The Economist at 175

A manifesto for renewing liberalism

Success turned liberals into a complacent elite. They need to rekindle their desire for radicalism

LIBERALISM made the modern world, but the modern world is turning against it. Europe and America are in the throes of a popular rebellion against liberal elites, who are seen as self-serving and unable, or unwilling, to solve the problems of ordinary people. Elsewhere a 25-year shift towards freedom and open markets has gone into reverse, even as China, soon to be the world’s largest economy, shows that dictatorships can thrive.

For The Economist this is profoundly worrying. We were created 175 years ago to campaign for liberalism—not the leftish “progressivism” of American university campuses or the rightish “ultraliberalism” conjured up by the French commentariat, but a universal commitment to individual dignity, open markets, limited government and a faith in human progress brought about by debate and reform.

Our founders would be astonished at how life today compares with the poverty and the misery of the 1840s. Global life expectancy in the past 175 years has risen from a little under 30 years to over 70. The share of people living below the threshold of extreme poverty has fallen from about 80% to 8% and the absolute number has halved, even as the total living above it has increased from about 100m to over 6.5bn. And literacy rates are up more than fivefold, to over 80%. Civil rights and the rule of law are incomparably more robust than they were only a few decades ago. In many countries individuals are now free to choose how to live—and with whom.

This is not all the work of liberals, obviously. But as fascism, communism and autarky failed over the course of the 19th and 20th centuries, liberal societies have prospered. In one flavour or another, liberal democracy came to dominate the West and from there it started to spread around the world.

Laurels, but no rest

Yet political philosophies cannot live by their past glories: they must also promise a better future. And here liberal democracy faces a looming challenge. Western voters have started to doubt that the system works for them or that it is fair. In polling last year just 36% of Germans, 24% of Canadians and 9% of the French thought that the next generation would be better off than their parents. Only a third of Americans under 35 say that it is vital they live in a democracy; the share who would welcome military government grew from 7% in 1995 to 18% last year. Globally, according to Freedom House, an NGO, civil liberties and political rights have declined for the past 12 years—in 2017, 71 countries lost ground while only 35 made gains.

Against this current, The Economist still believes in the power of the liberal idea. Over the past six months, we have celebrated our 175th anniversary with online articles, debates, podcasts and films that explore how to respond to liberalism’s critics. In this issue we publish an essay that is a manifesto for a liberal revival—a liberalism for the people.

Our essay sets out how the state can work harder for the citizen by recasting taxation, welfare, education and immigration. The economy must be cut free from the growing power of corporate monopolies and the planning restrictions that shut people out of the most prosperous cities. And we urge the West to shore up the liberal world order through enhanced military power and reinvigorated alliances.

All these policies are designed to deal with liberalism’s central problem. In its moment of triumph after the collapse of the Soviet Union, it lost sight of its own essential values. It is with them that the liberal revival must begin.

Liberalism emerged in the late 18th century as a response to the turmoil stirred up by independence in America, revolution in France and the transformation of industry and commerce. Revolutionaries insist that, to build a better world, you first have to smash the one in front of you. By contrast, conservatives are suspicious of all revolutionary pretensions to universal truth. They seek to preserve what is best in society by managing change, usually under a ruling class or an authoritarian leader who “knows best”.

An engine of change

True liberals contend that societies can change gradually for the better and from the bottom up. They differ from revolutionaries because they reject the idea that individuals should be coerced into accepting someone else’s beliefs. They differ from conservatives because they assert that aristocracy and hierarchy, indeed all concentrations of power, tend to become sources of oppression.

Liberalism thus began as a restless, agitating world view. Yet over the past few decades liberals have become too comfortable with power. As a result, they have lost their hunger for reform. The ruling liberal elite tell themselves that they preside over a healthy meritocracy and that they have earned their privileges. The reality is not so clear-cut.

At its best, the competitive spirit of meritocracy has created extraordinary prosperity and a wealth of new ideas. In the name of efficiency and economic freedom, governments have opened up markets to competition. Race, gender and sexuality have never been less of a barrier to advancement. Globalisation has lifted hundreds of millions of people in emerging markets out of poverty.

Yet ruling liberals have often sheltered themselves from the gales of creative destruction. Cushy professions such as law are protected by fatuous regulations. University professors enjoy tenure even as they preach the virtues of the open society. Financiers were spared the worst of the financial crisis when their employers were bailed out with taxpayers’ money. Globalisation was meant to create enough gains to help the losers, but too few of them have seen the pay-off.

In all sorts of ways, the liberal meritocracy is closed and self-sustaining. A recent study found that, in 1999-2013, America’s most prestigious universities admitted more students from the top 1% of households by income than from the bottom 50%. In 1980-2015 university fees in America rose 17 times as fast as median incomes. The 50 biggest urban areas contain 7% of the world’s people and produce 40% of its output. But planning restrictions shut many out, especially the young.

Governing liberals have become so wrapped up in preserving the status quo that they have forgotten what radicalism looks like. Remember how, in her campaign to become America’s president, Hillary Clinton concealed her lack of big ideas behind a blizzard of small ones. The candidates to become leader of the Labour Party in Britain in 2015 lost to Jeremy Corbyn not because he is a dazzling political talent so much as because they were indistinguishably bland. Liberal technocrats contrive endless clever policy fixes, but they remain conspicuously aloof from the people they are supposed to be helping. This creates two classes: the doers and the done-to, the thinkers and the thought-for, the policymakers and the policytakers.

The foundations of liberty

Liberals have forgotten that their founding idea is civic respect for all. Our centenary editorial, written in 1943 as the war against fascism raged, set this out in two complementary principles.

The first is freedom: that it is “not only just and wise but also profitable…to let people do what they want.” The second is the common interest: that “human society…can be an association for the welfare of all.”

Today’s liberal meritocracy sits uncomfortably with that inclusive definition of freedom. The ruling class live in a bubble. They go to the same colleges, marry each other, live in the same streets and work in the same offices. Remote from power, most people are expected to be content with growing material prosperity instead. Yet, amid stagnating productivity and the fiscal austerity that followed the financial crisis of 2008, even this promise has often been broken.

That is one reason loyalty to mainstream parties is corroding. Britain’s Conservatives, perhaps the most successful party in history, now raise more money from the wills of dead people than they do from the gifts of the living. In the first election in unified Germany, in 1990, the traditional parties won over 80% of the vote; the latest poll gives them just 45%, compared with a total of 41.5% for the far right, the far left and the Greens.

