Where have all the anti-globalization activists gone?

Over the last decade or so, every time there's a WTO meeting or G8 summit, a lot of protesters show up to bring attention to some very real concerns about free trade agreements. Most recently there have been a number of protests against the TPP.

Globalization has made the world richer, but the way it has been implemented has given much more power and wealth to corporations, and diminished the ability of nations to regulate activities within their borders. At this very moment, for example, a Canadian pipeline company is suing the US government for $15B for not approving a very unpopular pipeline proposal - and it's suing based on the rules of NAFTA.

So now Britain has voted to leave the EU. Polls showed that "the top issue among those voting to go was Britain's right to act independently" (link).

The deficiencies of the EU are widely recognized. As Paul Krugman wrote recently:

The E.U. is deeply dysfunctional and shows few signs of reforming.

...Today’s E.U. is the land of the euro, a major mistake compounded by Germany’s insistence on turning the crisis the single currency wrought into a morality play of sins (by other people, of course) that must be paid for with crippling budget cuts. Britain had the good sense to keep its pound, but it’s not insulated from other problems of European overreach, notably the establishment of free migration without a shared government.

...The most frustrating thing about the E.U.: Nobody ever seems to acknowledge or learn from mistakes. If there’s any soul-searching in Brussels or Berlin about Europe’s terrible economic performance since 2008, it’s very hard to find. And I feel some sympathy with Britons who just don’t want to be tied to a system that offers so little accountability, even if leaving is economically costly. (link)

Soon after England and Wales voted to leave the EU, Larry Elliott, Economics Editor at the Guardian, wrote an article in the Guardian titled "Brexit is a Rejection of Globalisation" (link). He talks about the free trade movements of the last 30 years resulting in "a much diminished role for nation states". Elliott argues that the EU failed:

Jobs, living standards and welfare states were all better protected in the heyday of nation states... than they have been in the age of globalisation. Unemployment across the eurozone is more than 10%. Italy’s economy is barely any bigger now than it was when the euro was created. Greece’s economy has shrunk by almost a third. Austerity has eroded welfare provision. Labour market protections have been stripped away.

...Torsten Bell, the director of the Resolution Foundation thinktank, analysed the voting patterns in the referendum and found that those parts of Britain with the strongest support for Brexit were those that had been poor for a long time. The result was affected by “deeply entrenched national geographical inequality”, he said.

There has been much lazy thinking in the past quarter of a century about globalisation. As Bell notes, it is time to rethink the assumption that a “flexible globalised economy can generate prosperity that is widely shared”.

So do you see my problem? Brexit is such an enormous boon for anti-globalization that it is being heralded as a reversal of the entire globalization trend. Why aren't the anti-globalization organizations marching in the streets?

I can answer that question, but it saddens me. Over the last week, "conventional wisdom" has decided that everyone who supports Brexit is racist. I have been practically spat on because of the sentiments I expressed in my last post (link), that "my head said Remain but my heart said Leave". One supposed old friend wrote:

60+ year old citizens of the UK who voted to leave (and they are the majority of wanna-be leavers) are delusional. They want to restore that tiny little island to its imperial greatness, or at least to its completely diminished splendour during WWII. They want an England with white rulers and black slaves.And of course the slaves are all rapists, and none of the white rulers is. Foreigners are all murderers and rapists. So the tiny little island may be able to pull in tourists to see its nearly dead monarch until she dies. Then the itiny little island dies. And this is where your heart is? I pity your heart. Unbelievable.

with a followup email the next day:

Fuck your heart Dwarf.

Every day recently, there are articles about thousands of people protesting Brexit; none about people supporting it. I just googled "Brexit" and the first hundred articles were overwhelmingly negative, largely based on the personalities of its spokespeople. The stock market in Britain is soaring (the FTSE 100 is at a 5-year high), but even that is being spun as negative with repeated claims that panicked Britishers are buying up everything in sight - which is a totally ridiculous argument.

Not many people, apparently, have the courage to take on the anti-Brexit crowd.

Even while arguing against Brexit, people could be starting a discussion of the ways the EU needs to improve. Instead, we have vitriolic articles about one person who said he regretted his vote to leave, that is magically turned into a claim that most leave-voters regret their decision; claims that an uptick in google searches for "European Union" in England means that those who voted Leave somehow didn't know what the EU is; and on and on.

I am confident that the economic shock of Brexit will soon subside. I am not so sure that the world community will ever regain its sanity about what just happened, and why.

Oh, and for those clinging to the notion that Brexit was purely motivated by ignorance and racism, read this article written by Larry Elliott a month before the vote, in which he argues for Leave: Brexit May Be the Best Answer to a Dying Eurozone.

Another View on Brexit

I wasn't eligible to vote on Britain's exit from the European Union, and I'm not sure how I would have voted. My head said Remain but my heart said Leave - and I find myself quite pleased that England and Wales found the strength to free themselves from the EU.

During the campaign, every article I read made the assumption that the Leave camp were all skin heads, xenophobes, illiterate farmers, or doddering old fools. ("Doddering old fool" was defined as anyone over 54.) They said that people who supported Brexit were doing it out of fear and loathing. The only rational reason for Leave that I saw was that Brexit would lower the value of the pound, thus boosting British manufacturing and blue collar jobs.

In fact, there are lots of good reasons for England and Wales to leave the EU. The EU is a mess. Eight years on, Europe hasn't recovered from the 2008 financial crisis. The central bank situation leaves Europe unable to fix its economy. (How did they think they could share a currency but not have a strong central bank?) European countries are having to resort to negative interest rates as unemployment soars.

I'm not even scratching the surface of the problems with the EU. The upshot is that this incompetent organization dictates a huge array of things that should be up to the people: Britain is unable to regulate everything from the size of trucks to how foods are packaged to, yes, immigration. Trade has superseded democracy.

