Finance’s Crisis of Legitimacy

Simon Johnson

18 July 2012
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WASHINGTON, DCThe recent departure of Robert Diamond from Barclays marks a watershed. To be sure, CEOs of major banks have been forced out before. Chuck Prince lost his job at Citigroup over excessive risk-taking in the run-up to the financial crisis of 2008, and, more recently, Oswald Grübel of UBS was pushed out for failing to prevent unauthorized trading to the tune of $2.3 billion.




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But Diamond was a banker supposedly at the top of his game. Barclays, it was claimed, had come through the 2008-2009 crisis without benefiting from government support. And, while his bank had been found in violation of various rules recently, including on products sold to consumers and on how it reported interest rates, Diamond had managed to distance himself from the damage.



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Press reports indicate that regulators were willing to give Diamond a free passright up to the moment when a serious political backlash took hold. Diamond started to fight back, pointing an accusatory finger at the Bank of England. At that point, he had to go.



There are three broader lessons of Diamond’s demise at Barclays.



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First, the political backlash was not from backbenchers or uninformed spectators on the margins of the mainstream. Top politicians from all parties in the United Kingdom were united in condemning Barclays’ actions, particularly with regard to its systemic cheating on the reporting of interest rates, exposed in the Libor scandal. (The London Interbank Offered Rate is a key benchmark for borrowing and lending around the world, including for the pricing of derivatives).



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Indeed, Chancellor of the Exchequer George Osborne went so far as to say, “Fraud is a crime in ordinary business; why shouldn’t it be so in banking?” His clear implication is that fraud was committed at Barclays – a serious allegation from Britain’s finance minister.


.After five years of global financial-sector scandals on a grand scale, patience is wearing thin. As Eduardo Porter of The New York Times put it,


Bigger markets allow bigger frauds. Bigger companies, with more complex balance sheets, have more places to hide them. And banks, when they get big enough that no government will let them fail, have the biggest incentive of all.”


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Second, Diamond apparently thought that he could take on the British establishment. His staff leaked the contents of a conversation he claimed to have had with Paul Tucker, a senior Bank of England official, suggesting that the BoE had told Barclays to report inaccurate interest-rate numbers.



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Diamond apparently forgot that the continued existence of any bank with a balance sheet that is large relative to its home economy – and its ability to earn a return for shareholdersdepends entirely on maintaining a good relationship with regulators. Barclays has total assets of around $2.5 trillionroughly the size of the UK’s annual GDP – and is either the fifth- or eighth-largest bank in the world, depending on how one measures balance sheets. Banks at this scale benefit from huge implicit government guarantees; this is what it means to betoo big to fail.”



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Diamond apparently believed his own rhetoric – that he and his bank are critical to economic prosperity in the UK. The regulators called his bluff and forced him to resign. Barclays’ stock price rose slightly on the news.


.The final lesson is that the big showdowns between democracy and big bankers are still to come – both in the United States and in continental Europe. On the surface, the banks remain powerful, yet their legitimacy continues to crumble.


Jamie Dimon, CEO of JP Morgan Chase, presided this year over reckless risk-taking to the tune of nearly $6 billion (we might call it a “three Grübeldebacle), yet his job apparently remains secure. Dimon even remains on the board of the Federal Reserve Bank of New York, despite the fact that the New York Fed is deeply involved in the investigation not only of JP Morgan Chase’s trading losses, but also of its potential involvement in the broadening Libor scandal.



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As Dennis Kelleher, the president of the advocacy group Better Markets, documented in recent congressional testimony, two years after the passage of the Dodd-Frank legislation, the US banking system continues to fight hard – and effectively – to undermine meaningful reform. (Kelleher’s testimony is a must-read assessment, as is his opening statement to the hearing).




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But progress is nonetheless being made. Dimon is the public face of megabanks’ resistance to reform; repeated and public egg on this particular face strengthens those who want to rein in these banks’ excessive and irresponsible risk-taking.



