploded all the unstable banking models irrespective of national frontiers.

Iceland’s three largest banks became insolvent as the credit crunch pinched their access to short-term financing while simultaneously overseas depositors began a run on those banks. This resulted in a panicky Icelandic government being forced to place in receivership and thus nationalize Glitnir Bank, Landsbanki and Kaupthing, the latter being the nation’s largest bank. The potential liabilities of these banks exceeded the entire GDP of Iceland by a multiple of five, forcing the government to seek emergency financial aid from the International Monetary Fund (IMF) as the country’s currency, the krona, went into free-fall collapse.

The financial catastrophe that has engulfed Iceland has crippled her economy and brought about a political crisis fed by social unrest and collective fear that is unprecedented in her history. Prime Minister Geir Haarde has been forced to announce his resignation and the calling of early elections, as he and his senior ministers have been virtually besieged by non-stop demonstrations representing the anger of a large proportion of the population. As the internal situation in Iceland deteriorates, her external image has been forever tarnished by the irrational behavior of the nation’s bankers. With numerous foreign depositors demanding access to their accounts from these now insolvent banks, the British government went so far as to publicly declare that Iceland was a terrorist state. Such is the level of discord that is being aroused by the Global Economic Crisis.

Undoubtedly, Iceland is about to enter an economic apocalypse. It is absolutely impossible for this small nation to cover a potential liability that is five times as large as its entire annual GDP without the largesse of the IMF, among other benefactors. Even with this assistance, Iceland will be economically crippled far into the future, creating a pall of gloom that is enveloping this small country.

Some will say that Iceland is an exceptional case, because even projections of severer financial carnage in the United States do not come near to five times the GDP of the world’s largest economy. Those comforting themselves with such logic miss the point. Even if all the potential losses from the insolvent banking sector in the United States, added to insolvent households, public and corporate debtors, amounts to “only” half the American GDP, the scenario that occurred in Iceland remains highly relevant. In both situations, be it with a small economy or the world’s largest, the systemic financial meltdown is beyond each country’s capacity to “repair” the damage utilizing its own economic resources. There is, however, one important distinction. Unlike Iceland, the United States does not have the option of running to the IMF for a bailout.

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Dr.Obadiah Mailafia is a distinguished African economist. Currently he is the Chairman of the Center for Policy and Economic Research (CEPER), in Abuja, Nigeria. Dr. Mailafia has had a distinguished career in government, academia and international development. He has been a university academic, international banker and a senior government official. He was until recently Deputy Governor of the Central Bank of Nigeria and a Senior Advisor to the President of Nigeria (with rank of Minister of State). He was also for several years an official of the African Development Bank Group. He is by training an economist and policy scientist, with research interests in monetary economics, international finance, and strategic management and development administration. On December 16^th, 2008. Dr. Mailafia delivered a speech on the current Global Economic Crisis for the Kaduna Chamber of Commerce in Nigeria. Though his talk dealt in part with the impact of the global meltdown on the Nigerian economy, Dr. Mailafia’s presentation provides an exceptionally cogent and lucid analysis of the ongoing global financial and economic turmoil. Below is an excerpt from the speech on the Global Economic Crisis, which Dr. Mailafia graciously provided permission for WWW.Global EconomicCrisis.com to publish on our blog.

Presentation on the Global Economic Crisis by Dr.Obadiah Mailafia:

From first principles, we must not forget that financial booms and busts are not a new phenomenon. What is disquieting about the current meltdown is that it is in the nature of a seismic tremor of earth-shaking proportions.

Within a few moths, some of the biggest financial giants have gone belly-up, while several more are in serious trouble. How indeed are the mighty fallen! Bear Stearns, AIG, Fannie Mae and Freddie Mac, Lehman Brothers and Merill Lynch. The automobile giants are virtually on their deathbeds while a good number of industrials are surviving only by the skin of their teeth. A rather prosperous central European nation, Iceland, has virtually sued for bankruptcy, resorting to an IMF standby arrangement - the first since the British ‘humiliation’ of 1967.

The contagion has spread to Europe, Japan, Asia, Africa and Latin America. An estimated US$1.7 trillion in bailout funds has already been committed by OECD countries, but we are yet to see the end of the tunnel, not to talk of any light in it. According to a recent report, the world stands in need of a staggering US$4 trillion to fully resolve this crisis.

Any explanation of the current financial turbulence must begin with the housing bubble fuelled by low interest rates, increased global liquidity and predatory lending by the financial giants. According to some estimates, the annual issuance of US sub-prime mortgage backed securities increased from a mere $56 billion in 2000 to a massive $508 billion in 2005, comprising something of the order of 20 percent of total US mortgages. By 2006, the housing bubble was beginning to unravel, as higher interest rates and rising oil and food prices - and a generalized decline in consumer confidence - were starting to take their toll.

For Robert Reich, former Labor Secretary under President Clinton, greed has to be the main explanatory variable. For billionaire investor George Soros, on the other hand, the main villain is former Fed Chairman Alan Greenspan whose monetary policies allegedly encouraged speculative exuberance even as interest rates were at an all-time low and asset prices were spiraling out of control. Predictably, President-elect Barack Obama puts most of the blame on the misguided policies of the Bush administration, describing the situation as “the most serious financial crisis since the Great Depression”. To all intents and purposes, the big ratings agencies must also bear some of the blame for failing to be more rigorous in their risk assessments. There  Acare yet others who blame the situation on the repeal of the Glass-Steagall act 1933 which had made a clear demarcation between general commercial banking on the one hand, and investment banking activities, on the other. The absence of such a demarcation was underlined as one of the factors accounting for the speculative exuberance that led to the 1929 Wall Street crash.

Linked to this is the dwindling capacity of regulatory authorities. The reality is that the world of high finance has become so complex in our digital age, with capital travelling at the speed of light and several instruments engineered using the arcane language of quantum physics. The hedge funds, which control over a US$1 trillion in assets, are not subject to many of the traditional regulatory regimes. Inevitably, such power without responsibility is bound, sooner or later, to lead to anarchy or even worse.

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