The Rag Blog

Behind the recent bad news lurks a much deeper concern: The world economy is now being driven by a vast, secretive web of investments that might be out of anyone’s control.

THE PAST YEAR has been a harrowing one for the world’s financial markets, shaken by subprime crises, credit crunches, and other ills. Things have only gotten stranger in the past week, with stock prices swinging wildly in every major market – drastically down, then back up.

Last week the Federal Reserve announced the biggest cut in overnight lending rates in more than two decades. Congress, not to be outdone, is slapping together a massive deficit spending package aimed at giving the economy an emergency booster shot.

Despite the anxiety, nobody is stockpiling canned goods just yet. The prevailing assumption in today’s economy is that recessions and bear markets come and go, and that things will work out in the end, much as they have since the Great Depression. That’s because there’s a collective confidence that the market is strong enough to correct itself, and that experts in charge of the financial system will understand how to mount a vigorous defense.

Should we be so confident this time? A handful of financial theorists and thinkers are now saying we shouldn’t. The drumbeat of bad news over the past year, they say, is only a symptom of something new and unsettling – a deeper change in the financial system that may leave regulators, and even Congress, powerless when they try to wield their usual tools.

That something is the immense shadow economy of novel and poorly understood financial instruments created by hedge funds and investment banks over the past decade – a web of extraordinarily complex securities and wagers that has made the world’s financial system so opaque and entangled that even many experts confess that they no longer understand how it works.

Unlike the building blocks of the conventional economy – factories and firms, widgets and workers, stocks and bonds – these new financial arrangements are difficult to value, much less analyze. The money caught up in this web is now many times larger than the world’s gross domestic product, and much of it exists outside the purview of regulators.

Some of these new-generation investments have been in the news, such as the securities implicated in the mortgage crisis that is still shaking the housing market. Others, involving auto loans, credit card debt, and corporate debt, are lurking in the shadows.

The scale and complexity of these new investments means that they don’t just defy traditional economic rules, they may change the rules. So much of the world’s capital is now tied up in this shadow economy that the traditional tools for fixing an economic downturn – moves that have averted serious disasters in the recent past – may not work as expected.

In tell-all books, financial blogs, and small-circulation newsletters, a handful of insiders have begun to sound the alarm, warning that governments and top bankers may simply no longer understand the financial system well enough to do anything about it.

…

But when the mortgage crisis broke last summer, it opened a window on something else: The existence of a huge wilderness of investments in the financial sector that are nearly impossible to track or measure, and which operate out of the view of both investors and regulators. It emerged that investment banks, hedge funds, and other financial players had issued, bought, and sold hundreds of billions of dollars’ worth of esoteric securities backed in part by other securities, which in turn were backed by payments on high-risk mortgages.

When borrowers began defaulting on their loans, two things happened. One, banks, pension funds, and other institutional investors began revealing that they owned huge quantities of these unusual new securities, called collateralized debt obligations, or CDOs. The banks began writing them off, causing the massive losses that have buffeted the country’s best-known financial companies. And two, without a market for these securities, brokers stopped wanting to issue risky mortgages to new home buyers. Home values began their plunge.

In other words, a staggeringly complex financial instrument that most Americans had never heard of, and which many financial writers still don’t fully understand, became in a matter of months the most important influence on home values in America. That’s not how the economy is supposed to work – or at least that’s not what they teach students in Economics 101.

The reason this had been happening totally out of sight is not difficult to understand. Banks of all stripes chafe against the restraints that federal and state regulators place on their ability to make money. By cleverly exploiting regulatory loopholes, investment banks created new types of high-risk investments that did not appear on their balance sheets. Safe from the prying eyes of regulators, they allowed banks to dodge the requirement that they keep a certain amount of money in reserve. These reserves are a crucial safety net, but also began to seem like a drag to financiers, money that was just sitting on the sidelines.

“A lot of financial innovation is designed to get around regulation,” says Richard Sylla, professor of economics and financial history at NYU’s Stern School of Business. “The goal is to make more money, and you can make more money if you don’t have to keep capital to back up your investments.”

The hiding places for these financial instruments are called conduits. They go by various names – the SIV, or structured investment vehicle, is one that’s been in the news a great deal the past few months. These conduits and the various esoteric investments they harbor constitute what Bill Gross, manager of the world’s largest bond mutual fund, called a “Frankensteinian levered body of shadow banks” in his January newsletter.

“Our modern shadow banking system,” Gross writes, “craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever.”

BROWNSVILLE, Texas — A federal judge urged the government Friday to use common sense and “good neighborness” in working out access to 12 pieces of private property in Cameron County that it says it needs to study land for the border fence.

U.S. District Judge Andrew Hanen did not rule Friday, but an order was expected early next week granting the government access but with some guidelines.

Hanen’s handling was markedly different from the way U.S. District Judge Alia Moses Ludlum handled an almost identical case in Eagle Pass. In that case, the government filed its lawsuit and Ludlum ordered the city to surrender 233 acres before it could muster a response.

Brownsville residents, including Mayor Pat Ahumada, have been among the most vocal critics of the border fence. Ahumada denied surveyors access to city-owned land, noting that early plans showed the fence cutting through downtown Brownsville.

Last fall, the Department of Homeland Security offered some property owners $3,000 for access to their land for surveys. Many refused on principle, with Ahumada calling it “blood money.”

By year’s end, Homeland Security Michael Chertoff sent letters to residents threatening to take them to court if access was not granted. So far, Eagle Pass and the Cameron County case have reached courtrooms.

The Justice Department sued 12 Cameron County landowners last week to get access to their property for 180 days for survey and other investigatory work. Hundreds of other property owners have already agreed to grant the access, said Andy Goldfrank from the Justice Department’s land acquisition division.

“We need to understand what is on the ground there,” Goldfrank said.

An attorney for two property owners in Brownsville said that with eminent domain laws, the government already has essentially taken his clients’ land.

“The government has won from the beginning,” attorney Albert Villegas said. “The question is only when (they will have access) and what they can do.” Villegas requested $100,000 over the $100 the law requires to be paid because the easement will tie up his clients’ downtown commercial property.

Hanen suggested the government’s approach has been just short of friendly.

“What I’m trying to do is engender into this process for lack of a better word, a little common sense or good neighborness,” Hanen said. “That’s the thing I’m asking, and maybe ultimately ordering is, use some common sense.”

Hanen asked many questions of the government and established some ground rules.
“We’re not here to debate the merits of the fence,” Hanen said. But “I don’t want anyone questioning the patriotism of the people who own this land. Some of it has been in their possession for generations.”

Alberto Mendoza, whose mother owns property in Cameron County, said his mother is willing to give temporary access to fence surveyers, but worries about receiving just compensation if the fence is builty through it.

“With that wall they cut my mom’s property in two pieces,” Mendoza said, with more than half of it, down to the Rio Grande, possibly ending up in a no-man’s land between the fence and the Mexican border.

Hanen also asked the government when it would be able to tell property owners exactly where the fence was going.

Goldfrank gave no specific answer, but said that they hoped to end the surverys in eight weeks and then begin discussions for a final layout.

Attorney David Garza said that until last Friday his client thought the government wanted access to all 1,400 of their acres. With the complaint filed last week, the government made clear it would only need access to about seven acres.

Since the land is leased to a farmer who planted winter wheat, Garza said his client wanted some indemnification in case the crop is damaged.

Hanen’s order is expected to include guidelines for how the government’s contractors may access the property so as to cause the least damage, but ultimately grant the temporary access they request. Villegas said he expects Hanen’s order next week.
President Bush has signed a law requiring 700 miles of fence be built along the Mexican border to help combat illegal immigration.

Illegal diggers are chipping away at Iraq’s heritage at thousands of largely unguarded sites. The artifacts may never be returned.

BAGHDAD — He works as a blacksmith in one of Baghdad’s swarming Shiite slums. But at least once a month, Abu Saif tucks a pistol into his belt, hops into a minibus taxi and speeds south.

His goal: to unearth ancient treasures from thousands of archaeological sites scattered across southern Iraq.

Images of Baghdad’s ransacked National Museum, custodian of a collection dating back to the beginning of civilization, provoked an international outcry in the early days of the war in 2003.

The ancient statues, intricately carved stone panels, delicate earthenware and glittering gold are now protected by locked gates and heavily armed guards. But U.S. and Iraqi experts say a tragedy on an even greater scale continues to unfold at more than 12,000 largely unguarded sites where illegal diggers like Abu Saif are chipping away at Iraq’s heritage.

“It may well be that more stuff has come out of the sites than was ever in the Iraqi museum,” said Elizabeth Stone, an archaeology professor at the State University of New York at Stony Brook.

Iraqi officials say the U.S. government has supported their efforts to retrieve looted antiquities from the Sumerian, Babylonian, Assyrian, Islamic and other civilizations, but they do not hide their bitterness that more was not done to secure them in the first place.

