The water served at the latest Group of 20 (G-20) meeting of finance ministers
and central bankers last weekend must have contained copious quantities of lead
or have been shipped over from Stalinist Russia using a time machine. For
nothing else apparently explains this newfound angst among the finance officers
of this group - and in particular those from the developed countries - to cut
off their noses to spite their political masters.
Cynical people wholly unlike myself may say that this august gathering somehow
figured out the futility of their actions and instead of admitting defeat
decided to engage in diversionary tactics such as egging on non-scandals. Be it
what it may, all
that chest-beating is of little consequence in terms of paving the way for a
resolution of the key issues confronting the global financial markets.
As a recap for readers unaware of the brouhaha, the US media have been
increasingly shrill in recent days about the "billions" of dollars in bonuses
paid in firms rescued with taxpayers' money. These range from AIG, which was
rescued with US Treasury funds from the middle of September to the present all
the way to Merrill Lynch, bought by Bank of America (which in turn received
government funds in December to replenish the capital lost in the purchase).
Interestingly, the initial scandal was brought about by the Bank of
America-Merrill Lynch merger, which had been hastily arranged by US authorities
in mid-September as investment banks teetered on the edge; Lehman Brothers did
go bankrupt in that period. Since then, a series of management challenges
within the newly merged entity may have created substantially enough bad blood
to cause the lid to be blown off the events leading to a Merrill Lynch decision
to pay US$3.6 billion to its employees just a working day or two before the
merger was officially consummated on January 1, 2009.
Realizing that the depth of problems not previously known about Merrill and
confronting a 80% decline in their own share price, Bank of America officials
had to move quickly to stem the damage; therefore deciding to fire the Merrill
Lynch chief executive, who had remained in the merged entity as part of the new
senior management team. Understanding this context is key: the bonus issue at
Merrill Lynch surfaced and became a lightning rod for populist anger only
because of the dynamics of declining share prices at Bank of America and the
resultant internal management squabbles.
To a large extent, government officials had stood by the side in the whole
charade, as their efforts to stabilize the financial system meant essentially
looking away at all the private arrangements being made between the buyer and
seller in terms of management positions, compensation and the like. Indeed, new
evidence showed that Bank of America actually wanted out of the mooted merger
with Merrill Lynch once it understood the scale of losses that had been hidden
from view.
By arranging the merger without proper scrutiny or understanding of Merrill's
books, in effect it was the US Treasury and the Federal Reserve that helped to
increase risks to their own financial system. Compounding the error, the Fed
persisted with the Bank of America rescue of Merrill Lynch because of the
scarring from the Lehman bankruptcy fiasco; however, it is clear that no
safeguards had been put in place to ensure that the combined entity would be
acceptable to the investing public.
Like Iraq, only worse
Closely mirroring the colossal incompetence shown by the two agencies (US
Treasury and Federal Reserve) in the Merrill Lynch rescue was the issue of the
government's own rescue of AIG. Concerned that a collapse of AIG could unravel
the vast market for credit default swaps and therefore imperil the entire
global financial system, the US government sought to provide funding for the
entity while it could cut the size of its overall exposures.
The problem with that arrangement was once again that the people put in charge
of monitoring the unwind of AIG - from the US government naturally - had no
real understanding of the credit derivative exposures at the heart of the
company. In effect, what AIG had done was to write many times the value of its
own shareholders' capital in insurance contracts on the fast-collapsing market
for credit globally in a futile bid to make some extra earnings.
In the dying days of the US administration of George W Bush, the greatest
mistake made in the aftermath of the Iraq War - firing all of Iraq's soldiers -
was repeated in the AIG rescue, when most of the senior management was fired
and a number of key risk-takers were simply dismissed from service.
As with the Iraq War, the Bush administration made the mistake of thinking that
it had the resources to start with a clean slate. And once again, that wasn't
to be because the very people who had run AIG into the ground were really the
only people who understood the entirety of the risk on the books as well as the
impact on the economics of the entity of a forced dismantling.
The new people put in place were usually on secondment from other departments
within AIG, with marginal understanding of the risks on the books, not to
mention only a passing familiarity with the technical aspects of trading in the
derivatives markets. Sure enough, the result of this colossal misallocation of
resources could have well been to accentuate rather than to ameliorate the
losses previously booked.
This observation is based on the steady worsening of AIG's liquidity position
since the government takeover, which suggests that while the contracts on which
the company owed money were being paid out, those on which it had to receive
funds weren't subject to aggressive collection. The paucity of experts clearly
has hurt the process.
To hire experts needed to fix the mess at government-owned companies in the US
as well as in the United Kingdom and other Group of Seven (G-7) members, it is
highly likely that proper incentives would have to be given. A realistic look
at the current AIG "scandal" shows that bonus payments were hardly material, at
less than 0.1% of the $150 billion that had been squandered by the government
as liquidity support for the company.
