FROM OUR
ARCHIVE Creative accounting and destructive
debt By Henry C K Liu April
3, 2002
Alan Greenspan, chairman of the US
Federal Reserve Board, frequently credits US
growth in the 1990s to a rise in productivity made
possible by advances in technology. Yet studies
have shown that computerization did not stimulate
much rise in industrial productivity in the 1990s.
Industrial computerization was essentially in
place long before 1995. The 1990s boom in the US
was not an industrial boom but a financial boom.
This was made possible by three developments: the
deregulation of financial
markets, the computerization
of trading of financial instruments, and
globalization, particularly financial
globalization.
The entire structured
finance (derivatives) phenomenon would not be
possible without any one of the above mentioned
developments. Structured finance in essence
allowed an unprecedented explosion of credit, by
unbundling risks for a wide range of risk-takers
who sought corresponding compensatory returns.
While hedging initially provided protection
against volatility to individual market
participants, it soon became a profit center for
financial institutions. This led to the
institutionalization of volatility as a market
opportunity. Financial institutions actually
sought volatility in the system to provide a
continuous profit stream.
Creative
accounting, whose peculiar logic evolved from
structured finance, also made the traditional
debt/equity ratio immaterial. Ways were devised
for the large market participants to structure
debt as hedges, through swaps that avoided taxes
and balance-sheet liabilities. Swaps enabled
borrowers legally to book loan proceeds as current
operating income and loan liabilities as future
capital expenditure that could be kept off the
balance sheet, inflating current earnings.
Circular counterparty risks suddenly became
neutralized risk, and cash flow from swaps became
net revenue. These practices are now known as
Enronitis.
On the macro level, the global
finance game has become a sure win for those who
use dollars, especially those whose government
issues dollars by fiat. The world market has
become a place where the United States makes
dollars and the rest of the world makes what
dollars can buy. But after the Asian financial
crisis of 1997, the whole world essentially
adopted dollarization, if not directly, at least
through hedges, albeit sometimes at prohibitive
cost.
At that point, the US economy
suddenly began to lose its exclusive dollar
hegemony advantage because US entities were no
longer the only ones with access to dollars nor
could US transnationals avoid non-dollar revenue.
To maintain the "strong dollar" monetary policy
instituted by US treasury secretary Robert Rubin
at the beginning of the Bill Clinton presidency,
the US Federal Reserve progressively tightened
dollar money supply throughout most of the 1990s.
But this did not slow the US economy because
structured finance permitted debt to expand
without a corresponding expansion of equity. A
strong dollar gave the US economy a boom in
low-cost imports, while the US trade deficit
merely forced foreign exporters to hold dollar
reserves to finance the US debt bubble through a
US capital account surplus. Japan did this for a
whole decade, pushing its own economy into
permanent recession while its dollar reserves
mounted. Mainland China, Hong Kong and Taiwan took
up the slack from Japan by 1995 and the three
Chinese economies together now hold more dollar
reserves than Japan does. China, starved for
capital for domestic development, thus finds
itself stuck with US$200 billion in US Treasury
bills that pay 5 percent while it is forced to
offer foreign direct investment high double-digit
returns. The annual interest gap alone is in
excess of $20 billion, which amounts to half of
China's current annual foreign-capital inflow.
Growth in the 1990s came from a structural
shift of the US economy from industrial capitalism
to finance capitalism. Through financial
globalization, the US shifted labor intensive
manufacturing off US soil to low-wage locations,
thus lowering the cost of manufactured products.
Financial products and services and intellectual
property valuation constituted most of the growth,
making the US a consumer market of last resort for
the whole world. London, Frankfurt, Paris, Tokyo,
Hong Kong and Singapore became financial outposts
of New York, sucking up dollar reserves to support
the US debt bubble.
This game is ending,
as the US consumer market becomes saturated and
condemned to low single-digit growth, regardless
of business cycles. The wealth effect from a
tripling of equity value did not double
consumption in the US, because aggregate demand is
constrained by a widening income disparity. The
rich have bought all the manufactured products
they need and the working poor cannot afford to
buy all they want. The wealth effect did double
investment globally, reflected in the phenomenal
rise in market capitalization of US transnationals
and financial institutions, particularly in the
so-called New Economy. The competition for credit
favored double-digit growth markets in the
developing countries, but the US continued to
dominate global finance through its sophistication
and innovation in finance and through dollar
hegemony.
The problem is that all
unregulated markets eventually self-destruct. Weak
competitors are naturally forced off the market,
leading to monopolies that are the result of
market failure of competition. Yet regulation
cannot cure the problem preemptively because
remedial regulation only makes sense after
disasters, never before.
There is
increasing evidence that the real threat to China
is not democracy or the market economy per se but
the peculiar US version of these institutions. The
19th-century industrial capitalism that Marx
observed no longer exists. Finance capitalism is a
system in which capital is only a notional value
upon which to build a gigantic mountain of hidden
debt. Representative democracy and unregulated
market fundamentalism in the US mode now work as
legalized constitutional devices to disfranchise
the poor and weak, both locally and globally.
Greenspan acknowledged this in his
semiannual monetary policy report to the US
Congress, before the Committee on Financial
Services on February 27: "From one perspective,
the ever-increasing proportion of our GDP [gross
domestic product] that represents conceptual as
distinct from physical value-added may actually
have lessened cyclical volatility. In particular,
the fact that concepts cannot be held as
inventories means a greater share of GDP is not
subject to a type of dynamics that amplifies
cyclical swings. But an economy in which concepts
form an important share of valuation has its own
vulnerabilities." He was of course referring to
Enronitis.
Greenspan's observation about
the vulnerabilities of conceptual valuation was on
target, although his warning of vulnerability was
disproportionately misplaced. Even after the Enron
and Global Crossing controversies, Greenspan
continues to resist regulation, preferring to rely
on market discipline. The risk is much higher than
he admits.
Past records do not reliably
project future vulnerability risk. Any risk
manager knows that accidents are always waiting to
happen. The fact that it has not happened in the
past does not mean it will not happen in the
future. In fact, with each passing day without an
accident, the risk of borrowed time increases. Low
probability is only a source of comfort if the
impact is not fatal.
Also, what Greenspan
did not say, but admitted by implication, was that
finance capitalism is operating with less and less
reliance on capital. Capital has become a notional
value in structured finance. Credit is no longer
anchored by equity but by circular hedges.
Debt-to-equity ratio is no longer a relevant
consideration. Practically all US major businesses
nowadays, with their high debt leverage, would
have negative real equity if the price/earning
(P/E) ratio were to return to historical norms.
Blue chips are being shut out of the unsecured
short-term commercial paper market. Corporate
credit ratings are inflated by exorbitant market
capitalization value, which in turn reflects
irrational P/E ratios. Even now, during what many
on Wall Street contend to be a savage bear market,
the Standard & Poor's 500 Index yields 25
times earnings. It would have to fall by another
41 percent to reach the median valuation
prevailing since 1957.
Such a decline can
happen in a period of days in this age of program
trading and socialized risk, even with circuit
breakers and trading curbs. When that happens,
structured finance will be a sea of dead and
wounded in counterparty casualties, regardless of
who won and who lost.
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