naked capitalism

There is so much crookedeness among our elites that it’s hard to know, absent more systematic study, whether Harvard is playing a leading role in this decline.

However, the glaring gap between Harvard president Drew Faust’s talk on ethics and her recent actions has stuck with me and I’ve concluded it merits discussion.

One of the basic rules of corporate behavior is that who you pay, promote, and appoint to plum jobs sends strong messages about what sort of behavior the organization really values, as opposed to the ones it professes to value. One common way in which companies signal that the official policies don’t matter all that much is via the Big Producer Syndrome. That occurs when individuals or units not only reap high compensation and other rewards, but are also subject to lower oversight. Most Wall Street firms, in the days when they were partnerships, recognized the need to strike a balance between giving employees the latitude to grasp fleeting opportunities and making sure they didn’t wind up doing harm to the franchise in the long term. The firms that didn’t manage that tension well over time were less successful than the ones that did. But that concern has long gone out the window in a world where financial services companies play with other people’s money and the notion of ethical standards is a quaint relic.

Nevertheless, when the ethics of executives generally and some of its graduates in particular come under harsh scrutiny, Harvard Business School tries to do a bit of image burnishing. After HBS grad Paul Bilzerian was sentenced for securities fraud in 1989, which was also when savings and loans and leveraged buyout companies were collapsing, the school went through a bit of soul searching. I was told by someone deeply involved in fundraising that it had concluded, based on some study, that ethics could not be taught, so it needed to rethink how it selected incoming students. I doubt anything came of that, since there hasn’t been any evidence of meaningful changes in Harvard’s or other school’s screening policies. Sociopaths could easily game any questions aimed at getting at ethical stances and real due diligence on that front would take more time and effort than an admissions department could undertake.

Fast forward twenty plus years. We’ve seen widespread bad behavior among the political and corporate elites, with Harvard at least holding its own. Former Harvard president Larry Summers was singled out by Inside Job as an example of corruption among academic economists. That isn’t surprising, since Summers protected fellow Harvard economics professor Andrei Shliefer when he and one Jonathan Hay were charged with conspiracy to defraud the US government, and Harvard was sued for breach of contract over an advisors program Shliefer and Hays ran in Russia in the 1990s. Some have claimed the real reason the faculty eventually revolted against Summers wasn’t his famed foot in mouth incident about women in math, but simmering anger about the failure to take action against Shliefer given that Harvard paid at least $31 million to settle the litigation.

Summers’ successor, Drew Faust, has tried to signal that Harvard has changed direction under her leadership, but her gestures range from unconvincing to all too revealing. For instance, she talked a good deal about how Harvard Business School had lost its ethical direction (that of course assumes it ever had one) and made a great deal of fuss about the selection of a new new dean who would help remedy this problem. From the Boston Globe:

A professor who has a strong interest in business ethics will become the new dean of Harvard Business School, at a time when the corporate world’s image has been pummeled by fallout from the 2008 collapse of financial markets and ongoing allegations of corruption and greed….

In his more than two decades on the school’s faculty, Nohria has been particularly active in business ethics, frequently writing and speaking on the need for changes in business and leadership training. A 2008 article written by Nohria and fellow faculty member Rakesh Khurana for the Harvard Business Review said “managers have lost legitimacy over the past decade in the face of a widespread institutional breakdown of trust and self-policing in business.’’ The two called for a “rigorous code of ethics’’ for business leaders, similar to the medical profession’s Hippocratic Oath.

If you believe crossing your heart and swearing you will behave in an upstanding manner will make an iota of difference in corporate conduct, I have a bridge I’d like to sell you.

Indeedm, Faust seems to be a fan of the sort of ethics posturing that is regularly lampooned by Lucy Kellaway of the Financial Times. Last April, she pointedly refused to take up a call by professor and former Harvard college dean Harry Lewis to criticize (mind you, merely criticize) professor Michael Porter for his role in producing a well paid report that depicted Libya as a shining example of democracy. Per the Harvard Crimson:

In February 2006, Porter presented a 200-page document to officials in Tripoli as a consultant to Monitor, a firm formed by several Harvard professors that was under several million-dollar contracts with the country.

In the report, Porter argued that Libya “has the only functioning example of direct democracy on a national level,” and that Libyans were able to directly contribute to the decision-making process, which drew heavy fire from Lewis in yesterday’s Faculty meeting.

“To put it simply, a tyrant wanted a crimson-tinged report that he was running a democracy,” Lewis said, bringing up the question of whether the University should acknowledge the “shame” when a faculty member disgraces the University in such a way…

In response to Lewis’ criticism, Faust said that it was not the president’s responsibility to serve as “public scolder-in-chief.”

She said that Harvard recently conducted a review of the University’s policies on conflict of interest. But she said it should also be the University’s priority to support all faculty members to pursue academic inquiry.

I’m sure you recognize the Newspeak. Being paid lots of money to gain access to a valued brand is depicted by Faust as “academic inquiry.”

In January, Faust again showed what the real game is at Harvard by naming Krishna Palepu, a professor at HBS, as her senior advisor for global strategy. An article in Harvard Gazette makes clear that he’s not simply providing input to Faust and other University leaders but also playing an important ambassadorial role:

As senior adviser, Palepu will work closely with the president, provost, and colleagues to help guide the University’s international strategy, refine and test some operational proposals of the International Strategy Working Group, and develop a more effective and coordinated approach to international fundraising and to engaging Harvard alumni living abroad. Palepu will consult widely with colleagues within the University and in the broader Harvard community as he undertakes this role.

In case you missed it, “engaging Harvard alumni living abroad” translates as “traveling to fundraise from rich alumni living overseas.”

Why is this a cause for concern? Palepu is accounting professor turned governance guru who took huge consulting fees by Indian standards while serving as a director of what turns out to be the largest corporate fraud in the history of the country, Satyam Computer Services. An op-ed by Premchand Palety in Mint, one of the biggest daily business newspapers in India, depicts Palepu as a bad role model in the ethics department:

Now the big question arises about the role of independent directors who are supposed to protect the interests of investors…Krishna G. Palepu, who belongs to Harvard Business School, has been too closely associated with Raju to qualify him for an independent director’s post. He has been [founder Ramalinga] Raju’s adviser for over a decade and was also actively associated with the Satyam Learning Centre in Hyderabad.

Palepu should have recused himself from taking the responsibility on grounds of conflict of interest…Palepu and Rao [another business school professor on the board] should have shown their leadership skills in influencing Raju to follow a better governance model . If Raju thought otherwise, as a last resort, they should have resigned from the board. Unfortunately they did nothing of the sort and have lowered their image and also the image of the institutions they represent…

The following is an excerpt from Palepu’s bio data on the Harvard Business School website:…

“Professor Palepu’s current research and teaching activities focus on strategy and governance…

In the area of corporate governance, Professor Palepu’s work focuses on how to make corporate boards more effective, and on improving corporate disclosure. Professor Palepu teaches these topics in several HBS executive education programmes aimed at members of corporate boards: Making Corporate Boards More Effective, Audit Committees in a New Era of Governance. He also co-led Harvard Business School’s Corporate Governance, Leadership, and Values initiative, launched in response to the recent wave of corporate scandals and governance failures.”

Is it so difficult to practice what you preach, Professor Palepu?

The past few months have witnessed many scams in the corporate world; most of them have been a result of bad governance and unethical practices…

The best way to inculcate ethics among students is to have a culture of ethics in the institutions, with faculty members as role models. Rao and Palepu have set a bad example by their conduct in the Satyam-Maytas case. They need to own up responsibility.

Note that this pointed piece ran on December 28, 2008. On January 7, 2009, Raju admitted that Satyam’s accounts were bogus (among other things, Raju had been withdrawing funds monthly to pay for 13,000 fictive employees). Per Wikipedia:

On 10 January 2009, the Company Law Board decided to bar the current board of Satyam from functioning and appoint 10 nominal directors. “The current board has failed to do what they are supposed to do. The credibility of the IT industry should not be allowed to suffer.” said Corporate Affairs Minister Prem Chand Gupta.

So the apparent message from Drew Faust is that being directly involved in an Enron-level scandal doesn’t count if it took place in a third world country. She is happy to have what amounts to a corporate governance fraud as a face to the international business community.

Faust can talk all she wants to about ethics. Her actions repeatedly indicate she isn’t willing to take any action that might get in way of the University’s fundraising or “entrepreneurship” by individual professors. I quit giving money to Harvard long ago, and her stance confirms my decision.

Fired up by my recent posts about dodgy New Zealand companies, Nick Shaxson asks what the hell is going on at 369 Queen Street, Auckland?

It is a first-class question, and by way of compensating for the fact that Mr. Shaxson and I are nearly five years late to this story, I have a snazzy elaboration. To fend off accusations of recycling old news, I also have an update that shows that this story is still of some current interest, notably to the cretinously blithe deregulating New Zealand Prime Minister, John Key.

My update may also add further to the workload of an athletic-looking but possibly harassed New Zealand regulator; there is already a pile of Questions in Parliament to Answer, arising from previous forays into this terrain by Naked Capitalism and NZ’s National Business Review.

So, to start on this shaggy dog story, what connects:

President Barack Obama and Senator Carl Levin and Representative Rahm Emanuel,
an aspiring actress in the Seychelles,
a fake English lord,
an intercepted illegal arms shipment,
Wachovia’s $380- billion Mexican drug cartel moneylaundering scandal (yes, billion),
“Russia’s largest tax fraud, an alleged $US230 million heist that led to the untimely deaths of four people and threatens to damage the Russian government”, according to the Sydney Morning Herald,
…and 369 Queen Street, Auckland, NZ

?

Let us start with the future POTUS and his mates (third download link here), who, in their letter to governors of February 2007, are concerned about the level of background checking performed in the US when companies are formed:

The central problem is that the 50 states are currently forming nearly 2 million companies each year with little to no information about who is behind those companies. While the vast majority of those companies operate legitimately, a small minority do not, functioning instead as conduits for organized crime, money laundering, terrorist financing, tax evasion, and other misconduct.

So, the US is just like New Zealand, then, but with volumes two orders of magnitude larger, and with no US-wide standard of disclosure or data presentation, either, which multiplies the complexity of the problem by another chunky factor, I suppose. By way of collateral, the three Congressmen append a couple of press stories, one from USA Today, from which we snip these details:

Wyoming incorporation records show that at least 90 companies created since 2002 list Stella Port-Louis as the sole listed officer. Many of the firms, such as Export Deutschland AG and Motorcomsa S.A., have foreign corporate names…

JoLyn Jordan, an official of Registered Agency Services, a firm that files incorporations, said she believed Port-Louis was a nominee for owners outside the USA. “I don’t know who she is, or if she’s for real,” said Jordan. Asked how to determine if they were shell firms created for crime, Jordan said, “You don’t know.”

Jack Blum, an international tax expert and former special counsel to the Senate Foreign Relations Committee, said money laundering investigations have historically focused on the Seychelles. While saying he had no information about the Port-Louis firms, he said the filings seemed designed to frustrate.

“Whoever’s trying to research it will go batty,” said Blum.

Well, I know that feeling; in my last post on NZ companies, I ended up wondering whether Rod Alvar was a real person. But Stella Port-Louis is less of a will of the wisp: here she is, looking winsome, and lo, not only is she in control of 90 Wyoming companies, she also helmed, by January 2010 at any rate, 338 New Zealand ones. Stella turns out to be an aspiring actress; socially a narrow cut, maybe, above the auto mechanics and taxi drivers to be found running spurious banks in NZ, but just as much in need of some spare cash. Evidently, we have the same background-check-defeating business model identified in the last NC post; having started the companies, she innocently hands them on their real end-users: crooks.

The same article gives most of the promised connections in one hit:

Her companies, with names like Petro Tex Ltd, El Mondo Ltd, London Group and Nelson Trading Ltd, are based at Level 5, 369 Queen St, Auckland.

A co-director at the same address is Lu Zhang, gender uncertain, who is the director of dozens of companies. One of them, SP Trading Ltd, rented a plane that was used to fly arms from North Korea to Iran, but it was seized by Thai authorities in Bangkok.

….