Instead people are retreating into group identities defined by race, religion or sexuality. As a result, that second principle, the common interest, has fragmented. Identity politics is a valid response to discrimination but, as identities multiply, the politics of each group collides with the politics of all the rest. Instead of generating useful compromises, debate becomes an exercise in tribal outrage. Leaders on the right, in particular, exploit the insecurity engendered by immigration as a way of whipping up support. And they use smug left-wing arguments about political correctness to feed their voters’ sense of being looked down on. The result is polarisation. Sometimes that leads to paralysis, sometimes to the tyranny of the majority. At worst it emboldens far-right authoritarians.

Liberals are losing the argument in geopolitics, too. Liberalism spread in the 19th and 20th centuries against the backdrop first of British naval hegemony and, later, the economic and military rise of the United States. Today, by contrast, the retreat of liberal democracy is taking place as Russia plays the saboteur and China asserts its growing global power. Yet rather than defend the system of alliances and liberal institutions it created after the second world war, America has been neglecting it—and even, under President Donald Trump, attacking it.

This impulse to pull back is based on a misconception. As the historian Robert Kagan points out, America did not switch from interwar isolationism to post-war engagement in order to contain the Soviet Union, as is often assumed. Instead, having seen how the chaos of the 1920s and 1930s bred fascism and Bolshevism, its post-war statesmen concluded that a leaderless world was a threat. In the words of Dean Acheson, a secretary of state, America could no longer sit “in the parlour with a loaded shotgun, waiting”.

It follows that the break up of the Soviet Union in 1991 did not suddenly make America safe. If liberal ideas do not underpin the world, geopolitics risks becoming the balance-of-power, sphere-of-influence struggle that European statesmen grappled with in the 19th century. That culminated in the muddy battlefields of Flanders. Even if today’s peace holds, liberalism will suffer as growing fears of foreign foes drive people into the arms of strongmen and populists.

It is the moment for a liberal reinvention. Liberals need to spend less time dismissing their critics as fools and bigots and more fixing what is wrong. The true spirit of liberalism is not self-preserving, but radical and disruptive. The Economist was founded to campaign for the repeal of the Corn Laws, which charged duties on imports of grain into Victorian Britain.

Today that sounds comically small-bore. But in the 1840s, 60% of the income of factory workers went on food, a third of that on bread. We were created to take the part of the poor against the corn-cultivating gentry. Today, in that same vision, liberals need to side with a struggling precariat against the patricians.

They must rediscover their belief in individual dignity and self-reliance—by curbing their own privileges. They must stop sneering at nationalism, but claim it for themselves and fill it with their own brand of inclusive civic pride. Rather than lodging power in centralised ministries and unaccountable technocracies, they should devolve it to regions and municipalities. Instead of treating geopolitics as a zero-sum struggle between the great powers, America must draw on the self-reinforcing triad of its military might, its values and its allies.

The best liberals have always been pragmatic and adaptable. Before the first world war Theodore Roosevelt took on the robber barons who ran America’s great monopolies. Although many early liberals feared mob rule, they embraced democracy. After the Depression in the 1930s they acknowledged that government has a limited role in managing the economy. Partly in order to see off fascism and communism after the second world war, liberals designed the welfare state.

Liberals should approach today’s challenges with equal vigour. If they prevail, it will be because their ideas are unmatched for their ability to spread freedom and prosperity. Liberals should embrace criticism and welcome debate as a source of the new thinking that will rekindle their movement. They should be bold and impatient for reform. Young people, especially, have a world to claim.

When The Economist was founded 175 years ago our first editor, James Wilson, promised “a severe contest between intelligence, which presses forward, and an unworthy, timid ignorance obstructing our progress.” We renew our pledge to that contest. And we ask liberals everywhere to join us.

Hank Paulson Still Remembers the 'Terror-Filled Nights' of the Financial Crisis

By William D. Cohan

U.S. Secretary of the Treasury Henry Paulson is shown in 2007
U.S. Secretary of the Treasury Henry Paulson is shown in 2007 Photo: Daniel Acker/Bloomberg

If Hollywood decides to produce a movie about a government official who finds himself mired in the middle of a once-in-a-lifetime crisis, Hank Paulson could easily be cast in the lead role.

He’s tall, bespectacled, ruggedly handsome, and still has pretty much the same athletic physique he had when he started 50 years ago on the varsity football team at Dartmouth. (His nickname was “Hank the Hammer.”)

He is also the former CEO of Goldman Sachs and of course was the Treasury secretary, under President George W. Bush, during the 2008 financial crisis. 

These days, Paulson, now 72, runs the Paulson Institute, a non-partisan “think and do” tank with offices in Chicago, Washington, and Beijing that is devoted to strengthening the economic ties between the U.S. and China, with an emphasis on environmental sustainability and conservation.

Paulson had recently returned from an environmental adventure vacation in Brazil when we spoke by phone to get his perspective on the financial crisis, 10 years later.

Barron’s: When did you first become aware that there was an unusual amount of trouble that might be brewing in the fi nancial markets? There are a couple of dates that appear to me, whether it was the crack in the ABX index of subprime mortgage securities in February 2007, the crack in the Bear Stearns hedge funds April-May 2007, or some other point. Was it as early as the beginning of 2007 that you began to see it?

Hank Paulson: The events you cite, those two events, were flashing yellow lights but as far as I was concerned the financial crisis arrived in force in early August 2007, when BNP Paribas halted redemptions on their three investment funds. And that’s what really began to freeze liquidity and we went into high gear. And I was really fortunate to have had a year to build strong working relationships with President Bush, Ben Bernanke, Tim Geithner, and members of Congress before the crisis hit. ….

It was in the spring of 2008 when we began to believe a rescue of the financial system might be necessary and we began doing contingency planning for that.

You mean after Bear?

I can’t pinpoint it exactly but we were working on some things when Bear went down. Let’s just say it was in the spring and it was intensified after Bear.

It’s very frustrating to feel a great sense of responsibility to act and not have the emergency powers you need, and to know that you can’t get them from Congress. For a long time we knew that if we went to Congress and tried to get emergency powers and failed we would precipitate the crisis we were trying to prevent.

In terms of your question about Bear, no advance planning really prepares you for the real thing. The markets were dynamic, and we were operating in uncharted waters which were rapidly changing.