“Iraq floats over two seas; one is oil and the other is antiquities,” said Abdul Zahra Talaqani, media director for Iraq’s Ministry of State for Tourism and Archaeology. “The American forces, when they entered, they protected all the oil wells and the Ministry of Oil . . . but the American forces paid no attention to Iraq’s heritage.”

The thefts were already taking place before the U.S.-led invasion in March 2003, but U.S. and Iraqi experts say they surged in the ensuing chaos.

Abu Saif, a man in his mid-30s with dark eyes, calloused hands and a long, black coat, was 14 when relatives introduced him to the hunt for buried treasure. Asked why he does it, he grins.

“For the thrill of it,” he said.

In the beginning, he was a lookout for others. Now, he has his own tightknit group of four or five diggers. He collects tips from farmers about possible archaeological sites and researches them in his small collection of dogeared books before traveling inconspicuously to meet his team and excavate. They work quickly, finishing a job in two to three days.

If they are successful, which they usually are, he shares the find with his diggers and the property owner. He considers what he does a hobby and says he sells only what he needs to cover costs. But he is vague about who the buyers are.

Talaqani says criminal gangs buy artifacts from men like Abu Saif and smuggle them out of the country. U.S. officials also suspect that Sunni and Shiite paramilitary groups may be taking a cut.

Abu Saif, who asked to be identified by a traditional nickname, admits that he once paid members of a Shiite militia to protect a site where he was digging. But a few hours later, another group of gunmen turned up and demanded more money. Now, he says, he refuses to deal with the militias.

He avoids the more famous sites such as the ancient cities of Isin, Shurnpak and Umma because “there are eyes upon them.” But he says there are plenty of out-of-the-way places near Kut and Nasiriya that yield small treasures. The artifacts include coins, jewelry and fragile clay tablets etched in wedge-like cuneiform script, recording myths, decrees, business transactions and other details of Mesopotamian life.

At his two-story cinder-block home, he pulls out old jewelry boxes and rummages through spools of thread to find ancient gems of agate and carnelian. His most treasured possession is a thumb-sized cylinder with a man’s face carved into one side and a woman’s face into the other. An appraiser told him it was from Babylonian times and was worth as much as $4,000. Asked whether he planned to sell it, he looked horrified and said, “No, these are my children!”

Stone has been tracing the thefts at 2,000 sites in the south using DigitalGlobe satellite imagery. She estimates that looters have torn up about 167 million square feet.

“It’s a huge amount of area,” she said. “Archaeologists have dug just a tiny fraction of that.”

She said small-scale digging began in the 1990s, when government neglect and a United Nations embargo pushed a large number of farmers into penury in the largely Shiite south, home to many of Iraq’s richest archaeological sites. But in the weeks before the 2003 invasion, the images show holes spreading rapidly across many of the smaller and medium-sized sites.

Turn on the TV today, and you could be forgiven for thinking it’s 1999. Democrats and Republicans are bickering about where and how to intervene, whether to do it alone or with allies and what kind of world America should lead. Democrats believe they can hit a reset button, and Republicans believe muscular moralism is the way to go. It’s as if the first decade of the 21st century didn’t happen — and almost as if history itself doesn’t happen. But the distribution of power in the world has fundamentally altered over the two presidential terms of George W. Bush, both because of his policies and, more significant, despite them. Maybe the best way to understand how quickly history happens is to look just a bit ahead.

It is 2016, and the Hillary Clinton or John McCain or Barack Obama administration is nearing the end of its second term. America has pulled out of Iraq but has about 20,000 troops in the independent state of Kurdistan, as well as warships anchored at Bahrain and an Air Force presence in Qatar. Afghanistan is stable; Iran is nuclear. China has absorbed Taiwan and is steadily increasing its naval presence around the Pacific Rim and, from the Pakistani port of Gwadar, on the Arabian Sea. The European Union has expanded to well over 30 members and has secure oil and gas flows from North Africa, Russia and the Caspian Sea, as well as substantial nuclear energy. America’s standing in the world remains in steady decline.

Why? Weren’t we supposed to reconnect with the United Nations and reaffirm to the world that America can, and should, lead it to collective security and prosperity? Indeed, improvements to America’s image may or may not occur, but either way, they mean little. Condoleezza Rice has said America has no “permanent enemies,” but it has no permanent friends either. Many saw the invasions of Afghanistan and Iraq as the symbols of a global American imperialism; in fact, they were signs of imperial overstretch. Every expenditure has weakened America’s armed forces, and each assertion of power has awakened resistance in the form of terrorist networks, insurgent groups and “asymmetric” weapons like suicide bombers. America’s unipolar moment has inspired diplomatic and financial countermovements to block American bullying and construct an alternate world order. That new global order has arrived, and there is precious little Clinton or McCain or Obama could do to resist its growth.

The Geopolitical Marketplace

At best, America’s unipolar moment lasted through the 1990s, but that was also a decade adrift. The post-cold-war “peace dividend” was never converted into a global liberal order under American leadership. So now, rather than bestriding the globe, we are competing — and losing — in a geopolitical marketplace alongside the world’s other superpowers: the European Union and China. This is geopolitics in the 21st century: the new Big Three. Not Russia, an increasingly depopulated expanse run by Gazprom.gov; not an incoherent Islam embroiled in internal wars; and not India, lagging decades behind China in both development and strategic appetite. The Big Three make the rules — their own rules — without any one of them dominating. And the others are left to choose their suitors in this post-American world.

The more we appreciate the differences among the American, European and Chinese worldviews, the more we will see the planetary stakes of the new global game. Previous eras of balance of power have been among European powers sharing a common culture. The cold war, too, was not truly an “East-West” struggle; it remained essentially a contest over Europe. What we have today, for the first time in history, is a global, multicivilizational, multipolar battle.

In Europe’s capital, Brussels, technocrats, strategists and legislators increasingly see their role as being the global balancer between America and China. Jorgo Chatzimarkakis, a German member of the European Parliament, calls it “European patriotism.” The Europeans play both sides, and if they do it well, they profit handsomely. It’s a trend that will outlast both President Nicolas Sarkozy of France, the self-described “friend of America,” and Chancellor Angela Merkel of Germany, regardless of her visiting the Crawford ranch. It may comfort American conservatives to point out that Europe still lacks a common army; the only problem is that it doesn’t really need one. Europeans use intelligence and the police to apprehend radical Islamists, social policy to try to integrate restive Muslim populations and economic strength to incorporate the former Soviet Union and gradually subdue Russia. Each year European investment in Turkey grows as well, binding it closer to the E.U. even if it never becomes a member. And each year a new pipeline route opens transporting oil and gas from Libya, Algeria or Azerbaijan to Europe. What other superpower grows by an average of one country per year, with others waiting in line and begging to join?

Robert Kagan famously said that America hails from Mars and Europe from Venus, but in reality, Europe is more like Mercury — carrying a big wallet. The E.U.’s market is the world’s largest, European technologies more and more set the global standard and European countries give the most development assistance. And if America and China fight, the world’s money will be safely invested in European banks. Many Americans scoffed at the introduction of the euro, claiming it was an overreach that would bring the collapse of the European project. Yet today, Persian Gulf oil exporters are diversifying their currency holdings into euros, and President Mahmoud Ahmadinejad of Iran has proposed that OPEC no longer price its oil in “worthless” dollars. President Hugo Chávez of Venezuela went on to suggest euros. It doesn’t help that Congress revealed its true protectionist colors by essentially blocking the Dubai ports deal in 2006. With London taking over (again) as the world’s financial capital for stock listing, it’s no surprise that China’s new state investment fund intends to locate its main Western offices there instead of New York. Meanwhile, America’s share of global exchange reserves has dropped to 65 percent. Gisele Bündchen demands to be paid in euros, while Jay-Z drowns in 500 euro notes in a recent video. American soft power seems on the wane even at home.

And Europe’s influence grows at America’s expense. While America fumbles at nation-building, Europe spends its money and political capital on locking peripheral countries into its orbit. Many poor regions of the world have realized that they want the European dream, not the American dream. Africa wants a real African Union like the E.U.; we offer no equivalent. Activists in the Middle East want parliamentary democracy like Europe’s, not American-style presidential strongman rule. Many of the foreign students we shunned after 9/11 are now in London and Berlin: twice as many Chinese study in Europe as in the U.S. We didn’t educate them, so we have no claims on their brains or loyalties as we have in decades past. More broadly, America controls legacy institutions few seem to want — like the International Monetary Fund — while Europe excels at building new and sophisticated ones modeled on itself. The U.S. has a hard time getting its way even when it dominates summit meetings — consider the ill-fated Free Trade Area of the Americas — let alone when it’s not even invited, as with the new East Asian Community, the region’s answer to America’s Apec.