Since the Brexit vote, everyone's going on about market turbulence as if markets have fallen into the sinkhole of hell. In fact, markets have been turbulent since January, mostly because of fears that China won't grow as fast as it used to. Market turbulence is a serious problem but is nothing new. In general, the market goes down and then it goes up again.

I'm not ordinarily a fan of direct democracy. Voters in my town were conned by anti-vaxxer types into voting to take fluoride out of our water. Californians have damaged their public schools by their crazy and conflicting propositions, resulting in some schools being forced to offer after-school dance classes while cutting core subjects.

But this is different. Free trade agreements and common markets restrict our democratic rights. We, the people, should have a say in that. David Cameron called this vote for all the wrong reasons, but still, history will show that he did an important and progressive thing in allowing Britons to decide to Brexit.

Troubling news from the Bank of Canada

The Bank of Canada, like all central banks, is supposed to be independent from the government. That, as the Globe & Mail put it this morning, is sacrosanct.

When a governor resigns, the BoC's board of directors is supposed to recommend a candidate to the finance minister. However, we learned this week that Stephen Harper decided to make the Governor of the Bank of Canada a political appointment, so Jim Flaherty did not involve the board of directors at all. This is a disturbing repeat of the way Harper changed the appointment of judges a few years ago.

We learned that Harper's interference in the BoC goes much deeper:

• The whole world sees Mark Carney as one of the great economic minds of our times and as the world's greatest central bank chief - the whole world but Stephen Harper, who apparently pushed Carney out of his position early. Carney's no fool - he got himself a much better job at the Bank of England - but Canada has lost immensely, and at a time when our economy is still in peril.
  
• Carney's pick for his successor, and the person groomed for the job, was ignored by Harper in what appears to be a petty retaliation against Carney. Harper's nastiness towards Carney went so far that he held the Ottawa press announcement of Carney's replacement at the same time as Carney's Toronto goodbye party, ensuring that Carney couldn't make it.
  
• We learned that Harper has been letting his ego drive in other ways: lecturing Carney about basic economics, releasing photos that seek to show Carney as an inferior, and so on.

Is all this important? Very.

A central bank exists to set monetary policy for a country, but its real business is to maintain stability and confidence in the economy and financial markets. The governor is supposed to be free from political interference so the markets (and public) know that central bank decisions are being made impartially. By making the job a political appointment - and by forcing out the previous governor - Harper is removing that freedom from political interference.

Let's be very clear. Our prime minister is not an economist. He holds the same degree I do and has no work experience as an economist. Worse, his approach to economics is ideological rather than pragmatic. He is motivated by ego and political ambition rather than a concern for the citizens of the country.

Note: In a very strange "letter from the editor" in the Globe yesterday, John Stackhouse admitted that during the prorogation, he knew that Carney felt that Harper/Flaherty did not have a plan for how to deal with the recession. Carney's assessment was not exposed at the time, even though the opposition was saying that was why they prorogued parliament and Harper was claiming that prorogation was over the per-vote subsidy.

Financial Turmoil May Be Over... But It's Not Likely

Today the Conference Board of Canada came out with the prediction that the recession is behind us. Baloney.

Sure, it may be over. But it's not likely. The problem is, we're getting our economic news from people who want us to believe it's over - from economists and analysts at financial institutions that have a commercial stake in keeping us active in the capital markets, and from government and organizations who believe (with reason) that if they tell us it's over we'll start spending and make it be over.

All this is well and good, except that most of us have our retirement savings tied up in things that will lose big time if the rosy predictions are incorrect.

And it is very likely that the rosy predictions are incorrect. Recent US job numbers and car sales all point to trouble ahead. A second dip (which could result in a much worse depression next year) would be caused by a downward spiral of higher savings rate, higher unemployment rate, more business failures and lower spending. Additional pressure will come from workers whose EI has run out, consumers whose credit history is damaged, home owners who are continuing to default on mortgages, and possible coming problems with credit card debt and another wave of sub-prime mortgage balloons.

Rosy predictions by the Conference Board of Canada and the US Federal Reserve Board and so on are designed to increase optimism and hence increase consumer/business spending. But they have another effect. Just look at the Comments section on the Globe article referenced above: half the commenters are calling for an end to government stimulus spending. That idea is madness, but it seems to be catching hold in Canada and the US.

Smart money says we should be very conservative in our investing: especially if your investments have recovered, move the funds into something more crash-proof; and speak up to support the government stimulus package.

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Pseudo-Specialists Defining Policy

A culture of irresponsibility took root from Wall Street to Washington to Main Street...

- President Obama

The culture of irresponsibility wasn't restricted to greedy guts who were reeling in hundreds of millions in shady financial dealings. It extended to policy-makers, media, and the civil servants who worked in the regulatory agencies and bond-rating companies. It was born in universities. It was the direct result of the way Economics is taught. Economics, at least as I was taught it in Canada in the 80s, is an indoctrination into simplistic free-market ideology backed up by complicated math based on dubious assumptions.

A number of people have been writing lately about Sheila Bair, head of the Federal Deposit Insurance Corporation, who repeatedly blew the whistle on subprime mortgages and other financial shenanigans prior to the financial industry collapse last year, but was shouted down and is still shut out by the powers that be who are planning America's financial industry reform.

A prevailing argument is that Bair was able to see beyond the paradigm of the day because she's female - not part of the old boy's club, wired differently, more caring, whatever. I don't know about that, but I can see one thing that Sheila Bair has that sets her apart from the rest: an undergraduate degree in philosophy with no formal economics training. (She's also a lawyer.)

Economists have taken over too much of the policy area. Social scientists should provide input, but not set policy. We live in a world dominated by pseudo-specialists, when what we need is pragmatic generalists.

