Plugging the leaks

With pain and misgiving, the United States Congress bailed out Wall Street in order to prevent a meltdown of America’s financial system. But the $700 billion to be used may flow into a leaky bucket, and so may the billions provided by governments throughout the world.

The US financial institutions that went bankrupt in 2008 – or that would have gone bankrupt without government help – were in trouble because they lacked equity capital. They did not lack that capital because they never had it, but because they paid out too much of their abundant earnings in previous years to shareholders, leveraging their operations excessively with debt capital. If no measures are taken to increase the minimum equity requirements for banks and other financial institutions, financial crises like the current one could recur.

Anglo-Saxon financial institutions are known for their high dividend-payout ratios. From a European perspective, the hunger for dividends and the emphasis on short-term performance goals that characterize these institutions is both amazing and frightening. Investment banks, in particular, are known for their minimalist equity approach. While normal banks need an equity-asset ratio of at least 7%, investment banks typically operated on a ratio of only 4 percent.

The lack of equity resulted largely from the concept of “limited liability,” which provided an incentive for excessive leveraging. Earnings left inside a financial institution can easily be lost in turbulent times. Only earnings taken out in time can be secured.

Lack of equity capital, in turn, made risk-averse shareholders hire gamblers to manage their limited-liability investment companies. The managers chose overly risky operations, because they knew that the shareholders would not participate symmetrically in the risks.

While upside risks would be turned into dividends, downside risks would be limited to the stock of equity invested. Claims against the personal wealth of shareholders would be blocked by the limited liability constraint. The banks’ creditors or governments ultimately would bear any losses. The mutual interaction between the incentive to minimize equity capital and the incentive to gamble in order to exploit the upside risks caused America’s crisis.

In theory, bank lenders and the government could anticipate the additional risks they encounter when a company chooses a high-leverage strategy. Lenders may charge higher interest rates, and the government may charge higher taxes or fees.

But this theory fails to match reality. Governments do not tax the return on equity less than debt interest, and lenders do not sufficiently honor the benefits of high equity with lower interest rates, owing to a lack of information about the true repayment probability. This is why equity capital held by financial institutions typically is more than twice as expensive as debt capital and why these institutions try to minimize its use.

The provision of limited liability not only turned Wall Street into a casino, but so-called “Main Street” also was induced to gamble, because homeowners enjoyed a limited liability similar to that of the companies. When low-income borrowers took out a loan to buy their homes – often 100% of the purchase price – they typically could use the home as collateral without warranting the repayment with additional wealth or even their income. Thus, they were protected against the downside risk of falling house prices and profited by speculating on the upside risk of appreciation.

Such homeowners knew that with rising prices they would be able to realize a gain by either selling their homes or increasing their debt, while in the case of falling prices they could simply hand over the keys to their banks. Given the uncertainty about future house prices, they could reasonably expect gains, which induced them to pay even more in the first place. Gambling by Main Street caused the sub-prime crisis.

The crisis spread because the banking system was not sufficiently risk-averse – and in some cases even seemed to relish risk. Mortgage banks kept some claims on their books, but sold most of them to investment banks as “mortgage-backed securities.” The investment banks blended these securities into “asset-backed securities” and “collateralized debt obligations” (CDOs) and sold them on to financial institutions throughout the world. These institutions, attracted by the high rates of return that were promised, invariably neglected the downside risks.

The buyers of the CDOs were often misguided by rating agencies that performed badly and did not provide reliable information. As private rating agencies live on the fees they collect from rated companies, they cannot easily downgrade important clients or the assets they sell. The big American investment banks received excellent ratings up to the last moment, and so did the CDOs with which they betrayed the world.

All of this explains why the US had such a formidable period of growth in recent years, despite the fact that household savings were close to zero, and why foreigners were willing to finance a record US current-account deficit of more than 5 percent of GDP – higher than it has been since 1929. That period is now over.

The US must carry out fundamental reforms of its financial system to plug the equity leaks and recover investors’ confidence. But even then it will have a hard time continuing to sell financial assets to the rest of the world. American households will need to learn to accumulate wealth by cutting consumption rather than speculating on real estate. A painful decade of stagnation for America lies ahead.

Hans-Werner Sinn is Professor of Economics and Finance, University of Munich, and President of the Ifo Institute.

Copyright: Project Syndicate, 2008

Who killed Wall Street?

You don’t have to break a sweat to be a finance skeptic these days. So let’s remind ourselves how compelling the logic of the financial innovation that led us to our current predicament seemed not too long ago.

Who wouldn’t want credit markets to serve the cause of home ownership? So we start by introducing some real competition into the mortgage lending business. We allow non-banks to make home loans and let them offer creative, more affordable mortgages to prospective homeowners not well served by conventional lenders.

Then we enable these loans to be pooled and packaged into securities that can be sold to investors, reducing risk in the process. We divvy up the stream of payments on these home loans further into tranches of varying risk, compensating holders of the riskier kind with higher interest rates. We then call on credit rating agencies to certify that the less risky of these mortgage-backed securities are safe enough for pension funds and insurance companies to invest in. In case anyone is still nervous, we create derivatives that allow investors to purchase insurance against default by issuers of those securities.       

If you wanted to showcase the benefits of financial innovation, you could not have come up with better arrangements. Thanks to them, millions of poorer and hitherto excluded families became homeowners, investors made high returns, and financial intermediaries pocketed the fees and commissions. It might have worked like a dream – and until about a year and a half ago, many financiers, economists, and policymakers thought that it did.

Then it all came crashing down. The crisis that engulfed financial markets in recent months has buried Wall Street and humbled the United States. The near $1 trillion bailout of troubled financial institutions that the US Treasury has had to mount makes emerging-market meltdowns – such as Mexico’s “peso” crisis in 1994 or the Asian financial crisis of 1997-1998 – look like footnotes by comparison.  

But where did it all go wrong? If our remedies do not target the true underlying sources of the crisis, our newfound regulatory zeal might end up killing useful sorts of financial innovation, along with the toxic kind.

The trouble is that there is no shortage of suspects. Was the problem unscrupulous mortgage lenders who devised credit terms – such as “teaser” interest rates and prepayment penalties – that led unsuspecting borrowers into a debt trap? Perhaps, but these strategies would not have made sense for lenders unless they believed that house prices would continue to rise.

So maybe the culprit is the housing bubble that developed in the late 1990’s, and the reluctance of Alan Greenspan’s Federal Reserve to deflate it. Even so, the explosion in the quantity of collateralized debt obligations and similar securities went far beyond what was needed to sustain mortgage lending. That was also true of credit default swaps, which became an instrument of speculation instead of insurance and reached an astounding $62 trillion in volume.

So the crisis might not have reached the scale that it did without financial institutions of all types leveraging themselves to the hilt in pursuit of higher returns. But what, then, were the credit rating agencies doing? Had they done their job properly and issued timely warnings about the risks, these markets would not have sucked in nearly as many investors as they eventually did. Isn’t this the crux of the matter?

Or perhaps the true culprits lie halfway around the world. High-saving Asian households and dollar-hoarding foreign central banks produced a global savings “glut,” which pushed real interest rates into negative territory, in turn stoking the US housing bubble while sending financiers on ever-riskier ventures with borrowed money. Macroeconomic policymakers could have gotten their act together and acted in time to unwind those large and unsustainable current-account imbalances. Then there would not have been so much liquidity sloshing around waiting for an accident to happen.

But perhaps what really got us into the mess is that the US Treasury played its hand poorly as the crisis unfolded. As bad as things were, what caused credit markets to seize up was Treasury Secretary Henry Paulson’s refusal to bail out Lehman Brothers. Immediately after that decision, short-term funding for even the best-capitalized firms virtually collapsed and the entire financial system simply became dysfunctional.

In view of what was about to happen, it might have been better for Paulson to hold his nose and do with Lehman what he had already done with Bear Stearns and would have had to do in a few days with AIG: save them with taxpayer money. Wall Street might have survived, and US taxpayers might have been spared even larger bills.

Perhaps it is futile to look for the single cause without which the financial system would not have blown up in our faces. A comforting thought – if you still want to believe in financial sanity – is that this was a case of a “perfect storm,” a rare failure that required a large number of stars to be in alignment simultaneously.