The East Asian Community is but one example of how China is also too busy restoring its place as the world’s “Middle Kingdom” to be distracted by the Middle Eastern disturbances that so preoccupy the United States. In America’s own hemisphere, from Canada to Cuba to Chávez’s Venezuela, China is cutting massive resource and investment deals. Across the globe, it is deploying tens of thousands of its own engineers, aid workers, dam-builders and covert military personnel. In Africa, China is not only securing energy supplies; it is also making major strategic investments in the financial sector. The whole world is abetting China’s spectacular rise as evidenced by the ballooning share of trade in its gross domestic product — and China is exporting weapons at a rate reminiscent of the Soviet Union during the cold war, pinning America down while filling whatever power vacuums it can find. Every country in the world currently considered a rogue state by the U.S. now enjoys a diplomatic, economic or strategic lifeline from China, Iran being the most prominent example.

Without firing a shot, China is doing on its southern and western peripheries what Europe is achieving to its east and south. Aided by a 35 million-strong ethnic Chinese diaspora well placed around East Asia’s rising economies, a Greater Chinese Co-Prosperity Sphere has emerged. Like Europeans, Asians are insulating themselves from America’s economic uncertainties. Under Japanese sponsorship, they plan to launch their own regional monetary fund, while China has slashed tariffs and increased loans to its Southeast Asian neighbors. Trade within the India-Japan-Australia triangle — of which China sits at the center — has surpassed trade across the Pacific.

After months of denial to soothe a nervous market, the Federal Reserve, the US central bank, finally started to take increasingly desperate steps to try to inject more liquidity into distressed financial institutions to revive and stabilize credit markets that have been roiled by turmoil since August 2007 and to prevent the home mortgage credit crisis from infesting the whole economy.

Yet more liquidity appears to be a counterproductive response to a credit crisis that has been caused by years of excess liquidity. A liquidity crisis is merely a symptom of the current financial malaise. The real disease is mounting insolvency resulting from excessive debt for which adding liquidity can only postpone the day of reckoning
towards a bigger problem but cannot cure. Further, the market is stalled by a liquidity crunch, but the economy is plagued with excess liquidity. What the Fed appears to be doing is to try to save the market at the expense of the economy by adding more liquidity.

The Federal Reserve has at its disposal three tools of monetary policy: open market operations to keep Fed Funds rate on target, the discount rate and bank reserve requirements. The Board of Governors of the Federal Reserve System is responsible for setting the discount rate at which banks can borrow directly from the Fed and for setting bank reserve requirements. The Federal Open Market Committee (FOMC) is responsible for setting the Fed Funds rate target and for conducting open market operations to keep it within target. Interest rates affects the cost of money and the bank reserve requirements affect the size of the money supply.

The FOMC has 12 members – the seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining 11 Reserve Bank presidents, who serve one-year terms on a rotating basis. The FOMC holds eight regularly scheduled meetings per year to review economic and financial conditions, determine the appropriate stance of monetary policy, and assess the risks to its long-run goals of price stability and sustainable economic growth. Special meetings can be called by the Fed chairman as needed.

Using these three policy tools, the Federal Reserve can influence the demand for, and supply of balances that depository institutions hold at Federal Reserve Banks and in this way can alter the federal funds rate target, which is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight. Changes in the federal funds rate trigger a chain of effects on other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and market prices of goods and services.

Yet the effects of changes in the Fed Funds rate on economic variables are not static nor are they well understood or predictable since the economy is always evolving into new structural relationships among key components driven by changing economic, social and political conditions. For example, the current credit crisis has evolved from the unregulated global growth of structured finance with the pricing of risk distorted by complex hedging which can fail under conditions of distress. The proliferation of new market participants such as hedge funds operating with high leverage on complex trading strategies has exacerbated volatility that changes market behavior and masked heightened risk levels in recent years. The hedging against risk for individual market participants has actually increased an accumulative effect on systemic risk.

The discount window is designed to function as a safety valve in relieving pressures in interbank reserve markets. Extensions of discount credit can help relieve liquidity strains in individual depository institutions and in the banking system as a whole. The discount window also helps to ensure the basic stability of the payment system more generally by supplying liquidity during times of systemic stress. Yet the discount window can have little effect when a liquidity drought is the symptom rather than the cause of systemic stress.

Banks in temporary distress can borrow short term funds directly from a Federal Reserve Bank discount window at the discount rate, set since January 9, 2003 at 100 basis points above the Fed Funds rate. Prior to that date, the discount rate was set below the target Fed Funds rate to provide help to distressed banks but a stigma was attached to discount window borrowing. Healthy banks would pay 50 to 75 basis points in the money market rather than going to the Fed discount window, complicating the Fed’s task in keeping the Fed Funds rate on target. Part of the reason for raising the discount rate 100 basis point above the Fed Funds rate on January 9, 2003 was to remove this stigma that had kept many banks from using the Fed discount window. (For a historical account of the change of the discount rate, see Central bank impotence and market liquidity, Asia Times Online, August 24, 2007.)

Both the discount rate and the Fed Funds rate are set by the Fed as a matter of policy. On August 17, 2007, the discount window primary credit program was temporarily changed to allow primary credit loans for terms of up to 30 days, rather than overnight or for very short terms as before. Also, the spread of the primary credit rate over the FOMC’s target federal funds rate has been reduced to 50 basis points from its customary 100 basis points. These changes will remain until the Federal Reserve determines that market liquidity has improved. The Fed keeps the Fed Funds rate within narrow range of its target through FOMC trading of government securities in the repo market.

A repurchase agreement (repo) is a loan, often for as short as overnight, typically backed by top-rated US Treasury, agency, or mortgage-backed securities. Repos are contracts for the sale and future repurchase of top-rated financial assets. It is through the repo market that the Fed injects funds into or withdraws funds from the money market, raising or lowering overnight interest rates to the level set by the Fed. (See The Wizard of Bubbleland – Part II: The repo time bomb Asia Times Online, September 29, 2005).

Until the regular FOMC meeting scheduled for January 29, 2008, the discount rate had been expected to stay at 4.75% while the Fed Funds target would stay at 4.25%, with a 50 basis points spread, half of normal, which had been set at a spread of 100 basis points since January 9, 2003. From a high of 6% set on May 18, 2000, the Fed had lowered the discount rate in 12 steps to 0.75% by November 7, 2002 and kept it there until January 8, 2003 while the Fed Funds rate target was set at 1.25%, 50 basis points above. On January 9, 2003, the discount rate was set 100 basis points above the Fed Funds rate target. Then the Fed gradually raised the discount rate back up to 6% by May 10, 2006 and again to 6.25% on June 29, 2006. On August 18, 2007, in response to the sudden outbreak of the credit market crisis, the Fed panicked and dropped the discount rate 50 basis points to 5.75%, and continued lowering it down to the current level of 4.75% set on December 12, 2007.

On Monday, January 21, a week before the scheduled FOMC meeting, global equities plunged as investor concerns over the economic outlook and financial market turbulence snowballed into a sweeping sell-off. Tumbling Asian shares – which continued to fall early on Tuesday – led European stock markets into their biggest one-day fall since the 9/11 terrorist attacks of 2001 as the prospect of a US recession and further fall-out from credit market turmoil prompted near panic among investors, forcing them to rush to the safety of government bonds.

About $490 billion was wiped off the market value of Europe’s FTSE Eurofirst 300 index and $148 billion from the FTSE 100 index in London, which suffered its biggest points slide since it was formed in 1983. Germany’s Xetra Dax slumped 7.2% to 6,790.19 and France’s CAC-40 fell 6.8% to 4,744.45, its worst one-day percentage point fall since September 11, 2001. The price collapse was driven by general negative sentiments and not, so far as was apparent at the time, by any one identifiable event.

After being closed on Monday for the Martin Luther King holiday, US stock benchmarks echoed foreign markets with big declines, extending large losses from the previous week, with bearish sentiments accelerated by heavy selling across global markets. About an hour before the NY Stock Exchange open on Tuesday, the Federal Reserve announced a cut of 75 basis points of the Fed Funds rate target to 3.50%, the first time that the Fed has changed rates between meetings since 2001, when the central bank was battling the combined impacts of a recession and the terrorist attacks.

Fed officials decided on their move at a videoconference at 6pm US time on Monday, January 21, with one policymaker – Bill Poole, the president of the St Louis Fed, dissenting. In a statement, the Fed said it acted “in view of a weakening of the economic outlook and increased downside risks to growth”. It said that while strains in short-term money markets had eased, “broader financial conditions have continued to deteriorate and credit has tightened further for some businesses and households”. And new information also indicated a “deepening of the housing contraction” and “some softening in labor markets”.

Subsequently, French bank Societe Generale SA said that bets on stock index futures by a rogue trader had caused a 4.9 billion-euro ($7.2 billion) trading loss, the largest in banking history. This led to speculation, rejected by the bank, that the market declines in Europe on Monday were in part the consequence of the Societe Generale unwinding trading positions linked to European stock index futures on January 21, when equity markets in France, Germany and the UK fell more than 5% and the day before the Fed rate cut.

“It’s not possible that our covering operations contributed to the market’s fall,” said Philippe Collas, the head of asset management at the bank, according to a Bloomberg report on January 25.

The Fed in announcing its rate cut pledged to act in a “timely manner as needed” to address the risks to growth, implying that it expects to cut the federal funds rate rates still further and will consider doing so at its scheduled policy meeting on January 30.