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The Fourth Way: Proactive Liberal Reaction to Crisis

Like many people, I have been floating along assuming that the recent utter failure of unregulated-market theory would result in a change to more regulation, more government oversight, and more involvement of the public purse.

The opposite may be happening. Large economies are acquiring such massive deficits that national agendas will be overwhelmed in the years 2010-2015 with the need to restore fiscal health. As happened in many countries throughout the 1990s, even liberal governments will become deficit hawks and make restraint their number one priority. Everything will be slashed, including much-needed social programs, foreign aid that has long-term economic benefits... even budgets for regulatory agencies.

Despite all the talk about reducing business cycles, we are now in fact creating a world in which business cycles are enhanced by tag-along government spending cycles. We have a market crash and/or recession, followed by government bailouts and/or stimulus, followed by the development of a new market bubble and/or economic growth, followed by government cutbacks to pay off the bailout/stimulus.

You could argue that the government cutbacks put a damper on the upswing, and they might in fact have a positive effect on dampening inflation, but the problem is that by always reacting to market-caused problems, we never have a coherent, cost-effective or humane economic policy.

Part of the challenge is to create the bureaucratic and public will to achieve something without letting the entire rest of the agenda get swept along. For example, the biggest regulatory debacle in the recent financial crisis was caused by the Office of Thrift Supervision (OTS), an American regulatory board that was created after the Savings and Loans crisis in an attempt to impose more effective regulations. But the OTS was created in the early 90s - during the era of deficit reduction priorities - and keeping an eye on the bottom line resulted in the creation of a regulatory board that was directly financed by, and so overly beholden to, the institutions it was supposed to regulate. (More about that here.) The fiscal restraint culture resulted in a new regulatory body that provided less protection and more hazard than ever before.

Conservative politicians revel in the idea of being able to reshape the country during fiscal restraint: it's a great excuse for further gutting public health and ushering in two-tier health care; gutting social spending; and so on. But liberal politicians could prepare for the coming half-decade of government cutbacks by creating a strategic vision for how to handle it.

If we accept that business cycles happen and plan for them, then we can have a more coherent economic agenda. This goes beyond having "shovel ready" infrastructure projects always queued up in anticipation of stimulus need. It may mean forging a new relationship with civil service unions that creates more flexibility in the system - even if not as much flexibility as exists with private sector employees, then at least somewhat more. It means long range economic planning that includes crisis management and that creates strategic priorities that can be maintained through good times and bad. (For example, perhaps instead of granting annual budgets to programs, governments should set up endowments.) It means finding a way to cut back spending that is temporary and humane.

Two decades ago, the "third way" transformed liberal politics by melding fiscal restraint with social progressiveness: by taking responsibility for how to pay for what we want to achieve as a society. Now we need a way to expand liberal principles to deal with economic crises in humanitarian, cost-effective, and coherent ways. Government needs to become less reactive to market shocks. It's not fair to create lavish social programs during rosy times and then slash them a few years later. Equally as disturbing, it's inefficient.

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Antilibertarianism

The recent financial crisis delivered a death blow to the ideology of free market capitalism that reigned for the last 25 years. But are we thinking seriously enough about what dismissing it means? There are wider implications than regulatory reform.

In the Reaganite positioning, big government was bad. Supplying social services was called "tax and spend," which was equated with waste and corruption. That was just spin of course: a major function of government is necessarily the provisioning of social services. On a micro level we could think of a condominium building: if the condo association decided to collect no condo fees and provide no services, then the snow wouldn't be plowed from the driveway and the hallways wouldn't be vacuumed; the leak in the roof wouldn't get fixed; the legal requirements of the association wouldn't be met.

Throughout the last 25 years we have had a trend of government cut-backs that have been not only harmful to our well-being, but also inefficient and costly. We need to rethink government's role in providing services: ideally, we need a new philosophy for the role of the state. It's not a trivial activity and presents some major challenges. I'm not just thinking of the need for prioritizing, but also the need to rethink the government's relationship with civil service unions; devise a public credo that provides for a more equitable sense of government handouts; figure out how to handle the retiring baby boom generation; and so on. We need to change the debate to a more realistic understanding than the old neo-con slash approach: use cost-benefit analysis to show the real cost of not spending money in some cases, such as reducing money for preventative health care or the training of doctors. And so on: I don't think I've probably even skimmed the main issues.

The US has a visionary president now, but Canada can't rely on him to create a conceptual approach to this post-Libertarian era because the US has a much more limited view of social services than Canadians do. Stephen Harper is obviously not going to provide that kind of vision: he's an old-order neo-con. But Michael Ignatieff might be the perfect person for the job, with the intellectual depth and the visionary perspective necessary to forge something new and appropriate for Canada.

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The Sustainability of Stimulus

Stimulus is a funny sort of public policy. In normal years we rightly decry government deficits, but in severe recessions deficits are not only good but necessary. It's not always easy to make the case for recession spending, especially when the media is full of "green shoots" articles claiming that the recession is easing.

These days, polls and articles are all pointing towards a shift in priorities. Six months ago everyone was worried about avoiding a depression. Today, everyone seems to be worried about the deficit.

The worst thing we could do now is pull back on deficit spending. The US did that in the 30s and the Japanese in the 90s, in both cases causing a prolonged era of economic hardship. We need to not only stay the course on deficit spending this summer, but prepare ourselves to continue to increase our deficits over the next year, perhaps longer. In other words, $50B is likely not the end of it.

Cutting back on deficit spending will not reduce the deficit. It's a false economy to hold back now because the subsequent fall in economic activity will reduce government revenues to the point that we'll have the deficit anyway, along with unemployment and bankruptcies and other havoc.

