Global Economic Crisis

In the New York Times the oracle of Omaha, billionaire investor Warrent Buffet, has written a powerful piece warning about the growing danger of America’s expanding debt to GDP ratio. While defending massive deficits in the short run as necessary to save the financial system from collapse and economy from imploding, Buffet warns that in the long term an answer must be found for America’s fiscal imbalance.

“Unchecked greenback emissions will certainly cause the purchasing power of currency to melt. The dollar’s destiny lies with Congress,” concludes Buffet in his piece.

If the fate of fiscal sanity lies with the same Congress that is spending money like a fleet of drunken sailors, what are the odds that America will avoid hyperinflation?

A major point made by others and me is that a high ratio of national debt to GDP creates a substantially elevated risk of inflation. Furthermore, I suggest that this may lead to a conclusion by decision-makers that the only policy response that can reduce this dangerous ratio of public indebtedness is to allow high levels of inflation, which in turn “grows” the nominal GDP not through higher output of goods and services, but through reduction of the constant value of the currency. Professor Krugman is dismissive of this point, making reference to the United States having a level of public debt that exceeded the GDP right after World War II, without severe consequences.

Let us look at the facts. The United States ended World War II with a labor force, including a substantial military, which was fully employed but had been restricted in the opportunities to spend disposable income. This was due to rationing on basic commodities such as foodstuffs, and the termination of production of major consumer durables such as automobiles owing to industrial mobilization in support of the war effort. After VJ day the pent-up consumer demand exploded, while consumer goods remained in short supply in the immediate post-war period. The result was a combination of real growth and high inflation, both dynamics contributing to the attenuation of the public debt to GDP ratio. Thus in 1946, the national debt ratio reached its highest level, 121%. By 1948, that ratio had declined significantly, at 93.7%. Now, let us observe the inflation rate during this period: 8.3% in 1946, a staggering 14.4% in 1947 and 8.1% in 1948. These figures clearly demonstrate that having a level of public debt exceeding 100% of the GDP does have inflationary consequences, and suggests that inflation in turn reduces the real value of the nominal public debt as a proportion of national GDP.

Perhaps the most disturbing aspect of Paul Krugman’s piece, beyond superficial and trivializing dismissal of those he disagrees with on the question of high levels of deficit spending, is his marginalization of those he disputes by resorting to rhetorical generalizations. Thus, he issues this inexplicable diagnosis of those who hold economic views that are contrary to his own: “But it’s hard to escape the sense that the current inflation fear-mongering is partly political, coming largely from economists who had no problem with deficits caused by tax cuts but suddenly became fiscal scolds when the government started spending money to rescue the economy. And their goal seems to be to bully the Obama administration into abandoning those rescue efforts.”

One of the inflation fear mongers is a supporter of President Obama’s stimulus spending program, NYU economics professor Nouriel Roubini. This is what he had to say at a recent symposium on the economic crisis, which Professor Krugman also participated in: “…we have to worry about the long run. If we’re going to finance budget deficits by printing money, we may have high inflation, even risk of hyperinflation in some countries. That’s what happened in Germany in the 1920s during the Weimar Republic. We are having large budget deficits and increasing the public debt, we don’t know whether it’s going to be $5 trillion or $10 trillion of more debt. But there are only a few ways of resolving that debt problem: either you default on it as countries like Argentina did; or you use the inflation tax to wipe out the real value of the debt; or you have to raise taxes and cut government spending. And given the size of the deficits, over time that’s going to be a painful political choice to make. So we need the stimulus in the short run, but we need to restore medium-term fiscal sustainability.”

Another supporter of President Obama’s economic policies, who also opposed George W. Bush’s deficit-financed tax cuts, is billionaire investor Warren Buffet. This is what the oracle of Omaha had to say about the linkage between high public debt to GDP ratios and the risk of inflation: “A country that continuously expands its debt as a percentage of GDP and raises much of the money abroad to finance that, at some point, it’s going to inflate its way out of the burden of that debt.”

In writing off those observers who are concerned about the inflationary dangers emerging from the exploding national debt, Paul Krugman resorts to paraphrasing Franklin Roosevelt, claiming the only thing we have to fear about inflation is the fear of inflation itself. It seems, however, that there is one authority that is of like mind with Professor Krugman. In December 2002, Treasury Secretary Paul O’Neill, about to be fired for opposing the Bush tax cuts, had a meeting with Vice President Dick Cheney. In response to O’Neill’s warning of the long-term implications for the nation’s economic health of escalating federal deficits, Cheney told the soon-to-be but prescient ex-Treasury Secretary, “You know, Paul, Reagan proved deficits don’t matter.”

I never thought I would witness the day when Paul Krugman and Dick Cheney agree on economic policy.

The ancient Greek philosopher, Plato, constructed a political theory based on the royal lie or myth. As described in Plato’s Republic, the ruling elites of a political entity have the right to lie to their citizens-but not vice versa. The rationalization is that a royal lie and deception maintains social cohesion and prevents the collapse of the state. Thus platonic logic gives rise to the so-called stress test for American banks, the royal myth conceived by Treasury Secretary Timothy Geithner and Fed Chairman Ben Bernanke, in order to deceive investors, market sentiment and the American people as to the true state of the nation’s financial institutions.