So what will the post-mortem on Wall Street show? That it was a case of suicide? Murder? Accidental death? Or was it a rare instance of generalized organ failure? We will likely never know. The regulations and precautions that lawmakers will enact to prevent its recurrence will therefore necessarily remain blunt and of uncertain effectiveness.

That is why you can be sure that we will have another major financial crisis sometime in the future, once this one has disappeared into the recesses of our memory. You can bet your life savings on it. In fact, you probably will.

Copyright: Project Syndicate, 2008.

Ethical business

Research recently carried out by Ethical Investment Research Services (EIRIS), a research organisation designed to reflect the investment principles of the group of churches and charities that helped set it up, found that the top listed companies on the London Stock Exchange have made great strides in the past five years to tackle ethical issues head on, spurred on by the demands of “responsible” investors and stakeholders.

According to the research, in the last three years (2005 – 2007) over 80% of company policies and over 70% of management systems with regards to environmental policy are assessed as being “good” or “exceptional”, with a four fold increase in companies assessed as having exceptional environmental policies.

The survey also found that there has been a significant move towards tackling wider corporate responsibilities such as human rights. For example, EIRIS found that 94% of companies operating in countries of concern have some form of human rights policy, and over a third of these (39%) are considered “advanced”.

But some experts query aspects of EIRIS’ research, in particular its focus on the top 100 companies. Mark Chadwick, CEO at environmental management consultancy Carbon Clear, says that there needs to be a much wider review than just to look at the world’s largest 100 companies. “There are thousands of small and medium enterprises out there – just in the UK alone – as well as some other very large companies that aren’t listed on the FTSE that think that ethical and socially responsible behaviour and disclosure do not apply to themselves,” he says.

It is fair to say that the level of investor pressure and regulatory obligation for firms outside of the FTSE100 or listed on other exchanges such as the Alternative Investment Market (AIM) is much lower than for those listed on the main exchange. Consequently, those companies do not feel compelled to constantly improve their ethical behaviour or level of disclosure about corporate governance, meaning that EIRIS’ findings are likely to be more than a little skewed.

According to Chadwick, legislation such as the UK’s Carbon Reduction Commitment is going to force more organisations – and not just the largest in terms of revenue – to take more notice of their environmental and social policies. This is because the legislation, a new mandatory emissions trading scheme which begins in January 2010, will force all organisations whose electricity consumption is over 6000 megawatts per hour to bid for further allowances to cover their emissions. At the end of each year the government will compile performance tables to show which organisations have managed to reduce their carbon emissions the most. The government estimates that the rules will affect over 5,000 UK organisations.

“This kind of legislation, which takes a wider view than just focusing on 100 entities, will ultimately compel the majority of organisations in the UK to take their ethical, environmental and social responsibilities more seriously because it’s enshrined in law. We all know that legal risk is one of the key drivers of changing corporate behaviour,” says Chadwick.

Other business monitoring groups believe that the UK’s largest companies have a responsibility to encourage greater disclosure and compliance with industry best practice in the smaller companies that they deal with, such as suppliers and other contractors. They think that the “clout” that larger companies have to dictate terms will be a key driver in enforcing compliance with ethical codes.

Philippa Foster Back, director of the Institute of Business Ethics (IBE), an organisation that promotes ethical business practices, says that “from our research, around 60%-65% of companies in the FTSE350 have codes of ethics, compared to over 90% in the FTSE100. We believe that the world’s largest companies have the opportunity and responsibility to help smaller companies become more ethical because they now think that smaller companies have the obligation to act more ethically.”

But does such encouragement amount to corporate bullying? Already, some firms – particularly those in the US – are forcing suppliers (especially in developing countries like China and India) to sign contracts which stipulate that any ethical breach stays at a local level – meaning that if the US firm is found at fault for unethical behaviour on the part of a foreign supplier (for example, the supplier uses child labour), then the supplier agrees to take the rap.

On paper it may sound fair enough – why should a company in the US take the blame for practices in its supply chain that it does not carry out in its own workplace – but the reality can be quite different. Regulators and enforcement agencies have already picked up on the idea that these companies may be using their suppliers from the developing world as scapegoats, and so are now more inclined to look more deeply at the ethical guidelines that they are asking such companies to abide by.

Gateway to growth

Saudi Arabia is one of the world’s top 10 emerging and developing countries, and the largest Arab economy, with 10 percent of the total GDP of the Middle East.

It has more than 25 percent of the world’s oil reserves and a current estimated revenue surplus of €34bn. Private investors are developing €54bn of energy sector specific projects. The country’s resources go beyond oil, however – it has known gold deposits totalling 20 million tonnes, and an estimated 60 million tonnes of copper deposits that have not yet been exploited.

It also has one of the world’s fastest growing IPO markets, and the largest equity market in the Middle East, with approximately 120 listed companies, which is also ranked as the 11th largest stock market in the world. However, investors outside the GCC – the Gulf Cooperation Council, covering Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates – have been barred until now from participating in the Tadawul, the Saudi stock market, which was founded in the 1930s, although the Tadawul All Share index has a market capitalisation of about €305bn. Indeed, it was only in 1997 that investors from the other GCC states were allowed to participate in the exchange, and even then they were barred from buying shares in banks and insurance companies, a rule that was dropped just a year ago. The result is that around 90 percent of all business on the Tadawul is by individual Saudi investors. The only way Western investors have been able to access the bourse has been through the under-developed mutual funds sector.

Further investment
On August 20, however, the Capital Market Authority of Saudi Arabia (CMA) announced it would be allowing the entry of non-resident foreign investors on the Saudi bourse through a “swap agreement” with what will be termed “authorised persons”.

The “authorised persons” will retain the legal ownership of the shares and agree to transfer the economic benefits of the Saudi companies listed on the Tadawul to non-resident foreigners. Both institutional as well as individual investors from abroad will be allowed to invest, the CMA said.

Bankers operating in Saudi Arabia, which has a population of about 25 million and it is ruled by the Al Saud dynasty, have been pushing for greater liberalisation to allow foreign participation, not only because their overseas customers want to participate in the growth of the Saudi economy, but also, they say, because having foreign retail and institutional investors involved would reduce some of the volatility found in the Saudi stock exchange, which is dominated by retail investors who, it is claimed, buy and sell too much on rumours and emotion rather than market-based analysis.

The Saudi authorities must also be hoping that allowing foreign investors in at last will also help lift the Tadawul, which has been one of the worst-performing markets in the region this year. In 2006, the market fell by more than 50 percent. Although it rose 43 percent in the final quarter of 2007 it has been down about 24 percent this year.

Expanding expertise
However, the CMA is undoubtedly aware that the country’s stock market could be damaged by a flood of fresh liquidity, something that, because of high oil prices, the whole of the GCC area is suffering from an excess of, which threatens to accelerate already rising inflation. For this reason the liberalisation of the Saudi bourse is progressing slowly and cautiously, step by step. One analyst commented after the announcement on August 20: “It is a step towards further liberalisation of the market, but more importantly it shows that the Saudis want to do this very gradually and very slowly for two reasons. One is that opening up the market to foreign investors brings up more liquidity and that’s the last thing they need right now. But what they [the Saudis] are interested in is bringing in expertise, hoping that the presence of foreign investors will slowly force local investors to adopt much more transparent rules of doing business.”

Commentators certainly see big benefits from the liberalisation, however. Another said: “This development will undoubtedly increase foreign capital inflows to the Kingdom’s stock market, promote greater transparency, reduce volatility associated with dominance of the retail investors in the Saudi market, and encourage more comprehensive equity research on listed companies.” The aim, observers believe, is that by gradually opening up the Tadawul, the CMA can encourage Saudi Arabia to become a major competitor with the UAE and Qatar for the title of the region’s financial centre. Just before the announcement that foreigners would finally be allowed to participate in the market, the CMA also issued new regulations saying that investors with stakes of five percent or higher had to disclose their positions, a move intended to increase transparency and reassure other potential investors.