Anti-recessionary spending is often seen as a blunt sword: in terms of fighting the recession it doesn't much matter what you spend the money on, as long as it stays in the economy. But there are reasons why we should be very concerned with fine-tuning: (1) After the recession we'll have to drastically cut spending to get the deficit under control: there will not be money for infrastructure spending for a long time, so we'd better finance important infrastructure projects now. (2) Timing is vital: if we maintain stimulus spending too long we risk causing inflation or even stagflation.

In short, we're on life support now, and it's madness to pull the plug before we're able to breathe on our own. The outcry against deficit spending seems possible only in a world where media and policy makers are largely isolated from economic realities. Many Canadians know how bad the economy is. At the downtown Toronto office of a friend of mine, an ad was placed for one day for a minimum wage receptionist job: they got 250 resumes, some from engineers and MBAs. A woman I know at an employment agency told me that for months now, companies that routinely roll over contracts for skilled financial workers have demanded pay cuts up to 20%. On a purely economic level, every penny taken out of someone's pocket is a penny less to get the economy back on its feet. We're not out of this by a long shot.

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Policy Prescriptions for Retirement

There's an excellent article in today's Globe called Saving for Retirement Baffles the Boomers, by Doug Peters and Arthur Donner. Unfortunately, the article's subtitle, "Take a breath, think longevity, public policy and type of plan," is somewhat misleading. The advice in the article is: change public policy so that we have larger public pensions. Here's part of what they have to say:

The large pension plan knows how long we'll live because it deals in large numbers of people and uses averages for life expectancy. Thus, large defined-benefit plans can estimate fairly precisely the amount of savings one needs for the lifespan of the average pensioner in their plan. The large defined-benefit plan can also take a long-term view of interest rates and market returns, a perspective not often available to the individual investor. This again increases the economic efficiency of such plans as the CPP.

Three obvious public policy conclusions flow from this analysis:

Substantially increase the size of the CPP so it provides for a much larger proportion of income replacement on the retirement of Canadians. Many studies have recommended this idea. An increase in CPP contributions and coverage could be done over several years in a way that ensures the CPP remains fully funded.

Develop a system whereby companies and their employees can buy additional defined-benefit pension coverage from the CPP. These supplementary pensions would need to be fully funded and would be fully portable (as they are held in the CPP). An add-on plan to the CPP would provide companies and individuals with the economic efficiencies and the substantial cost savings that only a large plan can generate.

Develop a strategy to get companies that have lost the incentive to provide defined-benefit plans back into the business of offering them. This will not be easy. Companies have moved away from such plans because of complex pension laws designed to protect workers, and their experience that such plans are costly and difficult to manage. In addition, employees are wary of such plans when they see large companies fail to fully fund their plans or go bankrupt with their pension plans underfunded.

A policy of both increasing the CPP and allowing companies and individuals to buy supplementary pensions from the CPP is one acceptable policy move. Another is a much closer monitoring of pension plans by regulators. A positive move in this direction would be the establishment of the proposed national pension guarantee system.

Another feature of such a system would be to require underfunded pension plans to pay higher premiums for coverage. In other words, any company that requests relief from its required funding - that is, additional time to make up a pension deficiency - should pay an additional premium for such forbearance.

Bad News

We're having some spotty good news on the economic front these days. That happened at the start of the Great Depression as well. One thing I think we can be sure of is that there are rough times ahead - and it annoys me no end that there isn't enough discussion of what's coming and how we're going to deal with it. In particular:

- There will be a series of more shocks to the system. The most likely causes are the collapse of a number of countries' economies - Estonia, Latvia, Lithuania, Hungary, and several others that are teetering at the moment. Each would cause a big negative shock around Europe, resulting in more loan defaults and more collapses in the financial system. This thing is like a wildfire that isn't completely extinguished, and keeps flaring up. If bad enough, who knows what countries will go down - major European economies may be at risk. There will be other sorts of shock as well: more US mortgage defaults, more large corporate collapses, who knows what else.
- Obama's attempt to bail out the US financial system is not going to work. He's spending a ton of money, but his plan is bad. At some point he's going to have to adopt a new approach, but by then hundreds of billions will be squandered, limiting future options. It will take a long time for the US financial sector to rebuild.
- Obama's attempt to stimulate the US economy is not going to be very effective. There is simply too much delay until the stimulus hits the street, and in the meantime the economy will plummet; unemployment will soar; companies will fail. The US congress, lacking good leadership or strong resolve, will continue to react to citizen anger with populist pandering rather than create good economic plans.
- The repercussions from the problems to date will play out throughout the system. Stimulus programs and bailouts have greatly increased debt, and paying that off will dampen economic activity for years to come. Municipal, provincial and federal tax revenue will fall; grants will plummet; arts and charitable organizations will fold up... there will be all sorts of cutbacks that will drag down economic recovery.
- As we emerge from the recession, we will likely be hit by inflation and high interest rates.

I like Obama, and I think he's making a really good effort. But why would anyone think that a young academic with two years experience at the federal level could handle the biggest economic crisis in 80 years? Sure he's doing a better job than the Texas playboy did or that the old man could have done, but that will be cold comfort in the dark days ahead.

In the meantime, you'd think the media, public and government would have learned from our failure to see the developing crisis last year. After railing that we should have seen it coming, everyone has apparently put back on their blindfolds.

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One Year Ago Today: The Bear Stearns Bailout Started It All

The Wall Street Journal's editorial page is not what you would call critical of business. But today James Freeman, WSJ's assistant editorial page editor, has an explosive op-ed in which he argues that the bailout of Bear Stearns a year ago was a contributing factor in the size of the financial crash last fall - because it caused the rest of the finance industry to expect to be bailed out.