So the kind of planning you might have done before the financial crisis started, or in early days, wouldn’t be that relevant as the situation worsened.

At that moment you thought we’ve got to do what we need to do to save Bear because –

Yeah, we said “Anything we can do we need to do. We don’t know how bad it is but there’s a significant risk it will be bad.” That was the mindset. We didn’t have much time for debate.

While Bear Stearns’ failure in normal markets would not hurt the U.S. economy, we believed that the system was too fragile and fear-driven to take a Bear Stearns bankruptcy. To those who argue that Bear Stearns created moral hazard and contributed to the Lehman failure, I believe just the opposite—that it allowed us to dodge a bullet and avoid a devastating chain reaction.

If Bear had failed, the hedge funds would have turned on Lehman with a vengeance. Lehman would have failed almost immediately and the result would have been much worse than Lehman’s September failure, which occurred after we had stabilized Fannie Mae and Freddie Mac and Bank of Americaacquired Merrill Lynch. I would hate to imagine what would have happened if this whole thing started before we’d stabilized Fannie and Freddie.

So if Bear had actually gone bankrupt, what do you think of this idea that Dick Fuld of Lehman would have gotten religion and said “Oh, boy, I’m bigger than Bear Stearns?”

Lehman would have gone bankrupt very soon thereafter

The inter-bank lending market was freezing. All the conversations I had with international finance ministers after the Bear rescue was, “Why should we feel good? Why should we be doing business with any of your investment banks?” There was a lot of fear.

After the summer did you think the worst had been averted? Bear rescued, Freddie and Fannie shored up, or did you suspect that another step down was likely?  
Bear Stearns was a huge wake-up call for us and reinforced our anxiety about the likelihood of another step down and not having the necessary tools to deal with it. Despite what all the lawyers said to me beforehand that we didn’t have tools to guarantee liabilities or put capital in a non-bank, I just couldn’t believe there wasn’t an authority somewhere that would allow us to do it.

So we went to the Justice Department, we went everywhere we could and we learned we didn’t have the necessary power to rescue a failing nonbank without a buyer. Ben and I consulted with Barney Frank about not having the authority to manage a failure of a non-bank like Lehman.

Barney understood and confirmed what we feared. He said we couldn’t get Congress to act unless they were convinced Lehman was going to fail and that its failure would seriously harm our economy. Of course, sounding that alarm would have led to the firm’s immediate failure. I used Bear Stearns to get both Fannie and Freddie to commit to raise equity and used it to jump start the Fannie/Freddie legislation in the Senate at a meeting in early April with Sen. Richard Shelby and Sen. Chris Dodd who had been reluctant to come to a compromise to move the legislation.

Afterwards, Tim and I began actively trying to convince Dick Fuld to attract a strategic equity investor or sell his company. We went into high gear and we did a lot contingency planning, none of which gave us any comfort.

So let’s then turn to the umpteenth time: Why didn’t the government rescue Lehman?

An interview with Tim Geithner on this topic was done recently at the Yale School of Management and he speaks much more authoritatively on the limits of the Fed powers than I, but here goes. While our responses may have looked inconsistent, Ben, Tim, and I were united in our commitment to prevent the failure of any systemically important financial institution.

But we had a balkanized, outdated regulatory system without sufficient oversight or visibility into a large part of the modern financial system and without the necessary emergency powers to inject capital, guarantee liabilities, or wind down a non-banking institution. So we did whatever we could on a case-by-case basis.

We dealt with four failing investment non-banks before getting the TARP legislation from Congress: Bear Stearns, Merrill Lynch, Lehman, and AIG. One of them, Merrill Lynch, didn’t take government support because it found a buyer. With Bear we were fortunate to have a well-capitalized buyer in JPMorgan that, importantly, was willing to guarantee the Bear liabilities during the pendency of the shareholder vote.

For Lehman, we had no buyer and we needed one with the willingness and capacity to guarantee its liabilities. Without one, a permissible Fed loan would not have been sufficient or effective to stop a run. To do that, the Fed would have had to inject capital or guarantee liabilities and they had no power to do so. Now, here’s the point that I think a lot of people miss: In the midst of a panic, market participants make their own judgments and a Fed loan to meet a liquidity shortfall wouldn’t prevent a failure if they believed Lehman wasn’t viable or solvent. And no one believed they were.

But a Fed loan was able to prevent an AIG failure and avoid catastrophe because AIG had a portfolio of insurance companies, and these were insurance companies with independent credit ratings, which both the Fed and the market believed had sufficient value to secure a loan and ensure that AIG was viable after receiving a loan to cover a huge liquidity shortfall at the holding company.

Then a couple of months later, after AIG’s losses mounted, it took government capital to restructure and to satisfy the rating agencies that the company was viable and fortunately at the time we had capital.

At the end of the day we got lucky with AIG. If it had failed it would have been an order of magnitude worse than Lehman and the government funds that were put in AIG all came back with a big profit. So it worked out well, but it is really an ugly story.

AIG is a cautionary tale. We should not have let our financial regulatory system fail to keep up with modern financial markets. No single regulator had oversight visibility or adequate powers to deal with AIG. Its insurance companies were regulated at the state level, its holding company was like a giant hedge fund sitting on top of the insurance companies, and it was regulated by the ineffective Office of Thrift Supervision, which also regulated—get this—Countrywide, WaMu, IndyMac, GE Capital. They all selected their regulator. So you get the picture, it’s regulatory arbitrage.

And let’s talk about you personally. The lowest moment for you and how you got through it emotionally and physically, and what support you got from your family?

There were so many “Oh boys.” I can’t distinguish. I mean, Lehman going down; narrowly avoiding the implosion of $3.5 trillion of money market funds with 30 million investors which were a primary source of commercial paper financing for many businesses; the House voting the TARP down the first time; the weekend in November after I thought we’d stabilized the banking system when Citi almost failed and needed a second rescue, or near the end of 2008, when I learned that Merrill Lynch had a huge quarterly loss and Bank of America had to be pushed to make good on its deal to acquire Merrill.

During the days, I was too busy to be fearful, but I had to deal with raw fear when I woke up at night and big problems seemed insurmountable. I had a number of terror-filled nights when I looked into the abyss and saw food lines and Great Depression-like scenarios, wondering how we could ever put our concentrated, complex financial system back together again if one other institution went down and precipitated a string of serial failures. How would we put Humpty Dumpty back together again?