Lu Zhang may be little more than a figment of the imagination of a “professional client” in London who needed to hide their activities from the US, which has sanctions on North Korea and Iran. Providing just such a service is GT Group, based in Vanuatu, a Melanesian country that receives $18 million a year in New Zealand aid.

Vanuatu, like the Seychelles, is a no-questions-asked tax haven, or, as it likes to put it, centre for international business corporations.

GT Group is owned by accountant Geoffrey Taylor, who claims to be an English lord, and his family. It set up and owns Vicam (Auckland) Ltd, which appears to do nothing but clone itself into more than 1000 other entities, such as SP Trading.

There is more about the buffoon Taylor and the arms trading deal here, if you like a spot of colour. Then we have a connection to the Wachovia moneylaundering scandal via the Sydney Morning Herald:

Last year police intelligence sources told Fairfax newspapers and the ABC’s 7.30 Report that about half the cocaine now entering Australia was being sent from Mexico, and that the Sinaloa cartel was behind many of the shipments.

During the court proceedings it was alleged that four New Zealand firms registered by the GT Group – Keronol Ltd, Melide Ltd, Tormex Ltd, and Dorio (NZ) Ltd – helped launder about $40 million of the proceeds using Latvian bank accounts and Wachovia’s London branch.

The US investigation provided a suggestion that the Taylor name was linked to an infinitely wider and more complex global network.

Indeed it was; via those companies,

…the GT Group was linked to the biggest money-laundering operation in US history.

Wachovia Bank – now a subsidiary of the global financial giant Wells Fargo – was fined $US160 million for helping to disguise the illegal origins of up to $US378 billion for Mexican drug lords.

And there was more:

The business magazine Barron’s reported that late last month documents emerged out of London that linked a shell company called Bristoll Export, registered in New Zealand by GT Group, to a scandal that some commentators claim has the potential to be Russia’s Watergate.

It centres on Russia’s largest tax fraud, which occurred on Christmas Eve, 2007, when Moscow tax officials approved a same-day refund of $US230 million to a gang masquerading as representatives of Hermitage Capital, once the largest portfolio investor in Russia.

You may or may not be surprised to hear that:

The Taylors…said they were blameless. In a press release issued in New Zealand by Ian Taylor – another of Geoffrey’s sons – he explained GT Group’s role was simply to incorporate and to act as a registered agent for SP Trading ”at the request of one of our professional clients based in the United Kingdom”. It was not responsible for and had no knowledge of what the company got up to.

As no law was broken, the authorities had no choice but to agree.

Taylor’s friends at Sorenson Law, mentioned in the linked piece about Stella Port-Louis, don’t think they’ve done anything wrong either:

Mr Sorensen said GT Holdings were just “one of a number of people who are there”.

He would not guess at how many companies were registered to the floor.

“What’s their business is their businesses and I don’t entertain what other people’s businesses are about at all.”

Looking at the distinctive addresses of a Sorenson Law company and an Ian Taylor company, one suspects, on purely stylistic grounds, that the association of Taylor and Sorenson may in fact be a little closer than Mr Sorenson would have us believe:

LANGATE LIMITED (2097954) Registered NZ Limited Company

C/-Gt Group Limited, Level 5, 369 Queen Street, Auckland, New Zealand

and

LIFETIME CORPORATION LIMITED (1220738) Registered NZ Limited Company

C/- Sorensen Law, Level 5, 369 Queen St., Auckland, New Zealand

They do seem to have hit on precisely the same abbreviated style, precisely the same punctuation, and precisely the same way of referring to Level 5, 369 Queen St. As it happens, that’s a style that the many other non-Taylor, non-Sorenson-Law companies in that building never adopt. I’d be interested in the Sorenson Law companies, if I were a regulator.

Anyway…here we are, finally, at 369 Queen St., Auckland. An impressive 1,450 companies have been registered there, of which ~1250 have been struck off.

So “what the hell” is going on there now? Three salient things.

First, despite the complete innocence of Messrs Taylor and Sorenson, the authorities seem to have judged that the Geoffrey Taylor companies are better struck off the register, and someone is gamely ploughing through those, turfing them out again. Perhaps it is a taxi driver or an aspiring actress, working the other side of the street. I notice that one of the struck-off companies, Oilex Ltd, still seems to have a web site, of sorts. Is it still trading, or not? A grown-up should check.

Second, our striker-off-of-companies may get a good long gig, because other hands are at work too. Someone called Ian Taylor is still busy: a director of 179 companies. And though they may not all be the same Ian Taylor, the history of a few of these companies does suggest that the GT Group business model is still running smoothly. For a start, when we wade through a sampling of the above, we find an unrepentant Ian Taylor still registering companies in late 2010 and in 2011. Is this the same Ian Taylor as the GT Group one? I think it must be – compare addresses with this Vicam-linked, Vanuatu-linked and so, GT Group-linked company, still not struck off. And there is an Ian Taylor company, ECOPAR LIMITED, with a Panamanian connection (which are the subject of a recent round of Parliamentary questions). And in another hint of the now familiar methods, we have Taylor (founding director) handing over another NZ company, GT Gloria Trading, to an improbable Czech! There is a recent twist to the MO, too. Taylor appears to have found a stooge to help keep his name off the register: this company was registered on 28th June 2011; it isn’t directed by Taylor, but it is wholly-owned by the Taylor company RSHRS LTD.

Third, there seems to be some kind of emerging Irish connection. Are the Irish horning in on this NZ company formation lark? It would make sense. They have a lot of debt payments to make. Note the company address history of Peter Keogh and Sons (NZ). And then see the company address, and directors’ addresses, of

CARRAIG DONN NEW ZEALAND

EAST COAST CATERING (NZ)

GRANDFORD

MARCON NZ

Now you may well think, reviewing all this, that the NZ authorities haven’t really done a bang-up job of sorting out their company register. In fact, they don’t even seem to be able to stabilise the companies registered in one floor of one single building, even when they already have a massive red flag planted firmly over this one address. Though I have to admit, the NZ company registry is very nicely designed. It is just the contents that are garbage.

I suppose that’s it’s not a great job the NZ authorities are doing, really, but as long as they’ve got political constraints, and budgetary ones, and mutts like Niko Kloeten of the NZ National Business Review, and me, to ferret through their register for them, buckshee, they have the best outsourcing deal of all.

Until they get the authentication of their registrants sorted, and better legal protections for the register, it’s just a game of whack-a-mole, after all, though with several hundred billion dollars worth of international relations at stake.

You see, I wouldn’t like to be in Prime Minister John Key’s shoes when he explains, to US President Barack Obama, how the NZ government’s inept custody of New Zealand’s Company Register continues to facilitate money laundering, just after the biggest moneylaundering ring in world history was shown to depend on shoddy New Zealand registration, and four and a half years after Obama’s first warning.

Nor, come to that, would I particularly relish the prospect of explaining to Prime Minister Medvedev Putin whoever of Russia how a key component of the biggest tax fraud in Russian history was facilitated by other shoddily registered New Zealand companies.

Oh Mr Key, if you don’t want New Zealand to be either an international pariah, or a laughing stock, I’d take a look at the New Zealand Company Registry and its protections right now. Perhaps there will be another 200+ parliamentary questions, about this new batch of companies, in another couple of weeks. Would that get your attention?

A recent post by Ezra Klein, “What ‘Inside Job’ got wrong,” manages the impressive feat of being spectacularly off base, rhetorically dishonest, and embarrassingly revealing of the lack of a moral compass all at once.

Since being off base is a major part of Klein’s brand, I suppose one should not be surprised; those who’ve had the good fortune to have limited contact with his output can read Jon Walker’s “Ezra Klein: Insurance Exchanges Don’t Work and Must be Expanded Dramatically,” or Physicians for a National Health Care Program’s “Does Ezra Klein really think ‘managed care didn’t kill anyone’?” for two of many examples.

I’m going to shred this piece in some detail, first, because it will be entertaining, and second, I hope that it will encourage readers to take a cold, bloodyminded look at the excuses made for malfeasance in our elites.

Let’s start at the top:

I finally watched “Inside Job” this weekend. It was an excellent documentary for people who don’t want to understand the financial crisis but want to believe they would’ve seen it coming. Watching it, you’d think that the only people who missed the meltdown were corrupt fools, and the way to spot the next one is to have fewer corrupt fools. But that’s not true. Worse, it’s dangerously untrue. In telling the wrong story about how the financial crisis happened, it misinforms about how to keep it from happening again.

The only objection Klein raises to Inside Job is that it punctures the favorite defense of economists, regulators, and their mouthpieces in the media “whocoulddanode?” Klein rejects the notion that corruption played a role; there no effort to rebut the evidence proffered in Inside Job and numerous other accounts (including on this blog and in ECONNED). He simply sidesteps the issue of corruption via straw-manning: “corrupt fools”.

The most corrupt were decidedly not fools, they knew better and still took the destructive, profitable course. One can say a lot of bad things about Larry Summers, but no one would call him a fool, and given his track record (Inside Job sidesteps Summers giving his pal Andrei Shleifer a free pass over allegations of self-dealing in Russia that Harvard had to pay at least $31 million to settle), the “corrupt” label fits all too well. Similarly, it is no accident that the hedge fund Magnetar, which successfully bet against lethal CDOs that it created, was named a type of star that emits copious amounts of toxic radiation. Bear Stearns, hardly known for having an elevated sense of morality, still refused to create CDOs for John Paulson in 2005 because it was obvious to them that the deals would be designed to fail. But pretty much everyone else on the Street was happy to peddle the finance equivalent of sewage to their clients. And that’s hardly a new tradition; the Frank Partnoy book FIASCO describes how he and his colleagues took great pride in the early 1990s ripping off the faces of customers and blowing them up (their lingo, not mine)

And courtesy Richard Smith, let’s look at some of Klein’s rhetorical sleights of hand:

Watching it, you’d think that the only people who missed the meltdown were corrupt fools (straw man), and the way to spot (no, avert, not “spot”; you are getting ahead of yourself, the next few paras are about spotting) the next one is to have fewer corrupt fools. But that’s not true (isn’t it? would a lower corrupt fool quota help, or not?). Worse, it’s dangerously untrue (how: what’s untrue? what’s dangerous?). In telling the wrong story about how the financial crisis happened (unsubstantiated assertion), it misinforms about how to keep it from happening again (unsubstantiated assertion).

From this unpromising start, the post goes completely off the rails. Yes, Klein makes weak attempts to fulfill some of the charges made, but as we will see, they range from not-terribly-convincing to outright absurd.

But first, we need to perform an osculectomy, which former investment banker and New York Observer columnist Michael Thomas has outed as a surgical procedure only done on a very hush-hush basis in New York, Los Angeles, and Washington, DC. It becomes necessary when Party A has kissed the ass of Party B with such intensity that a vacuum bond is formed that is so strong that it can only be broken by surgical intervention. In this case, Klein needs to be forceably detached from the posterior of Michael Lewis.

Klein holds up Michael Lewis’ book The Big Short as the ne plus ultra on the financial crisis. That’s mighty peculiar, since Lewis wrote about the subprime shorts, a subset of players involved in the US mortgage mess (which itself was the detonator rather than the totality of the financial crisis), and even then only some carefully selected players (his most notable omission is John Paulson). And it isn’t even the best account of this investment strategy; the more comprehensive and instructive book there is Greg Zuckerman’s The Greatest Trade Ever, which was published five months before The Big Short . As we wrote in March 2010:

Lewis’ tale is neat, plausible to a mass market audience fed a steady diet of subprime markets stupidity and greed, and incomplete in critical ways that render his account fundamentally misleading. It’s almost too bad the book’s so readable, because a lot of people will mistake readability for accuracy, and it’s a pity that Lewis, being a brand name author, has been given a free pass by big-name media like 60 Minutes (old people) and The Daily Show (young people) to sell to an audience of tens of millions a version of the financial crisis that just won’t stand up – not if we’re really trying to get to the heart of the matter, rather than simply wishing to be entertained by breezy well-told stories that provide a bit of easy-to-digest instruction without challenging conventional wisdom.

The balance of the post provides ample support for those charges.