In overnight trade, Asian shares extended their losses. Japan’s Nikkei 225 index accumulated its worst two-day decline in nearly two decades, losing more than 5% and falling below 13,000 for the first time since September 2005.

Initially, the Fed move caused S&P stock futures to jump but within half an hour they were lower than they had been at the moment the rate cut was announced. The Dow Jones Industrial Average, down 465 points shortly after market open, fluctuated throughout the day before closing with a milder drop of 126.24, or 1.04%, at 11,973.06, the first closing below 12,000 since November 3, 2006.

The move was the first unscheduled Fed rate cut since September 17, 2001 and its largest increment since regular meetings began in 1994. It was a sharp departure from traditional gradualism preferred by the Fed and wild volatility in the market can be expected as a result. S&P equity volatility as measured by the Vix index surged 38%, eclipsing the high set in August when the credit crisis first surfaced.

The aggressive Fed action triggered a rebound in European stock markets, but was not enough to stop the US equity market – which had been closed when markets fell globally on Monday – from trading lower. At midday the S&P 500 index was at 1,302.24 down 1.7% on the day and 11.3% so far this year amid mounting concern over the prospect of a US recession and further credit market turmoil. While financial stocks had rebounded 1.8% in morning trading, other main sectors were sharply lower, by a 3.4% decline in technology shares.

While the Fed has the power to independently set the discount rate directly and keep the Fed Funds rate on target indirectly through open market operations, the impact of short-term rates on monetary policy implementation has been diluted by long-term rates set separately by deregulated global market forces. When long-term rates fall below short-term rates, the inverted rate curve usually suggests future economic contraction.

Both discount and Fed funds loans are required to be collateralized by top-rated securities. Since August 2007, the Fed has been faced with the problem of encouraging distressed banks to borrow from the Fed discount window without suffering the usual stigma of distress, accepting as collateral bank holdings of technically still top-rated collateralized debt obligations (CDOs) which in reality have been impaired by their tie to subprime home mortgage debt obligations that have lost both marketability and value in a credit market seizure.

As economist Hyman Minsky (1919-1996) observed insightfully, money is created whenever credit is issued. The corollary is that money is destroyed when debts are not paid back. That is why home mortgage defaults create liquidity crises. This simple insight demolishes the myth that the central bank is the sole controller of a nation’s money supply. While the Federal Reserve commands a monopoly on the issuance of the nation’s currency in the form of Federal Reserve notes, which are “legal tender for all debts public and private”, it does not command a monopoly on the creation of money in the economy.

The Fed does, however, control the supply of “high power money” in the regulated partial reserve banking system. By adjusting the required level of reserves and by injecting high power money directly into the banking system, the Fed can increase or decrease the ability of banks to create money by lending the same money to customers multiple times, less the amount of reserves each time, relaying liquidity to the market in multiple amounts because of the mathematics of partial reserve. Thus with a 10% reserve requirement, a $1,000 initial deposit can be loaned out 45 times less 10% reserve withheld each time to create $7,395 of loans and an equal amount of deposits from borrowers.

But money can be and is created by all debt issuers, public and private, in the money markets, many of which are not strictly regulated by government. While a predominant amount of global debt is denominated in dollars, on which the Fed has monopolistic authority, the notional value used in structured finance denominated in dollars, which reached a record $681 trillion in third quarter 2007, is totally outside the control of the Fed. Virtual money is largely unregulated, with the dollar acting merely as an accounting unit. When US homeowners default on their mortgages en mass, they destroy money faster than the Fed can replace it through normal channels. The result is a liquidity crisis which deflates asset prices and reduces monetized wealth.

As the debt securitization market collapses, banks cannot roll over their off-balance sheet liabilities by selling new securities and are forced to put the liabilities back on their own balance sheets. This puts stress on bank capital requirements. Since the volume of debt securitization is geometrically larger than bank deposits, a widespread inability to roll over short term debt securities will threaten banks with insolvency.

The Fed can create money, not wealth

Money is not wealth. It is only a measurement of wealth. A given amount of money, qualified by the value of money as expressed in its purchasing power, represents an account of wealth at a given point in time in an operating market. Given a fixed amount of wealth, the value of money is inversely proportional to the amount of money the asset commands: the higher the asset price in money terms, the less valuable the money. When debt pushes asset prices up, it in effect pushes the value of money down in terms of purchasing power. In an inflationary environment, when prices are kept high by excess liquidity, monetized wealth stored in the underlying asset actually shrinks. This is the reason why hyperinflation destroys monetized wealth.

When the central bank withdraws money from the market by selling government securities, it in essence reduces sovereign credit outstanding because a central bank never needs to borrow its own currency, which it can issue at will, the only constraint being the impact on inflation, which can become a destroyer of monetized wealth when inflation is tolerated not as a stimulant for growth but merely to prop up an overpriced market in a stagnant economy.

Yet debt can only be issued if there are ready lenders and borrowers in the credit market. And the central bank is designed to serve as “lender of last resort” when lenders become temporarily scarce in credit markets. But when borrowers are scarce not due to short-term cash flow problems but due either to low credit rating or insufficient borrower income to service debts, the central bank has no power to be a “borrower of last resort”.

The role of “borrower of last resort” belongs to the federal government, as Keynes observed when he advocated government deficit spending to moderate business cycles. The Bush administration, through the Treasury, sells sovereign bonds to finance a hefty fiscal deficit. The only problem is that it spends both taxpayer money and proceeds from sovereign bonds mostly on wars overseas, leaving the domestic economy in a liquidity crisis.

To address an impending recession, the Bush 2008 proposal of a $150 billion stimulus package of tax relief, representing 1% of GDP, would target $100 billion to individual taxpayers and about $50 billion toward businesses. Economists said a reasonable range for tax cuts in the package might be $500 to $1,000 per tax payer, averaging $800. Bush said the income tax relief “would help Americans meet monthly bills and pay for higher gas prices”. The policy objective is to keep consumers spending to stimulate the slowing economy, as consumer spending accounts for about 70% of the US economy.

Speaking after the president, Secretary of the Treasury Henry Paulson said he was confident of long-term economic strength, but that “the short-term risks are clearly to the downside, and the potential cost of not acting has become too high.” He added that 1% of GDP would equate to $140 billion to $150 billion, which is along the lines of what private economists say should be sufficient to help give the economy a short-term boost.

“There’s no silver bullet,” Paulson said, “but, there’s plenty of evidence that if you give people money quickly, they will spend it.”

Yet the Republican proposal favors a tax rebate, meaning that only those who actually paid taxes would get a refund. That means a family of four with an annual income of $24,000 would receive nothing and only those with annual income of over $100,000 would get the full $800 rebate per taxpayer, or $1,600 for joint return households.

Further, against a total US consumer debt (which includes installment debt, but not home mortgage debt) of $2.46 trillion in June 2007, which came to $19,220 per tax payer, the Bush rebate of $800 would not be much relief even in the short term. In 2007, US households owed an average of $112,043 for mortgages, car loans, credit cards and all other debt combined. Outstanding credit default swaps is around $45 trillion, which is three times larger than US GDP of $15 trillion and 3,000 times larger than the Bush relief plan of $150 billion.

Bush did not push for a permanent extension of his 2001 and 2003 tax cuts, many of which are due to expire in 2010, eliminating a potential stumbling block to swift action by Congress, since most the controlling Democrats oppose making the tax cuts permanent. The 2008 tax relief proposal harks back to the Bush 2001 and 2003 tax cuts, which were at variance with established principles that an effective tax stimulus package needs to maximize the extent to which it directly stimulates new economic activity in the short-term and minimize the extent to which it indirectly restrains new activity by driving up interest rates.

The Bush tax cuts were implemented without first adopting an overall stimulus budget; without designing business incentives to provide reasons for new investment, rather than windfalls for old investment; nor designing household tax cuts to maximize the effects on short-term spending; without focusing on temporary (one-year) items for businesses and households, not permanent ones. Most significant of all, they failed to maintain long-term fiscal discipline.

The flawed 2001 Bush tax stimulus package included five items: 1) A permanent tax subsidy (through partial expensing) of business investment; 2) permanent elimination of the corporate alternative minimum tax; 3) permanent changes in the rules applying to net operating loss carry-backs; 4) acceleration of some of the personal income tax reductions scheduled for 2004 and 2006 and 5) a temporary household tax rebate aimed at lower- and moderate-income workers who actually paid income taxes, a condition that reduced its effectiveness.

The 2001 Bush tax stimulus package included permanent changes that were less effective at stimulating the economy in the short run than temporary changes but more expensive. And its acceleration of the recently enacted tax cuts for higher-income taxpayers was poorly targeted and potentially counter-productive. A more effective stimulus package would combine the household rebate aimed at lower- and moderate-income workers with a temporary incentive for business investment. Yet for the last two decades, even in boom time, the US middle class has not been receiving its fair share of income while increasingly bearing a larger share of public expenditure. The long-term trend of income disparity is not being addressed by the bipartisan short-term stimulus package.