I had great support from President Bush, a calm, strong leader, always willing to make tough, unpopular decisions. He bucked me up when I repeatedly brought him bad news. I can only imagine what I might have said if I had a Treasury secretary who kept coming back with bad news. I had two of the best partners imaginable in Ben and Tim, and that working relationship and trust in each other helped immeasurably.

I had a terrific core team at Treasury who worked around the clock, and time after time they came through for us. Then, as you said, my wife Wendy was a calming and reassuring presence at home. It just made all the difference, and we relied very heavily on prayer. Prayer is a big part of my life and looking to a higher power, a divine mind as a source of strength, courage, wisdom, and creativity.

Given your connection to China, do you ever wonder if the next crisis could be started in China?  

It’s impossible to predict, but the world is becoming smaller and more interconnected and interdependent every day so it’s quite likely that the next financial crisis will begin outside the United States.  
Do you think we’re on the precipice of another financial crisis, as I do? Or are you thinking that will be years away? Or is it, as ever, just very difficult to know? Do you think financial crises are inevitable given human nature and the DNA of our banking system?

The timing, cause, and severity of the next financial crisis are impossible to predict. Of course someone will get it right and will be credited with doing so, but he or she won’t spot the next one. But future crises are a certainty, they’re inevitable. As long as we have banking systems, as long as we have fragile banking and financial markets, no matter what the political system, government policies will be imperfect and flawed, and they’ll lead to excesses, which will manifest themselves in the financial system.

So the best we can hope for is to maintain our economic competitiveness so that we’re more resilient to the economic shocks when they come, and deal with the excesses before they are too great, and have the right people equipped with the necessary tools to mitigate the harm to the U.S. economy.

And I’m concerned that some of the tools we effectively used to stave off disaster have now been eliminated by Congress. These include the ability of Treasury to use its exchange stabilization fund to guarantee the money market funds, the emergency lending authority the Fed used to avoid the failure of Bear and AIG, and the FDIC’s guarantee of bank liabilities on a systemwide basis, which was critical.

Importantly, we now have the ability to wind down a failing non- bank on an orderly basis. We wish we had this for Lehman, but the presumption is for it to be used without any government money, which may not be effective in a crisis unless it is used in a manner that is inconsistent with Congressional intent.

Ten years later, what stands out to you most about the crisis and what do you think you learned most about human nature, Wall Street, politics, American society and culture? What would you have done differently if you could and where does that experience rank in your life experiences, which have all been pretty remarkable?

Wow that’s a lot to unpack. The crisis exposed the worst attributes of human behavior, particularly greed. It exposed some big shortcomings in our regulatory system. It exposed a political system where it takes a crisis to get Congress to act on something that’s controversial or unpopular. But what I’m most grateful for is the way the crisis ultimately brought out the best in our government, which allowed us in the fall of 2008 to avoid catastrophe.

So twice Republicans and Democrats in Congress came together on a bipartisan basis to give Treasury unprecedented powers. First for Fannie and Freddie, and then for the TARP. These are the last two times Congress has done something that was consequential and controversial on a bipartisan basis. There was also an unusual level of teamwork across government agencies and great policy continuity from the Bush to the Obama administration.

The Bush administration as first responders developed capital market stabilization programs and put in most of the capital. The Obama administration then adapted the programs where necessary, managed them very well, initiated stress tests, and implemented a massive fiscal stimulus program. President Obama selecting Tim as his Treasury secretary and Ben continuing as chairman of the Fed were critically important to the transition.

We made plenty of mistakes. We didn’t predict the troubled mortgage market as a trigger for the crisis. We didn’t predict the problems in the shadow banking markets. I was unsuccessful at communicating to the American people that the rescues of big banks were not done in the interest of helping Wall Street. They were intended to protect the hard-earned savings and homes of our citizens.

Fortunately, my biggest mistakes during the crisis were quickly corrected by reversing course right on the battlefield. First with Fannie and Freddie, when we sought and received the emergency powers from Congress. I didn’t believe I’d have to use it to nationalize these institutions. If I had, I would have been transparent and we might not have received the Congressional authorization we so desperately needed, so that mistake actually worked in our favor.

I can only imagine how bad it might have been if Fannie and Freddie had not been stabilized before Lehman failed. And just imagine that, and how much further home prices would have declined. Many more homeowners would have lost their homes if we didn’t have Fannie and Freddie as the only source of mortgage financing during the crisis. This is one of the most consequential actions that we took. ....

We faced an epic crisis with an outdated regulatory system and authorities and without a playbook. And rather than having regrets about the big mistakes, we got the big things right.

Where does serving as Treasury secretary rank in my life experiences? The opportunity to serve my country during a time of crisis and to have helped us get out of the crisis is the honor of my life. It’s just as simple as that.

Did you ever think that 10 years later, the stock markets basically have never been higher, the unemployment rate has basically never been lower. Is the proof in the pudding?

We’ve got a lot to be grateful for. And I’m particularly grateful that Ben had the courage to pursue extraordinary monetary policy in the face of withering criticism and for Tim’s creativity and equanimity. But I’m mindful of the fact that the crisis put a very heavy burden on millions of Americans, particularly those who were least able to bear it.

So we must make sure our regulatory system and authorities are sufficient to mitigate the next crisis. Now is the time to do just that. We can and we should do better.

And now that our economy is strong, it is important to begin to address a fiscal deficit that threatens our long-term economic security. It’s also important to deal with some of the other perverse economic problems that predated the crisis and contributed to it, particularly the plight of so many Americans that are being left behind and are not fully benefitting from our economic success. This income disparity, driven by automation and globalization, is increasing and threatens our democracy.

The economic policies that have served us well for years aren’t working as well as they should in today’s America. Just like our regulatory system, which was put in place decades before the crisis, didn’t serve us well during the crisis.

Ten years after Lehman collapse few lessons have been heded

Rating agencies still wield huge influence and investment executives remain unaccountable

Arturo Cifuentes

A decade after the largest bankruptcy in American history, much remains to be explained and understood © Getty

Anniversaries call for reflections. And 10 years after the collapse of Lehman Brothers, the largest bankruptcy in American history, some inexplicable issues linger unresolved.

First, the survival of Moody’s and Standard & Poor’s (now known as S&P Global Ratings). The 2010 US Senate investigation was damning: both rating agencies, amid extensive conflicts of interests and using questionable models, gave triple A ratings to financial instruments that turned out to be houses of cards. Moreover, S&P admitted in 2015 as part of a settlement with the justice department (in which it paid $1.4bn), that its rating process was marred by irregularities.