Taking the right steps

One company that has already set up arrangements to act as an “authorised person” for foreign investors, both retail and institutional, looking to take advantage of the new regulations announced by the CMA on August 20 is FALCOM, based in Riyadh, with branches in Jeddah and Khubar. FALCOM, which was established in 2005, provides Islamic investment banking services including asset management, brokerage services, investment advice and treasury products. It now has 150 employees and a capital base of one billion Saudi riyals (€185m), and runs an internet trading service for customers called Tadawuly, and a suite of tools for stock market technical analysis through www.falcomwatch.com. FALCOM Financial Services was recently awarded the “Best New Investment Bank 2008’ award by Global Finance & Arabian Business, and it is about to open its doors to investors in the GCC region with a licence to operate in Oman.

FALCOM’s Chief Executive, Adib Al Suwailim, said the move by the Saudi Capital Markets Authority to allow non-resident foreign investors access to the stock market through “benefits swap agreements” with authorised licensed intermediaries who would legally own the shares is “a clear sign of liberalisation of the equity markets in the near term. With this move, the CMA has taken yet another investor-friendly step.”

The scale of interest “is likely to be tremendous across the board, and the Saudi market is currently performing well below its historic levels,” Mr al Suwailim said. “The initiative comes at the right time, when sentiments in the local market are down and valuations are attractive. This measure will cheer up the investors who witnessed the meltdown of the bull run in 2006 and fluctuating fortunes over the next two years. The Tadawul All Share Index, the market benchmark, has lost 23.3 percent to date in 2008. Over the longer term, the entry of sophisticated and deep-pocketed investors will lead to reduced volatility.”

FALCOM is now inviting institutional and retail investors to open accounts with it through which they can invest in a total benefits swap and thus gain access to the Saudi Arabian stock exchange. “FALCOM, being a member of the exchange, will execute the transactions, and buy and hold shares in the investor’s name, with an undertaking to transfer unconditionally the economic benefits of the holding to the ultimate beneficiary, the foreign investor, through the counter party broker,” the company said.

The company backs up its services with what it describes as “innovative financial products and wealth maximising solutions, ably assisted by a highly tech-savvy and dedicated professional team committed to support our client needs with benchmark standards of integrity, proficiency and commitment.”

It also provides a report service called FALCOM MarketToday, which covers valuable information such as valuation parameters, TASI support/resistance levels, last 10 days coverage, average prices on the day, money movers, 52-week high/lows and so on, much of it information not covered by any other investment banker, it says, and released by 4.30pm every day. Another of the company’s services, FALCOM MarketWeek, covers not just fundamental information but also stock volatility, weekly performance of stocks, company research, stock market research, strategy reports, and economic research are also regular feature.

Overall, FALCOM says, it believes that the announcement by the CMA will attract huge interest from foreign investors looking to diversify their portfolios. The Saudi stock market is “the most lucrative in the region because of its size and liquidity”, the company says, and the IPO market has been “abuzz with activity over the past two years. In 2007, 25 new companies were listed whereas so far in 2008, 15 new companies have been listed.”

Observers say they expect public companies in Saudi Arabia to open up to foreign investors gradually, albeit on a limited basis, over the next few year, probably under a system like the one in operation in Qatar, where foreigners are restricted to 25 percent ownership in all stock, or the UAE, where foreigners cannot own controlling stakes. All the same, the agreement on all sides is that the CMA’s move is good news for everybody, from Saudis to outsiders.

For further information shankar.biswas@falcom.com.sa

Mixed US economic winds

It would not be so bad for the president if a sizable fraction of the electorate shared his continuing optimistic delusions. Instead, in cities, towns and countryside, plain people of both political parties now fear that even twice 20,000 new US troops sent to Iraq would fail to create a viable and prosperous Iraqi democracy. There is, perhaps, one area where President Bush is enjoying some unearned luck. That area is the US macro-economy.

In terms of economics the six Bush years have not lived up to the Kennedy-Johnson 1960s growth era; nor to the Clinton epoch of 1994-2000. Still, during 2001-06 the record for real growth and freedom from inflation has been moderately OK on Bush’s watch. Don’t think that it was Bush’s promised program of “compassionate conservatism” that fended off unemployment and persistent recession. It was certainly not faith-based compassion that lowered tax burdens on my affluent neighbours in the comfortable suburbs.

In writing up for the future record books, top economic historians will give major credit to the Greenspan and Bernanke Federal Reserve. As with most of today’s central banks, the Federal Reserve policy-makers are accorded a degree of independence from both the executive and legislation branches of government. I cannot award Alan Greenspan a perfect A-plus grade: Unwisely he did opt to let the late-1990s Wall Street stock market bubble run its course for too long. And, rashly, Dr Greenspan did given his blessing to the Bush tax giveaway to the most affluent.

However, in comparison with the general run of past US and global central bankers, Greenspan did exercise canny flexibility. Will Gov. Ben Bernanke’s new bid for explicit inflation targeting work out better than Greenspan’s flexibility? Only time will tell. Two new unforeseeable complications have been testing Bernanke’s preferred strategy. First came the recent supply-side shock from OPEC’s oil-price rise that for a time doubled petroleum price to $80 per barrel. Second, the Federal Reserve did have to lower interest rates more than a dozen times to fend off the recession brought on by the bursting of Wall Street’s late 1990s stock market bubble. Inadvertently, this contributed to a housing and real estate bubble. I write ‘contributed to’ because in any case the US was susceptible to similar real estate bubbles experienced in both Europe and Asia.

If we are ever tempted to think economics has become an exact science, reality disabuses us from our hubris. No experts predicted that those many lowerings of US interest rates would principally stimulate consumption spending rather than, as Keynesians used to think, principally stimulate capital formation. Why think expanded consumption spending to be worse than expanded investment spending? The answer is this: Bush already inherited a US society opting to save less than the country will need down the road when 10 years from now the post-1946 baby boom generation will be retiring.

A cautious and sound Republican fiscal policy would certainly not concentrate on cutting out inheritance taxes on the ultrarich. That tactic perforce shifted the emphasis onto monetary rather than fiscal policy to counter the 2001-03 recessionary forces. Some approving words can be said for reducing the tax rates on corporate dividend receivers to 15 percent and reducing the long-term capital gains tax rate also to 15 percent. Admittedly these new measures will not serve to reverse globalisation-induced inequality of incomes. Still, objective experts must concede that they do get some credit for stepping up the US’s ‘total-factor productivity.’ It is this last process that America’s future growth pace must depend upon most.

What about the new Democratic control of both houses of Congress? This will serve to check the bale influences of lobbyists and tendencies toward ‘plutocratic democracy.’

Raising the minimum wage will be irresistibly popular. But its macro impact will not be great. Market wage rates have already risen to beyond $7-plus per hour. Don’t expect material reduction in inequality to come from this measure. The 2006 electoral landslide against the Republicans provides no mandate for a new burst of trade union militarism. Under globalisation that path would markedly speed up loss of American jobs to lower-paid workers in Asia and Eastern Europe. It is centrist democratic actions that will maximise the probability of a Democratic president being elected in 2008.

A stampede to protectionism ought, in my judgment, to give way to restoration of regulatory programmes and fiscal programmes that go some cautious distance toward transferring some of the winnings from globalisation to the lower-middle classes, who are both numerous and hurting. Easy for me to map out such realism, but it will be devilishly hard to contrive the compromises necessary to evolve toward a ‘golden mean’ mixed economy.

© 2007 Paul Samuelson, Distributed By Tribune Media Services, Inc.

Coping with the global financial panic

All through the many years of the 1929-1939 Great Depression, Wall Street publicists and President Herbert Hoover would repeatedly announce: “Recovery is just around the corner.” Yale university’s great economist Irving Fisher preached the same message. They were wrong. And history repeats itself.

Today, Federal Reserve Gov. Ben Bernanke admits that nobody, including himself, is able to guess how near to bankruptcy the biggest banks in New York, London, Frankfort and Tokyo might be as a result of the real estate crisis.

Why this new vacuum of non-transparency? As one of the pioneer economists who helped create today’s utterly new-fangled securities, I must plead guilty that these new mechanisms both (1) mask transparency, and (2) tempt to rash over-leveraging.

Why should my non-economist readers care about the above technicalities? The best reason is that we must worry whether the policy tools that served so well for Alan Greenspan’s Federal Reserve and for the Bank of England will now have to be changed.