Klein’s touting of Lewis is in keeping with his posture towards the crisis: he wants to stay on the well trodden path of accepted narratives. And that serves the perps just fine. Complexity, opacity and leverage were the generators of this disaster; the more the financial services industry can do to deter investigation into them, the better.

The piece gets even more bizarre:

In 2007, Lewis wrote a piece mocking the worrywarts trying to sound the alarm at Davos. “Davos,” he wrote, “is where people with no talent for risk-taking gather to imagine what actual risk-takers might do.”

It’s ironic that Lewis, who later wrote a book lionizing outsiders who bet against the herd mentality when they were later proven right, took the low risk course in early 2007 and ridiculed nay sayers. If you read the short Bloomberg piece, Lewis was the loud and proud mouthpiece of conventional superficial nonsense circa January 2007: he had bought the Great Moderation and the idea that the world had actually reduced risk significantly by slicing, dicing, and trading it. Before you say it’s easy for me to say that, in post four days before the Lewis piece, “The Beginning of the End?“, we wrote:

We’ve commented from time to time on loose credit conditions (see our “Rising Tide of Liquidity“, plus Part 2 and Part 3 on the same topic) and indifference to risk (“Where Has the (Perception of) Risk Gone?“).

The tide may be turning. Today, the New York Times had a lengthy, well researched article, “Tremors at the Door,” on the reversal of fortune in the subprime mortgage market. Defaults by borrowers have risen to a level where the lenders themselves are increasingly in jeopardy:

Yet Klein tries to invert the interpretation of this embarrassingly bad Lewis piece:

He knows financial markets, knows the people in financial markets, and knows the products in financial markets. But he missed it. Completely. And no explanation of the financial crisis that doesn’t have room for Lewis to miss it is sufficient.

What kind of meshugas is this? Because Klein’s favorite financial writer missed the onset of the crisis, we are to give all the analysts, economists, regulators, and bankers a free pass? And he can say this with a straight face after the Financial Crisis Inquiry Commission documented in far more detail than Inside Job that there were plenty of warning signs?

Let’s get down to real basics: can Klein simply not tell the difference between Lewis, a bond salesman 25 years ago, and author/journalist since then, and a genuine in-touch expert on some aspect or other of modern finance?

Or do we assume Klein does know the difference, which makes Klein’s remark a decidedly, not to say, insanely journalist-centric view of the crisis. I shall not speculate about why a journalist who doesn’t know anything about finance might be tempted to conclude that the crisis was actually all about journalism. Still, it’s impressive (though not necessarily in a good way) to see someone actually publish that conclusion, quite unselfconsciously; if that’s what he meant to say.

And this is where Klein’s choice (whether deliberate or out of learned blindness) is particularly convenient ; it’s the device he uses to dodge the central issue of corruption. As Tom Adams noted via e-mail:

I am fairly amazed that someone purporting to be writing about how “inside Job” is dangerously wrong can spend the entire rest of the article discussing Michael Lewis.

In so doing, Klein ignores the most obvious reason that he is effectively confirming his own summary about “Inside Job” – that it suggests anyone who didn’t see it coming was corrupt.

Obviously – the answer is that Lewis has been corrupted as well. It’s not the hard corruption of CDO salesmen saying the CDO manager was independent when he was fig leaf that allowed the bank to dump its toxic exposures, or of mortgage brokers telling their customers they were getting a 30 year fixed rate mortgage and instead giving them documents for an options ARM at closing, but it is a form of corruption nevertheless. He is a member of the NYC media elite, a group enraptured by its own wonderfulness. For Lewis and his peers, the crisis aws an excellent marketing device and they exploited it for their own purposes. Lewis was not interested in explaining (or anticipating) the financial crisis. He was interested in selling books. With his books, he is also deeply in love with his own narrative devices – outsider takes on the establishment, acts unconventionally, wins.

He was not looking to explain why everyone got it wrong nor did he bother to take on two of the biggest forces in the market – Paulson and Magnetar – because they didn’t fit his narrative. And the narrative was what mattered because Lewis has honed his storytelling approaches and has a large audience eager for more stories that present the same arc. That is what the was selling, not the “truth”.

Then Klein tries the dodge because no one saw the particular way the crisis played out, no one can be held responsible for not seeing it:

A lot of observers understood we had a housing bubble — Dean Baker, for instance, had been sounding the alarm for years — but few of the housing skeptics saw everything going on behind the bubble: That the subprime mortgages had been packaged into bonds, that the bonds had been sliced into tranches, that the formulas being used to price and rate the tranches got the variable expressing correlation wrong, that an extraordinary number of banks had purchased an extraordinary amount of insurance against getting that correlation wrong from AIG, that AIG had also priced the correlation wrong and would be unable to pay its debts in the event of a meltdown, that a meltdown would freeze the mostly unregulated shadow market that major financial institutions and players used to fund themselves, that the modern financial system was so fragile that an uptick in delinquent subprime mortgages could effectively crash the global economy.

Klein needs to get out more. See the fallacy in his reasoning? Note he demand that someone have foretold the specific path the crisis went down for them to get credit for having called it. And as an aside, par for his knowledge of the crisis, Klein’s discussion of AIG is badly confused. He mistakes the damage that the collapse of AIG would have caused via its status as being the world’s biggest insurer (which would have been horrific) with the losses that resulted from AIG having written credit default swaps on subprime-related CDOs that it could not honor (you can debate how much that ultimately cost, but the New York Fed forked over roughly $30 billion, which is a large but not financial-system-wrecking number).

Why is Klein’s requirement that someone have been able to project the course of the crisis unreasonable? Even if you can specify PERFECTLY the rules that govern how a system works, in a system subject to not all that many forces, it quickly becomes impossible to make an accurate forecast. This issue was identified in 1899 by mathematician Henri Poincaré, who won a prize for demonstrating that a long-unsolved puzzle from physics, that of determining the movements of three or more celestial objects (meaning their gravitational forces could affect each other), was for all practical purposes unsolvable. You needed to specify their initial conditions (mass, location, velocity) to such an extraordinary degree of precision that even a miniscule error leads the
actual path of the object to diverge from the predicted path. Those deviations increase as time passes, so that the actual path may lose all resemblance to the predicted path.

Think of how much more complicated our financial system is than the movements of three celestial bodies. We can’t specify how actors operate with highly accurate mathematical formulas. We have a lot more than three actors. Therefore any attempts to predict what will happen are likely to be subject to the same problem that Poincaré stumbled upon: even if you can describe the forces at work accurately, you cannot make useful predictions, at least not over anything other than very short time frames.

But you could nevertheless very clearly see in late 2006 and 2007 that Things Were Going to End Badly merely by reading the Financial Times. You could tell we were in the midst of a global credit mania. There was regular discussion of the “wall of liquidity”. Credit spreads for every type of lending were at unprecedented, astonishingly low levels by any historical standards. It was not hard to anticipate with so much profligate lending going on in every sector of the market that there would be tremendous losses down the road.

If you want to see what a financial services expert who was not a credit markets insider could infer before the crisis, I suggest you read the paper released in April 2007 by an equity analyst, Henry Maxey of the UK investment management boutique Ruffer. It’s a remarkable piece of work.

Cracking the Credit Market Code

We then get to more dictation from the Ministry of Truth via Klein:

What’s remarkable about the financial crisis isn’t just how many people got it wrong, but how many people who got it wrong had an incentive to get it right. Journalists. Hedge funds. Independent investors. Academics. Regulators. Even traders, many of whom had most of their money tied up in their soon-to-be-worthless firms. “Inside Job” is perhaps strongest in detailing the conflicts of interest that various people had when it came to the financial sector, but the reason those ties were “conflicts” was that they also had substantial reasons — fame, fortune, acclaim, job security, etc. — to get it right.

Huh? He can write this with a straight face? He has the incentives 100% wrong.

Asset bubbles are very popular. They look like increased wealth to the community. That’s why regulators are reluctant to intervene. If they do, they make people look less prosperous immediately, and they can’t prove the counterfactual, if they had left things alone, the damage would have been worse. Recall the orthodoxy then was you couldn’t recognize a bubble in progress, better to clean up afterwords. And that’s before you get to the corruption that Klein is so keen not to discuss: regulatory revolving doors, annual bonus cycles which promote the institutionalized “devil take the hindmost” attitude, known in finance as “IBG-YBG” for “I’ll be gone, you’ll be gone”.

Did Klein miss the rise of access journalism? Clearly so. Even then, the Economist, the oracle of leading edge conventional wisdom, pointed out the existence of a global housing bubble in June 2005, in a can’t-miss-it cover story with lots of supporting analysis. The subtitle: “The worldwide rise in house prices is the biggest bubble in history. Prepare for the economic pain when it pops.”

The salient characteristic of this bubble was the so-called wall of liquidity. There were plenty of nervous longs as of early 2007, but they figured they could get out when things got bad. That turned out to be incorrect, and predictably so, because liquidity collapses in bear markets.

But with hedge funds and other money managers subject to monthly reporting, and punished if they show lower performance than their peer group, their incentives are to follow the herd. Contra Lewis and popular wisdom, every mortgage industry conference had worried panels about subprime from 2005 onward. I’ve spoken to industry participants who said they knew they were rationalizing continuing to participate in the market because the institutional pressures were to do so. Other people looked to be making money, so exiting the market would lead to pushback from shareholders. And this behavior isn’t new either. As Keynes said, “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him”

And then we get to Klein giving everyone (most importantly the elites!) a free pass:

And ultimately, that’s what makes the financial crisis so scary. The complexity of the system far exceeded the capacity of the participants, experts and watchdogs. Even after the crisis happened, it was devilishly hard to understand what was going on. Some people managed to connect the right dots, in the right ways and at the right times, but not so many, and not through such reproducible methods, that it’s clear how we can make their success the norm.

This is worse than useless, since Klein incorrectly throws up his hands and effectively says no one can understand what happened and therefore there’s no answer. One of the reasons the crisis has been so “difficult to understand” is that the government and banking elites have been taking extraordinary efforts to obscure the truth. The AIG bailout, the GSE bailouts, the alphabet soup of Fed facilities, the con game of the “stress tests”, the refusal to release information, the ridiculous government programs to “restart” the market, the efforts to deny the mortgage crisis, HAMP, the ongoing efforts to prop up the banks even though the are insolvent, they are all massive efforts at obscuring what really happened and what is still going on. This is not a coincidence; it is a deliberate effort orchestrated by the banks, the Fed, and the Treasury.

And plenty of people have sound proposals for what ought to be done. The best formal work in this area, if Klein would bother doing even the most basic digging, comes from the Bank of England. The answer, in short form, is prohibition: banning certain activities and products, breaking up the banks and implementing other measures to reduce the interconnectedness of the system and contain risk taking.

Before you say we can’t do that, the banks will decamp to the Caymans or innovate around it, let me tell you the dirty secret the finance industry does not want you to know: the ECB or the Fed and possibly even the Bank of England could impose what amounted to a global regulatory regime on the biggest banks any time they wanted to (and that could include hard restriction on lending to parties outside the regulatory cordon sanitarie).

First, any big bank needs to be backstopped by a pretty solid central bank. They all know that even if they harrumph otherwise, no big bank is going to take much counterparty risk with a not-credibly-backstopped big player; they’d see their funding costs rise and the positions they could take reduced, which would quickly reduce profits and those sacrosanct bonuses). Second, all bank payment systems in a particular currency ultimately need to be settled via central bank payment system for that currency (for instance, the US’s Fedwire is the critical dollar payment system) and there is no way for the banks to innovate around that. And the big dealer banks need direct access to Fedwire; going through a correspondent is not viable from a cost and operational standpoint. If you are a serious capital markets player, your need to trade dollar and euro instruments. The need to use to central bank controlled facilities in the dollar and euro means the Fed and ECB could dictate terms if they chose to.

So this gets us back to the issue that Klein wants us to ignore: corruption and capture. The problem is not that there are no solutions. There are steps that we could take now to make modern finance much less risky, but that involves imposing pain on bankers. And that has not happened because, as Simon Johnson pointed out in May 2009, is that the US has suffered a “quiet coup” and is now in the thrall of financial oligarchs. The obstacle isn’t scariness or complexity, it’s the lack of political will.