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Meanwhile, the European situation looks explosive. The European Union’s approach to bank regulation encouraged financial institutions to load up on government debt supposedly a “risk-freeasset. Now, given the profound sovereign-debt crisis in the eurozone periphery, government defaults threaten to take down the big banks. The European Central Bank has provided a great deal of emergencyliquidity funding to banks, which they use to buy even more government debt. This holds down interest rates on that debt in the short run, but creates even bigger potential losses in the case of potential default.


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Banks and politics are deeply intertwined in all advanced economies. Diamond discovered that, ultimately, politicians trump bankers at least in the UK.



.But what really matters is legitimacy and informed public opinion. Do you really believe the increasingly dubious notion that megabanks, as currently constituted, are good for the rest of the private sector, and thus for economic growth and job creation? Or do you begin to consider more seriously the increasingly mainstream proposition that global megabanks and their leaders have simply become too powerful and dangerous?



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Simon Johnson, a former chief economist of the IMF, is co-founder of a leading economics blog, http://BaselineScenario.com, a professor at MIT Sloan, a senior fellow at the Peterson Institute for International Economics, and co-author, with James Kwak, of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.

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Interview

SATURDAY, JULY 21, 2012

Coming: The End of Fiat Money

By LESLIE P. NORTON

Stephanie Pomboy, founder of MacroMavens, sees the world hurtling toward a day in which money will again be backed by gold or other hard assets. Until then, she also sees plenty of trouble.

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"Hear Me Now, Believe Me Later," was the title of two separate and prescient pieces penned by Pomboy, an economist and founder of the MacroMavens research boutique. One, published in March 2006, foretold the disastrous costs of the housing bubble. The second, somewhat later, laid out the consequences of the bubble's "financial echo." Today, Pomboy predicts something more draconian: the demise of fiat moneycurrencies that aren't backed by anything other than government decrees that they have value.






We checked in with her last week, as central banks around the globe weighed more easing and as Fed chief Ben Bernanke described to Congress the headwinds facing the U.S. economy, including the automatic tax increases and spending cuts set for year end, called the "fiscal cliff." With the Fed being the biggest buyer of Treasuries, Pomboy thinks the 40-year-old fiat system will crack within five years.



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Barron's : What don't investors anticipate today?





Pomboy: That the Fed will be a presence in the Treasury market for a long, long, long time. Some believe that, with another round of quantitative easing, we move forward, emerge from the morass, and the need for further intervention will dissipate. But the Fed is really the only natural buyer of Treasuries anymore. It will have to continue to monetize Treasury issuance at the same time all the other major developed economies—from the Bank of Japan to the Bank of England to the European Central Bank—are doing the same. Pursue that to its natural conclusion, and you see the inevitable demise of fiat money. To look at our policies and not be concerned about the risks to our currency would be dangerously naive.




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One step at a time. When is the next round of QE?
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Bernanke left the door wide open to moving when the data mandate. I believe it will happen before the next election. The one success the Fed has achieved with its postbubble, postcrisis stimulus is reinflating financial assets. To watch the S&P 500 go down every day is to watch it be undone. The Fed is trying to engineer a wealth effect, so high-end consumers spend, so companies catering to them will hire and increase capex, [capital expenditures] and—lo and behold!—the seeds of a sustainable recovery will be sown. It hasn't played out like that. They have financial-asset inflation and high-end consumer spending. The logjam is that corporations are disinclined to increase hiring and expand.





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Which accounts for the fat margins investors love.




Cost-cutting has been a huge driver of those margins, but what is still underappreciated is that, if you look at the recovery in GDP since before the crisis, 83% of the increase is explained by higher prices. Only 17% is from an increase in demand. That explains the profit margin story. Companies have been able to pass on higher prices, even in the most discretionary forms of consumer spending. If you look at retail sales, actual units sold are lower than they were before the crisis.