When Congress approved the massive $700 billion bailout of U.S. banks and Wall Street firms last October, the justification was that without this massive indebtedness being incurred by the American taxpayer, the U.S. and even global financial system would collapse. Yet, from this perilous state of only a few months ago, a stress test is concocted by the Obama administration to “prove” that these same banks are relatively healthy, well capitalized, with only a few banks requiring a collective total of $75 billion to cover probable losses that can be anticipated during the months ahead as unemployment continues to rise. Furthermore, this $75 billion capital infusion can be generated directly from private investors, without the injection of additional taxpayer support, so says Geithner & Company.

What is going on here? I think the prophet of doom of this unprecedented global financial and economic crisis, NYU economics professor Nouriel Roubini, summed it up best when he wrote recently, “Geithner’s hope is that he can subsidize banks long enough for them to earn their way back to health. But the public isn’t keen on more bailouts, so Geithner’s challenge is to convince us that banks are solvent.”

However, as Roubini and other economists and financial analysts have pointed out, much of the U.S. banking sector is functionally insolvent, stress test or no stress test. Roubini himself estimated that U.S. financial institutions will incur $3.6 trillion in losses from the ongoing economic crisis, while the IMF calculates that global exposure to toxic assets is over $4 trillion, more than half this sum related to losses in the United States. These figures far surpass the current capitalization of U.S. banks, making Geithner’s $75 billion figure a fantasy number, unrelated to actual economic and financial realities. In other words, a royal lie, straight out of Plato’s Republic, with suitable accoutrements customized for the Global Economic Crisis.

The stress test is a public relations exercise on a grand scale. Originally, word “leaked” out that all the major U.S. banks would pass the stress test. Markets reacted skeptically, leading Treasury and the Federal Reserve to come up with a compromise number; big enough to look credible yet not so large as to suggest there is an insolvency danger afflicting the nation’s banks.

A mythological approach towards the Global Economic Crisis, especially as it relates to financial institutions, will insure that an already dire situation becomes inevitably calamitous. The most dangerous flaws in the U.S. and global banking system are not even hinted at with Treasury’s stress test. They have to do with a volatile man-made financial toxin, otherwise known as derivatives.

The oracle of Omaha, billionaire investor Warren Buffet, once described derivatives as “financial weapons of mass destruction.” As regards the world of credit and finance, he is absolutely correct. What exactly are these nefarious derivatives? Though conceived of as complex financial instruments, in essence they are private contracts between financial counterparties, which have the characteristics of a bet, in effect gambling on a range of financial and economic activity. This can include price direction of commodities, equity markets and global currencies, among many other “derivatives” of financial and economic activity. Banks, investment firms and insurance companies loaded up on derivatives until their balance sheets choked on them, driven by what was seen as an easy way to generate cash flow-and significant cash bonuses for the supposed geniuses who devised these monstrosities. Then came the collapse of the subprime mortgage market in the United States, and the fragile derivatives empire began to unravel.

AIG was the first demonstration of how dangerous derivatives had become to the global financial system. A small branch of the insurance giant, based in London, bet heavily on a form of derivatives paper known as a credit default swap, in effect insurance based on gambling about the stability of securitized mortgages. When the U.S. housing market collapsed, AIG lacked the capital to pay off the bets it had lost heavily on with its CDS paper, forcing the U.S. government to come to the rescue. The tab so far, just for this one company, is nearly $200 billion. I would not be surprised if AIG’s credit default swap losses ultimately top half a trillion dollars, all of which the American taxpayer will be expected to make whole. And by no means is AIG the only derivatives bomb waiting to explode, a terrifying truth completely veiled by the mythology of the stress test.

How dangerous is the derivatives toxin to the U.S. and global banking system? To give just one example, Geithner’s stress test claims that Citigroup, the country’s third largest bank, only requires a mere $5 billion in additional capitalization to maintain its financial health under the worst anticipated economic storms that may still arise. However, Citigroup has a derivatives exposure equal to nearly three times its total assets

of $1.2 trillion. Most of the other U.S. banks have equally threatening levels of derivatives exposure; in the case of J.P. Morgan Chase its exposure is nearly four times its assets of $1.7 trillion.

What makes derivatives so frighteningly dangerous is that they are almost totally devoid of government regulation. Their opacity makes it virtually impossible to gauge the exposure of U.S. and foreign banks to these destructive financial instruments with any degree of precision. However, it is currently estimated that the combined value of all derivatives contracts in the world equals a sum of money that seems impossible to fathom: $1.2 quadrillion! That number exceeds the total GDP of the entire planet by many dozens of times. In effect, the developed world, led by the United States, has created a vast, unregulated shadow economy based entirely on risky paper and exotic casino-style capitalism, with actual bets being placed by the major actors within the U.S. and global banking system as though they were roulette wheel patrons in Las Vegas.

It is the fear of the derivatives toxin that has frozen credit markets, leading to the Global Economic Crisis. Geithner’s stress test, along with the phony Q1 “profits” reported by these same insolvent U.S. banks, can in no way alter the darkening truth about the calamitous state of the U.S. banking sector.

It appears, unfortunately, that the Obama administration has bought into the royal lie as the best solution to the nation’s perilous financial and economic crisis. They are desperately playing for time, hoping somehow that markets will be fooled into regaining confidence, and that things will revert to some level of normalcy, without the added expense of further bank bailouts and nationalization of key financial institutions. Sadly, by taking what appears to be the easy way out, I fear that the economic policymakers in Washington have embarked on path that can only offer a financial and economic apocalypse that may defy our worst nightmares.