It’s easy to understand why Klein writes this sort of piece. What is hard to fathom is why anyone, other than his patrons, continues to give what he has to say much credence.

We wrote a couple of days ago about the young versus old economy struggle over who will be the next leader of the IMF in the wake of Dominique Strauss-Kahn’s resignation. Ever since its inception, the IMF had had a European in charge. Christine Lagarde, the finance minister of France, is the favorite, and the US and Europe have enough votes to determine the outcome.

Representatives of several emerging economies voiced their objections, pointing to a comment made by Jean-Claude Junker, president of the Euro group, in 2007: “The next managing director will certainly not be a European”.

The Financial Times reports that the unhappiness has gone beyond complaints in the media to an open rift. The IMF executive directors from China, India, Russia, Brazil, and South Africa issued a statement calling for “a truly transparent, merit-based and competitive process.” Good luck with the “merit” part; meritocracies are nice aspirations but unattainable in practice. Once you establish that candidates have the core skills needed to do a job, the decisions typically boils down to matters of taste (what vision for the organization do they represent) and politics. It also managed to get in a dig:

The recent financial crisis which erupted in developed countries, underscored the urgency of reforming international financial institutions so as to reflect the growing role of developing countries in the world economy.

I’d put the odds of a non-European getting the nod given the parlous state of eurozone finances at close to zero. The FT claimed the developing economies aren’t in a great position to be making demands given that some countries (but none of the letter signatories) have not yet paid their IMF dues, but that does not sound like a terribly persuasive argument. And given the insistent tone of the letter, throwing developing nations a sop in giving the number two post to an emerging economy candidate will probably not prove sufficient.

While the immediate consequences of rebuffing the BRICs + South Africa demand may seem to be nil, a snub may accelerate some of the centrifugal forces on the international finance scene. We pointed out that during the Asian crisis, Japan tried to organize an intra-regional solution, only to be swatted down by the US. It’s reasonable to expect younger economies to try to strengthen the position of other venues for economic cooperation, such as ASEAN.

This snub also runs the risk of securing less international cooperation in a pinch. We pointed out that China and India are moving in the direction of strengthening ring-fencing of their financial firms by requiring foreign banks to hold enough reserves to meet local regulatory standards (the current regime, “home-host”, takes the view that the home country regulator has primary responsibility for capital adequacy and the local subsidiary can carry very little in the way of reserves in the local market; the assumption is that it will ring home to the mother ship if it needs help.

This tempest may simply appear to be a matter of national ego. But if the West does not accede to the demands of the emerging nations, the ill will it creates at a time when the global economy is more fragile that the recent growth figures suggest could undermine other efforts to achieve greater international regulatory cooperation.

Update 4:00 AM: I managed to write this post without seeing that the FT’s Martin Wolf had weighed in on this topic. He argues forcefully that the IMF reasons for continuing to prefer Europeans do not stand up to scrutiny. Key extracts:

While I find this European argument has some force, it does not have enough force. The counter-argument is that it is in the Europeans’ interest to receive unbiased and independent advice from the IMF. That, Mr Strauss-Kahn could not give. Mme Lagarde will not be independent either. But someone is going to have to make Europeans recognise that debt restructuring will almost certainly be needed and that, given this, it would be better to fix financial systems directly, rather than indirectly via lending to quite possibly insolvent governments.

On balance, then, I do not think the case for a European head of the IMF is made overwhelming by the current crisis. Then one has to recognise the enormous advantages in terms of the global legitimacy and effectiveness, not just of the IMF, but of the multilateral institutional order, of making a transition to open global selection of the IMF’s new head. It has to be recognised that the place of the old advanced countries and of Europe, in particular, in the world economy is declining rapidly. According to the IMF’s own statistics, the share of the EU in global output, at purchasing power parity, will shrink from 25 per cent in 2000 to 18 per cent in 2015 – an astonishingly rapid rate of decline (see chart). The EU remains over-represented in the IMF: even after all the reweighting, the voting share of the Netherlands will be 1.76 per cent, against 2.62 per cent for India….

I would not myself exclude a European, as some I respect would. But the time has come for the incumbent powers to recognise that they cannot continue to dominate the global scene. If they persist in running these institutions, the rising powers will, inevitably, turn away from them altogether, to create replacements they can control. This would Balkanise management of the global economy, to no one’s true long-term advantage.

Regimes that do not bow to the winds of change get blown away. The Europeans need to recognise that truth in time. They will not do so. But it will prove a big mistake.

By Satyajit Das, the author of “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives”

Martin Gilman (2010) No Precedent, No Plan: Inside Russia’ 1998 Default; MIT Press, Cambridge, Massachusetts

Victor C. Shih (2008) Factions and Finance in China; Cambridge University Press, Cambridge, Massachusetts

Carl E Walter and Fraser J. T. Howie (2010) Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise; John Wiley, Singapore

According to myth, Russian minister Grigory Potyomkin ordered the erection of fake settlements, consisting of hollow facades of villages along the Dnieper River, to impress Empress Catherine II, about the value of her new conquests during her visit to Crimea in 1787. More than two centuries later, emerging market nations have borrowed the strategy. These three books provide insights into the Potemkin-village-like structure of emerging economies.

In “No Precedent”, Professor Gilman, a former International Monetary Fund (“IMF”) staffer and experienced Russian hand, focuses on the 1998 default of Russia on its debt. “No Precedent” is covers the chronology of the Russian default. Professor Gilman provides a highly readable description of the Russian financial crash with default on domestic treasury bills, sharp devaluation of the Ruble, and a three-month freeze of foreign bank payments.

The greatest insight, though not necessarily a surprising one, is the lack of institutional structure in post Communist Russia as well as the lack of infrastructure and expertise to deal with the opening up of the economy after 1989. The lack of political structure and leadership is evident: “The problem on the government side was that no one was clearly in charge.” Professor Gilman identifies the lack of information and absence of policy coordination. The finance minister and the head of the Russian Central Bank do not talk to each other. People without official government positions frequently make crucial decisions, often by default. “No Precedent” also provides insight into Russia’s recovery and the rise of the siloviki (shadowy military and security forces) and Putin.

For practitioners who have experience in emerging markets or under in extremis situations , the insights will ring very true. As they say, all battle plans dissolve during the first exchanges with the enemy.

Russia’s default provides useful insights into the current problems of many European sovereigns. Problems of tax collection to maintain a functioning state able to meet its financial obligations are not dissimilar to those of some peripheral European countries. Russia’s recovery from default and it financial rehabilitation were driven by devaluation of the Ruble and luck (higher oil prices). With the first option probably unavailable in the near term, it seem troubled European economies will need more of the latter. Greece, I am told, makes very good chess sets.

Professor Gilman’s favourable views of the IMF’s role, while understandable (IMF head Michel Camdessus provides a foreword), appears a little self-serving. Despite this minor criticism, “No Precedent” is well worth reading, complementing Chrystia Freeland’s “Sale of the Century” as a record of this stage of Russia’s modern evolution.

Political economist Dr. Victor Shih and bankers Messrs. Carl Walter and Fraser Howie focus on China and its banking system. Dr. Shih’s “Factions and Finance in China” focuses on the underlying political drivers that shape China’s domestic banking system. Dr. Walter and Mr. Howie’s “Red Capitalism” focuses on the financial structure of China’s banking system and its evolution over the last 20 years. Both analyses bear out the subtitle of Dr. Walter and Mr. Howie’s subtitle – Fragile Financial Foundation of China’s Extraordinary Rise.

The analysis in these two books reaffirms the non-market nature of China’s domestic economy and the over riding, paranoid controlling role of the Chinese Communist Party over any activity. The central purpose of the regime’s constant presence in the banking sector is to further two objectives: firstly, assuring depositors of the safety of their money, and secondly access to money to manipulate economic outcomes. Policymakers, frequently inexperienced in functioning market economies, seize and maintain control over financial policies to control credit. This allows the use of financial resources to provide short term apparent fixes to the economy. At a personal level it allows individuals to gain promotion and power. Camouflaged in superb state of the art infrastructure, markets are “primitive”, lacking basic mechanisms for allocating capital and pricing risk.

As Dr. Shih sums up: “”Although particular financial outcomes or control over the banking sector were not the ultimate objectives of factional politics, the banking sector became an important means of political survival in China. With its vast store of money from increasingly prosperous depositors, the banking sector became a victim of its own success as the party leadership… increasingly saw banks as a bountiful source of political resource… the political elite’s need for a highly fungible policy and political resource – money – led to a persistence reluctance to liberalise the banking sector beyond state control. Banking policies were made to bolster the short-term strength of both generalist and technocratic factions with little regard to long-term consequences.”

Despite the commentariat’s speculation about “capitalism with Chinese characteristics”, the Chinese financial system, at least, emerges as a relic of Soviet era bureaucracy, where Borgia court intrigues substitute for decision making. Perhaps, there is little difference between the Chinese banking system and Wall Street after all.

The historical background provides insight into China’s recovery from the 2008 crisis. Predictably, the State instructed the banks to lend vast sums to restore growth to target levels. Based on previous experience, the lending, much of it secured over land, will result in large NPLs (non-performing loans). In 1999, NPLs were 39% of total loans of Chinese Banks. Between 2001 and 2007, the major banks spun off $480 billion in bad loans into government sponsored Asset Management Companies (“AMCs”) to prepare them for initial public offering to raise capital. Most of these NPLS remain unresolved, being rolled over with Government guarantees indefinitely.

The central importance of bank depositors from ordinary Chinese to the entire system of financial games also raises questions about the willingness of China to increase domestic consumption. The absence of these deposits would destroy a central pillar of the system of patronage and control dominated by the Chinese Communist Party. The structure also focuses attention on the productivity of investments, fuelled by bank lending.

Both books also highlight the myth of low debt levels in China. Dr. Walter and Mr. Howie argue that actual government debt levels, properly measured, are not 20% of GDP but closer to 76%.

The puzzling thing is investor’s willingness to ignore these deep fault lines in the popular narrative about the China growth story. The reason is provided by Stanley Fischer, now Governor of the Central Bank of Israel but at the time at the IMF:

One has to wonder how people can both have been investing at triple digit interest rates and expecting that in the end the West would find the money to enable Russia to continue to pay. Surely, they should have understood that the markets were trying to tell them something. Actually, there may be an explanation. The people who did not expect Russia to be able to pay were already out of the market. Those who remained in the market were the optimists, who thought that somehow the market had got it wrong. Those were the people who appeared genuinely shocked when Russia could no longer pay.

The relevant question was not whether Grigory Potyomkin’s villages were fake. The real question was always whether Empress Catherine believed them to be real.

The Pentagon, to secure supply lines, is effectively making payments to warlords in Afghanistan. Not only is that undermining the central government (as in by reinforcing competing centers of power), but it also appears to be helping to fund the insurgents.

Now before you put that overview in the “You cannot make this stuff up” category, actually, it’s the reverse. This is a completely predictable outcome given the situation in Afghanistan, which is that the US, like the Soviets before us, controls only the cities, and is in completely hostile territory elsewhere.

Remember, for all practical purposes, there is no infrastructure in Afghanistan. As reader Crocodile Chuck pointed out, “The entire military supply chain is flown in: equipment, materiel, food, fuel. It’s like staging a war on the moon.” So if you want to secure passage across the countryside, say to move munitions or troops, you need the cooperation of the not so friendly locals. The warlords aren’t above taking bribes, but the officialdom has somehow managed to harbor the illusion that paying money to people who are hostile to our occupation is likely to result in the funds being used against us. Bloomberg gives an overview:

Contractors on a $2.1 billion job trucking U.S. supplies into Afghanistan are paying millions of dollars in protection money to warlords controlling their routes, according to a congressional report.

Contractors told congressional investigators they believe that, in turn, “the highway warlords make protection payments to insurgents” who are fighting the U.S., though there wasn’t direct evidence backing that claim..

Yves here. That “wasn’t direct evidence” looks like someone desperately trying to find a fig leaf. Back to the piece:

The eight contractors who carry food, fuel, ammunition and other goods under the Afghan Host-Nation Trucking Contract are expected to provide for their own security without U.S. military escorts.