He writes, "If nature had been allowed to take its course, Bear's directors and executives would have faced the liability tsunami of bankruptcy, and creditors would likely have suffered as well. Watching this horror show, would the leadership at AIG and Lehman have spent more of the next six months seeking to avoid this fate?" Instead, after the Bears bailout every other financial institution expected to be bailed out. Freeman says that the Lehmans Brother CEO was "stunned" to find that his company was allowed to fail.

Here's what I wrote about Bear Stearns one year ago.

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Buy American

It turns out that the "Buy American" provision in the US stimulus package will mean the government can't buy from American economic giants IBM, GE and Proctor & Gamble, all of which derive over half their revenue outside the US.

That's just one small indication of the problem with protectionism. We live in an integrated world, and it's simply no longer possible to "protect" jobs at home.

Some have argued that the Buy American provision will protect only 1,000 US jobs, but has the potential to lose many times that. The reasoning: the provision will mostly affect steel and iron, which are capital-intensive industries. It is estimated that banning government imports of steel will increase US output by 500,000 tonnes - or 1,000 jobs. On the other hand, retaliation could have huge effects. If other governments reduced US imports in their government procurements by just 10%, the US would lose 65,000 jobs.

Another writer reminds us that a "Buy American" provision in the building of a California bridge would have resulted in a $400M increase in the price of the bridge, just because of higher domestic steel prices.

I can't verify these numbers, and I don't know the specific effects on Canada from US protectionism. Recently I heard a steel union representative talking on CBC; he was very confident that US steel companies would not lay off workers here because they had recently invested a lot in the steel factories. A few days later a big US steel company laid off all 1,600 employees at one plant. My point: logical arguments about how "rational" economic agents will behave are not very reliable.

The Buy American provision has another bad consequence: it is leading Europeans like Angela Merkel to criticize growing US protectionism - including even recession-related expenditures like the auto industry bailout, which she calls "distortion and protectionism". Merkel could be laying the groundwork for a troubling new round of trade battles.

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The Rich Use Taxpayer Money to Further Enrich Themselves - As Usual

US President Obama's Chief Economic Advisor Larry Summers on This Morning with George Stephanopoulos today, commenting on AIG paying out $165M in employee bonuses this week ($450M total) after being given $170B in federal bailouts:

"We are a country of law. There are contracts. The government cannot just abrogate contracts."

Will the government adopt the same stance when demanding that auto workers accept cuts to remuneration? In that case, there seems to be a whole different attitude: accept reductions to pay and benefits or you can't expect to keep your job. There are even demands for cuts to payments to auto union pensioners.

If you're going to force auto workers to accept pay cuts for relatively minor bailouts you sure as hell better force financial institutions to accept pay cuts.

To put the bailout in perspective, US taxpayers are paying on average over $1,000 in 2008 - just to bail out AIG. And it's just one of dozens of financial institutions being bailed out. The bailout to the auto industry is going to be something like one 10th of just the AIG amount.

I see the justification in the auto industry negotiations: the auto industry is not profitable, and so costs have to be reduced to make it a sustainable industry. Has the financial industry somehow not been judged in the same way?

Most of the AIG bonuses go to the Financial Products Division, the group that ruined AIG. In the last three months of 2008, AIG lost $62B - the largest losss of any company ever. Some individual bonuses are as large as $6M. The company argues that the average bonus is only $19,000, but you can manipulate the average: the key thing is the top amounts. Plus, the company claims that if they aren't paid people will quit, but really: in today's economy, where will they go? You might argue that they'll sue: well pass a law.

The bonus issue is just part of the scandal at AIG. There are also troubling questions about counterparty payouts: while a company in distress might have forced counterparties to take a cut on payouts (especially since a lot of the transactions were highly speculative), AIG used federal bailout funds to voluntarily pay 100% - and is now resisting efforts to provide a list of who was paid. Again, it seems like the rich and powerful are using government bailouts to transfer money among themselves.

You might argue that it's all about power. AIG is too big to fail so the government's hands are tied. Baloney. The government now owns 80% of AIG. The government has all sorts of options up to and including taking control of the company, sending people to jail, and levying massive fines.

I'm not blaming Obama for this; he has a whole lot better take on this than his opposition. This is just the way the system works. It's a mindset: a paradigm that needs to be broken and replaced with something more equitable. It's doubtful it will ever change. Everyone's mad about this but nobody's mad enough.

Update: Counterparty payments released

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Inflation is Coming! Inflation is Coming!

One of the biggest complaints about our current economic crisis is that it was so unexpected. Why couldn't economists predict it? If we had only had a little advance notice, we could have protected our life savings.

Well, the next stage of the crisis has been predicted and we should all be planning for how to deal with it: inflation. Not just inflation, but possibly hyper-inflation of the like we haven't seen since the early 80s. We can predict the possibility of inflation because of the size of the economic rebound that's coming. It will probably be exacerbated in the US and Canada by the poor implementation of the stimulus packages - particularly, by the delay in implementing them. In the short term we're all focused on the possibility of deflation, but once recovery kicks in inflation will be the problem. That may happen in spring 2010.

How can we deal with inflation?

Inflation erodes wealth, so savings and investments suffer unless they're protected by returns that are higher than the inflation rate. Locking in savings at today's rates is a bad idea. On the other hand, if you can lock in fixed rates when interest rates are high you can do very well. (This was a common success story in the 80s and 90s.) So there's some wisdom in staying liquid.

Inflation erodes the value of debt. Say you put $10,000 on your mortgage this year to pay it down; next year that might only be worth $9,000. On the other hand, interest rates rise due to inflation: mortgage rates got as high as 22% in the early 80s. So locking in mortgage rates is a good idea.

If you don't get cost of living increases in your salary, your real salary decreases. It's a good time to start strategizing on how to keep your salary from eroding.

Of course, inflation isn't going to hit immediately. It will probably take six months to a year before we start to see it, and our central banks may be able to head it off so that we don't get walloped by it at all.