War costs

The Congressional Research Service (CRS) report, updated November 9, 2007, shows that with enactment of the FY2007 supplemental on May 25, 2007, Congress has approved a total of about $609 billion for military operations, base security, reconstruction, foreign aid, embassy costs, and veterans’ health care for the three operations initiated since the 9/11 attacks: Operation Enduring Freedom (OEF) Afghanistan and other counter terror operations; Operation Noble Eagle (ONE), providing enhanced security at military bases; and Operation Iraqi Freedom (OIF). A 2006 study by Columbia University economist Joseph E Stiglitz, the 2001 Nobel laureate in economic, and Harvard professor Linda Bilmes, leading expert in US budgeting and public finance and former Assistant Secretary and Chief Financial Officer of the US Department of Commerce, concluded that the total costs of the Iraq war could top $2 trillion.

Greenspan sees no Fed cure

Alan Greenspan, the former Fed chairman, wrote in a defensive article in the December 12, 2007 edition of the Wall Street Journal: “In theory, central banks can expand their balance sheets without limit. In practice, they are constrained by the potential inflationary impact of their actions. The ability of central banks and their governments to join with the International Monetary Fund in broad-based currency stabilization is arguably long since gone. More generally, global forces, combined with lower international trade barriers, have diminished the scope of national governments to affect the paths of their economies.”

In exoteric language, Greenspan is saying that short of moving towards hyperinflation, central banks have no cure for a collapsed debt bubble.

Greenspan then gives his prognosis: “The current credit crisis will come to an end when the overhang of inventories of newly built homes is largely liquidated and home price deflation comes to an end … Very large losses will, no doubt, be taken as a consequence of the crisis. But after a period of protracted adjustment, the US economy, and the global economy more generally, will be able to get back to business.”

Greenspan did not specify whether “getting back to business” as usual means onto another bigger debt bubble as he had repeatedly engineered during his 18-year-long tenure at the Fed. Greenspan is advocating first a manageable amount of pain to moderate moral hazard, then massive liquidity injection to start a bigger bubble to get back to business as usual. What Greenspan fails to understand, or at least to acknowledge openly, is that the current housing crisis is not caused by an oversupply of homes in relation to demographic trends. The cause lies in the astronomical rise in home prices fueled by the debt bubble created by an excess of cheap money.

Mortgage crisis to corporate debt crisis

Many homeowners with zero or even negative home equity cannot afford the reset high payments of their mortgages with current income which has been rising at a much slower rate than their house payments. And as housing mortgage defaults mount, the liquidity crisis deepens from money being destroyed at a rapid rate, which in turn leads to counterparty defaults in the $45 trillion of outstanding credit swaps (CDS) and collateralized loan obligations (CLO) backed by corporate loans that destroy even more money, which will in turn lead to corporate loan defaults.

Proposed government plans to bail out distressed home owners can slow down the destruction of money, but it would shift the destruction of money as expressed by falling home prices to the destruction of wealth through inflation masking falling home value.

Credit insurers such as MBIA, the world’s largest financial guarantor, whose shares have dropped 81% in 2007 to $13 from a high of $73, are on the brink of bankruptcy from their deteriorating capital position in light of rating agencies reviews of residential mortgage-backed securities and collateralized debt obligations that have been insured by MBIA, or similar insurers, reviews that are expected to stress claims-paying ability.

On December 10, 2007, MBIA received a $1 billion boost to its cash reserves from private equity firm Warburg Pincus in an effort to protect its credit rating. By January 10, 2008, MBIA announced it would try to raise another $1 billion in “surplus notes” at 12% yield. The next day, traders reported that the deal was facing problems in attracting investors and might have to raise the yield to 15%. But Bill Ackman of Pershing Square Capital Management told Bloomberg that regulators can be expected to block payment to surplus note holders. Further, raising enough new capital to retain credit ratings would so dilute existing shareholder value as to remove all incentive to save the enterprise.

Maintaining an AAA credit rating is of utmost important to bond insurers like MBIA because they need a strong credit rating in order to guarantee debt. Moody’s, Standard & Poor’s and Fitch are all reviewing the financial strength ratings of bond insurers, which write insurance policies and other contracts protecting lenders from defaults.

For the insurers to maintain the necessary triple-A rating, their capital reserve would have to be repeatedly increased along with the premium they charge. There will soon come a time when insurance premium will be so high as to deter bond investors. Already, the annual cost of insuring $10 million of debt against Bear Stern defaulting has risen from $40,000 in January 2007 to $234,000 by January of 2008. To buy credit default insurance on $10 million of debt issued by Countrywide, the big subprime mortgage lender, an investor must as of January 11, 2008 pay $3 million up front and $500,000 annually. A month ago, the same protection could be bought at $776,000 annually with no upfront payment.

Credit-default swaps tied to MBIA’s bonds soared 10 percentage points to 26% upfront and 5% a year, according to CMA Datavision in New York. The price implies that traders are pricing in a 71% chance that MBIA will default in the next five years, according to a JPMorgan Chase & Co valuation model. Contracts on Ambac Financial, the second-biggest insurer, rose 12 percentage points to 27% upfront and 5% a year. Ambac’s implied chance of default is 73%.

MBIA and competitors such as Ambac and ACA Capital insure mortgage-backed securitized debt and bonds, which came under pressure as the subprime fallout all but wiped out mortgage credit. The credit ratings agencies have since tried to determine whether the bond insurers’ ability to pay claims against a sudden rise in defaulted debt has been impacted by the deterioration of the home mortgage market. A ratings downgrade has broad fallout, causing billions of bonds insured by the firms to also lose value. Banks have been major buyers of debt insurance on the bonds they hold.

MBIA is also facing a series of class action suits for misrepresenting and/or failing to disclose the true extent of MBIA exposure to losses stemming from its insurance of residential mortgage-backed securities (RMBS), including in particular its exposure to so-called “CDO-squared” securities that are backed by residential mortgage-backed securities. Other class action suits involve alleged violation of the Employee Retirement Income Security Act of 1974 (ERISA) relating to MBIA 401(k) plan.

Synthetic CDO-squared are double-layer collateralized debt obligations that offer investors higher spreads than single-layer CDOs but also may present additional risks. Their two-layer structures somewhat increase their exposure to certain risks by creating performance “cliffs” that cause seemingly small changes in the performance of underlying reference credits to produce larger changes in the performance of a CDO-squared.

If the actual performance of the reference credits deviates substantially from the original modeling assumptions, the CDO-squared can suffer unexpected losses. On January 11, MBIA announced in a public filing it has $9 billion of exposure to the riskiest structures known as CDO of CDO, or CDO-squared, $900 million more than the company disclosed only three weeks earlier. MBIA also said it now had $45.2 billion of exposure to overall residential mortgage-backed securities, which comprises 7% of MBIA’s insured portfolio, as of September 30, 2007.

The triple-A credit rating of the bigger bond insurers is crucial because any demotion could lead to downgrades of the $2.4 trillion of municipal and structured bonds they guarantee. This could force banks to increase the amount of capital held against bonds and hedges with bond insurers – a worrying prospect at a time when lenders such as Citigroup and Merrill are scrambling to raise capital. Significant changes in counterparty strengths of bond insurers could lead to systemic issues. Warren Buffett’s Berkshire Hathaway set up a new bond insurer in December 2007 after the New York State insurance regulator pressed him to do so.

If credit insurers turn out to have inadequate reserves, the credit default swap (CDS) market may well seize up the same way the commercial paper market did in August 2007. The $45 trillion of outstanding CDS is about five times the $9 trillion US national debt. The swaps are structured to cancel each other out, but only if every counterparty meets its obligations. Any number of counterparty defaults could start a chain reaction of credit crisis. The Financial Times reported that Jamie Dimon, chief executive of JPMorgan, said when asked about bond insurers: “What [worries me] is if one of these entities doesn’t make it …? The secondary effect …? I think could be pretty terrible.”

The danger of high leverage

The factor that has catapulted the subprime mortgage market into content crisis proportion is the high leverage used on transactions involving the securitized underlying assets. This leverage multiplies profits during expansive good times and losses in during times of contraction. By extension, leverage can also magnify insipid inflation tolerated by the Fed into hyperinflation.

As big as the residential subprime mortgage market is, the corporate bond market is vastly larger. There are a lot of shaky outstanding corporate loans made during the liquidity boom that probably could not be refinanced even in a normal credit market, let alone a distressed crisis. A large number of these walking-dead companies held up by easy credit of previous years are expected to default soon to cause the CLO valuations to plummet and CDS to fail.

Commercial real estate is another sector with disaster looming in highly leveraged debts. Speculative deals fueled by easy cheap money have overpaid massive acquisitions with the false expectation that the liquidity boom would continue forever. As the economy slows, empty office and retail spaces would lead to commercial mortgage defaults.