This has led to an ad-hoc system where the principal private security subcontractors are “warlords, strongmen, commanders and militia leaders who compete with the Afghan central government for power and authority,” the report said…

The trucking contracts cover 70 percent of the U.S. overland supply chain that typically starts in Pakistan, moving in convoys of as many as 300 trucks through Pashtun tribal lands to U.S.-controlled distribution hubs near Bagram Airfield and Kandahar Airfield.

Yves here. The Associated Press reported that the Afghan “security firms” could be getting as much as $4 million a week from the trucking contractors for protection.

The part that is a wee bit misleading is the suggestion that military escorts would end the need for payoffs. It is going to be interesting to see what happens if this inquiry does indeed put an end to the bribes, because the result may well be much more serious problems with resupply. An article in the Boston Globe noted:

“While is it important that we continue to do all we can to combat illicit financial flows, setting up an alternative to Afghan private security contracts — such as having US troops escort the goods — would be costly and entail additional dangers,’’ said Jeremy Pam, guest scholar at US Institute of Peace.

As we pointed out in an earlier post, the sudden touting of the presence of a lotta minerals in Afghanistan (which it turns out was not news, except maybe to the chump American public) appeared to be an effort to bolster a military campaign that is going not at all well. We cited our sometimes guest poster Richard Kline, who pointed to an unintentionally damning piece in the Christian Science Monitor and provided this take:

Here are a few points in takeaway, directly from statements of joes in the 12th infantry a few miles outside Kandahar.

1) They absolutely do _not_ control the countryside.

2) The Taliban engage them—when they want to, where they want to, as they want to—not the other way around.

3) The occupiers are engaged in an attritional contest where everywhere they go is now mined and they lose a steady, bloody drip of casualties anytime they move.

4) The Taliban have received heavy reinforcements from outside the region which the occupiers are unable in any meaningful way to interdict.

5) The Taliban can, and do, kill anyone who cooperates in any remote way with the occupation, and neither the occupation nor its regime can do anything about this whatsoever.

6) The operational objective of this particular unit was, in effect, to ‘inconvenience the manueverability’ of the Taliban units.

7) The operational objective of their regional command (in Kandahar) was ‘to control the big cities so that they (the Taliban) would have to come to terms with us.’

And keep in mind, this is all taking place at the height of The Surge II in the region with maximum deployment of assets declared as the primary objective of the present occupation campaigning season.

There is a word for this configuration of conditions: defeat. This is why Stan McChrystal is re-polishing his shiny balls: he and his are completely immobilized, have lost any operational initiative that they may have had, can’t do a damn thing about it, and are now trying to keep the large population centers hostage to some kind of settlement. This looks highly like the Soviet occupation of Afghanistan, minus the saturation bombing but with far more boots on the ground. This looks amazingly like the Indochina dumb-a-thon; even the kind of rhetoric used by the guys in the article I mention would be entirely in place, trying to paint a picture of failure as one where the occupation is ‘in control and on plan’ by milspeak fuzziness and omission, much of it the unintentional result of what is left when candor is excluded.

The problem, as Kline pointed out later in comments, is that the US has chosen not to understand the nature of this engagement:

….this is a Pashtun war against a widely detested occupation. We’re not fighting the largely mythical al-Qaida, imperialist talking points nothwithstanding: we’re fighting the people who live on the ground, and their immediate cousins who live over the crestline….

The Taliban has demonstrated, deep support from a plurality of the Pashtuns of Afghanistan on its worst day. That day is behind us. They likely have majority support now, and have backing in areas where one never would have expected that in a generation such as the North Slope. All most as importantly, the Taliban completely dominate the security of the countryside: no one whom they dislike survives, at this point. No one turns them in and survives. No one takes $29 of wampum and an iPod from the occupiers and survives. Sure, the Taliban would rather make nice and have strong support, but the demonstrated fact, in _multiple current reports_ is that the insurgency dominates the locals totally. The US can do nothing about this. Stan McChrystal thought he had a sepoy army and collaborationist bureaucracy read to roll to handle the countryside once he ‘manhandled’ Those People’ out of the way; he has now been disabused of that notion; nothing of the sort exists, OR WILL EXIST…

The war is lost, I said. Now, ‘lost’ is a relative term….The Taliban cannot, yet, eject the occupation; it may be that they never can on their own, as they are now. The occupation cannot defeat the Taliban, and the cost for staying in the Great Game only gets higher as the insurgency gets better and broader. I mentioned several analogous conflicts for the present state of conditions describing the war in the Stans. I left out the best one, though: South Lebanon. Israel had all the air one could ever want, vast ‘technological superiority,’ held every town, had a better force ratio _by far_ than the occupation has or will ever have in the Stans, and operated in terrain generally more favorable to an occupier than that of Afghanistan, and snatch-and-grabbed ‘leaders’ profusely—and left with their tails between their legs. The tactics used by the insurgency in South Lebanon are those exactly being used in Afghanistan, and that is 100% no coincidence, and not simply because they worked there. The Israelis couldn’t win in Lebanon anymore than we can win in Afghanistan, and got tired of the expense of non-losing, not least because the insurgency there were gradually getting better weapons, raising the costs, and had generally outfought the occupiers huddled in their iron coffins…

Strategically,the situation is exactly the same [as the Soviet occupation of Afghanistan]: the Soviets held the cities, but not the countryside, not ever. The present Taliban-led insurgency is far more effective than the mujahideen ever were, and operationally active in more of the countryside, this despite the fact that the US has significantly more ground in place than the Soviets ever did.

Yves here. Other factoids strongly suggest our little adventure (actually, technically a NATO operation, as reader aet pointed out) is not going swimmingly. The UK wants out. A story last week in Der Spiegel (hat tip reader Swedish Lex) similarly indicated that Germany is thinking about exiting:

The belief that things will end well in Afghanistan is dwindling in Germany. An increasing number of security experts recommend an orderly withdrawal and even those who were involved in sending the Bundeswehr on the mission are now voicing doubts about ultimate success….

Asked if everything is going well in Afghanistan, [former Defense Minister Peter] Struck bursts out with, “No!” Asked if the German Armed Forces, the Bundeswehr, are where they had hoped to be, he exclaims, “No, of course not!” He can clearly remember the days following Sept. 11, 2001. Struck was chairman of the SPD’s parliamentary group when then-Chancellor Gerhard Schröder declared Germany’s full solidarity with the United States. This statement effectively meant Germany would be going to Afghanistan. “One year, then we’d be back out, that’s what we thought back then,” Struck says, poking at his fish, before adding, “We thoroughly deceived ourselves.”…

The price is soaring higher and higher, in terms of both human lives and finances. Officially, the mission costs Germany €1 billion ($1.2 billion) per year, but experts place the true costs at three times that amount, which would make it 10 percent of the country’s defense budget. Official data has the war in Afghanistan costing Germany over €6 billion so far.

Yves here. I wonder how long the drip drip drip of lack of progress in Afghanistan, plus continuing budget pressures in the US, will lead us to find a graceful exit. Unfortunately, having put our prestige on the lines, I suspect it will not be soon.

It’s easy for Americans to pooh-pooh bearish talk about the dollar. Yet the sterling was once the reserve currency, and has fallen, what, by 80% since it lost its standing.

With increasingly dubious accounting and lax enforcement, the US capital markets no longer stand out by virtue of being better regulated. Yes, they still may be deeper and more liquid. But overseas buyers have to look hard at foreign exchange risk. The direction for the dollar in the long term is certain to be down. Overextended debtors trash their currencies (see the Great Depression, the Nordic and Swedish banking crises, and the Asian crisis for a few of many examples).

What is interesting about the Xie piece is that even the stalwart Chinese retail investor has become leery of the dollar. Despite th logic of “oh if you sell, you only hurt yourself”, the flip side is if you become certain you are indeed holding a depreciating asset, it makes sense to exit. You want to be early, not late, out.

And that logic, if it starts to take hold, in classic run on the bank fashion, could lead to a disorderly fall in the dollar. It isn’t clear what the trigger might be, but Bob Shiller contends that sudden flights from markets don’t necessarily require an event to kick them off. And given that Willem Buiter, who though fond of colorful writing, is hardly an extremist, foresees a collapse in dollar assets if the US fails to contain its fiscal deficit, talk of a dollar plunge isn’t a a radical view.

From the Financial Times:

Emerging economies such as China and Russia are calling for alternatives to the dollar…Because the magnitude of the bad assets within the banking system and the excess leverage of its households are potentially huge, the Fed may be forced into printing dollars massively, which would eventually trigger high inflation or even hyper-inflation and cause great damage to countries that hold dollar assets…

….emerging economies…have amassed nearly $10,000bn (€7,552bn, £6,721bn) in foreign exchange reserves, mostly in dollar assets. Any other country with America’s problems would need the Paris Club of creditor nations to negotiate with its lenders on its monetary and fiscal policies to protect their interests. But the US situation is unique: it borrows in its own currency, and the dollar is the world’s dominant reserve currency. The US can disregard its creditors’ concerns for the time being without worrying about a dollar collapse.

The faith of the Chinese in America’s power and responsibility, and the petrodollar holdings of the gulf countries that depend on US military protection, are the twin props for the dollar’s global status. Ethnic Chinese, including those in the mainland, Hong Kong, Taiwan and overseas, may account for half of the foreign holdings of dollar assets….

The Chinese love affair with the dollar began in the 1940s when it held its value while the Chinese currency depreciated massively. Memory is long when it comes to currency credibility. The Chinese renminbi remains a closed currency and is not yet a credible vehicle for wealth storage. Also, wealthy ethnic Chinese tend to send their children to the US for education. They treat the dollar as their primary currency.

The US could repair its balance sheet through asset sales and fiscal transfers instead of just printing money. The $2,000bn fiscal deficit, for example, could have gone to over-indebted households for paying down debts rather than on dubious spending to prop up the economy. When property and stock prices decline sufficiently, foreign demand, especially from ethnic Chinese, will come in volume. The country’s vast and unexplored natural resource holdings could be auctioned off. Americans may view these ideas as unthinkable. It is hard to imagine that a superpower needs to sell the family silver to stay solvent. Hence, printing money seems a less painful way out.

The global environment is extremely negative for savers. The prices of property and shares, though having declined substantially, are not good value yet and may decline further. Interest rates are near zero. The Fed is printing money, which will eventually inflate away the value of dollar holdings. Other currencies are not safe havens either. As the Fed expands the money supply, it puts pressure on other currencies to appreciate. This will force other central banks to expand their own money supplies to depress their currencies. Hence, major currencies may take turns devaluing. The end result is inflation and negative real interest rates everywhere. Central banks are punishing savers to redeem the sins of debtors and speculators. Unfortunately, ethnic Chinese are the biggest savers.

Diluting Chinese savings to bail out America’s failing banks and bankrupt households, though highly beneficial to the US national interest in the short term, will destroy the dollar’s global status. Ethnic Chinese demand for the dollar has been waning already. China’s bulging foreign exchange reserves reflect the lack of private demand for dollars…

America’s policy is pushing China towards developing an alternative financial system. For the past two decades China’s entry into the global economy rested on making cheap labour available to multi-nationals and pegging the renminbi to the dollar. The dollar peg allowed China to leverage the US financial system for its international needs, while domestic finance remained state-controlled to redistribute prosperity from the coast to interior provinces. This dual approach has worked remarkably well. China could have its cake and eat it too. Of course, the global credit bubble was what allowed China’s dual approach to be effective; its inefficiency was masked by bubble-generated global demand.

China is aware that it must become independent from the dollar at some point. Its recent decision to turn Shanghai into a financial centre by 2020 reflects China’s anxiety over relying on the dollar system. The year 2020 seems remote, and the US will not pay attention to something so distant. However, if global stagflation takes hold, as I expect it to, it will force China to accelerate its reforms to float its currency and create a single, independent and market-based financial system. When that happens, the dollar will collapse.

The Financial Times reports that the freeze on depositor withdrawals at Russian bank Globex is leading to high levels of withdrawals at other Russian banks, which doesn’t qualify as being a run…..yet.

From the Financial Times (hat tip reader Michael):

Globex on Wednesday banned depositors from withdrawing their money as confidence in the Russian banking system began to show signs of evaporating.