It used to be enough for the central bank to “lean against the wind.” That means, lower its interest rates when unemployment is too high and deflation threatens. And when business growth is too brisk, central banks are supposed to raise their interest rates to dampen growth and to forestall price-level inflation that threatens to exceed 2 percent per year.

This month, central bankers and Treasury cabinet officers cannot know whether current interest rates are high or whether they are low.

Surprising but true. Safest bond interest rates are indeed low. But financial panic engendered by the burst bubble of unsound U.S. and foreign mortgage lending means that even mammoth General Electric would find it expensive now to finance a loan needed to build a new and efficient factory.
The situation is not hopeless. New, rational regulations that discourage predatory lending and rash borrowing could have helped a lot.

Stabalising
Also, as we learned during the Great Depression, the government’s treasury and its central bank must be both the lenders of last resort and the spenders of last resort. Speculative markets will not stabilize themselves.
The art of best policy is actually the middle way. Not too much freedom for market forces. And definitely not too little freedom.

Global markets have moved into a new epoch. China, India and even Russia and Ireland are currently growing at almost twice the pace of the United States and the core countries of the European Union. Gone are the days when a U.S. president can command the ocean tide to come in and command it to go out.

The U.S. population is five percent of the global total. And still it enjoys per person about 20 percent of total global output. That’s the picture now. Will this last?

When I come to write a newspaper piece like this 10 years from now, I believe America may still lead the pack in average real per capita affluence. But in all probability, the China that has already displaced Japan as the economy with the second biggest total gross domestic product will likely, by 2017, have a total GDP equal to America’s.

When that happens, a typical Chinese family will still be a lot poorer than a family in the United States or even Ireland! Remember, China’s population is several times that of America or any European country. Don’t even ask me what the U.S. dollar in 2017 will be worth.

President George Bush and Vice President Dick Cheney will be long since retired on their respective Texas and Montana ranches, but their rash 2000-2007 tax-cut-and-spend policies will by then have harvested the follies that they foolishly sowed.

Since we live ever in the short run, global leaders must make their best guesses about what to be doing in 2008. Here are my tentative suggestions.

Watch the developments alertly. If America’s Christmas retail sales fail badly — as they could do when high energy prices and high mortgage costs pinch consumers’ pocket books — then be prepared to accelerate credit infusions by central banks on the three main continents.

Price instability
Keep in mind threats of excessive inflation. But be aware that the skies will not fall if the price-level indices blip up from 1.9 to 2.6 percent per annum. What worsens the public’s expectations about price instability is excessive spike-ups in the cost of living chronically maintained.

Finally, to reduce the burden of mass foreclosures of over-expensive mortgages, pioneer as we did with the Depression-era Reconstruction Finance Corp. to explore new quasi-public agencies that specialiSe in supplementing for-profit ordinary lenders.

This suggests expanding in a controlled way the lending powers of quasi-public agencies such as Fannie May and Freddie Mac. Better that they should lose a bit when they help homeowners of modest means fend off foreclosures on their onerous mortgages. Maybe such novel innovations will turn out not to be needed. But keeping in mind worst-case freezing up of bank and other lending agencies, advance exploratory planning will be worthwhile insurance.

What the world does not need now is tolerance for any persistent weakness in global Main Street growth. It is better when physicians worry unduly about a patient’s health than when they worry too little. Good advice also for governmental leaders.

© 2007 Paul Samuelson Distributed By Tribune Media Services, Inc.

Globalisation and its discontents

For reasons we shall never know, thereafter China stagnated. It was the Dutch society in the Age of Exploration that ended highest on the flagpole of per capita Gross National Product. Then in the 17th century, Isaac Newton, standing on the shoulders of Copernicus, Kepler and Galileo, initiated our current epoch of continuous scientific progress. For two centuries, up to the late years of Empress Victoria’s reign, it was Britain that ruled the roost.

Around 1900, Britain’s rebellious child, America, with its plentiful resources, took over world economic leadership. However, 30 years from now, experienced historians in 2037 will probably trace America’s decline relative to the billions of Chinese back to the likes of young President George Bush, Vice President Dick Cheney and Cheney’s minions.

History shows that historians never do get things quite right. Even if voters had put the most perfect philosopher kings into office between 2000 and 2008, by mid-century the population living on the Pacific Rim, one-third of the world’s total, would still have surpassed North America plus Europe in total real economic output.

Why and how? It will be much the same story of how and why the United States was able to learn and utilise the best technology known to the Germans, French and British. Freed of Communist Mao’s know-nothingism, low-wage Chinese have similarly been able singularly to copy Western technologies.

By coincidence, a billion low-paid, educable workers in India – freed of Nehru’s Fabian socialism – will also increasingly out-compete more and more initially higher paid North American and Western European workers.
Readers will misinterpret my text if they think that it foretells a dismal story for the present affluent regions. Economics, unlike geopolitics, is not a zero-sum game. When Germany’s Bismarck defeated France’s Louis Napoleon in 1870, that was indeed a zero-sum political-power game, where one side lost what the other side gained. By contrast, when Japan gained on America in per capita real income from 1950 to 1990, that did not imply any falling off of US per capita real income. US GDP per capita, in the Age After Keynes, in fact continued to rise, and did so faster than in historic capitalism’s past laissez-faire periods.
 
Let me now add what needs to be added in any essay on ‘Globalisation and its Discontents:’
1) The market mechanisms necessary and sufficient to propel total productivity, alas, will invariably at the same time exacerbate inequalities between winners and losers.

Digression: Simon Kuznets, a great quantitative economic historian, guessed wrong about the future. Professor Kuznets opined that initial growth would first worsen equality; but later, he expected, competitive markets would restore greater equality. Nobel Prize winners can, alas, be wrong. Laissez-faire market capitalism has never yet arched downward measures of inequality between the luckiest rich and the no-longer-secure middle classes!)

2) The lush fruits of science, which bring us improved life expectancy and greater quality of living, also worsen our environment and ramp up our vulnerability to the devastation of war and terrorists’ malevolence.

3) What can keep economics the Non-dismal Science are the considerations that the potentialities of science itself can (a) enable us to limit contamination of air and water and (b) rectify (somewhat) the degree of worsening inequalities.

4) Will our democratic political system automatically achieve these good offsets against environmental evils and pitiable income and wealth inequalities? No. Definitely not. These admirable things happen only if the majority of voters do, purely out of altruistic impulses, agree to tax some of the winners’ winnings and use these things to reduce some of the losses that the market will mete out to the losers.

Let me now get realistic. During the Great Depression, under Franklin Roosevelt’s eloquent New Deal leadership, we voters did have a feeling, “We are all at risk together. There but for the grace of fate, I would be jobless and homeless.” Therefore, in great majority, we voters did opt from 1932 until 1980 for a mixed society and not for a libertarian, laissez-faire, market-only civilisation.

That’s the way voters still think in successful places like Finland and Denmark. In those places, libertarian economists with names like Milton Friedman and Friedrich Hayek are little mentioned. Yet when polls about ‘happiness’ are taken around the world, it is from such mixed-economy places that the bulk of people report themselves to be ‘least unhappy’ and ‘least anxious.’

Realism and conscience require me to record a final weighty warning.

No democratic government anywhere can successfully second-guess the market mechanism by extreme transfer programmes from rich to poor in the hope of levelling out family differences in wealth and income. At best, the Golden Mean of the feasible best must utilise limited state-enforced income redistributions.

© 2007 Paul Samuelson, distributed by Tribune Media Services, inc.

Finding the new golden economic centre

In the first decades after World War II ended, Germany, Japan, France and even Italy did well. So they earned A or A-plus grades. Then, increasingly after 1960, new growth winners emerged: On the Pacific Rim, hot on Japan’s heels followed Taiwan, Singapore, Hong Kong and South Korea.
 
In the European Union, core countries such as Britain, France and Italy began to lose the momentum that the successful American Marshall Plan had stimulated. Gradually Spain, Finland, Norway, along with Holland and Belgium, gravitated to being lead bicycle riders in the growth sweepstakes.
Which regions were notoriously absent from the good-news headlines?

Sadly, many of the African countries that newly got their independence degenerated into one-dictator regimes. And, alas, in the Middle East, except for places generously blessed with oil resources, both the economic and the political scenes have been pitiable.