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It's entirely an inflation story on the retail sales side. Consumers aren't buying more because they feel great. They are spending more because the prices have gone up. But now consumers are reaching their limits. Since June 2010, households have drawn down savings. But in the past three months, they've put $65 billion back into the cookie jar, which suggests that they've reached their threshold. Middle-income consumers are also adjusting to the new realities of living within a budget. Wal-Mart [ticker: WMT] is attracting a broader audience. And you have a troubling slowdown at the high end, since financial assets are starting to teeter. As you see the fraying fortunes of these high-end retailers, and low- and middle-income consumers tighten their budgets, there's urgency for the Fed to act.





That sounds bad.






Well, consumers won't shut their wallets overnight. It's just that the rules of prior recoveries don't apply anymore. We've got secular deleveraging and a slower pace of consumer spending, a broad deceleration in nominal spending growth, for as long as it takes households to feel more comfortable with their balance sheets. It's a muddle-through scenario. On the corporate side, if they can no longer pass on higher prices, the margin squeeze intensifies. If the Fed at the same time introduces quantitative easing again, commodity price pressures might reaccelerate, squeezing margins further.




Right now, the estimates for growth, even as they come down, are probably too high. Ditto for profit growth.





What happens if we go over the fiscal cliff?





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If tax rates move back to prior levels, I definitely think the economy goes back into a recession—and likely a severe one. If there's a permanent deal, it's bullish, although in no way repealing the secular deleveraging and deflationary forces in the economy. A temporary deal would yield an economy in paralysis, much like what we've seen over the past year. On the other hand, if fiscal policy makers actually enacted some favorable policy, it could be the thing that staves off the demise of fiat money.





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If the data get really bad, there will be some sense of urgency to enact stimulative measures, rather than have corporations and high-end consumers staring down the barrel of a gun next year. That's a very low-odds prospect.





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What happens if Mitt Romney wins?





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In theory, it provides a more favorable backdrop for the U.S. economy and financial markets, but it remains to be seen what he can really do and how aggressive he is. Companies aren't sitting on $2 trillion in cash because they can't think of anything better to do; they are getting negative returns after inflation. Were they to open their wallets, albeit slowly, the seeds of a sustainable recovery would be sown. Perversely, the worse the data gets, the higher the odds of a positive outcome.





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There will be a backlash against the current administration and policy mix. But obviously, despite how negative the data has been recently, it doesn't look like we'll see a change in Washington. Companies in the entire postwar period have never increased hiring when profit growth is decelerating. A Romney victory with bold incentives might change that, but the more profit growth slows, the lower the odds that incentivizing companies with tax measures actually bears fruit.




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You clearly need to reduce taxes across the board and have a friendly regulatory environment. The key is to do something permanent: Companies need to feel this is a fundamental shift. Given the economic backdrop right now, here and in Europe, it's not the time to be tightening fiscal policy. I have a weakness for the Laffer Curve, that ultimately a tax cut to corporations, and sustaining the present tax system for consumers, would be a long-run positive and a step in reducing the government's role in the economy, which has been enormous over the past four years.





 
You recently wrote an entire piece about the importance of the Bank of Kazakhstan. Why?




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Economics is so dull! You have to inject a little levity when you can. We know that the Bank of China, India, and major emerging-market economies have been slowly diversifying out of their dollar reserves into hard assets. When you get to the point that the Bank of Kazakhstan is thinking: "We really need to figure out a way to diversify out of dollars," it is a pretty profound statement about the quality of the dollar. Here in the U.S., it doesn't seem like any investor is concerned about the risk of the demise of fiat money. I'm sure most people think I should be fitted for a straitjacket.





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The real urgency for QE is not the economic outlook, but that the Fed has made itself the only natural buyer of Treasuries; during QE2 they were 61% of the market. At the peak of the housing bubble and globalization nirvana, foreigners absorbed 82% of Treasury issuance; today, it's 26%. While we are enjoying a short flight-to-safety bid, courtesy of Germany's Angela Merkel and the euro-zone crisis, that's not a sustainable financing strategy. Now people are paying for the privilege, after inflation, of owning that paper.



