Page 1 of 2 Deaf frogs and the Pied Piper
By Chan Akya
A truly horrible joke from the days when vivisection was still permitted has it
that a scientist took to the lab a trained frog that could jump whenever it
heard the command "jump". In that respect, the amphibian was quite similar to
communist party members around the world, but anyway let's carry on with the
story.
In the lab, the scientist placed the frog on a table and swiftly sundered one
limb. He then said "jump" and the frog complied with some difficulty. He then
proceeded to do the same to the limb on the opposite side and said the same
thing - and the frog miraculously managed to jump again. Then the third limb
and the frog defied all odds by still jumping with just one limb. Finally, the
last limb was split and of course this time the frog could not jump.
The scientist wrote his conclusion in the journal, "When it lost all four
limbs, the frog became DEAF."
With all apologies to animal lovers, the story resonated with me
last week not so much because I happened to pass a French restaurant or two,
but rather the triumphant signaling of the end of market capitalism that is
being heralded by leftist newspapers and other media outlets globally. Across
Asia, the decline of American banks and government-sponsored intervention in
financial markets is being seen as the reason for everyone to return to
Japanese-style interventionist policies.
Asian bloggers have come to provide faint praise to the state intervention
policies of Henry Paulson and Ben Bernanke, as their moves somehow "prove"
anti-market policies, such as fixed currency pegs, state restrictions on bank
lending, restrictions on investing instruments such as short selling and the
like. Much like the "deaf" frog, a number of these conclusions are patently
erroneous and more to the point, downright dangerous for Asian policymakers.
To be sure, this is a bad time for anyone to be seen to be defending the ideals
of market capitalism and its supposed superiority, which appears rather weak in
the face of the most recent collapse of confidence globally. Fair weather
friends though are easy to find, perhaps what Asia needs now more than ever is
sensible debate on the subject. It is not the question of whether what is
touted as the Beijing Consensus is somehow superior to the Washington version,
it is whether either can serve the needs of the hundreds of millions Asians
still mired in poverty.
My defense of market capitalism is based on three aspects:
1. The ongoing crisis is due to state interventions, not despite them.
2. There is a secular change in global power structures underway.
3. Asia has more to lose from a return to communism or socialism than from a
renewed adherence to global market capitalism.
Doublespeak and the Pied Piper
Perhaps the bit of criticism about the current market collapse that really got
me chewing the leather is the one that involves the role of greedy bankers and
the like who created billions in unsafe securities that eventually piled on the
pain to their capital bases and let these institutions fail on a spectacular
level. The diagnosis, while correct in its observation of symptoms, fails to
nail the root cause of such excess, which was the availability of financing for
these ventures.
As I wrote last year, (see
Asia and the vicious cycle of bank bailouts, Asia Times Online, August
11, 2007), the main source of such funding was the billions of dollars
gathering dust in the vaults of Asian central banks. That was in turn coming
from the rise of trade surpluses with the US and other Western countries as
Asian central banks refused to make their currency regimes more flexible.
This lack of flexibility on currency movements was epochal state-driven
intervention; and something that every commentator today with an axe to grind
against market capitalism seems, quite conveniently, to forget. Then again,
doublespeak is de rigueur for communists around the world, so there is
little reason to labor that point.
Perhaps what made matters worse for the billions of savings entrusted to these
central banks was the quality of fund management that in turn arose from the
kind of mandates handed out. With the typical Asian central banks being
rule-bound, traditionally oriented fund managers with a mandate to preserve
capital rather than purchasing power, it soon became a bit too easy for former
Federal Reserve chairman Alan Greenspan and co to unleash untold miseries on
the global financial system.
There are two separate aspects to that previous paragraph, albeit interlinked.
The first is the mandate for Asian central bankers to capital preservation,
that is, if they were entrusted with US$100 billion in 2000, then they would be
expected to have slightly over $100 billion in 2001 of that money remaining.
This is very different from someone whose mandate is to preserve $100 billion
of purchasing power (for example of oil, steel, food grains, singing frogs or
anything else a growing economy like those in Asia need) in the years after
they were entrusted with that mandate. The first mandate is a typical
"communist" one; the second is a market-oriented capitalist one. No prizes here
for guessing which particular mandate the Asian central banks held.
The second aspect of that paragraph is the role of Greenspan when chairman of
the Federal Reserve, who shrewdly bet that the lack of available alternatives
globally (because Asian savings were growing faster than the bond markets of
developed markets) meant that a herd of bankers would follow him wherever he
went.
