It’s the Economy, Stupid – Part 2

New York. March 17, 2011.

“The United States always does the right thing.
After having tried every other conceivable alternative.”
Churchill had a point.
The problem, at the present time, is that we are still working on all the alternatives.

Often a crisis does less damage than the decisions taken to cope with it.
Under duress, we seldom do the right thing.
Not just us, of course.
Look at Ireland.
In one stroke, the Prime Minister transferred all the country’s banks’ debt to the taxpayers.
The banks ran the country into the ground.
But it is the ensuing decision to guarantee their debt that will haunt the country for a long time.

We have heard ad nauseum Rahm Emanuel’s quote on the opportunity a crisis offers.
You never want a serious crisis to go to waste, he famously asserted.
Unfortunately, we did just that.
We have reacted to the global financial meltdown by throwing all our knowledge out the window.
Gone are Schumpeter’s creative destruction and Adam Smith’s invisible hand.
So is Milton Friedman’s teaching that inflation is always a monetary phenomenon.
And, above all, we are challenging our grandparents’ warning that excessive debt leads to slavery.
True to our character, we had to try all conceivable alternatives first.

Our generation’s main sin is short term-ism.
For some time now, we have gotten away with it.
If it did not blow up yet, don’t fix it.
Focus on the here and now.
And forget that vision thing.
What matters is the next bonus, the next election.
Après moi, le déluge.

Warren Buffett warned of derivatives being weapons of mass destruction?
Wall Street and Washington shrugged it off.
The former wanted another bonus first.
The latter needed a market for subprimes to build the ownership society.
And the Federal Reserve Bank looked the other way, seemingly only interested in the S&P and the next quarter’s GDP number.

In these boom-bust cycles, all we have been doing is reacting to the last blow-up with short term fixes.
First, there was TARP.
It worked.
It saved the global financial system.
But why did we have to save the bankers’ bonuses with it?
In his memoirs, George W. Bush never mentions the moral hazard of his decision.
I must have missed that chapter in his book.
Bush believes, rightly, that he saved the economy from an immediate disaster.
But never does he seem to have given any thought to the long term consequences of this monumental decision.

Fairness matters, of course.
Better yet, Wall Street’s meltdown should have been an opportunity to clean up a rotten apple.
It was quite easy, actually.
Let’s assume the administration had fired top management, capped salaries and imposed a 5 year moratorium on bonuses to companies bailed out by the government.
Talent would have left the big Wall Street firms?
So what.
These irreplaceable people would have joined the competition that was still standing.
Forced to take real entrepreneurial risks, the best talents would have started their own companies.
In short, Wall Street would have reinvented itself.
We could even be contemplating a world liberated from Goldman’s jaws!

But what did we end up with instead?
Too-big-to-fail and a pay czar.
This, in return, has lead to a European-style cozy dominance of government approved banks.
Theodore Roosevelt must be spinning in his grave.

And how did we deal with too-big-to-fail banks?
We made them bigger and gave them a huge competitive advantage.
The implicit government guarantee has lowered these banks’ cost of financing to levels mere mortal banks will never be able to reach.
It is no longer a level playing field.
Haven’t we seen this movie before?
Fannie and Freddie’s implicit government guarantee changed the game too.
With catastrophic results.

In a different sector, what would have happened if some of the money thrown at GM and Chrysler had been directed to Tesla and Coda?
We could very well have a vibrant electric car industry by now.
Instead, we are stuck with the Volt.

In Europe, the financial crisis has changed the dynamic of the euro zone.
The virtuous circle has been reversed.
Frau Merkel and Monsieur Sarkozy are lobbying hard to destroy the economic benefits of the common market and the single currency.
One of which was the race to lower corporate tax rates, which greatly enhanced European companies’ competitiveness.
Lead by Ireland’s 12.5% rates, all euro zone countries had to lower their corporate taxes.
They all subsequently enjoyed rates below their Japanese and US counterparts.

This inevitably infuriated the bureaucrats in Paris, Berlin and Brussels.
Taxes have long been the answer to any problem in socialist economies.
The French in particular have never run into a problem they thought could not be fixed with new or higher taxes.
So, here they are today trying to “harmonize” taxes.
Make no mistake, the harmonization will be done at higher, not lower, levels.
Unfortunately, little Ireland seems isolated today in fighting for fiscal sanity.
How long will it be able to resist French dirigisme and German diktats?

