Friday, February 19, 2010

Who's Afraid of the Big Bad Wolf?

Is it all Walt Disney's fault? Maybe if we had all learned the original story of the Three Little Pigs instead of growing up with the Disney version we would know to be afraid of the big bad wolf. You see, in the original story the two lazy pigs who built their houses of straw and sticks were both eaten, whereas in the Disney version they run to their hardworking brother's house of bricks for protection. With all the talk of PIGS and Greece in the financial world today, it seems only natural to see the situation as an allegory with people, companies and nations representing the little pigs and debt as the big bad wolf.

If you haven't heard of the PIGS yet, it's an acronym for what are also known as the Club Med nations in the eurozone, Portugal, Italy (or Ireland if you listen to the Italians), Greece and Spain. All have been thrust into the international spotlight recently as their soaring debt, deficit and a slight credibility gap have been undermining confidence in the euro pushing it down from over $1.50 to around $1.35. The focus started out on Greece, but has now widened its spotlight onto Spain and Portugal bringing with it the huffing and puffing about default and the implications for the euro, a German/French bailout and good old moral hazard or an IMF rescue package and their wicked witch guidance.

Of course there's a variety of reasons for problems in the eurozone: loss of competitiveness due to eastward EU expansion, a sharp drop in tax revenue brought about by the financial crisis, lack of monetary policy options as they now don't have the option to devalue national currency - but the main problem is debt, too much of it. Yet, it's not like any of this happened at once, all three countries, plus most of the western world, have been running astronomical deficits for as long as I can remember. The IMF says that the G7 nations owed a combined $30 trillion US. So, what happened to make this a crisis? Fairy tales, like debt, have predictable story lines, so just follow the money to the beginning as we already know they end the same, night after night, empire after empire.

It's not surprising therefore that the Greek story seems a little repetitive as it parallels the events that led up to crisis 1.0 in 2008. Step one, create the illusion of stability. While the banknotes weren't issued until 2002, the euro came into being January 1st, 1999 when 11 countries took part in conversion day as rates between the euro and national currencies were irrevocably fixed. Greece wasn't one of the 11 as they failed to satisfy all the stipulations of the Maastricht Treaty. Then, as if magically, I love fairy tales, they did; becoming the 12th June 19, 2000. It's since been shown that the EU bought a pig in the poke as we learned in 2004 that total debt was over 100% and worse yet, deficits have been running well above 3% of GDP since the 90's every year except 2006. How'd they get away with it? Of course it was the big bad wolf, Goldman Sachs, and the magic of cross currency swaps.

Remember the wolf in last night's story where he created the illusion of security by bundling mortgages and other debts together, magically obtaining triple AAA ratings in order to buy cheap insurance from the AIG's of the world? Surprise! He also helped Greece to do the same thing. Much as Goldman knew they could rely on the US government to bailout corporate counter-parties due to their TBTF (too big to fail) status, sliding Greece into the eurozone ensured that the ECB (really Germany or France as direct European central bank intervention isn't allowed) would now be standing behind Greek liabilities. These days it seems the wolf also sells the building material to build our financial houses out of straw and twigs.

Cross-currency transactions are part of normal government refinancing as nations issue debt in dollars or yen, swap it for euro debt for a certain period and then exchange it back into the original currency at a later date. However, in Greece "around 2002 in particular, various investment banks offered complex financial products with which governments could push part of their liabilities into the future." Bankers devised a special kind of swap with fictional exchange rates which enabled Greece to receive a far higher sum than the actual euro market value of 10 billion in dollars and yen. Basically, Goldman Sachs secretly arranged additional credit of up to $1 billion for the Greeks disguised as a swap which didn't show up in their debt statistics allowing the books show in 2002 that the Greek deficit amounted to only 1.2% of GDP. After Eurostat reviewed the data in September 2004, the ratio had to be revised up to 3.7%. According to today's 2002 records, it stands at 5.2% (nothing compared to the 12.7% it had planned for this year). With bond maturities at between 10 and 15 years, it'll get even worse when Greece has to pay up for its swap transactions, while of course Goldman Sachs charged a hefty commission of $300 million for the deal and later sold the swaps on to a Greek bank in 2005.

In what amounted to a garage sale on a national scale, Greek officials essentially mortgaged the country’s airports and highways through a legal entity called Aeolos (god of the winds, they should of gone with Demeter to keep the pig theme) in 2001 which helped Greece reduce the debt on its balance sheet that year. In much the same way the wolf picks up the scent of a strapped homeowners forced to take out a second mortgage to pay off credit card debts, the Goldman pack has been stalking Greece to feed it's fairy tale debt habit. As late as November a team from Goldman Sachs led by president Gary D. Cohn arrived in Athens with a deal to create a financing instrument that would push Greek health care debt far into the future.

A similar deal in 2000 called Ariadne devoured the revenue that the government collected from its national lottery. Greece, however, classified those 'mythical' transactions as sales, not loans, despite doubts by many critics. The tide of fear caused by this uncertainty is now washing over other economically troubled countries on the periphery of Europe, making it more expensive for Italy, Spain and Portugal to borrow. For all the benefits of uniting Europe with one currency, the birth of the euro came with an original sin (sorry, I know mixing in biblical stuff now): countries like Italy and Greece entered the monetary union with bigger deficits than the ones permitted under the treaty that created the currency. Rather than raise taxes or reduce spending, however, these governments chose to artificially reduce their deficits by resorting to derivatives sold by and benefiting only the big bad wolf.