Yet both companies remain the de facto regulators of the global bond market — they dictate what institutional investors can and cannot buy. Worse, their opinions affect interest rates.

Contrast this situation with that of Arthur Andersen, which surrendered its licence in 2002 after the Enron accounting scandal, an event smaller in size and importance compared with the billions of failed triple A assets. Last year, Moody’s reported an income of almost $2bn and Raymond McDaniel, its chief executive (a position he has kept since before the subprime crisis) received a total compensation of $11m. Clearly, he did better than Kenneth Lay, Enron’s former chief: Lay died in 2006 of a heart attack while awaiting sentencing after being found guilty of fraud.

Second, the chief investment officers of the institutions that bought the failed triple A assets have not received any criticism. Remember that these instruments were not sold to retail investors; they were only available for allegedly sophisticated players, who, presumably, knew what they were doing.

A case in point: the Abacus transaction, a mortgage-based collateralised debt obligation put together by Goldman Sachs in April 2007. By the end of that year, the $150m that IKB, a German investor, had put in the deal were wiped out. Goldman was vilified in the press, and it ended up paying $500m in fines to the Securities and Exchange Commission. On the other hand, nobody ever asked who the executives behind the German investment decision were.

It is worth remembering that the subprime bonds involved in the deal were fully disclosed (with their Committee on Uniform Security Identification Procedures) in the marketing material. And the ABX index, a subprime mortgage-based indicator, had lost one-third of its value between January and March of that year, which should have served as a warning before IKB wrote a cheque for $150m.

Did the IKB officials perform adequate due diligence? What about their fiduciary responsibility? These questions remain unanswered. We only know that while bankers lost the PR battle, most decision makers behind these triple A investment decisions remain unaccountable.

Third, the rationale behind the new insurance regulations is ill-founded. Solvency II, the insurance regulation initiative, was motivated by the collapse of AIG. However, AIG was an insurance company in name only. In reality, it was a highly leveraged speculative fund that ventured beyond the domain of traditional life and casualty companies.

The insurance sector survived the crisis fairly well. This is not to say that insurance regulation should not be improved. But Solvency II, which relies heavily on short-term volatility metrics, is unsuited to address the risks faced by insurance companies because they are not subjected to margin calls or bank-like runs; their potential problems are related to future liabilities that are easier to anticipate. Thus, their regulation should be based on assessing shortfalls, not short-term assets price variations.

Furthermore, one could argue that insurance companies are the natural holders of illiquid assets, but Solvency II, with its myopic risk view, will discourage these investments, and therefore will increase systemic risk by making insurance company portfolios less diversified.

Finally, the lack of mea culpa from the economics profession. Granted, many economists — Paul Krugman and Paul Romer are two notable examples — have acknowledged the shortcomings of most pre-crisis economics models. To be clear, nobody expects economic models to predict crises, future prices and recessions with total accuracy. But at least they should be able to explain the basic functioning of the economy.

The admission by Olivier Blanchard, in 2016, that incorporating the financial sector to macro models would be a good idea is revealing. (In essence, Mr Blanchard’s statement was akin to that of a structural engineer who realises that not incorporating gravity to its models might render them useless.) In any event, despite many exceptions, most tenured economics professors keep teaching the same simplistic, faith-based, empirically challenged models, combined with the belief that almost anything can be explained with a linear regression.

So 10 years after Lehman, much remains to be explained and understood. Coming up with better macroeconomic models is a long-term endeavour, fixing the current insurance regulation could take a few years and identifying the executives behind those unwise investment decisions made more than years ago is pointless.

But reforming the credit rating market is an urgent necessity. We can safely say that both S&P and Moody’s have proven to be solid triple A: they withstood the subprime crisis well. Shame on the regulators.

The author is an adjunct professor at Columbia University, finance and economics division, in New York and a research associate at Clapes UC in Santiago, Chile. He testified twice as an expert before the US Senate as a result of the subprime crisis.

The Paper Gold Market Is Screaming “Short Squeeze”

Every once in a while the trading action in a given market breaks through its historically normal boundaries and starts exploring new territory. This can mean one of two things: Either something fundamental has changed, creating a “new normal” to which participants will have to adapt. Or the extreme move is a temporary aberration that will eventually be corrected by an equally extreme snap-back into the previous range.

The gold and silver futures markets are posing this kind of question right now, with speculators – who are usually net long – going net short, and commercial traders – who are usually net short – going net long. The following table shows how each group traveled even further into this unfamiliar territory in the past week.

Gold COT short squeeze

The following chart illustrates how unusual this new market structure is. During most of the past year the speculators (gray bars) have been extremely long and the commercials (red bars) extremely short.

Now they’ve swapped attitudes, with speculators betting that gold is going to fall and the commercials taking the other side of that bet.

Gold COT chart short squeeze

The same process is at work in silver, where the departure from the norm is even more extreme. In other words, the speculators are very short and the commercials very long.

Silver COT short squeeze

Presented graphically, the far right of the chart illustrates just how unusual the current action is. It’s possible that these two groups of traders have never been in this relative position before.

Silver COT chart short squeeze

What does this mean? Either something has happened to realign speculator and commercial trader incentives and objectives, putting them permanently on the other side of their traditional positions, or the past few weeks’ action is an anomaly that will be corrected with an extreme move in the other direction.

Which is more likely? The latter almost certainly, because the commercials’ traditional net short position exists for business reasons. Gold and silver miners frequently sell their production forward using futures contracts to lock in a predictable price, and they place their orders through the banks that make up the bulk of commercial traders. As long as the miners continue to hedge, commercial traders will necessarily tend to be net short. Speculators, meanwhile, traditionally take the other side of this trade (because every trade has to have two sides), which means they have to be net long to make the market work. So at some point the balance has to be restored.

The timing is anyone’s guess, since the current market structure is virtually unprecedented. But when it happens it’s likely to be via a “short squeeze” in which the speculators begin to close out their long positions and find that they have to pay way up in order to do so. The resulting panic will bring a little sunshine into gold bugs’ recently dreary lives.