It's going to be a bumpy ride, and new crap is going to be flung at us before it's over. We can't fully protect ourselves, but we can at least brace for the next shock. We should all be planning for how to survive three more years of horrible economic conditions: unemployment, inflation, moribund markets, rollercoaster interest rates, corporate collapses, and the fallout from crisis in government budgets at all levels. An extra concern for Canadians is that our experience in past recessions is that unemployment remained high for a couple of years after the US rebounded.

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Okay, NOW I'm Angry

I've been reading a series of articles in the Washington Post about the financial crisis, called What Went Wrong. Among all the usual details of greed and insane right-wing anti-regulation ideology, one small fact really jumped out at me: one regulatory board, the Office of Thrift Supervision (OTS) was so lax in its oversight that financial institutions found ways to switch their business so they could be regulated by it.

The OTS is the agency that regulates Savings & Loans.

For those who don't remember, the American Savings & Loan crisis of 1986-1991 was so severe that it cost the US over $160B in bailouts and other costs. It was a cause of years of US budget deficits and was a factor in the 1990-1991 recession. Millions of Americans lost their investments and/or their jobs. At the time it was just about the worst financial disaster imaginable.

We were told that the situation had been corrected so nothing like this could ever happen again. In the "Financial Institutions Reform, Recovery and Enforcement Act of 1989" several reforms were put in place. One was the creation of the OTS.

According to an article in the WaPo series (Banking Regulator Played Advocate Over Enforcer: Agency let lenders grow out of control, then fail):
* The OTS referred to the banks it regulated as "customers."
* It referred to subprime mortagages as "innovations."
* After a major bank failed in 2001 the OTS director admitted to congress that its regulation was too lax, but deregulation continued at an enhanced pace.
* Many of the OTS-regulated banks, such as Countrywide and Washington Mutual, are among the biggest bank failures in history.

The reason for the insanity at OTS? OTS is essentially partly privatized: it is funded by assessments on the banks it regulates, with the most of its budget coming directly from the banks. The banks were its customers. The entire problem was systemic, preventable, and foreseeable. And it wasn't like screwing up O-rings on the space shuttle: the Republican-dominated congress that forced all this deregulation on the country did it to enrich their donors.

They could have paid for regulation by increasing taxes and it could have been exactly the same cost to the banks as lower taxes plus regulatory fees, but the ideology dictates that taxes be low and services be paid by user fees. It's one of those subtle differences that spells the difference between a system that works and a system that fails, in this case spectacularly.

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Deglob, Reglob?

For several years, disagrements at the WTO and other international organizations have been leading to pessimism about the sustainability of an integrated world economy.

Less than a year ago, peaking oil prices caused a lot of buzz that high transportation costs would spell the end of globalization.

This week, even the Economist is saying that the "integration of the world economy is in retreat on almost every front."

Criticism of globalization is rising everywhere. One China anlayst summed up the growing frustration in China by saying, "globalization was largely a fraud where Americans could endlessly consume and Chinese factories could endlessly manufacture without any adherence to economic fundamentals and creating a false and bloated version of prosperity and rising living standards."

The thing is, globalization is both desirable and necessary, and we simply can't go back. Without globalization rich countries still trade with each other, but poor countries are shut out or are unequal partners in any agreements they can get into. The WTO brings everyone to the table and even gives vetos to every member country, thus greatly reducing the ability of G20 countries to call all the shots.

Globalization increases prosperity for everyone and it levels the playing field, but it is also just an institutionalization of what is going to happen anyway. The only way global trade is going to stop is if civilization fails and we return to the dark ages. We are an integrated world. Some sorts of trade may become less affordable, but the movement of goods, capital, people and ideas will continue.

I'm for globalization, but I'd like to see some very major tweaks in the way we institutionalize it. We need better mechanisms for democratic control of economic activity. Globalization should be about responsible world governance, not a new way for national elites to circumvent their local laws to further enrich themselves. There should be more transparency and accountability. Globalization was supposed to make the world less vulnerable to business cycles, but it seems that the opposite has happened: world organizations should address this issue explicitly. In addition, transport should truly reflect costs, including the massive pollution caused by ships.

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First Man Standing

As a percentage of GDP, China enacted the biggest fiscal stimulus of any major economy, and it has already started to pay off: some analysts are now describing a V-shaped economic recovery there (unlike the US and Canada, which are still in the lower portion of an L).

As Canada and the US got stuck in political ideology that led us to dick around with programs that are too slow and include too much non-stimulative tax cuts, the autocrats in China were able to act decisively and do exactly what needed to be done.

I can't explain why western media is all about doom and gloom for China, when the opposite seems to be the case. (viz today's Globe article predicting mass political unrest due to unemployment in China, or yesterday's pessimistic Forbes article.) I can just say that there is reason to think that they're wrong, although Chinese economic recovery is not yet a given (they spent $600B on the first stimulus shock, and if their recovery suffers a reversal they may be out of bullets).

That China is poised to lead the world in economic recovery is very significant. As one China analyst notes, "to become a superpower, you really don’t need to have a plan for world domination. You only need to be the last man standing when everyone else has already collapsed." Or more accurately, the first man back on his feet.

Although it's early days, tangible results of China's success may already be starting to show: the economically devastated Taiwan is starting to soften on relations with China; the US, which under George Bush had a policy of isolating China and strengthening ties with India, is now reaching out to China.

But more interesting than the future of superpowerdom (and in any event, as I have argued before, demographics and other factors favor the continued supremacy of the US) are the shorter term effects of China pulling out of the recession first. Increased industrial activity in China will most likely cause an increase in oil prices: the west is currently not in an inflationary period only because of low oil prices, and we could get hit hard if our belated stimulus packages kick in just as there is other inflationary pressure. I would like to think that our governments are planning for this sort of contingency, but there hasn't been much evidence of that so far... they are in reactive mode, and always seem to be reacting to circumstances six months or a year in the past.