Emerging markets will also run into big problems because many borrowers in those markets have taken out loans denominated in foreign currencies collateralized by inflated values of local assets that could be toxic if local markets are hit with correction or if local currencies lose exchange value.

The last decade has been the most profligate global credit expansion in history, made possible by a new financial architecture that moved much of the activities out of regulated institutions and into financial instruments traded in unregulated markets by hedge funds that emphasized leverage over safety. By now there are undeniable signs that the subprime mortgage crisis is not an isolated problem, but the early signal of a systemic credit crisis that will engulf the entire financial world.

Myth of poor folk over-saving

Both former Fed chairman Greenspan and his successor Ben Bernanke have tried to explain the latest US debt bubble as having been created by global over-saving, particularly in Asia, rather than by Fed policy of easy credit in recent years.

Yet the so-called global savings glut is merely a nebulous euphemism for overseas workers in exporting economies being forced to save to cope with stagnant low wages and meager worker benefits that fuel high profits for US transnational corporations. This forced saving comes from the workers’ rational response to insecurity rising from the lack of an adequate social safety net. Anyone making around $1,000 a year and faced with meager pension and inadequate health insurance would be suicidal to save less than half of his/her income. And that’s for urban workers in China. Chinese rural workers make about $300 in annual income. For China to be an economic superpower, Chinese wages would have to increase by a hundredfold in current dollars.

Yet these underpaid and under-protected workers in the developing economies are forced to lend excessive portions of their meager income to US consumers addicted to debt. This is because of dollar hegemony under which Chinese exports earn dollars that cannot be spent domestically without unmanageable monetary penalties.

Not only do Chinese and other emerging market workers lose by being denied living wages and the financial means to consume even the very products they themselves produce for export, they also lose by receiving low returns on the hard-earned money they lend to US consumers at effectively negative interest rates when measured against the price inflation of commodities that their economies must import to fuel the export sector. And that’s for the trade surplus economies in the developing world, such as China. For the trade deficit economies, which are the majority in the emerging economies, neoliberal global trade makes old-fashion 19th-century imperialism look benign.

Central banks support fleecing

The role central banking plays in support of this systematic fleecing of the helpless poor everywhere around the world to support the indigent rich in both advanced and emerging economies has been to flood the financial market with easy money, euphemistically referred to as maintaining liquidity, and to continually enlarge the money supply by financial deregulation to lubricate and sustain a persistently expanding debt bubble.

Concurringly, deregulated financial markets have provided a free-for-all arena for sophisticated financial institutions to profit obscenely from financial manipulation. The average small investor is effectively excluded from reaping the profits generated in this esoteric arena set up by big financial institutions. Yet the investing public is the real victim of systemic risk. The exploitation of mortgage securitization through the commercial paper market by special investment entities (SIVs) is an obvious example.

When the Fed repeatedly pulls magical white rabbits from its black opaque monetary policy hat, the purpose is always to rescue overextended sophisticated institutions in the name of preserving systemic stability, while the righteous issue of moral hazard is reserved only for unwitting individual borrowers who are left to bear the painful consequences of falling into financial traps they did not fully understand, notwithstanding that the root source of moral hazard always springs from the central bank itself.

Local governments versus financial giants

The city of Baltimore is filing suit against Wells Fargo, alleging the bank intentionally sold high-interest mortgages more to blacks than to whites – a violation of federal law. Cleveland is filing suit against investment banks such as Deutsche Bank, Goldman Sachs, Merrill Lynch and Wells Fargo for creating a public nuisance by irresponsibly buying and selling high-interest home loans, resulting in widespread defaults that have depleted the cities’ tax base and left entire neighborhoods in ruins. The cities hope to recover hundreds of millions of dollars in damages, including lost taxes from devalued property and money spent demolishing and boarding up thousands of abandoned houses.

“To me, this is no different than organized crime or drugs,” Cleveland Mayor Frank Jackson said in an interview with local media. “It has the same effect as drug activity in neighborhoods. It’s a form of organized crime that happens to be legal in many respects.”

The Baltimore and Cleveland efforts are believed to be the first attempts by major cities to recover social costs and public financial losses from the foreclosure epidemic, which has particularly plagued cities with significant low-income neighborhoods. Cleveland’s suit is more unique because the city is basing its complaints on a state law that relates to public nuisances. The suit also is far more
wide-reaching than Baltimore’s in that instead of targeting the mortgage brokers, it targets the investment banking side of the industry, which feeds off the securitization of mortgages.

Greenspan blames Third World – not the Fed

Greenspan in his own defense describes the latest credit crisis as a result of a sudden “re-pricing of risk – an accident waiting to happen as the risk was under-priced over the past five years as market euphoria, fostered by unprecedented global growth, gained traction.” Greenspan spoke as if the Fed had been merely a neutral bystander, rather than the “when in doubt, ease” instigator that had earned its chairman wizard status all through the years of easy money euphoria.

The historical facts are that while the Fed kept short-term rates too low for too long, starting a downward trend from January 2001 and bottoming at 0.75% for the discount rate on November 6, 2002, and 1% for the Fed Funds rate target on June 25, 2003, long-term rates were kept low by structured finance, a.k.a. debt securitization and credit derivatives, with an expectation that inflation would be perpetually postponed by global slave labor. The inflation rate in January 2001 was 3.73%. By November 2002, the inflation rate was 2.2%, while the discount rate was at 0.75%. In June 2003, the inflation rate was 2.11% while the Fed Funds rate target was at 1%. For some 30 months, the Fed provided the economy with negative real interest rates to fuel a debt bubble.

Greenspan blames “the Third World, especially China” for the so-called global savings glut, with an obscene attitude of the free-spending rich who borrowed from the helpless poor scolding the poor for being too conservative with money.

Yet Bank for International Settlements (BIS) data show exchange-traded derivatives growing 27% to a record $681 trillion in third quarter 2007, the biggest increase in three years. Compared this astronomical expansion of virtual money with China’s foreign exchange reserve of $1.4 trillion, it gives a new meaning to the term “blaming the tail for wagging the dog”. The notional value of outstanding over-the-counter (OTC) derivative between counterparties not traded on exchanges was $516 trillion in June, 2007, with a gross market value of over $11 trillion, which half of the total was in interest rate swaps. China was hardly a factor in the global credit market, where massive amount of virtual money has been created by computerized
trades.

Belated warning on stagflation

I warned in May 9, 2007 (Liquidity boom and looming crisis, Asia Times Online): The Fed’s stated goal is to cool an overheated economy sufficiently to keep inflation in check by raising short-term interest rates, but not so much as to provoke a recession. Yet in this age of finance and credit derivatives, the Fed’s interest-rate policy no longer holds dictatorial command over the supply of liquidity in the economy. Virtual money created by structured finance has reduced all central banks to the status of mere players rather than key conductors of financial markets. The Fed now finds itself in a difficult position of being between a rock and a hard place, facing a liquidity boom that decouples rising equity markets from a slowing underlying economy that can easily turn toward stagflation, with slow growth accompanied by high inflation.

Seven months after my article, on December 16, Greenspan warned publicly on television against early signs of stagflation as growth threatens to stall while food and energy prices soar.

Crisis of capital for finance capitalism

The credit crisis that was detonated in August 2007 by the collapse of collateralized debt obligations (CDOs) waged a frontal attack on finance institution capital adequacy by December. Separately, commercial and investment banks and brokerage houses frantically sought immediate injection of capital from sovereign funds in Asia and the oil states because no domestic investors could be found quickly. But these sovereign funds investments have reached the US regulatory ceiling of 10% equity ownership for foreign governmental investors before being subject to reviews by the inter-agency Committee on Foreign Investment in the US (CFIUS), which investigates foreign takeover of US assets.

Still, much more capital will be needed in coming months by these financial institutions to prevent the vicious circle of expanding liabilities, tightening liquidity conditions, lowering asset values, impaired capital resources, reduced credit supply, and slowing aggregate demand feeding back on each other in a downward spiral. New York Federal Reserve President Tim Geithner warned of an “adverse self-reinforcing dynamic”.

Ambrose Evans-Pritchard of The Telegraph, who as a Washington correspondent gave the Clinton White House ulcers, reports that Anna Schwartz, surviving co-author with the late Milton Friedman of the definitive study of the monetary causes of the Great Depression, is of the view that in the current credit crisis, liquidity cannot deal with the underlying fear that lots of firms are going bankrupt. Schwartz thinks the critical issue is that banks and the hedge funds have not fully acknowledged who is in trouble and by how much behind the opaque fog that obscures the true liabilities of structured finance.

While the equity markets are hanging on for dear life with the Fed’s help through stealth inflation, the bond markets have collapsed worldwide, with dollar bond issuance falling to a stand still, euro bonds by 66% and emerging market bonds by 75% in Q3 2007. Lenders are simply afraid to lend and borrowers are afraid to take on more liabilities in an imminent economic slowdown. The Fed has a choice of accepting an economic depression to cut off stagflation, or ushering hyperinflation by flooding the market with unproductive liquidity. Insolvency cannot be solved by injecting liquidity without the penalty of hyperinflation.