Globex, a mid-sized retail bank with assets of $4bn (€2.95bn, £2.32bn), is the first Russian bank to experience a run on deposits during the crisis. It lost 13 per cent of its deposits last month, according to Maxim Raskosnov, an analyst at Renaissance capital, and a further 15 per cent this month according to Emilya Alieva, Globex’s vice-president.

At least a dozen other Russian banks have reported a sharp rise in withdrawals and account closures.

An economist with a leading western bank in Moscow said Globex was probably the first in what could be a number of bank panics, if the government did not take concerted action soon. “I think there are a large number of small and medium sized banks that are in the same situation,” she said.

Despite a Kremlin promise of $200bn in relief funds – $87bn this week – the fall-out of a stock market plunge and the global credit crunch appears to be worse than anticipated, analysts say.

So far, the crunch has not affected the living standards of ordinary Russians, but a rash of bank failures could.

Banks across Russia have faced a rise in outflows as depositors have begun to lose trust in all but the biggest state banks, VTB and Sberbank, which have received most of the government’s liquidity support.

Tatyana Sadovskaya, the director of a branch of Khnati Mansisk Bank in the city of Nizhnevartovsk, on Wednesday told Interfax news agency that in response to rumours of her bank’s insolvency: “People have formed long lines at cashiers and at bankomats, people are taking their deposits and closing their accounts.”

From a later FT article “The East is in the red“:

Across central and eastern Europe, the global crisis is biting hard, albeit very unevenly. In Russia, the authorities have set aside nearly $200bn (£116bn, €149bn) for a financial market rescue, Ukraine is in talks with the International Monetary Fund over emergency loans of up to $14bn, Hungary was on Thursday bailed out with a €5bn ($6.7bn, £3.9bn) loan facility from the European Central Bank.

Latvia and Estonia are suffering the region’s first recessions in a decade, while growth in oil-rich Kazakhstan has slowed to a crawl. Even in Poland, where Donald Tusk, the prime minister, insists his country is “an island of stability”, the crisis has raised doubts about Warsaw’s euro entry plans.

Stock markets have plunged accordingly, with Polish shares trading at less than half their peak levels and Ukraine’s down by three-quarters. Property markets have slowed, even if developers are still trying to hold up prices. After riding high earlier in 2008, some currencies have come under pressure, notably the Hungarian forint. In Ukraine, where the central bank has intervened to support the hryvnia, the credit default swap rate, a risk measure, has soared 1,400 points to 1,900, among the world’s worst.

The financial whipsaw has cut billionaires down to size, not least Oleg Deripaska, the Russian metals oligarch, who has sold valuable stakes to raise cash. Others are grabbing opportunities to buy cheaply: Mikhail Prokhorov, the Russian nickel investor, acquired 50 per cent of Renaissance Capital, a Moscow bank, for $500m – about one-quarter of its value of a year ago.

With the global crisis still raging, despite the calming effects of this week’s support moves in the US and the European Union, it is impossible to predict how events will play themselves out in a region increasingly important to the west as an export market and low-cost production base. But hopes it might escape unscathed have evaporated. Apart from corporate casualties, some countries could run into difficulties funding current account deficits. Erik Berglof, chief economist of the European Bank for Reconstruction and Development, says: “There is enormous uncertainty right now . . . These countries could deal with rising borrowing costs and an economic slowdown coming from the US and western Europe, but a complete shutdown of international borrowing – nobody can withstand that.”

Griping Online? Comcast Hears You and Talks Back New York Times

Economists’ new research shows positive effects of minimum-wage increases PhysOrg

A Turkish theater for World War III Chan Akyam, Asia Times. I have no idea how likely the author’s scenario is, but the piece does suggest, if nothing else, that Turkey is going to become a flash point.

It’s NOT international trade. Don’t be fooled Econospeak. The last paragraph swings and misses, but the rest of piece presents an underexamined line of thought.

TNK-BP chief executive Robert Dudley quits Russia Times Online, plus a different example of the same phenomenon, An Investment Gets Trapped in Kremlin’s Vise The New York Times. The number one issue in investing in countries that lack proper due process even for the natives is you are at risk of having your assets expropriated. China enthusiasts take note.

US Banks: The Good, the Bad and the Ugly Institutional Risk Analytics. This article says that the majority of banks in the US look to be in good shape and then looks at BankAtlantic, CapOne, and WaMu. This newsletter is the past has been more downbeat about about the banking industry, I wonder if it felt the need to distance itself from the bloggers that Shiela Bair said were “out of control”.

Antidote du jour:

Bond maven Bill Gross has raised his estimate of losses from the credit crunch to $1 trillion. One has to note that his firm is a large holder of Freddie and Fannie debt and he issued this pronouncement the day after the GSE rescue bill passed the House and looks certain to become law.

Note also that this is far from the gloomiest view on record. Well respected analyst Frank Venerose now predicts $2 trillion in credit related losses; Hedge fund Bridgewater, whose research is read by central banks, expects $1.6 trillion in markdowns; hedge fund manager John Paulson, who bet aggressively and successfully on the subprime debt debacle, anticipates $1.3 billion.

From Gross’ August newsletter:

The deflating U.S./global asset markets are much like Churchill’s Russia: a riddle wrapped in a mystery, inside an enigma. “Who is driving delevering?” asks the Financial Times, and the answer comes back, “all of us;” yet it is hard to see it except in the headlines or to fix it, given a lineup of 6.8 billion suspects….

Yves here. This is a tad disingenuous. The “who” question implies the deleveraging may not be warranted. As Veneroso stresses, it is necessary, inevitable, and long overdue. US debt totals nearly $50 trillion. GDP is a tad over $14 trillion. That gives a debt to GDP ratio of 350%. That is vastly in excess of anything this economy has seen, excluding the parabolic rise to this level. The previous peak was around 260% of GDP during the Depression, when Roaring Twenties debt reached unprecedented levels and then (in relation to GDP) spiked higher as GDP fell dramatically but the loans were slower to be written off..

Back to Gross, who compares capital to the mother’s milk of capitalism and then uses bovine metaphors:

Let’s blame it on the barn, or if you must, home prices. Here is one asset that all observers can agree is going down in price for justifiable reasons….

Yet housing, unlike other asset classes, carries with it an aura more like a bad dream than a fairy tale. Unlike the frog that when kissed turns into a handsome prince, housing can morph a froglike economy into something resembling Godzilla. That is because it is the most levered asset class and the one held by more “investor” citizens than any other. U.S. homes are market valued at over 20 trillion dollars with nearly half of the value supported by mortgage finance of one sort or another. At first blush that appears to be reasonably levered, but at the margin, homes purchased in 2004 and beyond are now at risk of turning upside down – negative equity – and there are some 25 million or so of those. The “upsidedownness” in many cases results in foreclosures, or outright abandonment and most certainly serves as an example of what not to do for millions of twenty-somethings or new citizens choosing between homeownership and renting. The dominoes fall month-by-month…. An asset deflation in turn becomes a debt deflation, as subprimes, alt-As, and finally prime mortgages surrender to the seemingly inevitable tide. PIMCO estimates a total of 5 trillion dollars of mortgage loans are in risky asset categories and that nearly 1 trillion dollars of cumulative losses will finally mark the gravestone of this housing bubble. The problem with writing off 1 trillion dollars from the finance industry’s cumulative balance sheet is that if not matched by capital raising, it necessitates a sale of assets, a reduction in lending or both that in turn begins to affect economic growth, creating what Mohamed El-Erian fears as a “negative feedback loop.”

A trillion dollars is a lot of money, but in this age of photoshop wizardry it seems that experts can make just about anyone or anything look good. Lose a trillion? Well, just write it off a little more slowly, or suggest that mark-to-market accounting is not applicable to banks and investment banks. As a matter of fact it may not be. GaveKal’s Anatole Kaletsky points out that “the whole point of a bank is to exchange short-term, liquid liabilities for long-term illiquid assets whose value is hard to gauge. This liquidity and maturity transformation, in fact is the main social function that a banking system provides.” I and others on PIMCO’s Investment Committee wholeheartedly agree. But the reluctance to remark rancid mortgage loans rests on the heretofore inevitable conclusion that home prices will bottom and then reflate within a reasonable period of time. If they go down even more, and stay down, well then Washington – Wall Street – and ultimately, Main Street – we have a problem. That is why Hank Paulson and in turn Christopher Cox are waving their independent but coordinated wands in an effort to 1) prevent a market run on the price of bank and investment bank stocks until there is enough time to reflate the U.S. housing market, and 2) ultimately recapitalize our primary mortgage lenders – FNMA and Freddie Mac. An interesting press release by the CBO on July 22nd, by the way, points out that the GSEs are barely solvent (9 billion dollars) when their assets are valued at current market prices. Housing’s cow needs to turn into a bull real quick.

Make no mistake, the current conundrum that must be solved is: how to make the price of 120 million U.S. barns stop going down in price and then to make them go up again. That, however, is easier said than done. One of the wisest men I know has this serious but admittedly impractical solution: have the government buy one million new/unoccupied homes, blow them up, and then start all over again. Absent that, he’s not quite sure what to do, nor am I, with the exception of the next paragraph’s proposal.

Up until this point, the joint efforts of the Fed and the Treasury have been directed towards maintaining the stability of our major financial institutions, recapitalizing their balance sheets in “current form,” and lowering the cost of mortgage credit. All are crucial to any solution, but it is this third and last point where markets have failed to cooperate. With Fed Funds having been lowered from 5¼% to 2%, it would have been logical to assume that the price of mortgage credit would go down as well and that the price of homes would at least slow their current descent. Not so. As Chart 2 points out, the yield on a 30-year agency mortgage-backed loan has actually risen since the Fed somewhat unexpectedly began to lower Fed Funds in early September of 2007. Add to that of course, the increased fees, points, and total spread that an actual homebuyer pays to finance his purchase now as opposed to then, and it is obvious that homes are not the bargains that starving realtors claim they might be. Financial asset prices, as well as those for homes, are really the discounted present value of what investors believe those assets will be worth far into the future. When the discount rate – in this case a 30-year mortgage – rises faster than the expectations for home prices themselves – then the price of a home falls. 7% + “all in” yields for current home financing, in contrast to prior periods of monetary easing, are lowering, not raising the discounted present value of an existing home. Blow them up? Well, yes, I suppose if we could. But absent that, lowering the cost of mortgage credit via the omnibus housing/GSE bill now placed before the Congress and the President is the best way to begin the long journey back to normalcy.

To return the housing, cow milking, asset price deflating metaphor to its broader context, the increasing price of credit is a common denominator worldwide in the delevering process which it drives, or in turn, is driven by. If the cost of credit – the discount rate for present value – would go down, then asset prices would be better supported. Stocks wouldn’t sink so fast, commercial real estate wouldn’t wobble so, and Donald Trump wouldn’t have to exaggerate as often about how rich he is (make sure to buy T-Bills or GSE mortgages with that $95 million, Donald – if it closes). But the cost of credit is going up, not down, in contrast to prior cycles, because astute investors recognize the myriad of global imbalances that threaten future stability. In addition to home prices, $130 a barrel oil and their resultant distortion of global wealth and financial flows head that list. For now, investors should remain in high quality assets – until – until, well…until the prospect for home prices points skyward or until the cows come home, whichever one’s first.

Readers will no doubt note the curious failure to acknowledge the delevering as the result of mounting insolvencies, which makes the idea of stopping the fall in loan prices an exercise in fantasy.

We’ve cribbed the title of a provocative post by Satyajit Das at Eurointelligence. He argues that the US’s days of continuing to borrow abroad with little worry as to the consequences may be nearing an end.

A good companion piece is Menzie Chinn’s Implications of adjustment to riskier dollar assets in a portfolio balance framework, illustrated in three steps . Great minds are working alike.

The key issue with US debt, which not enough analysts have focused on (Brad Setser being a noteworthy exception) is that our creditors are not merely lending to us to fund their exports. They are also lending us the money to pay interest on money they lent us in the past to buy their exports. At some point, the debt service component becomes too high relative to the portion that goes to fund current exports. Or the economies over time develop more robust consumer sectors and the importance of funding exports is less pronounced.