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We have over $1 trillion annually in Treasury issuance, and our foreign creditors are buying $300 billion. That's being absorbed by the flight-to-safety bid, as hedge funds cover short positions and bond managers extend duration.




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Our creditors have limited diversification choices, too.
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Changed Dynamics


Foreigners once were the prime buyers of U.S. Treasury securities, accounting for 82% of purchases. Now, they account for just 26%, and the Federal Reserve is the No. 1 customer.
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Well, they're now recycling dollars into hard assets. Conveniently, commodities trade in dollars. The thing that makes hard assets so alluring is their finite supply. All these central banks are going to discover they can't amass commodities as rapidly as the Fed, ECB, and BOE can debase their currencies. That's why we are speeding toward hard money.





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What triggers it, and when does it happen?





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It could happen in a couple of ways. One, the inflation rate in the U.S. picks up and the Fed finds itself forced to continue quantitative easing, because it must absorb the Treasury funding slack, despite rising headline inflation. At which point it's obvious to everyone that the Fed is buying Treasuries because it is slavishly monetizing the expansion of the government. That would be such a naked dollar-debasing tactic it might impel the Bank of China to say: "Look, we demand a capital-preservation guarantee."



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They made that threat almost two years ago. Instead of enforcing it, they've accelerated their diversification out of our paper. And in conjunction with Russia, they are working on trading in non-dollar transactions.




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I don't see it in the next 12 months. I think a five-year time horizon is very, very realistic. I envision a gold-backed currency system. We are going back to hard money, rather than a fiat system where debtors can silently default by inflating their debts away.




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How does the demise of fiat money affect investors?




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There would be a knee-jerk negative reaction, but when the dust settled, it would be clear we were actually moving into a responsible policy. The realization that we are going down this road will be very bearish for stocks and bonds with the exception of Treasuries, which the Fed will continue to cap. You will have immediate and dramatic increases in commodity prices and inflation expectations.




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I would own gold versus developed-market currencies. You want to be long emerging-market creditor currencies, versus developed-market debtors. Oil would be an absolute-return asset: Central banks are amassing strategic resources like oil. Companies tied to mining and commodity production are absolute-return areas.





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One relative-return play is to overweight large-cap multinationals that benefit from having consumers outside the U.S. and underweight small-cap U.S.-centric companies. Another play on the budget-conscious U.S. consumer versus fraying high-end activity is overweighting Wal-Mart versus Nordstrom (JWN). On the credit side, maybe underweighting a junk composite versus a triple-A-rated corporate composite, or even underweighting junk versus an emerging-markets bond composite.






Until then, what happens to our markets?





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Since 2002, I've been bullish on gold and on Treasuries and generally negative about stocks. Over that stretch, on an inflation-adjusted basis, stocks have gone exactly nowhere, gold has gone up a ton, and Treasury yields have gone from 5% to 1.5%. In general, we have diminishing marginal returns on each round of QE. I would see a high of 1400 on the S&P 500 and, should we go over the fiscal cliff, a low of 500. [The S&P was recently 1377.]






On the bond side, there's not a lot more money to be made. I wouldn't be short, because the Fed will really work to maintain rates at those levels. The highest-quality corporate yields may compress further. I'm concerned about junk, where spreads are hovering at 2005 lows. Is it reasonable for junk companies to borrow at the same rate when unemployment is higher and GDP and consumer spending growth are lower?




Thanks, Stephanie.

 
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Copyright 2011 Dow Jones & Company, Inc. All Rights Reserved



Europe’s Immigration Challenge

Peter Sutherland , Cecilia Malmstrom

20 July 2012
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LONDONEurope faces an immigration predicament. Mainstream politicians, held hostage by xenophobic parties, adopt anti-immigrant rhetoric to win over fearful publics, while the foreign-born are increasingly marginalized in schools, cities, and at the workplace. Yet, despite high unemployment across much of the continent, too many employers lack the workers they need. Engineers, doctors, and nurses are in short supply; so, too, are farmhands and health aides. And Europe can never have enough entrepreneurs, whose ideas drive economies and create jobs.