In contrast to today’s positive growth in China and India, a couple of billion folk who lived in those places between 1950 and 1970 were faring badly when so many of their neighbours were developing so rapidly. There is no mystery why mainland China stagnated miserably. Mao’s brand of communism was perpetually a dismal failure. Steel mills in the backyard were a joke – a bad joke.

Now we know what could not be understood back then: The Chinese population, given a chance to thrive in market economies, did possess tremendous potential. Mercantile successes by Chinese outside of China – in places like Malaysia and Indonesia – suggested strongly that the epoch after Mao’s death could be the great success that has actually taken place if only the market would be given a try.

Liberation from the empire
The Indian story involves some essential differences. The British Empire had brought considerable schooling to the Indian peninsula. After liberation from the empire in 1947, Indian’s great leader was the aristocratic Nehru, who favoured bringing from the West economic advisers steeped in British Labour Party Fabianism. Therefore, the Fairy Prince of the market mechanism was late in coming to awaken India from its sleep. But better late than never.

Economic history teaches no simple lessons. But the weight of past experience suggests strongly that one-party bureaucratic organisation of production and consumption does a bad job everywhere in giving people a good and growing standard of living.

Be warned, though. Don’t go from one extreme to another. No one knows better than 21st century economists that unregulated laissez-faire market mechanisms – unchecked by democratic governmental regulations and sensible macroeconomic policies – will generate both systemic income inequalities and boom-and-bust business cycles.

Before the 1929 Wall Street crash, pretty much pure capitalism prevailed, not only in America but also throughout the advanced West. Back then, before the age of penicillin and CAT scans and echograms, physicians also were limited in their ability to cure diseases and prolong quality of life.

Economic science was in a similar fix. It didn’t know then how to temper and attenuate the vicissitudes of economic fortune. That’s why economics had long earned the title the Dismal Science.

Personally, I knew all that well. The economic textbooks read at our top universities had little to say about the great worldwide depression as it worsened after 1929. Harvard and Chicago were alike in this respect when I attended them on comfortable scholarships. But both were late in recognizing the actual new facts of life. That was then. This is now. Probably France in the next few years will pick up steam under its new President Nicholas Sarkozy. Fanatical US patriots will then say, “France’s new success comes from aping the American pattern.”

Universally true
That’s a wrong interpretation. Yes, America’s business cycles have gentled down considerably. But this has been universally true. I’d prefer to say that such future French successes (if they materialise) are because they have begun to do some of the things that Ireland and Finland have been doing.

What are they? Among other things, the past activities of strong US trade unions dealing with Americans Fortune 500 corporations have vanished. Why? You might say that the AFL-CIO big unions committed suicide in the new free-trade globalized environment because every past union ‘victory’ actually betokened a defeat, which speeded the exit of US of auto, computer and myriad other manufacturing activities.

My sermon is not aimed for people abroad. Bush-Cheney Republicanism has been harmful in both Iraq geopolitics and its encouragement of corporate misgovernance. That’s why the Democratic Party is most likely to sweep our November 2008 elections. In the present scenario, non-centrist wings of the Democratic Party can gain considerable advantage. Republican strategists hope they will grow. Since the US electorate has not turned leftish en masse to any appreciable degree, the best last hope of the Machiavellian Republicans is that 2008 Democratic candidates for office preach protectionism and anti-market phobia.

Defining and reaching the optimal centre is not easy. And by definition, the centre is duller than the dubious extremes that surround it. Two basic truths will dramatize this. 1) Pruning back the give-to-the-richest tax breaks of President Bush’s will little affect America’s Schumpeterian innovation propensities. A good reason to do that pruning. And 2) However, at best, most of the new inequalities traceable to globalised and internal free trade cannot be achieved by any feasible acts of good government.

Centrist improvements are important but modest. Dramatic proposals from either the left or right will once again be proved in the long run to be fools’ gold only.

© 2007 Paul Samuelson Distributed By Tribune Media Services, Inc.

Teaching times

A century ago, the esteemed philosopher George Santayana warned, “Those who ignore history will be condemned to repeat it.” One can add, “And those of us who do know history will be condemned to repeat it with them.”

Why did our top experienced experts fail to anticipate the worldwide financial turmoil brought on by the 2006 bursting of the real estate bubble?

No one can be a perfect forecaster. But leaders do differ in their long-run average of prediction accuracy. Alan Greenspan, during his decades of public service and private consulting, was definitely better than most. Prior to 1997, he made only a few bad calls. But mostly these were venial sins, not what theologians call mortal sins.
However, just before his January 2006 retirement as top Federal Reserve governor, Chairman Greenspan made the mortal error that will mar forever his reputation.

While just before his eyes the bursting of the subprime mortgage bubble was taking place, Greenspan viewed it all through rose-colored glasses.

New models of financial engineering, under rash deregulation, were exploding with dysfunctional finance. To Dr. Greenspan, this looked like clever risk-bearing by respected Wall Street activists.

What was dysfunctional before and after the fact looked rosy to Dr. Greenspan. I suspect this traces to his gut remembrances of Ayn Rand extreme libertarianism.

Greenspan has been in plentiful company. None of the CEOs for the biggest investment banks ever had the least understanding of the mathematics of derivatives or of the intransparency and hyper-leveraging they were involving themselves in.

Now Wall Street Journal pundits tell us on Monday, Wednesday and Friday “the worst is behind us.” But on Tuesday, Thursday and Saturday, pundits tell us “the worst is yet to come.”

Which is right? What knowledge of past history could help answer that timing question? Actual economic history, almost by definition, is what mathematicians call a non-stationary time series. Their past probabilities can be helpful, but only somewhat. And when new things happen, palaver about history can sometimes be materially harmful.
There can always be something new under the sun — even if you shouldn’t bet on it. The 1929-1939 Great Depression couldn’t happen. But it did.

Hitler’s Germany almost won World War II. But it didn’t.

All of the above is a way of saying that no one can now know when the global economies will recover from recent serious turmoil.

This one can know, however. The system cannot be counted on to heal itself. Fed chief Ben Bernanke did the right thing when he stretched the powers of our central bank to check the financial bleeding.

My guess is that after the Democratic Party victories in November 2008, new shifts in policy toward the center will be needed: (1) to improve sensible regulating; and maybe (2) the U.S. will have to rely in the end on myriad federal spending to clean up the financial engineering messes.

That was what had to be done in both the United States and Germany back in the 1933-1939 period of recovery achieved by depression brought on by massive deficit (!) spending. This, and not easier credit by central banks, is what mostly restored job opportunity to the one in three American and German workers who were suffering long-term unemployment.

Searching for scapegoats is all too easy. The SEC monitors of speculative risk-takers were asleep at the switch. So were central bankers in the U.S., the U.K. and the new EU central bank.

And where were the great, tried-and-true accounting firms? They were leading and abetting the charge into unknown abysses of leveraging and risk-taking, rather than controlling against them. The list goes on and on.
I stop at the abject failure of the three principal rating agencies.

They indiscriminately gave AAA ratings to good fish, foul fish, and stinking-foul foul fish. Why? Because, of course, they would otherwise lose the fat fees their customers paid only to messengers of good-sounding news.
To sum up, the financial system on President Bush’s watch became systemically fragile and dangerous.

After all my bad news, it may come as cheerful when I say that the mess is not incurable. With time and good sense, after next November’s victory for centrist policies, each of the grave ills can be improved upon.

However, because homes, offices and factories are such long-lived durable goods, the housing meltdown is likely to last for years, not months. Furthermore, realists must expect the early kind of unwise actions by the Democratic victors: Such marred Franklin Roosevelt’s New Deal programs during his first few years in office. Also, the good economic deeds from President Clinton came mostly during his second term in the White House.

No democracy is perfect. One worrisome thing is the kind of promising to special groups that the victors had to make in order to become victors.

I leave for another day the threat of extreme protectionism bred by how much the middle classes have suffered during Bush’s eight years in office.

(C) 2007 PAUL SAMUELSON DISTRIBUTED BY TRIBUNE MEDIA SERVICES, INC.

The economist dogs that didn’t bark

Destined to burst – as it did burst and still does fester – it surprised and shocked global central bankers and Washington bureaucrats.