Here is the beginning of the Das post, which I recommend reading in its entirety:

High levels of debt are sustainable provided the borrower can continue to service and finance it. The US has had no trouble attracting investors to date. Warren Buffett (in his 2006 annual letter to shareholders) noted that the US can fund its budget and trade deficits as it is still a wealthy country with lots of stock, bonds, real estate and companies to sell.

In recent years, the United States has absorbed around 85% of total global capital flows (about US$500 billion each year) from Asia, Europe, Russia and the Middle East. Risk adverse foreign investors preferred high quality debt – US Treasury and AAA rated bonds (including asset-backed securities (“ABS”), including mortgage-backed securities (“MBS”)). A significant portion of the money flowing into the US was used to finance government spending and (sometimes speculative) property rather than more productive investments.

The real reason that the US actually has not experienced a sovereign debt crisis is that it finances itself in it own currency. This means that the US can literally print dollars to service and repay it obligations.

The special status of the US derives, in part, from the fact that the dollar is the world’s major reserve and trade currency. The dollar’s status derives, in part, from the gold standard that once pegged the dollar to the value of gold. The peg and full exchangeability is long gone. The aura of stability and a safe store of value based on the strength of US economy and military power has continued to support the dollar. In 2003, Saddam Hussein, when captured, had US$750,000 with him – all in US$100 bills. The dollar’s favoured position in trade and as a reserve currency is based on complex network effects.

Many global currencies are pegged to the dollar. The link is sometimes at an artificially low rate, like the Chinese renminbi, to maintain export competitiveness. This creates an outflow of dollars (via the trade deficit that in turn is driven by excess US demand for imports based on an overvalued dollar). Foreign central bankers are forced to purchase US debt with dollars to mitigate upward pressure on their domestic currency. The recycled dollars flow back to the US to finance the spending. This merry-go-round is the single most significant source of liquidity creation in financial markets. Large, liquid markets in dollars and dollar investments are both a result and facilitator of the process and assist in maintaining the dollar’s status as a reserve currency.

The dominance may be coming to an end. There is increasing discussion of re-denominating trade flows in currencies other than US$. Exporters are beginning to invoice in Euro or Yen. There are proposals to price commodities, such as oil and agricultural goods, in currencies other dollars. Some countries have abandoned or loosened the linkage of their domestic currency to the dollar. Others are considering such a move.

Foreign investors, including central banks, have reduced investment allocations to the dollar. The dollar’s share of reserves has fallen from a high of 72% to around 61%. Foreign investor demand for US Treasury bonds has weakened in recent times. Low nominal (negative real) rates on interest and dollar weakness are key factors.

Foreign investors may not continue to finance the US. At a minimum, the US will at some stage have to pay higher rates to finance its borrowing requirements. Ultimately, the US may be forced to finance itself in foreign currency. This would expose the US to currency risk but most importantly it would not be able to service its debt by printing money. The US, like all borrowers, would become subject to the discipline of creditors.

For the moment, the US$ is hanging on – just.

The post continues here.

As he is often wont to do, Ambrose Evans-Pritchard worries, in dire terms, about the poor prospects for growth and stability, It would be easy to dismiss him as histrionic were it not for the fact that some commentators who have been right so far about the progress of the credit crunch, are also hyperventilating. Witness Nouriel Roubini’s latest offering, “The Coming Systemic Bust of the U.S. Banking System: ‘Dead Stocks Rallying’“. By comparison, Evans-Pritchard is almost cheery.

In truth, this piece isn’t Evans-Pritchard’s best work (he and others have covered parts of this ground before), but some observations were nevertheless interesting and likely to elicit reader reactions. so I’m providing extracts.

From the Telegraph:

The world’s two biggest financial institutions have had a heart attack. The global currency system is breaking down. The policy doctrines that got us into this mess are bankrupt. No world leader seems able to discern the problem, let alone forge a solution.

The International Monetary Fund has abdicated into schizophrenia. It has upgraded its 2008 world forecast from 3.7pc to 4.1pc growth, whilst warning of a “chance of a global recession”. Plainly, the IMF cannot or will not offer any useful insights.

Its “mean-reversion” model misses the entire point of this crisis, which is that central banks have pushed debt to fatal levels by holding interest too low for a generation, and now the chickens have come home to roost. True “mean-reversion” would imply debt deflation on such a scale that would, if abrupt, threaten democracy.

The risk is that these same central banks will commit a fresh error, this time overreacting to the oil spike. The European Central Bank has raised rates, warning of a 1970s wage-price spiral. Fixated on the rear-view mirror, it is not looking through the windscreen.

The eurozone is falling into recession before the US itself. Its level of credit stress is worse, if measured by Euribor or the iTraxx bond indexes. Core inflation has fallen over the last year from 1.9pc to 1.8pc

The US may soon tip into a second leg of this crisis as the fiscal package runs out and Americans lose jobs in earnest. US bank credit has contracted for three months. Real US wages fell at almost 10pc (annualised) over May and June. This is a ferocious squeeze for an economy already in the grip of the property and debt crunch…..

The awful reality is that Washington has its back to the wall. Fed chief Ben Bernanke thought the US could always get out of trouble by monetary stimulus “à l’outrance”, and letting the dollar slide. He has learned that the world is a more complicated place.

Oil has queered the pitch. So has America’s fatal reliance on foreign debt. The Fannie/Freddie rescue, incidentally, has just lifted the US national debt from German ‘AAA’ levels to Italian ‘AA-’ levels.

China, Russia, petro-powers and other foreign states own $985bn of US agency debt, besides holdings of US Treasuries. Purchases of Fannie/Freddie debt covered a third of the US current account deficit of $700bn over the last year. Alex Patelis from Merrill Lynch says America faces the risk of a “financing crisis” within months. Foreigners have a veto over US policy…

My view is that a dollar crash will be averted as it becomes clearer that contagion has spread worldwide. But we are now at the point of maximum danger. Britain, Japan, and the Antipodes are stalling. Denmark is in recession. Germany contracted in the second quarter. May industrial output fell 6pc in Holland and 5.5pc in Sweden.

The coalitions in Belgium and Austria have just collapsed. Germany’s left-right team is fraying…

This is the healthy part of Europe. Further south, we are not far away from civic protest. BNP Paribas has just issued a hurricane alert for Spain….

China, India, East Europe and emerging Asia have all stolen growth from the future by condoning credit excess. To varying degrees, they are now being forced to pay back their own “inter-temporal overdrafts”.

If we are lucky, America will start to stabilise before Asia goes down. Should our leaders mismanage affairs, almost every part of the global system will go down together. Then we are in trouble.

Before you break out the champagne on the news that international investors like the US (or more accurately, hate its stocks less than those of other nations), the article does not address the weighting of equities relative to other asset classes (ie, total allocations could still be down due to shifting more capital to commodities, bonds, or even plain old cash). The relative allocation to the US could be up with the absolute amount invested down.

The article also does not say what proportion of the funds surveyed hedge their currency exposure (certain . Many of these investors presumably do, either on a fund by fund basis, or across all funds (some, of course, take a point of view in their currency overlays). I’ve always wondered how well hedging works for equities in practice, given that the portfolio value changes frequently due to changes in market prices and investor withdrawals/contributions, and that the timing and amount of dividends can change based on trading within the portfolio.

From the Telegraph:

Fund managers across the world are dumping stocks and retreating to cash in a mood of extreme pessimism, fearing that the looming economic crunch is an even greater threat than inflation.

The latest survey of investors by Merrill Lynch shows that an unprecedented 41pc now think that a world recession is either likely or very likely. The majority dismiss hopes of double-digit earnings growth next year as “fantasy”.

“People are a lot more scared about the macro-outlook. The survey has never seen anything like this before since it began a decade ago,” said David Bowers, the organiser of the report.

“Recession risk has taken over from inflation risk. Fund managers believe the global economy is deteriorating so fast that a wage-spiral is never going to happen, at least in developed markets,” he said. The survey is based on 191 funds managing assets worth $610bn (£305bn).

The US is emerging as the one bright spot in the global gloom, despite the credit mayhem. A net 7pc of investors are overweight in US equities, clearly betting that most of the bad news is already in Wall Street prices. The figure was negative in May…..

“The US has now become the country of cheap manufacturing. You’ve got 20pc wage inflation in emerging markets so FDI (foreign direct investment) is flowing back there,” said Karen Olney, Merrill’s chief European equity strategist.

The investor love affair with India, China, and Asian markets over the last nine months has turned sour.

“That trade is off,” said Mrs Olney. A net 75pc are underweight Indian equities as the country’s inflation reaches double digits. Chile (-69), Taiwan (-50), Korea (-50), Malaysia (-44) are not far behind.

Mr Bowers said investors had woken up to the nasty reality that emerging markets have let rip with inflation and will now have to jam on the brakes.

Those with dollar pegs or dirty floats like China have, in effect, been “destabilised” by the US Federal Reserve’s rate cuts….

Russia (+75) remains the darling of the emerging universe, but for how long? Almost two thirds of investors say oil is fundamentally overvalued…..

A net 42pc think the Bank of England has kept interest rates too high given the housing slump and the consumer squeeze…

Europe is not faring much better. Some 96pc think the economy will get worse over the next year, up sharply from the June survey. A majority believe inflation will fall, and a net 24pc say the European Central Bank is engaging in overkill. Not surprisingly, a record 32pc are now underweight eurozone equities…

Japan is sneaking back into favour after years in the wilderness, if only by default. “Japanese banks are the winner from the credit crunch. Japan now has the capacity to be the monopoly supplier of capital to the world once again,” said Merrill Lynch.

Ambrose Evans-Pritchard appears to be trying to corner the market in apocalyptic financial news. But his sources aren’t evangelicals, survivalists, or even goldbugs. The experts he cites are with respected financial firms, meaning they don’t sound alarms casually. Even more significant, the terms they are using to describe what might be coming are uncharacteristically dire.

The latest bad tidings in that the Fannie/Freddie turmoil may lead our favorite foreign credit sources to dial down their purchases of Treasuries and agencies a tad. We’ve become so dependent on foreign credit that a mere tightening of the spigot would have significant consequences.

Tim Price, a UK based investment manager, gives a long-form treatment of a theme I’ve mentioned: we are way way outside known historical patterns. That is troubling to anyone, but it is particularly unnerving to the order-liking mindsets of analysts and central bankers:

That stock market price action has been so consistently dreadful with such little evidence of a sustainable floor despite flurries of ostensibly positive news (Santander / Alliance & Leicester; some form of formal pastoral care for Fannie Mae and Freddie Mac) could be interpreted as a sign that many investors remain trapped at the “denial” stage of this particular market disaster. Or perhaps many investors, institutional and individual alike, are now mulling their deliberative options. And some, presumably, have already reached the decisive phase, and already pulled the plug on much of their market exposure and initiated the dash for cash. This may or may not prove to be the prudent strategy; only time will tell. It certainly seems to show the merit in the advice that if you’re going to panic, panic early. We would merely hazard the following suggestion: the current market environment is flushing out those investors (supposedly “professional” and individual) who are congenitally unsuited to be making substantial portfolio allocations to the equity markets. The fiendish difficulty for those who decide to be out of the market entirely will be when to decide to get back in.

Classic Buffettology advises us to get greedy when others are fearful. This would ordinarily be sound advice, if somewhat difficult psychologically to execute. But if that blanket exhortation proves to be deficient or at least premature this time around, it will be because the nature of the problems facing financial markets, central banks and commercial banks is off the charts. It feels difficult because many of us have never been here before: only part-way through the historic bust of an extraordinary credit boom, only part-way through a property market correction that could yet last for months if not years, and only part-way through probably the gravest systemic crisis facing the banking system since the 1970s, if not indeed the 1930s. What accelerates and amplifies the downwave in stock markets is the state of our brave and newly inter-connected world where all investors are effectively neurons firing in a vast collective brain. And the global investment brain has suffered a stroke, an ischemic shock triggered by a sudden catastrophic lack of confidence mixed with heady deleveraging.

Now to Evans-Pritchard (hat tip reader Dwight):

Merrill Lynch has warned that the United States could face a foreign “financing crisis” within months as the full consequences of the Fannie Mae and Freddie Mac mortgage debacle spread through the world.