Thus when interest rates were cut sharply in the early part of this decade well
below prudential levels, in turn driving bond yields far below what would have
been required to maintain purchasing power, Asian central banks did not flinch
but simply accepted the new yields. They even congratulated themselves on the
billions of profits on US government bond and agency holdings as rates fell,
much like a rat praises the cheese that got it into a trap.
In effect, what the US exploited was a closed system of bondholders with
specific mandates and constraints that were completely different from the
principles of market capitalism - that is, the mandate to maintain purchasing
power that I laid out above. Back to the subject: Greenspan was thus able to
play the Pied Piper, taking Asian savers with him to the river with his
beautiful phrases like "conundrum of long-term rates", "global savings glut"
and "marked reduction in inflation expectations". When yields on US Treasury
securities fell below inflation rates, the search was on for securities with
"similar" security characteristics, which in the world of bonds means credit
ratings; that is, the much-vaunted triple-A rating that bond managers are
trained to respect.
The genius of free markets shone through here. On the one hand, a few billion
dollars of demand existed for securities that could be rated triple-A but paid
more than the US government did. On the other, there was the giant US mortgage
market that had the benefit of recording low payment defaults in its history.
Wall Street engineers soon started putting the two together and creating in
their wake billions in enhanced value financial products - triple A mortgages
of every variety (prime, agency-backed, subprime, alt-A and what have you),
other securitized products with triple As (asset-backed securities, or ABS),
corporate equivalents of triple A securities (collateralized debt obligations -
CDOs; collateralized loan obligations - CLOs; and the like) and so on. Some
folks even tried to create triple-A rated securities on stock markets, but even
the rating agencies thought that would be too difficult to rate at that level
with any shred of conscience.
The other side of genius is of course greed. Wall Street banks that absorbed
the billions of profits from selling these securities soon took to eating their
own cooking, with comical results for their employees and shareholders, as
shown in the past few weeks. Yes, a few folks in Wall Street are indeed my
friends, but that doesn't mean I do not take a certain amount of pleasure in
watching these fancy white-shoe folks eating dust.
Just so we are clear though - the entire charade can be traced to the decision
of Asian central bankers (or more importantly their governments) not to float
Asian currencies. In a free-floating system, Asian currencies would have
appreciated sharply, rendering returns on US government securities too low to
bother. This would have shifted up meaningfully the US yield curve, destroyed
the basic mortgage math of a few million Americans (that is, made mortgages too
expensive for them), and thus failed to create the hundreds of billions in
mortgage-backed securities that now swirl around the world.
The Ponzi in my cradle
Pretty much the worst gift that you can give a newborn child now is a 50-year
bond issued by a European country like Italy, France, Germany or Britain.
Forget principal repayment after half a century of demographic decline; it is
unlikely that coupon payments will be made (or worth anything in terms of
purchasing power) by the time the kid turns 20.
Unprecedented losses in the financial crisis around the world expose not so
much the distinction between market capitalism and other forms of economic
organization - as the previous part of this article makes clear - but instead
highlight deeper structural flaws that have become apparent and therefore
priced into market calculations.
As I argued last week (see
Terminal velocity, Asia Times Online, September 23, 2008), demographic,
productivity and other changes mean that the Group of Eight (G-8) leading
industrial countries is spent and it is really up to Asian economies to take up
the mantle of the sole economically viable region of the world. This is an
argument made from two fronts: firstly, the profit generation potential of G-8
economies and secondly the long-term demographic disadvantage of these
countries.
The first point is relatively easy to make by looking at the contribution of
profits to total gross domestic product for G-8 economies and within that, the
share of the financial sector. This approached in 2007 over half of all profits
in the case of the US economy, even as profits peaked historically. While the
share was lower for Western Europe, Japan and Russia, tying back
export-oriented profits to the US economy (which was finance driven) makes all
these economies part of the same ball game.
In effect, the subsidized availability of finance from the rest of the world
and especially Asia was the primary engine of growth for the US and its G-8
colleagues. What has happened now from a portfolio management perspective is
that Asian central banks and other investors will find it immensely difficult
if not well nigh impossible to find enough "safe" investment choices to lend
to; and even fewer to trust on a longer-term basis.
Losses for European and Japanese banks in the latest US financial crisis rival
those of American institutions and in most cases far surpass them. For example,
the list of the biggest lenders to Lehman Brothers, the failed investment bank,
is entirely Asian; billions of dollars worth of bonds that the company
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