More importantly, the collapse of home prices bred huge losses for both rich and poor. That was an obvious effect of plunging price drop.

However, undreamed of was the actual fact that the whole global structure of credit — including credits quite unconnected with real estate or mortgage lending — froze up so as to threaten bankruptcy and losses to ordinary businesses and families.

I will try to sketch out briefly the main macroeconomic story of the last dozen years, globally and in the US.

In the last half of the 1990s, innovational improvements in technology did raise US and global productivity. That in turn set off a Wall Street stock market bubble.

All bubbles grow from their own momentum. I buy stocks because you have bid their prices up. You buy more stocks because I’ve pumped their prices up. Beautiful while it lasts.

Governor Alan Greenspan at the Federal Reserve observed this, but decided not to intervene. (Maybe he thought it would be enough to handle the mess when the bubble burst. Also, in line with his conservative youth, he would rashly say publicly: Intelligent and experienced bankers and accountants discern new sound values. Who are we to say they’re wrong?)

What is forgotten is that in every bubble, the biggest fool looks temporarily like the wisest and soundest pundit.

The Wall Street bubble burst in the spring of 2000. On schedule, a global recession set in. Sensible expansion-of-credit policies by the European Central Bank, the Bank of England and the Federal Reserve were able to keep the recession short and mild.

Worldwide low interest rates then set off a real estate bubble. How fortuitous to always have a new bubble replace a vanished bubble.

Financial frenzy
It is pointless to ask why governmental macro-economic agencies didn’t try out strong preventive regulating to cool down the crazy lending and borrowing practices in the 2000-2005 mortgage markets. They did not.
Academic economists were little better than public officials. Here is just one example: A guest columnist for the New York Times – well trained and a professor at an elite university — pointed out that one virtue of the frenzied financial practices was that they broadened home ownership by less affluent folk.

Yes, but no warning was given by that expert on how home ownership, coaxed out by misleading sub-prime lenders, translates in terms of economic science into dangerous leveraged high-cost betting on a real estate bubble that is to last forever.

Now I come to the biggest surprise of all. Back in, say, 1990, when there had been a previous drop in home prices, people got mortgages from their local banks. Such bankers knew a lot about their customers and the local neighbourhoods. Lenders and borrowers had a mutual interest in avoiding and minimising foreclosures of home ownership. That was then.

In the last decade, a thousand unregulated hedge funds have been born. New and non-transparent options (puts, calls, swaps) have replaced simply owning stocks and bonds outright, free of leveraging loans.

Furthermore, today’s mortgages are being ‘securitised.’ Banks divide them into graded packets. The most sound loans promise the lowest earning yields. The inflated loans to bad credit risks are sold to pay the buyer the highest yield — highest unless it goes into default. Does all this sound innocent and safe? Readers will hardly believe it when they are told that the rating agencies — Moody, Fitch, McGraw-Hill, S&P — blindly awarded highest AAA ratings to both the good-cheese packets and the rotten-cheese packets.

Economists and bankers hailed these new ways that could spread risk-sharing efficiently. What we didn’t foresee was that instead of reducing riskiness, these new instruments can tempt folks into leveraging two to one, 10 to one, and even 50 to one.

Why would the rating agencies bless both the good and the bad? Those who sell these non-transparent packets pay the rating agencies. Common sense assures that those who rate will get the most business and the most profits if they tell their customers what those customers want to hear so that they can persuade gullible risk-takers to pony up funds to keep the housing bubble bubbly.

Attention deficit?
This kind of bad stuff we expected back in 19th-century rigged plutocratic markets. Or maybe in the post-2000 island tax havens. But surely not in the US, EU, UK, Japan or Korea.

Central banks are supposed to monitor money-market procedures. My hypothesis is that Federal Reserve Governor Ben Bernanke or Bank of England Governor Alwyn King were focusing so intensely on targeting against excessive inflation that this diverted their attention away from the looming credit crunch in private markets.

Repeatedly, we heard economists declare: Central banks ought not to bail out foolish investors from losses due to rash investing. To do that would encourage more future rashness in investing.

True enough. But once Rome was burning, Nero could not let things take their course to teach people how to be careful with matches.

Finally, late but not too late, the European Central Bank led the Federal Reserve and even the Bank of England into averting macro-financial crises by pumping newly created moneys into the banking system.
Better late than never.

© 2007 Paul Samuelson Distributed By Tribune Media Services, Inc.

How rash deregulation bred our financial plague

“May your children live in interesting times.” That was an ancient curse, not a cheerful wish. Wars and revolutions are exciting stories. Peaceful, prudent prosperity is oh so dull. That’s the way macro-economics seemed to evolve between 1980 and 2005, both in America and more widely around the globe. How deceptive.

1) Inflation allegedly had been tamed at the cost of only two short back-to-back recessions in the 1980-81 period, when Gov. Paul Volcker ruled at the Federal Reserve.

2) This was followed by the salubrious Wall Street stock market bubble that Merlin the Magician, in the person of the wily Alan Greenspan, allowed to fester in its happy way.

“After all,” Dr. Greenspan remembered from his day in the Ayn Rand litter, “if prudent people invest in appreciating stocks or bonds, who are we to second-guess them by lowering permitted margin leveraging or by jacking up Fed interest rates?” Joseph Schumpeter’s innovations hopefully could be counted on to raise all ships.

The inevitable happened just when George Bush captured the presidency in 2000, and when Republican majorities reigned in both houses of Congress.

Bush’s “compassionate conservatism” translated into compassionate tax giveaways to the plutocrats, along with new deregulating of corporate accounting.

Cynics in Wall Street called it the new age of Harvey Pitt. Pitt was appointed to be chairman of the Securities Exchange Commission precisely because he had been legal counsel to the Big Four accounting firms.
Pitt’s first speech proclaimed the new day of a “kinder SEC.”

Loopholes
Lawyers, accountants and CEO’s caught Pitt’s innuendo: Reach for that dubious tax-avoidance loophole, and the IRS will not mind. Conceal losses and exaggerate profits by various off-balance-sheet devices that violate strict accounting rules legislated in the years before Bush.

Why rehash this somewhat old hat history? For one good reason.
Today’s global bankruptcies and macroeconomic quagmires trace directly to the financial engineering shenanigans that the Bush era officialdom both countenanced and encouraged. Young George Bush did not only make a mess of Mideast politics. In addition, the Bush-Rove version of plutocratic democracy accomplished the singular alchemy of converting a usual plain-vanilla boom-and-bust in housing into an old-fashioned, hard-to-manage, worldwide financial panic.

This time America was the Eve in Eden who tempted Swiss, German and U.K. bankers into eating the evil apple of non-transparency and unconscious gross over-leveraging.

Did Ayn Rand or libertarian Milton Friedman ever anticipate that Adam Smith’s marketplace Eden would come to the present disorder? Where were Bank of England Gov. Mervyn King and the heads of the European Central Bank and the Bank of Japan while the disasters were unfolding?
Just like the usual mediocre CEOs, world leaders never focused on the dangerous winds that were beginning to blow.

If today were 1929, the present financial epidemics would be the prelude to a prolonged worldwide depression. Fortunately, economic history has taught us a lot since then.

Central banks, as Walter Bagehot in the nineteenth century and Charles Kindleberger in the twentieth taught, are primarily the lenders of last resort. As Kipling would put it, “What do they know of money if only money they know?” When stocks and bonds are burning up or freezing down, preoccupation with inflation targeting, Gov. Bernanke’s initial mantra, is not nearly enough.

Whirlwind
Main Streets everywhere on the globe are waiting anxiously to see how governments cope with the whirlwind that excessive deregulation sowed: lost jobs; depleted saving nest eggs; high energy and raw material prices; negative capital gains on homes and diversified portfolios. Of course, some of these trace to one’s own sins of omissions and commissions. Some do arise from supply shocks: from interruptions in Mideast oil drilling, and from inflation of raw materials and foodstuff arising from new Chinese demands for better living standards. But more stem from the faulty social housekeepers who voters, rich and poor, elected to the highest offices in the land.