The country depends on Asian, Russian and Middle Eastern investors to fund much of its $700bn (£350bn) current account deficit, leaving it far more vulnerable to a collapse of confidence than Japan in the early 1990s after the Nikkei bubble burst. Britain and other Anglo-Saxon deficit states could face a similar retreat by foreign investors.

“Japan was able to cut its interest rates to zero,” said Alex Patelis, Merrill’s head of international economics.

“It would be very difficult for the US to do this. Foreigners will not be willing to supply the capital. Nobody knows where the limit lies.”

Brian Bethune, chief financial economist at Global Insight, said the US Treasury had two or three days to put real money behind its rescue plan for Fannie and Freddie or face a dangerous crisis that could spiral out of control.

“This is not the time for policy-makers to underestimate, once again, the systemic risks to the financial system and the huge damage this would impose on the economy. Bold, aggressive action is needed, and needed now,” he said.

Mr Bethune said the Treasury would have to inject up $20bn in fresh capital. This in turn might draw in a further $20bn in private money. Funds on this scale would be enough to see the two agencies through any scenario short of a meltdown in the US prime property market…..

Yves here. The problem is that the Treasury lacks statutory authority to do so, and despite going to the trouble to announce a plan on a Sunday before markets opened in Asia, there is no sign that anything concrete has been done to advance the ball.

Roughly $1.5 trillion of Fannie and Freddie AAA-rated debt – as well as other US “government-sponsored enterprises” – is now in foreign hands. The great unknown is whether foreign patience will snap as losses mount and the dollar slides.

Hiroshi Watanabe, Japan’s chief regulator, rattled the markets yesterday when he urged Japanese banks and life insurance companies to treat US agency debt with caution. The two sets of institutions hold an estimated $56bn of these bonds….

But the lion’s share is held by the central banks of China, Russia and petro-powers. These countries could all too easily precipitate a run on the dollar in the current climate and bring the United States to its knees, should they decide that it is in their strategic interest to do so.

Mr Patelis said it was unlikely that any would want to trigger a fire-sale by dumping their holdings on the market. Instead, they will probably accumulate US and Anglo-Saxon debt at a slower rate. That alone will be enough to leave deficit countries struggling to plug the capital gap. “I don’t see how the current situation can continue beyond six months,” he said.

Merrill Lynch said foreign governments had added $241bn of US agency debt over the past year alone as their foreign reserves exploded, accounting for a third of total financing for the US current account deficit….

Global inflation is now intruding with a vengeance as well. Much of Asia is having to raise rates aggressively, drawing capital away from North America. This may push up yields on US Treasuries and bonds, tightening the credit screw at a time when the US is already mired in slump.

Russia’s deputy finance minister, Dmitry Pankin, said the collapse in the share prices of Fannie and Freddie over the past week was irrelevant because their debt has been effectively guaranteed by the US government under the rescue package.

“We don’t see a reason to change anything because the rating of the debt of those agencies hasn’t changed,” he said.

Foreign policy experts doubt that the picture is so simple. Russia is likely to use its $530bn reserves as an implicit bargaining chip in high-stakes diplomacy, perhaps to discourage the US from extending Nato membership to the Ukraine and Georgia.

Vladimir Putin, now Russia’s premier, has stated repeatedly that his country is engaged in a new Cold War with the United States. It is clear that Moscow would relish any chance to humiliate the United States, provided the costs of doing so were not too high for Russia itself.

China is regarded as a more reliable partner, with a greater desire for global stability….

Yves here. Partner maybe, only in the way Ambrose Bierce defined it in the Devil’s Dictionary:

When two thieves have their hands so deeply plunged into each other’s pocket that they cannot separately plunder a third party.

If we think China is a friend, we will be disappointed.

Brad Setser, from the US Council on Foreign Relations, said the Chinese have a stake in upholding Fannie and Freddie, not least to ensure that their loans are “honoured on time and in full”.

David Bloom, currency chief at HSBC, said fears that regional banks could start toppling after the Fed takeover of IndyMac last week were now the biggest threat to the dollar.

“We have a pure dollar sell-off,” he said. “It’s a hating competition: at the moment the markets hate the dollar more than they hate the euro, even though German’s ZEW confidence indicator was absolutely atrocious.”

Ambrose Evans-Pritchard in “Monetarists warn of crunch across Atlantic economies” in the Telegraph points to a troubling development: a fall over last few months in M1 and M2 in the US, UK and EU.

Many have criticized the Fed for “printing money” of late. But the evidence suggests otherwise. First, all of the cash injections that the central bank has undertaken via its alphabet soup of new lending facilities have been met with roughly equal withdrawals though open market operations. Thus the new facilities themselves have not led to monetary expansion.

Second, critics like to point to the Fed’s negative real interest rates as lax monetary policy. In the dot-bomb environment, which was not a credit crisis, that charge is accurate, and that policy helped create our current mess.

But we now have credit contraction. Deleveraging is deflationary. Somewhat loose monetary policy is appropriate. Unlike 2002, banks or securities firms are not going out to create new debt, which is the mechanism by which low interest rates lead to inflation or asset bubbles. Mortgage lending has become dependent on the Federal government via Freddie, Fannie, and the FHA (and the future of that support is now in question). Consumer credit of all sorts is being reined in. Dow Chemical had to go to Warren Buffett to borrow to acquire Rohm & Haas because it could not get funding from banks. Our credit intermediation system is barely functioning.

And oil is now playing a role that is weirdly parallel to gold in 1931. England abandoned the gold standard, which was tantamount to a devaluation. The US stayed on it at that juncture and raised interest rates even though the economy was very fragile. Countries that stayed on the gold standard in 1931 on average suffered a 15% fall in real GDP in 1932.

But gold was not an essential economic input. Oil is, and thus constrains the Fed’s ability to lower rates further (not that it has much leeway at 2%, since most economists regard going below 1% as risking falling into the zero interest rate trap that has enmeshed Japan).

From the Telegraph:

The money supply data from the US, Britain, and now Europe, has begun to flash warning signals of a potential crunch. Monetarists are increasingly worried that the entire economic system of the North Atlantic could tip into debt deflation over the next two years if the authorities misjudge the risk.

The key measures of US cash, checking accounts, and time deposits – M1 and M2 – have been contracting in real terms for several months. A dramatic slowdown in Britain’s broader M4 aggregates is setting off alarm bells here.

Money data – a leading indicator – is telling a very different story from the daily headlines on inflation, now 4.1pc in the US, 3.7pc in Europe, and 3.3pc in Britain.

Paul Kasriel, chief economist at Northern Trust, says lending by US commercial banks contracted at an annual rate of 9.14pc in the 13 weeks to June 18, the most violent reversal since the data series began in 1973. M2 money fell at a rate of 0.37pc.

“The money supply is crumbling in the US. There was a very sharp lending contraction in the second quarter lending. If the Federal Reserve is forced to raise rates now to defend the dollar, it would be checkmate for the US economy,” he said.

Leigh Skene from Lombard Street Research said the lending conditions in the US were now the worst since the Great Depression. “Credit liquidation has begun,” he said.

The Fed’s awful predicament does indeed have echoes of the early 1930s when the bank felt constrained to tighten into the Slump in order to halt bullion loss under the Gold Standard. Investors – notably foreigners – dictated a perverse policy. Over 4,000 US banks collapsed. This time a de facto “Oil Standard” is boxing in Ben Bernanke. Benign neglect of the dollar has started to backfire. It is pushing up crude, with multiple leverage.

The monetary picture is highly complex. The different measures – M1, M2, M3, M4 – have all given false signals in the past. Each tells a different tale, and monetarists fight like alley cats among themselves.

The Federal Reserve stopped paying much attention to the data a long time ago. It has abolished M3 altogether. The US economic consensus is New-Keynesian (dynamic stochastic general equilibrium model). Delving into the money entrails is derided as little better than soothsaying.

That attitude, retort monetarists, is the root cause of the credit bubble. The money supply almost always gives advance warning of big economic shifts. Those who track the data are now calling on central banks to move with extreme caution. If the rate-setters overreact to an inflation spike caused by oil and food – or confuse today’s climate with the early 1970s – they may set off an ugly chain of events.

“The data is pretty worrying,” said Paul Ashworth, US economist at Capital Economics. “US lending is shrinking dramatically in real terms, and we know from the Fed’s survey that banks want to tighten further. People are clamouring for higher rates but we think deflation is now the biggest threat. The idea that the Fed should tighten with unemployment soaring is preposterous,” he said. The jobless rate jumped from 5pc to 5.5pc in May.

In Britain, the Shadow Monetary Policy Committee – hosted by the Institute for Economic Affairs, and a refuge for UK monetarists – issued its own alert this week. The focus is on “adjusted M4″, which covers loans to “private non-financial corporations” and may offer the best insight into the health of British business.

The growth rate has dropped from 16.1pc a year ago to minus 0.5pc in April. It is the suddenness of the decline that matters most. The data reeks of recession. Professor Patrick Minford from Cardiff Business School called for an immediate rate cut, arguing that the credit crunch is a more powerful and long-lasting force than the oil inflation.

Professor Tim Congdon from the London School of Economics said the UK was lurching from boom to bust. “Real money growth is virtually nil. The British economy is taking a thrashing and it is going to get worse. Corporate money balances have contracted 3pc over the last three months, which is double digits on an annualised basis. This is a serious squeeze for companies,” he said.

Mr Congdon warned three years ago that surging M4 would lead to a “dangerous” bubble, which is what occurred. He now fears the MPC will react too late as the process goes into reverse.

Roger Bootle from Capital Economics said Britain could be facing a “real economic crisis and a financial collapse. The MPC does not have the luxury of waiting until all is absolutely crystal clear. By that time the bird will have flown.”

The eurozone is at a later stage of the credit cycle. Even so, house prices are collapsing in Spain, and falling in Germany and France. German industrial orders have dropped for the last six months in a row. A joint IFO-INSEE survey said eurozone growth had stalled to zero in the second quarter.

“Consumer lending has fallen off a cliff. It is contracting in real terms,” said Hans Redeker, currency chief at BNP Paribas. Core inflation has fallen from 1.9pc to 1.7pc over the last year.

Unlike the Fed, the European Central Bank keeps a close eye on money data (though not on real M1, now shrinking). It looks at the broader M3 figures. There is a raging debate in Europe over the signals now being sent by this indicator.

The M3 growth is still 10.5pc, down from 11.5pc in January. However, the data has been badly distorted by the closure of the capital markets. Firms have been forced to draw down existing credit lines from banks, which shows up as M3 growth. (It is the same story with America’s M3 since the collapse of the Commercial Paper market).

“The credit lines are expiring. Companies cannot roll over loans. We are going to see the entire private credit multiplier go into a slowdown,” said Mr Redeker.

Jean-Claude Trichet, the ECB’s president, said last week that the M3 data “overstates the underlying pace of monetary expansion”. The ECB nevertheless pressed ahead with a rate rise to 4.25pc, setting off a storm of protest. This may go down as one of the most unwise monetary decisions of modern times.

The strain on eurozone banks is growing by the day. They bid a record $85bn (£43bn) at the ECB’s last auction for dollars. Only $25bn was available. The spreads on Euribor interbank lending are still at extreme stress levels.

Few disputes that “global inflation” is taking off. Over 50 countries now face double-digit price rises. Ukraine (29pc), Vietnam (27pc), and the Gulf states are out of control, with Russia (15pc), and India (11pc) close behind. China (7.1pc) is on the cusp. Interest rates are still below inflation across much of the emerging world. This is the driving force behind spiralling commodity prices.

The oil spike is already squeezing real wages in the Atlantic region. The debate is whether the Fed, Bank of England, and ECB should squeeze them further, trying to off-set energy rises with a deflationary bust in the rest of the economy. If and when oil peaks in this cycle, they may find inflation crashing faster than they dare to imagine.

The 9th Circle in Dante’s Inferno – starring Judas and Brutus – is a frozen lake. Cold can be more frightful than heat. “Blue pinch’d and shrined in ice the spirits stood,” (Canto XXXIII). Such awaits the victims of debt deflation.