UPDATE (October 22, 2009): Chinese economic policy was so successful that China is expected to have 9% growth this year, according to the Financial Times.

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Risk Part 7: Some Basic Accounting Problems

Avinash Persaud, chair of Intelligence Capital, describes current financial regulations as like seat belts that stop working when you need them. He says, "If the purpose of regulation is to avoid market failures, we cannot use, as the instruments of financial regulation, risk-models that rely on market prices, or any other instrument derived from market prices such as mark-to-market accounting. Market prices cannot save us from market failures. Yet, this is the thrust of modern financial regulation, which calls for more transparency on prices, more price-sensitive risk models and more price-sensitive prudential controls. ...if we rely on market prices in our risk models and in value accounting, we must do so on the understanding that in rowdy times central banks will have to become buyers of last resort of distressed assets to avoid systemic collapse."

Persaud argues that financial markets follow a sort-of Heisenberg uncertainty principle: since everyone is seeing the same data, using the same statistical tools, and chasing the same investment opportunities, then "under the weight of the herd, favoured instruments cannot remain undervalued, uncorrelated and low risk. They are transformed into the precise opposite. ...Paradoxically, the observation of areas of safety in risk models creates risks, and the observation of risk creates safety." He wrote in 2000 about the problem of market crises being exacerbated by this phenomenon: "market-sensitive risk models, increasingly integrated into financial supervision in a prescriptive manner... send the herd off the cliff."

Another problem with our current measurement of risk is that it too frequently looks at risk in isolation. In The Case for Collective Risk Reporting, David Shimko, president of Asset Deployment and a trustee at the Global Association of Risk Professionals, provides several examples of times when looking at risk in isolation was inadequate. One horrifying example is that banks do not have collective risk reporting, so can only evaluate the risk of their relationship with a company without knowing how many other banks the company is borrowing from. Another example is trading with an entity when you don't know who else they're trading with, and how vulnerable they are to their other counterparties.

Shimko suggests "a neutral risk report aggregation and disaggregation service, overseen or managed by the Fed, that would report each bank’s risk information on a no-names basis to the peer banks and other stakeholders. In so doing, risk information could be shared while the identity of the bank providing the information could be kept secret."

See also:
Risk Part 1: Issues
Risk Part 2: The Mess
Risk Part 3: Case Study - How Poor Risk Management Caused the Crisis
Risk Part 4: Regulatory Revision
Risk Part 5: Capitalism 2.0
Risk Part 6: Moral Hazard

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Risk Part 6: Moral Hazard

Moral hazard occurs when someone is in a position to take risks that can hurt other people, but that can only result in benefit to the risk-taker.

In our current financial environment, there are several causes of moral hazard:

* Bonuses to investment dealers - Traders invest other people's money, and they suffer no penalty for losing money. They are paid huge bonuses (sometimes as high as 20 to 50%) for showing short-term gains on their investments. This encourages them to invest recklessly - to look for high short-term returns, regardless of long-term problems.
* Layered leverage without transparency - There is a large group of players who benefit from the upside of investments but pass the downside on. These include the mortgage originator, underwriter, and mortgage pool sponsor; and the traders of credit default swaps, collateralized debt obligations and collateralized mortgage obligations.
* Government bailouts - Bailouts mean, essentially, that profit is privatized while risk is socialized.
* Sinecure - Senior management has become an elite group that looks out for itself, regardless of performance. Not only are management bonuses insufficiently tied to company performance, but CEOs who fail in one place are generally able to find similar work elsewhere.

The bad bonus system is not all the fault of the banks. When hedge funds started paying 20% bonuses they started attracting all the best traders, which pretty well forced the banks to increase bonuses.

There are lots of good suggestions for how to change trader incentive by reducing and restructuring bonuses. There's no question those need to be implemented.

But it doesn't help to incentivize the traders to think long-term if the bosses aren't thinking long-term. In fact, a lot of the current criticism smacks of scapegoating. After all, those bonuses got set up because it benefited the guys at the top, and it's at the top that the buck really stops. Currently, the organizational incentive is to push short-term profits at all costs - even at the cost of the company collapsing.

The problem goes beyond reckless investments; problems with over-leveraging and insufficient capital are just as bad, if not worse. By the time of the collapse last fall entire companies were precarious houses of cards that were doomed to collapse when the bubble burst. Worse, the only reason we didn't know it was going to happen was because of insufficient transparency. And all of this was in a heavily regulated, heavily scrutinized industry.

What we need to do is remove, or at least reduce, moral hazard throughout the financial industry. That means we need to go beyond capital requirements and leverage limits and address the root of the problem. People and organizations who have the priviledge of investing money should have to prove their ability to act responsibly. There should be serious jail time for people who take reckless risks. That would be a start.

See also:
See also:
Risk Part 1: Issues
Risk Part 2: The Mess
Risk Part 3: Case Study - How Poor Risk Management Caused the Crisis
Risk Part 4: Regulatory Revision
Risk Part 5: Capitalism 2.0
Risk Part 6: Moral Hazard
Risk Part 7: Some Basic Accounting Problems

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Risk Part 5: Capitalism 2.0

If the only lesson we get out of the current financial crisis is that we need to tweak the regulatory system, then we are in BIG trouble. Tax-payers in the western world are paying trillions of dollars to profit-taking corporations. This bailout may be necessary, but it is deadly dangerous. Every time we bail them out they get a little more complacent about taking risks that leave them needing more bailouts.