The old slogan, “It’s the economy, stupid,” finally penetrated into the White House. On schedule, with the speed of light, President George Bush, who had been taught better at Yale, seriously proposed making permanent the rash tax giveaways and deregulations that have brought on today’s economic scandals.

Discredited, radical-right supply-siders from President Reagan’s first-term circus came out of retirement to ask again for no taxes on the earnings of capital in favour of reliance for vital government services on flat taxes on wage earners.

When fear of risk stifles both investment and consumption spending, sensible and measured fiscal budgetary spending is the prescription to augment central banks’ lowering of interest rates.

What follies electorates perpetrate can be offset in future elections. However, it is a commonplace that today money buys votes legally. Therefore, realists will temper their optimism with guarded caution.

© 2008 Paul Samuelson. Distributed by Tribune Media Services, Inc.

President Bush digs in

In democratic politics, things change more slowly. Because President Bush’s first term was judged by the electorate to have been a geopolitical disaster in the Middle East, the Democratic rivals to Bush’s Republican party captured control of both chambers of Congress – a slim Senate majority, a larger House of Representatives majority, along with considerable repudiation of Bush policies by some in his own party.

Any who expected the new Democratic victors to initiate immediate drastic changes have had to learn the facts of life about how democracies operate. Yes, eventually the Democrats will achieve their promised raise in the minimum wage. But that will be almost a non-event. A few low-skilled jobs will become a bit better paid. So low will still be the new elevated minimum wage, relative to actual wage rates now paid, little good and little harm will be the only result.

Main Street Americans are so discouraged about the Iraq war and its endless daily casualties of US soldiers, all other political conflicts – including the economic ones – become overshadowed. Realists are resigned to the fact that if 21,000 additional young Americans get put into harm’s way, it will still be the case that civil war and terrorist chaos will continue in Iraq when we do pull out of there. Vietnam taught Americans the same hard lesson: Give up on hopeless ventures.

Thoughtful questioners ask present-day economics pundits: When the US stops spending trillions of budget deficits on Iraq-like wars, will the American economic locomotive be slowed down to a walk? Will there follow a 2007-08 US recession? If so, will it be big enough to lead to global macro slumps?

Nothing about the future can be 100 percent certain. But weighing all the different statistical evidence, I have to agree with the consensus view that 2007 will continue to be a moderately growing period for US gross domestic product and for employment. Why? First because our central bank, the Federal Reserve, has the powers and the savvy to lean strongly against any deflationary winds that might develop. Concretely, this means that Chairman Ben Bernanke and his confederates can stimulate credit and spending by cutting interest rates more than half-a-dozen times.

My words will not placate die-hard Wall Street Bush supporters who labor under the illusion – the delusion – that it has been this president’s rash giveaway tax reductions to those already affluent that brought about recovery from the 2002 recession following from Wall Street’s pricked 1997-2000 speculative bubble.

These ideologues forget that the important accelerations in total factor productivity of today’s America took place under the higher tax structure of the Clinton-Rubin era. Was this a one-time exception? No. The history books record how fast post-war America did grow under Roosevelt-Truman-Kennedy-Johnson. New times call for new wisdom. Centrist Democrats in concert with centrist Republicans can work out better policies than we had in the Gilded Age of the 1890s when Rockefeller monopolists in oil and Carnegie monopolists in steel controlled prices uncompetitively.

It was not wisdom when President Bush appointed Harvey Pitt to head the Securities and Exchange Commission — a man who announced in his first speech, “I am going to run a gentler and kinder SEC.” Having been law counselor to the four or five big accounting firms whose peccadilloes were to burgeon on his watch, his message was not: Pursue more efficiency if you wish for higher rewards. What his listeners heard was, “Reach out for new tax loopholes, You won’t be crucified for doing so.” Ironically, Enron, Arthur Andersen Accountants and WorldCom miscreants, whose feet were to be held to the first by Elliot-Spitzer-type prosecutors, might complain that they had been set up in a ‘sting game’ by Washington.

Under Reagan-Bush-Bush regimens, inequality between the wage of the CEO and median corporate workers has exploded from 40-to-1 to 400-to-1. Has that raised or lowered incentives to step up genuine economic growth?

My answer is that it has bribed top executives and the directors boards they dominate into the go-for-the-quick misrepresentation of corporate earnings. And to go for feasible stock options that present corporate shareowners with heads-insiders-win/tails-shareowners-lose.

Alas, somewhere some economists can be found to bless these corporate misgovernances. I am sure that if the late Milton Friedman had been asked to pronounce on the merits of ignoring option awards as a corporate cost in certifying operating earnings, that conservative libertarians would have avowed; Professor Hotelling at Columbia taught me that options do add to CEO pay by an objective present-discounted-value formula.

Each day in office, President Herbert Hoover made votes for Franklin Roosevelt, his successor. George Bush operates in the same Hoover mold.

As cynics say: History doesn’t repeat itself. But it does rhyme.

© 2007 Paul Samuelson, distributed by Tribune Media Services, inc.

America’s failed militarized foreign policy

Many of today’s war zones – including Afghanistan, Ethiopia, Iran, Iraq, Pakistan, Somalia, and Sudan – share basic problems that lie at the root of their conflicts. They are all poor, buffeted by natural disasters – especially floods, droughts, and earthquakes – and have rapidly growing populations that are pressing on the capacity of the land to feed them. And the proportion of youth is very high, with a bulging population of young men of military age (15-24 years).
All of these problems can be solved only through long-term sustainable economic development. Yet the United States persists in responding to symptoms rather than to underlying conditions by trying to address every conflict by military means. It backs the Ethiopian army in Somalia. It occupies Iraq and Afghanistan. It threatens to bomb Iran. It supports the military dictatorship in Pakistan.

None of these military actions addresses the problems that led to conflict in the first place. On the contrary, American policies typically inflame the situation rather than solve it.

Time and again, this military approach comes back to haunt the US. The US embraced the Shah of Iran by sending massive armaments, which fell into the hands of Iran’s Revolutionary Government after 1979. The US then backed Saddam Hussein in his attack on Iran, until the US ended up attacking Saddam himself. The US backed Osama bin Laden in Afghanistan against the Soviets, until the US ended up fighting bin Laden. Since 2001 the US has supported Pervez Musharraf in Pakistan with more than $10bn in aid, and now faces an unstable regime that just barely survives.
US foreign policy is so ineffective because it has been taken over by the military. Even postwar reconstruction in Iraq under the US-led occupation was run by the Pentagon rather than by civilian agencies. The US military budget dominates everything about foreign policy. Adding up the budgets of the Pentagon, the Iraq and Afghanistan wars, the Department of Homeland Security, nuclear weapons programs, and the State Department’s military assistance operations, the US will spend around $800bn this year on security, compared with less than $20bn for economic development.

In a stunning article on aid to Pakistan during the Bush administration, Craig Cohen and Derek Chollet demonstrated the disastrous nature of this militarized approach – even before the tottering Musharraf regime’s latest crackdown. They show that even though Pakistan faces huge problems of poverty, population, and environment, 75 percent of the $10bn in US aid has gone to the Pakistani military, ostensibly to reimburse Pakistan for its contribution to the “war on terror,” and to help it buy F-16s and other weapons systems.

Another 16 percent went straight to the Pakistani budget, no questions asked. That left less than 10 percent for development and humanitarian assistance. Annual US aid for education in Pakistan has amounted to just $64m, or $1.16 per school-aged child.

The authors note that “the strategic direction for Pakistan was set early by a narrow circle at the top of the Bush administration and has been largely focussed on the war effort rather than on Pakistan’s internal situation.” They also emphasize that “US engagement with Pakistan is highly militarized and centralized, with very little reaching the vast majority of Pakistanis.” They quote George Bush as saying, “When [Musharraf] looks me in the eye and says…there won’t be a Taliban and won’t be al-Qaeda, I believe him, you know?”

This militarized approach is leading the world into a downward spiral of violence and conflict. Each new US weapons system “sold” or given to the region increases the chances of expanded war and further military coups, and to the chance that the arms will be turned on the US itself. None of it helps to address the underlying problems of poverty, child mortality, water scarcity, and lack of livelihoods in places like Pakistan’s Northwest Frontier Province, Sudan’s Darfur region, or Somalia. These places are bulging with people facing a tightening squeeze of insufficient rainfall and degraded pasturelands. Naturally, many join radical causes.