Japan, for its part, has been very predictable in its answer to the great recession.
With any slowdown comes a new Prime Minister and a fiscal stimulus package.
This country of incredibly brave and stoic people deserves better leaders.
Their preparedness for an earthquake was examplary.
So is their unpreparedness for fiscal armageddon, unfortunately.
With a public debt already at 200% of GDP, today’s reconstruction needs could very well be the last straw that breaks the camel’s back.
But don’t hold your breath.
It took the nikkei a triple digit PE ratio to finally come back to reality.
Who knows to what unimaginable heights the Japanese public debt pile will go before the bond market will crack.
But crack it will.
Maybe even in our life time.

Because of their size differences, Baltic countries are hard to compare to Japan.
But the contrast of these countries’ reaction to fiscal challenges is striking.
When hit by the financial Tsunami, Estonia, Latvia and Lithuania tightened their belts.
A recession was inevitable.
They knew it and accepted it.
They slashed budgets by as much as 14% of GDP in Latvia and 9% in Estonia.
The economy shrank, unemployment reached Spanish proportions.
But it did not last long.
Unlike Japan in the 90’s, and the US today, the Baltic countries swallowed a bitter pill, took the hit and then quickly bounced back.
Today, they are reaping the benefits without having to worry about passing on a mountain of debt to their children.

China is yet another story.
The country has outdone even Bernanke in printing money.
The resulting bubble and double digit inflation will be hard to reign in.
This time a soft landing will be difficult to manufacture.

The worst legacy of the last two years’ turmoil, however, lies elsewhere.
It is the fact that the world economy has emerged from the financial crisis with a vacuum of leadership.
The US has lost that role.
Our credibility has been shattered.
It is difficult to continue to preach the virtues of capitalism while we abandoned them so quickly in the face of diversity.
It is hard to lecture emerging markets about free trade while trashing our currency to gain a competitive advantage.
Above all, we have lost the desire to lead.

The Germans call US fiscal and monetary policies “clueless”.
The Chinese refuse to budge on their currency peg, no matter the amount of pressure.
The US is incapable of finalizing overdue trade agreements with South Korea, Colombia or Panama.
The world has noticed and is a worse place for it.

There is a precedence for a leaderless economy in the modern era.
It was between the two world wars, Liaquat Ahamed, the latest Pulitzer Prize winner reminds us.
After the Great War, the UK was nearly bankrupt and no longer wanted to assume global leadership.
The rising power, the US, in turn was not yet ready or willing to take the mantel.
Ahamed argues that this vacuum was the cause of the Great Depression.
He then asks: If no single country is in a position to be responsible for stabilizing the global economy when it suffers a shock, is there an alternative mechanism?
We know it is not the G-20 or the G-2.

In a Foreign Affairs article, Bremmer and Roubini explain that we have entered the G-Zero era.
The G group thing started back when Giscard d’Estaing wanted to create an exclusive club where he could have some influence over the world economic superpower.
I believe it started with 4 countries.
That number grew quickly to six.
In 1976, Canada joined the six largest economies to form the G-7.
A decade and a half later, Gorbachev let the Berlin Wall be torn down and Russia was invited to join.
From G-8, we moved on to the G-20 in 2008.
That’s now a lot of countries with a lot of different interests.
It has become the United Nations of rich countries where everything gets debated forever.
And nothing can get done.
We live in a G-Zero world indeed.
And forget G-2.
China is not interested.

A world with a strong leadership matters for many reasons.
Most prominently because it is already resulting in a free for all attitude.
The media wants us to believe we have avoided a 30’s protectionist cycle.
But that is an illusion based on nice rhetoric.
Every country worries first and foremost about growth and jobs at home.
Ahamed points out, for example, that tension between China and the US is rising.
Not just on the currency manipulation issue.
There has also been a sharp increase in trade complaints China and the US have filed against each other at the WTO.
One could also highlight the difficulty in balancing a current account when one’s best companies are shut out of the other’s markets.
China’s ban on Google, Facebook, Twitter, etc is a case in point.

There is another similarity with the 1930’s:
An ominous arms race, which is limited to Asia so far.

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