The prevailing skepticism about immigration is not wholly unfounded. Many communities are genuinely polarized, which makes Europeans understandably anxious.




But to place the blame for this on immigrants is wrong, and exacerbates the problem. We are all at fault.



By not taking responsibility, we allowed immigration to become the scapegoat for a host of other, unrelated problems. The enduring insecurity caused by the global economic crisis, Europe’s existential political debates, and the rise of emerging powers is too often expressed in reactions against migrants. Not only is this unjust, but it distracts us from crafting solutions to the real problems.



European countries must finally and honestly acknowledge that, like the United States, Canada, and Australia, they are lands of immigrants. The percentage of foreign-born residents in several European countries – including Spain, the United Kingdom, Germany, the Netherlands, and Greece – is similar to that in the US.



Yet, despite this, we do not make the necessary investments to integrate newcomers into our schools and workplaces. Nor have we done enough to reshape our public institutions to be inclusive and responsive to our diverse societies. The issue is not how many new immigrants are accepted into the European Union, but acknowledging the nature and composition of the societies in which we already live.


It is ironic – and dangerous – that Europe’s anti-immigrant sentiment is peaking just when global structural changes are fundamentally shifting migration flows. The most important transformation is the emergence of new poles of attraction.



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Entrepreneurs, migrants with Ph.Ds, and those simply with a desire to improve their lives are flocking to places like Brazil, South Africa, Indonesia, Mexico, China, and India. In the coming decade, most of the growth in migration will take place in the global south. The West is no longer the Promised Land, placing at risk Europe’s ability to compete globally.



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The aging of Europe’s population is historically unprecedented. The number of workers will decline precipitously, and could shrink by almost one-third by mid-century, with immense consequences for Europe’s social model, the vitality of its cities, its ability to innovate and compete, and for relations among generations as the old become heavily reliant on the young. And, while history suggests that countries that welcome newcomers’ energy and vibrancy compete best internationally, Europe is taking the opposite tack by tightening its borders.



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But all is not lost. Europe got itself into this situation through a combination of inaction and short-sighted policymaking. This leaves considerable room for improvement. In fact, there are rays of hope in certain corners of Europe.



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Consider Sweden, which has transformed its immigration policy by allowing employers to identify the immigrant workers whom they need (the policy has built-in safeguards to give preference to Swedish and EU citizens). In more rational times, these reforms would be the envy of Europe, especially given the relative resilience of Sweden’s economy. They certainly have caught the attention of Australia and Canada, which aim to emulate them.



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There have also been innovations in integrating immigrants. Some initiatives, albeit modest, encourage those with immigrant backgrounds to apply for public-sector jobs in police forces, fire departments, media, and elsewhere. Such measures also respond to the urgent need for public institutions that look like the populations they serve.


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There are many other tools to advance integration. We understand well the importance of early childhood education, and what kinds of programs can bridge the gap between immigrant and native children. We know as well the importance of finding a job in the integration process. We know how to recognize immigrants’ skills better, and how to provide the right kind of vocational training. We know how to ward off discrimination in hiring.


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But, while we know what to do, we now need to muster the political will to do it. The good news is that, if we get integration right, we will be far more likely to bring publics along on more open immigration policies.



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Equally important is international cooperation on migration. Last year, during the Arab revolutions, the EU missed a historic opportunity to begin weaving together the two sides of the Mediterranean. It failed to open its doors to young students, entrepreneurs, and other North Africans. Today, the EU is making a more serious effort to engage its southern neighborhood. Among the potential opportunities are free-trade agreements, an easing of visa requirements for university students, temporary work programs, and incentives to attract entrepreneurs.



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No country is an island when it comes to migration, and none can address it alone. We have a long way to go, probably in a climate that will not turn favorable to immigration for many years. How much progress we can make will hinge on our ability to break through the myths about migration.



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Migration is changing in fundamental ways, and we must continue to push ourselves to devise systems and approaches that respond to new realities. If we succeed, human mobility can become one of the great assets of the twenty-first century.