Henry C K Liu is chairman of a New York-based private investment group. His website is at www.henryckliu.com.

WASHINGTON (CNN) — President Bush and his top aides publicly made 935 false statements about the security risk posed by Iraq in the two years following September 11, 2001, according to a study released Tuesday by two nonprofit journalism groups.

President Bush addresses the nation as the Iraq war begins in March 2003.

“In short, the Bush administration led the nation to war on the basis of erroneous information that it methodically propagated and that culminated in military action against Iraq on March 19, 2003,” reads an overview of the examination, conducted by the Center for Public Integrity and its affiliated group, the Fund for Independence in Journalism.

According to the study, Bush and seven top officials — including Vice President Dick Cheney, former Secretary of State Colin Powell and then-National Security Adviser Condoleezza Rice — made 935 false statements about Iraq during those two years.

The study was based on a searchable database compiled of primary sources, such as official government transcripts and speeches, and secondary sources — mainly quotes from major media organizations.

The study says Bush made 232 false statements about Iraq and former leader Saddam Hussein’s possessing weapons of mass destruction, and 28 false statements about Iraq’s links to al Qaeda.

Bush has consistently asserted that at the time he and other officials made the statements, the intelligence community of the U.S. and several other nations, including Britain, believed Hussein had weapons of mass destruction.

He has repeatedly said that despite the intelligence flaws, removing Hussein from power was the right thing to do.

The study, released Tuesday, says Powell had the second-highest number of false statements, with 244 about weapons and 10 about Iraq and al Qaeda.

Former Secretary of Defense Donald Rumsfeld and Press Secretary Ari Fleischer each made 109 false statements, it says. Deputy Defense Secretary Paul Wolfowitz made 85, Rice made 56, Cheney made 48 and Scott McLellan, also a press secretary, made 14, the study says.

“It is now beyond dispute that Iraq did not possess any weapons of mass destruction or have meaningful ties to al Qaeda,” the report reads, citing multiple government reports, including those by the Senate Select Committee on Intelligence, the 9/11 Commission and the multinational Iraq Survey Group, which reported that Hussein had suspended Iraq’s nuclear program in 1991 and made little effort to revive it.

The overview of the study also calls the media to task, saying most media outlets didn’t do enough to investigate the claims.

“Some journalists — indeed, even some entire news organizations — have since acknowledged that their coverage during those prewar months was far too deferential and uncritical,” the report reads. “These mea culpas notwithstanding, much of the wall-to-wall media coverage provided additional, ‘independent’ validation of the Bush administration’s false statements about Iraq.”

The quotes in the study include an August 26, 2002, statement by Cheney to the national convention of the Veterans of Foreign Wars.

Former World Bank chief Paul Wolfowitz has been appointed head of an influential panel advising the US government on arms control.

Mr Wolfowitz was ousted from the Bank last year over a scandal involving payments to his girlfriend, who was also a bank employee at the time.

He has long been a controversial figure in US and international politics.

As the Pentagon’s number two after Donald Rumsfeld, he was one of the leading architects of the war in Iraq.

Sensitive issues

Mr Wolfowitz’s insider status at the White House made him many enemies at home and abroad.

After a stormy two-year tenure at the World Bank, he was forced to leave because he authorised a large compensation package for his girlfriend.

His departure was further clouded by claims that he had tarnished the bank’s reputation and strained relations with other countries – particularly in Europe.

His return to government comes at a time when many key figures of the Bush administration are leaving.

The State Department has confirmed his appointment as chairman of the International Security Advisory Board which provides the department with independent advice on arms control and disarmament.

Mr Wolfowitz will report on a number of current sensitive issues such as nuclear deals with India and North Korea, and Iran’s contentious nuclear programme.

25/01/08 “The Independent” — — It’s not difficult to create orphans in Iraq. If you’re an insurgent, you can blow yourself up in a crowded market. If you’re an American air force pilot, you can bomb the wrong house in the wrong village. Or if you’re a Western mercenary, you can fire 40 bullets into the widowed mother of 14-year-old Alice Awanis and her sisters Karoon and Nora, the first just 20, the second a year older. But when the three girls landed at Amman airport from Baghdad last week they believed that they were free of the horrors of Baghdad and might travel to Northern Ireland to escape the terrible memory of their mother’s violent death.

Alas, the milk of human kindness does not necessarily extend to orphans from Iraq – the country we invaded for supposedly humanitarian reasons, not to mention weapons of mass destruction. For as their British uncle waited for them at Queen Alia airport, Jordanian security men – refusing him even a five-minute conversation with the girls – hustled the sisters back on to the plane for Iraq.

“How could they do this?” their uncle, Paul Manouk, asks. “Their mum has been killed. Their father had already died. I was waiting for them. The British embassy in Jordan said they might issue visas for the three – but that they had to reach Amman first.” Mr Manouk lives in Northern Ireland and is a British citizen. Explaining this to the Jordanian muhabarrat at the airport was useless.

Western mercenaries killed their 48-year-old Iraqi Armenian mother, Marou Awanis, and her best friend – firing 40 bullets into her body as she drove her taxi near their four-vehicle convoy in Baghdad – but tragedy has haunted the family for almost a century; the three sisters’ great-grandmother was forced to leave her two daughters to die on their own by the roadside during the 1915 Armenian genocide. Mrs Awanis’ friend, Jeneva Jalal, was killed instantly alongside her in the passenger seat.

The Australian “security” company whose employees killed Mrs Awanis and her friend – “executed” might be a better word for it, because that is the price of driving too close to armed Westerners in Baghdad these days – expressed its “regrets”. The chief operating officer of Unity Resources Group claims that she drove her car at speed towards the company’s employees and that they feared she was a suicide bomber.

“Only then did the team use their weapons in a final attempt to stop the vehicle,” Michael Priddin said. “We deeply regret the loss of these lives.” He refused to identify the killers or their nationality. Westerners in Baghdad – especially those who kill the innocent – are once they are known, rich in regrets. But they are less keen to ensure that the bereaved they leave behind are cared for.

Karoon was sick and had papers allowing her to enter Jordan; the family assumed that her siblings would be permitted to enter the country with her. Mr Manouk, an electrical engineer in Co Down, said that he went to the office of the United Nations Commissioner for Refugees in Amman and that they told him that the sisters had to come in.

“I also sought visas for them at the British embassy but the visa section said that the three had to be in Amman before they could do anything to help them. Karoon was told by the Jordanians she could come into Amman but that her other sisters could not. She would not leave her sisters. So all three went back to Baghdad the same day.

“I just could not believe this. At the airport I pleaded with the Jordanian security people to let me spend five minutes with my nieces – just five minutes only – but they refused.”

Mrs Awanis had two sisters in Iraq, Helen and Anna, who are looking after the girls until Mr Manouk – or anyone else – finds a way of rescuing them.

“I have a Jordanian friend who had at first arranged to enrol the two eldest girls in the university in Jordan, but it was of no use,” Mr Manouk says. “I had an awful evening at the airport. In my distress, I am writing to King Abdullah for his help. We are trying to get a settlement for my nieces with the Australian company whose people shot their mother. But they are not liable under Iraqi law. I want a proper settlement by law – through lawyers – not just a cash handout, which is the way Americans do things in Iraq.”

Like so many Armenian families, the Manouks are overshadowed by a history of mass murder. During the Armenian genocide of 1915, perpetrated by the Ottoman Turks, Paul Manouk’s grandfather – the three Iraqi orphans’ great-grandfather – was taken from his family by Turkish policemen in a line of other men and never seen again. His father, then just six years old, survived along with his mother. “But my father’s sister, we believe, was taken by a Kurdish man as his wife,” Mr Manouk said.

“My grandfather’s two other sisters had a terrible fate. Their legs had swollen on the long march south from their home in Besni, near Marash, and they could not keep walking, so my grandmother took the decision to leave them on the roadside and keep the son so that our ‘line’ would survive. The two little girls were never seen again.”

The family had almost reached the border of the Ottoman province of Mesopotamia – modern-day Iraq – on the long march of ethnic cleansing when, like tens of thousands other Armenians, they lost their loved ones through exhaustion and starvation. A million-and-a-half Armenians died in the genocide.

After the British occupation of Iraq in 1917, British troops escorted the remains of the Manouk family to Basra where one of the aunts looking after the three Awanis sisters still lives.

Their father, Azad Awanis, died after a heart operation in 2004. Mrs Awanis was driving her Oldsmobile taxi through the dangerous streets of Baghdad to earn money for her family after her husband’s death, little realising that her new job – and a bunch of trigger-happy mercenaries – would orphan her children.

Paul Manouk met his British wife in Edinburgh in 1974, when he was studying for a PhD in medicine. A normally imperturbable man, he describes himself as still being in a state of shock at the killing of his younger sister.

In yesterday’s press briefing, a reporter asked White House Press Secretary Dana Perino about the tie between the current U.S. economy and the Iraq war. Perino quickly dismissed the reporter’s question, insisting that the U.S. economy has been “very strong” and adding that the money was necessary to “take the fight to the enemy” after 9/11.