Why Bush’s Quiet Role in Financial Crisis Deserves Attention Now

Political polarization, populism and protectionism suggest the next threat will be met with far less political will than the last

By Greg Ip

Former President George W. Bush’s unsung role in helping resolve the financial crisis merits greater appreciation today
Former President George W. Bush’s unsung role in helping resolve the financial crisis merits greater appreciation today Photo: David J. Phillip/Associated Press

The day after Lehman Brothers failed, Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke went to President George W. Bush with bad news. Insurer American International Group Inc.needed $85 billion or it, too, would collapse.

Though unhappy and frustrated, Mr. Bush approved the loan, saying, “If we suffer political damage, so be it,” Mr. Paulson later wrote.

Scholars of the crisis rightly focus on the decisions that the three crisis managers—Mr. Paulson, Mr. Bernanke and New York Fed President Tim Geithner—made to rescue the financial system. Though unpopular at the time and still second-guessed, their actions were vital in avoiding a second Great Depression. Yet most would have been impossible without the president’s support, which Mr. Bush gave unreservedly from start to finish.

Mr. Bush’s unsung role merits greater appreciation today. Ten years after the crisis, the financial system is stronger, but the political system is far more fragile. Polarization, populism and protectionism mean the next crisis will be met with far less political will than the last.

You don’t have to look far to see the potential potential consequences. Fractured politics are largely why the eurozone took so much longer to respond to and recover from its crisis than the U.S. The bloc lacks a unified fiscal authority, so decisions on how to commit public funds had to pass muster with a skeptical German public. For that reason the eurozone insisted on austerity and Draconian bailout terms for crisis-stricken countries that worsened the downturn. The European Central Bank couldn’t take the sorts of radical steps the Fed did for at least two years because of German political resistance.

The Depression tells a similar story. President Herbert Hoover’s efforts to stem growing unemployment and bank failures fell short because he wanted private-sector solutions when government money was needed. One promising effort to shore up shaky banks with public money fizzled when an indignant Congress demanded recipients’ names be published, a stigma that drove banks away. Mr. Hoover signed tariff and tax increases into law out of misguided political orthodoxy.

After Franklin D. Roosevelt defeated Mr. Hoover in 1932, speculation mounted that he would suspend the dollar’s convertibility to gold. Shortly after taking office he did, which was critical in reversing the economy’s downward spiral. But the four months in which he didn’t answer speculation on his plans for the dollar accelerated the outflow of gold and the resulting tidal wave of bank failures.

Mr. Bush’s legacy is overshadowed by many controversies of his own making, such as the U.S. invasion of Iraq, but his responsibility for causing the crisis that would cost his party the White House was at most minor and shared with predecessors.

Nonetheless, he was prepared to abandon political orthodoxy to fix it. In his memoir, Mr. Bush recalls lobbying a Republican congressman to approve the Troubled Asset Relief Program, which would eventually inject billions of dollars into banks. The legislator protested that he couldn’t be “part of the destruction of the free market.” Mr. Bush retorted: “Do you think I like the idea of doing this? Believe me, I’d be fine if these companies fail. But the whole economy is on the line.”

Unlike Roosevelt, Barack Obama didn’t allow a dangerous vacuum to form as the White House changed hands. He stayed in touch with Mr. Paulson during the 2008 election campaign, mustered Democratic votes for TARP, and appointed Mr. Geithner his Treasury Secretary. Mr. Geithner devised the “stress tests” that restored confidence in the banking system. (John McCain, the Republican candidate, vacillated more on bailouts, though he ultimately voted for TARP.) Still, for all the credit Mr. Obama is given for turning the economy around, the toughest decisions were made by Mr. Bush.

They will be far harder to make in the next crisis. Ray Dalio, founder of hedge fund Bridgewater Associates, has just published a meticulous study of debt crises as a free e-book. In an interview, he says a significant takeaway is that resolving a crisis depends in great part on whether the crisis fighters “have the knowledge and authority to make decisions or if they are encumbered by the political environment.”

Chinese leaders, he believes, have both the necessary know-how and authority to deal with an eventual crisis. For the U.S., he’s more pessimistic, partly because its leaders have fewer tools: interest rates can’t be lowered as much, and Congress curbed much of the discretion the Fed and Treasury used to stem the panic. Politically, Mr. Dalio believes inequality and populism will only worsen in the next downturn, depriving crisis managers of the political freedom they need to make unpopular decisions.

President Trump is adept at feeling the pulse of his base at any given moment and shifting his position accordingly, yet crisis management often requires doing the opposite of what the public demands. His belief that international relations are zero-sum would make cross-border cooperation harder. Meanwhile, what little unity the eurozone was able to muster in recent years will be harder with populists now governing Italy and leading the opposition in Germany.

Much of Mr. Bush’s legacy has been dismissed by Democrats and renounced by Republicans. Yet when the next crisis rolls around, both may find they miss him.

Foreign Accents Will Lose Charm for U.S. Stocks

The boost U.S. companies have been getting from their overseas operations is about to go away

By Justin Lahart

A run of strong earnings from retailers such as Walmart suggests that Americans are stepping up spending.
A run of strong earnings from retailers such as Walmart suggests that Americans are stepping up spending. Photo: Timothy Fadek/Bloomberg 

The world is about to become a tougher place for American companies. 
U.S. corporate profits have been strong and, while a strong domestic economy and lower taxes have provided a huge boost, investors shouldn’t discount the important role the global economy has played. An unusual period of synchronized growth has both bolstered companies’ overseas sales and, until recently, strengthened other countries’ currencies, lifting their value when translated into dollars. A recent FactSet analysis found that second-quarter earnings at S&P 500 companies that do more than 50% of their sales from overseas was up 13.5% in the second quarter from a year earlier. At companies that did less than half of their business overseas, earnings grew by 8.6%.

Lately, though, there have been some cracks in the global growth story. Turkey’s financial woes and collapsing currency have rekindled worries about emerging market vulnerabilities. China’s economy is decelerating and a slowdown in Chinese investment suggests there is more to come.

Manufacturing surveys show that global factory-sector growth reached its peak in January, falling since then. The trade spats the U.S. has entered into could weigh further on overseas growth, particularly for export-oriented economies. In turn, retaliatory tariffs against the U.S. could hurt American companies as customers overseas look for alternatives.

Compounding the problem for U.S. companies, all of these issues—Turkey’s troubles, China’s slowdown, cooler manufacturing growth and trade disputes—have bolstered the dollar’s value. So far this quarter it is averaging 4.5% higher than a year ago, on a trade-weighted basis. That will exert a drag on U.S. companies’ overseas profits for the first time in five quarters.