The Bush administration fails to recognize these fundamental demographic and environmental challenges, that $800bn of security spending won’t bring irrigation to Afghanistan, Pakistan, Sudan, and Somalia, and therefore won’t bring peace. Instead of seeing real people in crisis, they see caricatures, a terrorist around every corner.

A more peaceful world will be possible only when Americans and others begin to see things through the eyes of their supposed enemies, and realize that today’s conflicts, having resulted from desperation and despair, can be solved through economic development rather than war. We will have peace when we heed the words of President John F. Kennedy, who said, a few months before his death, “For, in the final analysis, our most basic common link is that we all inhabit this small planet. We all breathe the same air. We all cherish our children’s future. And we are all mortal.”

Copyright Project Syndicate, 2007. www.project-syndicate.org

Putting politics aside to save Iraq

American decisions in the next few months will not be able to end the crises in Iraq and the Middle East before the change of American administrations; they may drive them out of control. Even while the political cycle tempts a debate geared to focus groups, a bipartisan foreign policy is imperative.

The experience of Vietnam is often cited as the example for the potential debacle that awaits us in Iraq. But we will never learn from history if we keep telling ourselves myths about it. The passengers on American helicopters fleeing Saigon were not American troops but Vietnamese civilians. American forces had left two years earlier. What collapsed Vietnam was the congressional decision to reduce aid to Vietnam by two-thirds and to cut if off altogether for Cambodia in the face of a massive North Vietnamese invasion that violated every provision of the Paris Peace Accords.

Should America repeat a self-inflicted wound? An abrupt withdrawal from Iraq will not end the war; it will only redirect it. Within Iraq, the sectarian conflict could assume genocidal proportions; terrorist base areas could re-emerge.

Under the impact of American abdication, Lebanon may slip into domination by Iran’s ally, Hezbollah; a Syria-Israel war or an Israeli strike on Iranian nuclear facilities may become more likely as Israel attempts to break the radical encirclement; Turkey and Iran will probably squeeze Kurdish autonomy; and the Taliban in Afghanistan will gain new impetus. Countries where the radical threat is as yet incipient, as India, will face a mounting domestic challenge. Pakistan, in the process of a delicate political transformation, will encounter more radical pressures and may even turn into a radical challenge itself.

That is what is meant by ‘precipitate’ withdrawal – a withdrawal in which the U.S. loses the ability to shape events, either within Iraq, on the anti-jihadist battlefield or in the world at large.

The proper troop level in Iraq will not be discovered by political compromise at home. To be sure, no forces should be retained in Iraq that are dispensable. The definition of “dispensable” must be based on strategic and political criteria, however. If reducing troop levels turns into the litmus test of American politics, each withdrawal will generate demands for additional ones until the political, military and psychological framework collapses. An appropriate strategy for Iraq requires political direction. But the political dimension must be the ally of military strategy, not a resignation from it.

Public concerns
Symbolic withdrawals, urged by such wise elder statesmen as Sens. John Warner, R-Va., and Richard Lugar, R-Ind., might indeed assuage the immediate public concerns. They should be understood, however, as palliatives; their utility depends on a balance between their capacity to reassure the U.S. public and their propensity to encourage America’s adversaries to believe that they are the forerunners of complete retreat.

The argument that the mission of US forces should be confined to defeating terrorism, protecting the frontiers, preventing the emergence of Taliban-like structures and staying out of the civil-war aspects is also tempting. In practice, it will be very difficult to distinguish among the various aspects of the conflict with any precision.

Some answer that the best political result is most likely to be achieved by total withdrawal. The option of basing policies on the most favourable assumptions about the future is, of course, always available. Yet, in the end, political leaders will be held responsible — often by their publics, surely by history — not only for the best imaginable outcome but for the most probable one, not only for what they hoped but for what they should have feared.

Nothing in Middle East history suggests that abdication confers influence. Those who urge this course of action need to put forward what they recommend if the dire consequences of an abrupt withdrawal foreseen by the majority of experts and diplomats occur.

The missing ingredient has not been a withdrawal schedule but a political and diplomatic design connected to a military strategy. Much time has been lost in attempting to repeat the experience of the occupations of Germany and Japan. Those examples, in my view, are not applicable. The issue is not whether Arab or Muslim societies can ever become democratic; it is whether they can become so under American military guidance in a timeframe for which the U.S. political process will stand.

Western democracy and that of Japan developed in largely homogeneous societies. Iraq is multi-ethnic and multi-sectarian. The Sunni sect has dominated the majority Shia and subjugated the Kurdish minority for all of Iraq’s history of less than a hundred years. In homogeneous societies — even in societies where divisions exist without being rigid — a minority can aspire to become a majority as a result of elections. That outcome is improbable in societies where historic grievances follow existing ethnic or sectarian lines and are then enshrined in the political structure through premature elections.

Reconciliation vs. conflict
American exhortations for national reconciliation are based on constitutional principles drawn from the Western experience. But it is impossible to achieve this in a six-month period defined by the American troop surge in an artificially created state wracked by the legacy of a thousand years of ethnic and sectarian conflicts. Experience should teach us that trying to manipulate a fragile political structure — particularly one resulting from American-sponsored elections — is likely to play into radical hands. Nor are the present frustrations with Baghdad’s performance a sufficient excuse to impose a strategic disaster on ourselves. However much Americans may disagree about the decision to intervene or about the policy afterward, the US is now in Iraq in large part to serve the American commitment to global order and not as a favour to the Baghdad government.

It is possible that the present structure in Baghdad is incapable of national reconciliation because its elected constituents were elected on a sectarian basis. A wiser course would be to concentrate on the three principal regions and promote technocratic, efficient and humane administration in each. The provision of services and personal security coupled with emphasis on economic, scientific and intellectual development may represent the best hope for fostering a sense of community. More efficient regional government leading to substantial decrease in the level of violence, to progress toward the rule of law and to functioning markets could then, over a period of time, give the Iraqi people an opportunity for national reconciliation — especially if no region is strong enough to impose its will on the others by force. Failing that, the country may well drift into de facto partition under the label of autonomy; such as already exists in the Kurdish region. That very prospect might encourage the Baghdad political forces to move toward reconciliation. Much depends on whether it is possible to create a genuine national army rather than an agglomeration of competing militias.

Diplomacy
The second and ultimately decisive route to overcoming the Iraqi crisis is through international diplomacy. Today the United States is bearing the major burden for regional security militarily, politically and economically while countries that will also suffer the consequences remain passive. Yet many other nations know that their internal security and, in some cases, their survival will be affected by the outcome in Iraq and are bound to be concerned that they may all face unpredictable risks if the situation gets out of control. That passivity cannot last. The best way for other countries to give effect to their concerns is to participate in the construction of a civil society. The best way for us to foster it is to turn reconstruction step-by-step into a cooperative international effort under multilateral management.

It will not be possible to achieve these objectives in a single, dramatic move. The military outcome in Iraq will ultimately have to be reflected in some international recognition and some international enforcement of its provisions. The international conference of Iraq’s neighbours, including the permanent members of the Security Council, has established a possible forum for this. A U.N. role in fostering such a political outcome could be helpful.

Such a strategy is the best road to reduce America’s military presence in the long run; an abrupt reduction of American forces will impede diplomacy and set the stage for more intense military crises further down the road.

Pursuing diplomacy inevitably raises the question of how to deal with Iran. Cooperation is possible and should be encouraged with an Iran that pursues stability and cooperation. Such an Iran has legitimate aspirations that need to be respected. But an Iran that practices subversion and seeks hegemony in the region — which appears to be the current trend – must be faced with red lines it will not be permitted to cross. The industrial nations cannot accept radical forces dominating a region on which their economies depend, and the acquisition of nuclear weapons by Iran is incompatible with international security. These truisms need to be translated into effective policies, preferably common policies with allies and friends.

None of these objectives can be realized, however, unless two conditions are met: The United States needs to maintain a presence in the region on which its supporters can count and which its adversaries have to take seriously. Above all, the country must recognise that bipartisanship has become a necessity, not a tactic.

© 2007 Tribune Media Services, Inc.