But are firms like Goldman really the big bad wolf? After all, they've done nothing illegal (so far, we think) and they're simply providing a service, supplying for a demand. They weren't doing anything wrong when they bundled junk debt into pretty packages, secured AAA ratings then bought insurance on default for low prices from companies like AIG. Neither was it illegal when they started selling those same securities short, causing their prices to fall and triggering massive contractual payouts from AIG when the value of the bonds fell below certain levels. They were simply playing by the rules of the game when they benefited from their timely trades and ensuing government bailouts. When will we sit up and take notice that the wolf is now as influential on the fairy tale genre as the Brothers Grimm? The same little piggy has roast beef whether the market goes up or down and the rest of us have none.

Much of that nasty debt that Wall Street bundled into pretty packages came courtesy of Main Street. Living within one's means sounds so simple; don't spend more than you can afford. Yet today's reality isn't that easy. Temptation is all around and folks need their flat screen TV's, new cars and homes to put all their stuff in. Governments play a roll here too; whether it's encouraging behemoths like Fannie May and Freddie Mac to give mortgages to people who can't afford them or offering tax incentives for people and corporations to take on debt; tax shields make corporate debt as much as 42% cheaper than equity. Individuals are able to write off all their mortgage interest, up to a million dollars, and companies can write off all the interest on their debt, but not things like dividend payments. Yet these incentives are clearly unnecessary; people will always need mortgages to buy homes, the deductions do nothing to increase home ownership while businesses already like debt as it offers leverage. The business-interest deduction, meanwhile, may lower an individual company’s taxes, but it also means that the overall corporate tax rate is higher, so its real impact is to give companies with lots of debt an unjustified advantage. So the system skews decision making in favor of debt and housing away from equity and other investment choices which magnifies risk making the economy more fragile and volatile.

Three Little Pigs from Guy Galer on Vimeo

The big bad wolf can even be re-branded; the leveraged buy-out firms of the 80's became the private equity firms of the 90's. Like the wolf in sheep's clothing though, the name change hasn't affected their modus operandi, company-flipping through debt which has squeezed the life out of any number of venerable companies and engorged many a Gordon Gecko. Sometimes they even set their sites on sports franchises. The Glazer family's purchase of Manchester United, the world's most valuable sports team, will provide a case study for future generations on how financiers enriched themselves while destroying our cultural icons. Thus far success on the field has managed to paper over the financial cracks but the creaking from the mountain of debt recently forced them to float a £500 million bond. While the demand for the bond issue was strong, it's only a matter of time until the interest payments (£325 million since the Glazier acquisition in May 2005) and the 'fees and loans' being issued to family interests sink the club. After all, you can't sell Cristiano Ronaldo to service your debt every year.

The wolf in Disney's Three Little Pigs was said to be an allegory for the Depression at the time of it's Silly Symphony 1933 release. Sadly, today's PIGS have been forced into responding to their financial woes by reducing many programs begun during that era; squeezing their people in order to keep the wolf from the door. Cutting social programs always come before financial reform or reducing spending on things like defense. Which of course brings us to the US, the Federal Reserve and it's magical printing press. Just as you fatten a hog before the feast, the US has been gorging on debt. With their 14 figure debt and $3.7 trillion deficit (yes just one year), optimistically it'll only take until 2020 for debt to reach 100% of GDP when yearly debt maintenance payments of 20% of GDP should be reached, a figure considered unsustainable.

Like a child believing this time the fairy tale will end differently, America and the neoliberal economic model are following the path of all empires. First, the ideology becomes corrupted and the believers lead us down an economically unsustainable model which inevitably forces the currency down until finally, military power loses its supremacy. Spending half of the world's total on defense every year won't help avoid the fate of the Habsburg's in Spain, pre-revolutionary France, the Ottoman and British Empires, or even the Soviets. Just google "Roman Empire economic collapse" to see how many results come up with the end of the American empire to see how most people think this story ends.

No government can ever balance their budget when the poor live hand to mouth, the working class and the middle class are mired in debt, and corporations and the wealthy can buy tax breaks and/or hide their money from the tax man in off-shore accounts. Yes, we need debt, without it we wouldn't have money apparently. Just as s a growing youth is said to have a wolf in its belly, it can quickly expand out of control; Einstein may or may not have said "compounding interest is the most powerful force in the universe". Conservatives rail against it while needing it to supply their pet projects and war machines, liberals feign concern while writing huge checks that necessitate it and all the while the balance of power in the world shifts inexorably east.

Financial regulation is the brick house that can protect us from the wolves. Having seen how their game of financial Armageddon chicken worked out in 2008 when the rest of the world blinked and handed over mountains of cash, this time the wolf has decided to stick it's snout directly into the carcass of sovereign nations. It's only America that can save herself and the financial world but she better act soon. Goldman Sachs and the gang are hunting ever bigger prey, taking an ever larger portion of the pie, living high on the hog if you will, while the rest of us make do with less. Breaking up the TBTF or limiting their size through taxation using ideas such as the Tobin tax on financial transactions is a first step. More importantly we need to change the consumption culture in which we simply make pigs of ourselves; here once again government can play a role by shifting to more consumption based taxes. If there's a moral to learn from this story it's that the only way to catch the wolf in the pot is to stop consuming more than we produce.