Make no mistake: these people have a mandate and it is to make as much money as possible. Their commitment to maximizing profits is as zealous as commitment can be. Like the creature on the late show, they will not stop. Like the Mississippi River, when they hit an obstruction they will overflow banks and find new routes. Even in the face of enormous pressure to act responsibly, after taking billions in bailout money they paid themselves billions in bonuses. The bailout became just another strategy to accumulate wealth, and that is just the nature of our current economic system.

Capitalism 2.0 is a change in basic principles: from "working to create value for shareholders" to "working to sustainably create value for all stakeholders". There are two key differences here:

Term - Decision making considerations need to move from short-term to long-term. Currently, the entire system is set up so that players make short-term decisions that put money in their pockets, and once there, they own it: there's no giving it back. Meanwhile, the decisions they make have long-term effects on everyone else. In the last few years the principle of short-term advantage was pushed to the limit by investment traders. The system encouraged them to make decisions that yielded short-term bonanzas but ulitimately caused the entire system to collapse.

Scope - The beneficiaries of business decisions need to move beyond a narrow group of the power elite. We charitably call this group shareholders, but in Cap1 a company is disproportionately run for the benefit of a handful of senior executives. (To get an idea of some of the extra remuneration head honchos give themselves, go to http://finance.yahoo.com, type a stock symbol or company name in the "Get quotes" box, and then scroll down the page and click on "Insider Transactions" in the left column.)

One example: we have to nationalize parts of our banks. Nassim Taleb has been arguing for this. There is a "utility" function to banks, clearing cheques and the like, that is fundamental to the running of our economy but that is threatened by the risk-taking parts of the bank. I have to agree that the utility functions of banks should be nationalized, and that everyone must understand that the risky investment part of banks will never again be bailed out.

The need for nationalization goes beyond the banks. Over and over in this crisis we hear people saying that there are companies that are too big to fail. And when the Bush administration ignored that warning and let Lehman Brothers fail, chaos descended. The lesson has to be that the market cannot be allowed to handle everything.

The idea of nationalization may seem shocking to some, but it's really not a huge change from the present. Paul Krugman wrote recently, "not a week goes by without the FDIC taking several smaller banks into receivership. Nationalization is actually as American as apple pie." Most of the world's biggest oil companies are nationally owned. The move to privatize hydro operations is quite a recent phenomenon. Americans are horrified by the idea of "socialized medicine", but we in Canada are quite comfortable with a medical system that doesn't insert profit-takers throughout the process.

Another fundamental change required by Cap2 is the move from rule-based regulation to principle-based regulation. In Cap1, businesses can do anything that is not illegal. Business should be regulated in the way that driving is: you need to demonstrate fitness to participate. Part of this is rethinking what is legitimate business. For example, Robert Bonfiglio says, "Buying a Credit Default Swap that exceeds the actual amount of what you are protecting, or on something you don't own or have any money invested in, is gambling and should be subject to taxes and the laws of gambling in the state which the bet is placed."

The Cap1 concept of financial oversight is simply a joke. The watchdog for all the Wall Street hedge funds was a handful of inexperienced bureaucrats. And the models that are used in credit risk are a joke, analysing single transactions without looking at all the transactions of an organization. There needs to be so much more oversight that the concept of oversight reaches another dimension. We need a holistic approach to risk management. (See The Case for Collective Risk Reporting and the article "Integrated Risk Assessment", here.)

Capitalists have proved that they will act just as predicted by economic models, and that that means they can't be trusted. You may argue: what about corporate donations? But corporate donations are a way to create goodwill, which is just another line on the balance sheet. It reduces taxes, increases brand value, and makes shares worth more. It also gives personal advantages to senior executives who administer and fete the money they are giving away (which does not come out of their own pockets).

The ability of the Cap1 capitalist to find loopholes and routes around the rules are as powerful as the aforementioned creature on the late show and Mississippi River. Then once they get around the rules and make their money, our Cap1 value structure lauds them for being wealthy. A case in point is Conrad Black. Now in jail as a convicted felon, he was the cock of the walk for 25 years after being exposed as a con man in Peter Newman's best-selling "The Canadian Establishment". He was an important man because he was rich, even though we knew he was a crook.

For a long time we have known that the system is rotten, but have been told that while imperfect, it is the most efficient way to operate. The current collapse of the financial system has changed all that.

Part of our acceptance of Cap1 was a phony dichotomy between unfettered capitalism and state-centralized communism, as if those were the only options. Now that capitalism isn't working, it's clear that we need to find another option.

Capitalism has changed whether we accept it or not. We have entered a period of extreme business cycles. In the upswing there is enormous wealth-mongering that inevitably leads to a crash that requires bailout. Some call this corporate socialism but that is much too kind a word, as it is really a massive fraud perpetrated on the public by the power elite. The remuneration that senior executives at large corporations pay themselves has gone way beyond any fair amount required by competition to keep good talent - especially since top executives now get hundreds of millions of dollars a year even when the company loses money, and even (in the form of golden parachutes) when they are fired. It's not about attracting talent: it's about power rewarding itself. It has been going on for years, but recently has been on a sharp increase. There's only one word for it: egregious.

After all the scandals and all the trillions in bailouts, if we don't have the will to take real action now we'll never have it. And we need to strengthen our resolve to make some real structural change. Only when we accept the principle of Cap2 ("the purpose of business is to sustainably create value for all stakeholders") can we start to transform our political-economic system into something that works for the people.

The question is whether we can grab the monkey by the tail and get a harness on it. Every lobbyist in every national capital will be against this one, and the politicians are mostly part and parcel of the same community.

Update: Greenspan Backs Bank Nationalization

See also:
Risk Part 1: Issues
Risk Part 2: The Mess
Risk Part 3: Case Study - How Poor Risk Management Caused the Crisis
Risk Part 4: Regulatory Revision
Risk Part 5: Capitalism 2.0
Risk Part 6: Moral Hazard
Risk Part 7: Some Basic Accounting Problems

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