Think of it as an insurance payment on your investment, and suddenly bonuses
don't seem like a bad idea at all.
Tax bogeyman
The second bogeyman at the G-20 meetings was tax and, in particular, actions on
tax havens. In a concerted move since the beginning of the year, governments of
the G-7 leading industrialized nations have embarked on a collision course with
various tax havens around the world, ranging from the US offshore (Cayman
Islands, Bermuda, British Virgin Islands), European (Ireland, Switzerland,
Austria, Luxembourg, Liechtenstein) as well as Asian destinations (Singapore).
While it is understandable that the G-7 would try to close their finance
loopholes to ensure greater tax collections over the near term, given the vast
increase in government spending that has been unleashed, it is also pertinent
to note that the initiative is pointless for the following reasons:
1. Most rich individuals keeping funds offshore are no longer all that
rich, having suffered vast losses on their investments within G7. This means
much of the offshore funds will be used to repay banks for loans and so on; the
available pot of wealth would diminish drastically under the circumstances.
2. Cuts in the income of the richest groups of people would mean that
their ability to actually shift funds abroad remains questionable. Your average
hedge-fund trader or property mogul is simply in the wrong business now; there
is no potential turnaround in the situation over the near term. 3. Uncertainty with respect to tax treatment of inward investment flows
comes at a particularly bad time for G-7 economies, given their need to grab
pretty much whatever they can get over the next few months to pay for new
investments in infrastructure and other initiatives.
Anger towards tax havens also misses the larger point, namely the failure of
many countries to reward their entrepreneurs in the first place. High tax
rates, and in particular the idiotic socialist idea of "progressive" tax rates
wherein higher earners pay higher tax rates mean that the very people who are
in the best position to reinvest in falling markets are often the very ones
frozen out.
Think of it like this: if a businessman had 75% of his income, it is highly
likely that he would invest a larger portion of disposable income back in the
economy to enhance returns. Instead, if he were to be taxed so as to leave a
paltry 50% in his hands with the government getting the extra 25%, it is likely
that the government funds would be spent badly, leaving the economy overexposed
to a downturn.
That is precisely where large parts of G-7 economies - the United Kingdom and
the US are both good examples - find themselves. Both countries ran deficits
through the past eight years or so; and instead of government borrowings going
towards longer-term competitive advantages (investments) they were instead
misallocated to near-term populism (spending).
This isn't a political argument per se, given that the Republicans ran the US
for the period while left-leaning Labour ran Britain; what it basically means
is that governments are generally poor allocators of resources and worse
spenders of taxpayer money.
Throw them a bonus ...
As with the disastrous conduct of the Iraq war, it is possible to re-imagine
scenarios for the bailout of both AIG and Merrill Lynch as follows:
1. Both AIG and Merrill Lynch are put in a federal protection program
that guarantees their access to liquidity. 2. The government sends in qualified people - that is, folks who know a
CDO from a DVD - to look into the books of the companies. 3. The bits of the companies without these funky exposures, for example
the Merrill brokerage network, the AIG international business and so on, would
be sold to buyers who have no reason to believe that any danger lurks below the
surface. In this case, it is highly possible that the parts of the business
could have fetched well more than what they actually have.
4. The bad bits are quarantined and examined closely by people with deep
understanding of the businesses (for example, the foremost market experts on
credit), as well as those with a history of actually making money on these
things. Such individuals, rather than the moth-eared superannuated Muppets
found by the US government, would have demanded a high wage or a bonus for
their services (depending on whether they currently worked for these companies
or not).
5. Incentivizing those people would have helped to reduce the potential
fallout of losses from the AIG-Merrill situation, allowing the rest of the
financial system to continue performing a whole lot better. Yes, that word
again: pay the people who actually can help a bonus in order to ensure they do
so.
Meanwhile in the real economy:
1. The US government announces a program of budgetary spending aimed at
improving the quality of its infrastructure and to reduce overall energy
consumption. 2. In parallel, it cuts the maximum tax rates in the country for the
next five years to under 25%, allowing for reinvestment of profits into
business growth. Longer-term growth prospects suddenly improve wholesale,
allowing for a steeper government yield curve. This means more profits for the
financial sector as well, and a more normal investing environment for everyone
else, including insurance companies and pension funds.
3. The improvement in its fiscal positions from these steps allows the
government to keep the US dollar stable in global markets, thereby removing any
excuse for lazy Asian bankers to maintain their currency pegs.
4. With floating currencies, Asian consumers find their voices, and this
leads to first gradual and then wholesale changes in trade accounts globally
with the US deficit falling as Asia saves less.
Snap. There ends the dream. Instead of the above, what we have is
ham-handed meddling in the private sector, barrels of pork being unrolled onto
the unsuspecting public, significant future tax increases in store across G-7,
wholesale currency devaluations around the world ... and all the other topics
that are familiar to the average reader of Asia Times Online.
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