Oil prices are at approximately $88 a barrel, although they have dropped from the record high of $100 earlier this month. As Nobel laureate Joseph Stiglitz recently noted in Vanity Fair, “The soaring price of oil is clearly related to the Iraq war. The issue is not whether to blame the war for this but simply how much to blame it.”

Before the war, economists were predicting that oil prices at just $75 a barrel could potentially send the U.S. economy into a recession. Therefore, the current economic situation should not come as a complete shock to the Bush administration. A look at economists’ pre-war predictions:

“A war against Iraq could cost the United States hundreds of billions of dollars, play havoc with an already depressed domestic economy and tip the world into recession because of the adverse effect on oil prices, inflation and interest rates, an academic study [by William Nordhaus, Sterling professor of economics at Yale University] has warned.” [Independent, 11/16/02]

“If war with Iraq drags on longer than the few weeks or months most are predicting, corporate revenues will be flat for the coming year and will put the U.S. economy at risk of recession, according to a poll of chief financial officers.” [CBS MarketWatch, 3/20/03]

“If the conflict wears on or, worse, spreads, the economic consequences become very serious. Late last year, George Perry at the Brookings Institution ran some simulations and found that after taking into account a reasonable use of oil reserves, a cut in world oil production of just 6.5 percent a year would send the United States and the world into recession.” [Robert Shapiro, former undersecretary of commerce in the Clinton administration, 10/2/02]

“Gerd Häusler, the IMF’s director of international capital markets, said that ‘purely from a financial markets perspective, a serious conflict with Iraq would not be a very healthy development.’ … Häusler said there could be a repeat of what happened in 1990 following the Iraqi invasion of Kuwait, when there was a sharp rise in oil prices.” [World Bank, 9/02]

24/01/08 “ICH” — — Forget everything you’ve read about the “Great Escape” from Gaza. It’s all rubbish. The whole farce was cooked up in an Israeli think tank as way to rid Palestine of its indigenous people. Here’s an excerpt from the Israeli newspaper Arutz Sheva which explains the real motive behind the incident:

“MK (Israeli Knesset member) Aryeh Eldad is hailing the Arab exodus to Egypt as proof that voluntary transfer is indeed an option.”

“The Israeli left continues to claim that there is no such thing as voluntary transfer, and simply ignores reality,” Eldad said. (Arutz Sheva)

Voluntary transfer. Bingo.

So the fleeing Palestinians just fell into a trap. Now they’ve been banished to Egypt by their own volition. We’ll have to wait and see how many are allowed to return.

The media has played its traditional role in the Gaza fiasco, trying to make it look like Hamas’ “terrorist masterminds” struck a major blow against Israel. It’s just a way of diverting attention from Israel’s role in the ongoing humanitarian crisis. Here’s the way Ha’aretz summed it up:

“Hamas chalked up a real coup. Not only did the organization demonstrate once again that it is a disciplined, determined entity, and an opponent that is exponentially more sophisticated than the Palestine Liberation Organization.

Israel, Egypt and the Palestinian Authority are now forced to find a new joint border control arrangement, one that will probably depend on the good graces of Hamas….The Hamas action yesterday was anything but spontaneous. It was another stage in the campaign that began in Gaza’s night of darkness on Sunday. As Gaza was plunged into widely televised blackness, Palestinian children armed with candles were brought out on a protest march and organized into prime-time demonstrations in support of the Egyptian and Jordanian branches of the Muslim Brotherhood.” (“Gaza border breach shows Israel Hamas is in charge, Ha’aretz)

Nonsense. Israel is not the victim any more than Palestinian children are “armed” with candles. The candles are a symbol of hope; something that is sadly lacking under Israeli rule. The truth is that Israel was getting battered in the media for cutting off food, water, energy and medical supplies to 1.5 million civilians (some of whom died in the hospital when the power was turned off on their respirators) so they looked for a way to do an about-face without appearing weak. Ha’aretz would like us to believe that our sympathy for starving women and children is the result of the propaganda we’ve seen in the “Palestinian-owned” media.

What a laugh; the “Palestinian-owned” media.

Hamas poses no threat to Israel and it controls nothing; certainly not the border. They’ve even suspended all suicide attacks since they won democratic elections a year and a half ago. But that is not enough for Israel whose goal is to extinguish any trace of Arab solidarity or Palestinian nationalism. Nearly all of the 4,000 articles now appearing on Google News follow this same absurd narrative about ‘clever terrorists’ who’ve out-foxed Israel and liberated their people. It’s just another way of concealing the criminal brutality of the 60 year long occupation. In truth, Hamas probably had nothing to do with the destruction of the wall. It’s just part of Israel’s plans to exile more Palestinians.

According to the article in Arutz Sheva, Egyptian President Hosni Mubarak decided to follow orders from Hamas’ chief Khaled Mashall and “ignore Israeli calls to close the border. Mashaal seemed to indicate that Hamas was asserting sovereignty over northern Sinai, calling upon the Arab world to take advantage of the Islamist group’s new stronghold to provide aid directly without Israeli interference.”

Now, that’s a stretch. In other words, US puppet Hosni Mubarak—-who gets $2 billion a year in aid from the United States—has suddenly decided to take orders from the head of a group that is on the State Dept’s list of terrorist organizations so that he can fulfill his obligations as a “loyal Arab”?

Ridiculous.

Besides, Hamas has no interest in northern Sinai or any other territorial ambitions. Its only purpose is to resist Israeli occupation.

So far an estimated 350,000 residents of Gaza have fled across the border since Wednesday. The Egyptian police have done nothing to stop them from entering the country. “A significant number have remained in Egypt…traveling south to Egyptian population centers.”

The Jewish Telegraphic Agency reported on 1-24-08 that:

“Israeli officials proposed that Egypt take over responsibility for sustaining the Gaza Strip.

Israeli media quoted members of the Olmert government as saying Thursday that, after Palestinians overran the Gaza-Egypt border, there was an opportunity to demand that Cairo take care of the needs of the coastal territory.

“We need to understand that when Gaza is open to the other side, we lose responsibility for it. So we want to disengage from it,” Deputy Defense Minister Matan Vilnai told Army Radio. “We are responsible as long as there is no alternative.” (JTA)

Are we expected to believe that in the last 24 hours Israel decided willy-nilly to relinquish control over parts of the Gaza Strip? Israel has devoted a considerable amount of time to building settlements in a way that removes any possibility of creating a contiguous Palestinian state. It is highly unlikely that their plans for Gaza are taken any less seriously. In fact, we are probably seeing a manifestation of those plans right now via the expulsion of 350,000 Palestinians.

The Jerusalem Post’s Yaakov Katz clarifies how the destruction of the border wall serves Israel’s long-term policy objectives:

“Without even knowing it, Egypt helped Israel on Wednesday to complete the disengagement from the Gaza Strip. Egyptian President Hosni Mubarak said he opened the crossing for Gazans since they were “starving due to the Israeli siege,” what he did proved to the world that his country is perfectly capable of caring for the Palestinians when it comes to food and medical care.

Wednesday’s events and particularly Mubarak’s decision to open a floodgate into his country for hundreds of thousands of Palestinians, demonstrated that there are alternatives to Israel when it comes to being Gaza’s provider. ” (Jerusalem Post)

That says it all, doesn’t it? The Palestinians are regarded as a mere nuisance and a drain on Israeli resources. Now that the wall has conveniently been knocked down, the problem appears to be solved.

Hamas had nothing to do with blowing up the wall. And if they did, they were just unwitting accomplices in Israel’s masterplan to drive more Palestinians off the land and to absolve themselves of any responsibility for the ones that remain.

THE Taliban has seriously rejoined the fight in Afghanistan, an NGO security group said in a report that concluded the country was at the beginning of a war, not the end of one.

The Afghanistan NGO Safety Office (ANSO) said the Taliban’s “easy departure” in 2001, when a US-led invasion drove them from power, was more of a strategic retreat than an actual military defeat.

“A few years from now, 2007 will likely be looked back upon as the year in which the Taliban seriously rejoined the fight and the hopes of a rapid end to conflict were finally set aside by all but the most optimistic,” ANSO said.

About 1980 civilians were killed in 2007 – half by insurgents and the rest almost equally by soldiers or criminal groups, the group said.

Abductions and killings were likely to escalate this year, with growing links between insurgents and criminal gangs increasing the threat, ANSO said.

It said the NATO-led International Security Assistance Force (ISAF), which is helping the government fight insurgents, is “in fact just now entering a period of broad and deep conflict, the outcomes of which are far from certain.”

ISAF may number about 41,000 soldiers but “realistically” could not have more than 7000 for combat, with the rest mostly support staff or prevented from fighting because of national restrictions, the group said.

The size of the Taliban force was unknown, but estimates ranged from 2000 to 20,000.

“There would not appear to be any capacity within ISAF to stop or turn back anticipated AOG (armed opposition groups) expansion,” the report said.