Meanwhile, the domestic economy continues to do well. A run of strong results from retailers such as Walmartin recent days suggests that Americans are stepping up spending. In the months ahead, companies that do all or most of their business at home ought to do well. Investors should notice this, gravitating toward stocks with a little less global flair.

The US Economy and the Midterm Elections

Michael J. Boskin

STANFORD – The US economy is growing, inflation has finally hit the US Federal Reserve’s 2% target, and unemployment is quite low – and at an all-time low for African-Americans and Hispanics. For the first time in memory, there are more job openings listed by US companies than there are unemployed people. Such conditions usually foreshadow rising real (inflation-adjusted) wages, which would indicate that American workers, many of whom were left behind in the anemic post-crisis recovery, might finally reap benefits from the strong economy.

Electoral models predict that a strong economy favors the party in power, and that a weak economy dooms it to crushing losses. And yet, with the economy in its best condition in over a decade, most polls show a substantial Democratic Party lead in the run-up to the 2018 midterm congressional elections this November. Moreover, most political pundits predict that the Democrats will take back control of the House of Representatives. And some even foresee a “blue wave” in which Democrats also retake the Senate, despite having to defend far more seats than the Republicans. In several recent special elections, Republicans have held on by far narrower margins than in past elections for the same congressional seats.

There are a number of plausible explanations for this anomaly. For starters, the pollsters and pundits could simply be wrong, as many were in the 2016 election. At the same time, President Donald Trump may be hurting his and his party’s electoral prospects, especially among suburban women, by launching personal attacks against those who criticize him – including the popular basketball star LeBron James. And it is possible that, despite high ratings for his handling of the economy, many voters may not attribute the economy’s strength to Trump’s policies.

But another possibility is that the “economic effect” on elections no longer holds true. While economic distress may harm the party in power, economic strength might not help it as much as in the past. As voters become wealthier, more have the luxury of focusing on other issues.

In the Democratic primary election for New York’s 14th district earlier this year, democratic socialist Alexandria Ocasio-Cortez trounced incumbent Representative Joseph Crowley, the fourth-ranking Democrat in the House. Clearly overconfident, Crowley barely even campaigned. Since then, Ocasio-Cortez has become a media darling, appearing alongside Vermont Senator Bernie Sanders, a self-described socialist who narrowly lost the Democratic presidential nomination in 2016. While much of the energy among Democrats is on the far left, the party has made a point of selecting candidates with a real chance of winning in November.

Meanwhile, in the Republican primaries, candidates endorsed by Trump, or closely aligned with him, have tended to prevail. But Republicans do not currently have as much enthusiasm as Democrats, which may affect turnout among the party’s supporters in November.

Midterm elections are almost always a referendum on the president and his policies. In the 2010 and 2014 midterm elections, strong Republican majorities were viewed as a repudiation of President Barack Obama. Accordingly, Democrats have been framing the midterms as a referendum on Trump. At the same time, Republicans have tried to make the midterms about Nancy Pelosi, the liberal House Minority Leader from San Francisco who would likely return as Speaker if the Democrats gain a House majority. The problem is that a potential Speaker is a tougher target to hit than a sitting president, let alone one as persuasive in the media as Trump.

For now, attention is being paid to the economy’s potential role in the election. But after Election Day, the results will, in turn, affect economic policies, and thus the economic outlook.

If Republicans retain the House and Senate, the pro-growth tax and regulatory reforms enacted thus far will be sustained, and perhaps even expanded. Likewise, if they keep the Senate, conservative federal judges will continue to be confirmed.

By contrast, a Democratic majority in the House will predictably block Trump’s legislative proposals; and a Democratic majority in the Senate (a long shot) will stonewall conservative judicial appointees. Though divided governments sometimes produce policy compromises and preside over a strong economy, it is hard to imagine that happening if Democrats retake either or both chambers of Congress.

After all, even supposedly moderate Democrats have moved further to the left to ward off socialist challengers. And more Democrats are coalescing around an agenda of greatly expanded government spending and higher taxes (though they haven’t yet spoken much about the latter).

A widely circulated Gallup poll recently found that a higher percentage of Democrats are amenable to socialism than to capitalism. Hence, most of the Democrats veering to the left are proposing universal government-provided health insurance (“Medicare for all”), tuition-free college, and a federal job guarantee or basic income.

Of course, enacting that agenda would require a Democratic president and majorities in both chambers of Congress. And even then, it would cost tens of trillions of dollars. Paying for it would require a large European-style value-added tax (VAT) or dramatically higher income and payroll taxes, most likely leading to European-style economic stagnation.

For their part, the Republicans are divided between traditional free-market, free-trade conservatives and Trumpian “economic nationalists” who want to restrict immigration and trade in lieu of concessions by America’s trading partners.

So, after the November elections, the strong US economy may be threatened by an escalating trade war or the specter of higher taxes. With growth slowing in China, Europe, and elsewhere, the global economy will need America to avoid those dangerous policy mistakes.

Michael J. Boskin is Professor of Economics at Stanford University and Senior Fellow at the Hoover Institution. He was Chairman of George H. W. Bush’s Council of Economic Advisers from 1989 to 1993, and headed the so-called Boskin Commission, a congressional advisory body that highlighted errors in official US inflation estimates.

A City Tries To Save Itself

Amsterdam Seeks To Rein in Tourists

In recent years, it has become increasingly clear that Amsterdam, a city of 850,000, is unable to cope with the 18 million tourists who visit each year. City planners are experimenting with ways of limiting their numbers.

Amsterdam's red light district  Stephen Hodes, who bears a slight resemblance to actor Robin Williams, stands at an intersection in Amsterdam's historic center, and alternates between slapping his hands together above his head and closing his eyes. He's about 70 years old, with a ring of gray hair, and dressed in a partly unbuttoned, casual gingham shirt. From here, he has a view of Central Station, where trains arrive every few minutes, disgorging armies of people with rolling suitcases into the city. Nearby, the hop-on/hop-off boats, every last seat filled, arrive and depart. In front of the venerable Hotel Victoria, between the Damrak shopping area and the red-light district, hordes of tourists bike through red lights on their rented bicycles. Instead of looking at the street, they are staring at Google Maps on their smartphones, causing residents to jump back on the sidewalks and swear out loud. Hodes counts three accidents and four collisions in 20 minutes.

This is his experiment, his desperate measure. But it's also the totally normal state of affairs in summertime Amsterdam, the chaos that blooms in a city beloved and overrun by growing masses of people.

Hodes was one of the first people to rent out bicycles in Amsterdam at the beginning of the 1970s. Then he moved to New York, to work as the head of marketing for the Dutch tourist office. For many years, he was responsible for selling Amsterdam, the city of free thinkers, to Americans. This capital of culture, city of Rembrandt, Van Gogh, Anne Frank, nightlife, free sex and legal drugs. "Holland is hot even in winter," went one of the marketing slogans he used at the time.

Now, 30 years later, Hodes still loves his city, but he is also suffering because of what it has become. "A consumption ghetto," he says, "a city on the verge of collapse." And he knows that he isn't entirely free of blame, which also might be part of what motivates him. Hodes is the founder of Amsterdam in Progress, a think tank which works on behalf of universities and the city to create ideas and plans for Amsterdam's salvation. "It requires radical solutions," says Hodes, who claims that it's too late for anything less. "Amsterdam needs to make itself scarce, the city cannot become a whore like Venice."

Hodes describes his concept as "limitation." He argues that "we need to decisively lower the number of flights and overnight stays, otherwise the residents will flee." The planned airport for low-fare airlines in Lelystad, a short train ride from Amsterdam, he argues, should never be approved, because it would raise the number of flights each year by 60 percent, from half a million to 800,000. And the city's passenger terminal for cruise ships, he says, shouldn't be expanded. Finally, the city's annual economic growth should not be allowed to exceed 1 or 2 percent.

Hodes emphasizes that officials shouldn't consider closing off the city, but that supply and demand should be better regulated. "When a music festival is sold out," says Hodes, while standing on the traffic-clogged intersection, "then it is sold out, then people have to wait or come back the next year. That's just how it is."

Swamped By Visitors

The city is indeed overwhelmed by the masses. It simply wasn't built for them. In 2005, 11 million people visited each year. Now, that figure is over 18 million. And many aren't just staying for a few hours, but for up to three nights, and every tenth stays for a week. Amsterdam already has as many Airbnb overnight stays each year as Madrid and Berlin, over 2 million, even though it is considerably smaller, with 850,000 inhabitants. "It's a village," says Hodes.

But Amsterdam is located in the progressive Netherlands, and citizens' advocacy groups, like Hodes', have been around for a while. And the city's municipal government could play a kind of pioneering role for other tourist centers, like Barcelona, Florence or Dubrovnik, by developing concepts to combat the over-commodification of the city, or at least taking a stab at it.

A few canals south of there, at City Hall, two district managers are giving a talk on behalf of newly elected Mayor Femke Halsema. Their goal is to explain how creative ideas can be used to return quality and diversity to a city, how one can set limits without building fences and to discuss the dilemma of wanting to remain a liberal city while establishing rules that apply to everyone, including visitors.

Two years ago, they developed "City in Balance," a remarkably strict catalogue of measures: Residents are allowed to rent their apartments and houses for a maximum of 60 days per year on home-sharing platforms like Airbnb and, as of 2019, that allowance will drop to 30. The construction of new hotels in the city center has been banned. Since November 2017, the city government has also banned beer bikes, a bachelor-party excrescence with a beer tap.

A more revolutionary measure is their decision to ban businesses catering exclusively to tourists: souvenir shops, postcard kiosks, cheese stores like the Cheese Company, which no resident would ever set a foot in, and the waffle-and-crepes stores, also known as "Nutella shops," that seem to spring out of the ground everywhere. The ban has been in effect for 10 months now, and is directed at new openings, not at already existing businesses. Still, no urban tourist center has gone this far.

And then there's the city's marketing coup, "Enjoy and Respect," an unprecedented campaign aimed at scaring people into better behavior. It is targeted at Amsterdam's most frequent guests: party-loving men between the ages of 18 and 34, devoted to alcohol and other drugs, and largely from the United Kingdom, Germany or the rural Netherlands. Whenever these men log onto the internet in the red-light district and the entertainment district of Leidseplein, images pop up with slogans explaining that Amsterdam deserves respect, and noting the 140-euro fines for loud singing, rambunctious behavior, littering and urinating on building walls. Even drinking on the street is punishable by a 90-euro fine.

Two weeks ago, the mayor announced that the so-called Handhaver, municipal employees who enforce these rules, can and will collect fines immediately using card readers.

On a normal Friday night in Amsterdam's red-light district, one sees "crowd managers" and "traffic controllers," as well as people wearing orange T-shirts with the word "host." They stand on bridges and in narrow alleys, and explain why the red-light district is red, and, in a friendly manner, point to the fact that 3,000 people, in need of quiet, still live here.

The Problem Continues

It seems harmless, given the bellowing, sweating masses of people pushing each other through the narrow alleys, past the windows with the women shaking their rears. Past the men in Super Mario costumes, English men having bachelor parties who get disastrously drunk and sleep outside before boarding their planes home the next day. Beer bikes may have been banned, but not their nautical counterparts, the so-called cocktail boats that glide through Amsterdam's canals to the sounds of techno, one after the other, carrying groups of tourists and cases of alcohol.

For tourism expert Stephen Hodes, who is himself battling the genie he helped out of the bottle in Amsterdam, the city's measures aren't radical enough. But he does like the idea of ombudsman Arre Zuurmond, who moved into the red-light district for three months to live and find out what measures might be necessary to rescue the city from the worst. His horrified tweets and photos from what he described as an "out-of-control urban jungle" got locals worked up and alarmed the municipal government as well. "There is a lot of fear," says Hodes, "that the city will become an amusement park and the last residents will disappear."

Hodes himself took this step long ago. He moved from his old canal house on the beautiful Oude Schans when the noise of the houseboats began disturbing him at night. "The overnight guests were always so stoned that, after a few minutes, they forgot their promise to be quiet." Hodes now lives on flat land, in a house with a yard looking out onto sheep and windmills. He lives in Muider, near Muider Castle, which has recently become known as Amsterdam Castle. It's another idea by Hodes' successors in the marketing department: Tourists are to be redirected there and to the North Sea beach of Zandvoort, which has been rechristened Amsterdam Beach.

"It's working," says Hodes, who also expresses concern about the development. "So well, that tourist buses are now parking in my village, and travel to Amsterdam has become even more attractive."