Bill Totten's Weblog

Sunday, September 07, 2008

How the Chicago Boys Wrecked the Economy

An Interview with Michael Hudson

by Mike Whitney (August 29 2008)

Michael Hudson is a former Wall Street economist specializing in the balance of payments and real estate at the Chase Manhattan Bank (now JP Morgan Chase & Company), Arthur Anderson, and later at the Hudson Institute (no relation). In 1990 he helped established the world's first sovereign debt fund for Scudder Stevens & Clark. Dr Hudson was Dennis Kucinich's Chief Economic Advisor in the recent Democratic primary presidential campaign, and has advised the US, Canadian, Mexican and Latvian governments, as well as the United Nations Institute for Training and Research (UNITAR). A Distinguished Research Professor at University of Missouri, Kansas City (UMKC), he is the author of many books, including Super Imperialism: The Economic Strategy of American Empire (new edition, Pluto Press, 2002)

Mike Whitney: The United States current account deficit is roughly $700 billion. That is enough "borrowed" capital to pay the yearly $120 billion cost of the war in Iraq, the entire $450 billion Pentagon budget, and Bush's tax cuts for the rich. Why does the rest of the world keep financing America's militarism via the current account deficit or is it just the unavoidable consequence of currency deregulation, "dollar hegemony" and globalization?

Michael Hudson: The United States Treasury presently owes $3.5 trillion to foreign central banks. There is no way it can pay this off, even if it had any intention of doing so. So foreign sales of exports - and also of their companies and technology - is a gratis gift to the United States, as is foreign receipt of the dollars thrown off by our international military spending.

As I explained in Super Imperialism, central banks in other countries buy dollars not because they think dollar assets are a "good buy", but because their currencies will rise against the dollar if they do NOT recycle their trade surpluses and US buyout spending and military spending by buying US Treasury, Fannie Mae and other bonds. A currency rise would price their exporters out of dollarized world markets. It is this threat of beggar-my-neighbor currency depreciation that enables the United States to spend abroad and get a free international ride without constraint.

Other countries do have an array of economic responses available, to be sure. These include:

(1) capital controls to block further dollar inflows (foreign central banks would have to approve sales of domestic firms to US buyers or major exports to dollar-area payers);

(2) floating tariffs against imports from dollarized economies (the tariff would be equal to the dollar's depreciation against their own currency; this is how the United States protected itself from low-priced German exports when that nation's currency buckled in 1921 as a result of its reparations tribute);

(3) buyouts of US investments in dollar-recipient countries (Europe and Asia would use their central bank dollar holdings to buy out US private investments at book value); and

(4) subsidized exports to dollarized economies with depreciating currency

These are the kind of similar responses that the United States would adopt if it were in the position of a payments-surplus economy facing payments from a fiat-currency country. In a symmetrical world, Europe and Asia would treat the United States in much the way that its Washington Consensus boys treat Third World debtors: buy out their raw materials and other key sectors, including their basic infrastructure, their export plantations, and their government policy makers as well.

Whitney: Economist Henry Liu said in his article "Dollar hegemony enables the US to own indirectly but essentially the entire global economy by requiring its wealth to be denominated in fiat dollars that the US can print at will with little in the way of monetary penalties ... World trade is now a game in which the US produces fiat dollars of uncertain exchange value and zero intrinsic value, and the rest of the world produces goods and services that fiat dollars can buy at 'market prices' quoted in dollars". Is Liu overstating the case or have the Federal Reserve and western banking elites really figured out how to maintain imperial control over the global economy simply by ensuring that most energy, commodities, and manufactured goods are denominated in dollars? If that's the case, then it would seem that the actual "face-value" of the dollar does not matter as much as long as it continues to be used in the purchase of commodities. Is this right?

Hudson: Henry Liu and I have been discussing this for many years now. We are in agreement, and his Asia Times articles provide a running analysis of dollar hegemony. The paragraph you quote is quite right.

Whitney: What is the relationship between stagnant wages for workers and the current credit crisis? If workers wages had kept up with the rate of production, isn't it less likely that we would be in the jam we are today? And, if that is true, then shouldn't we be more focused on re-unionizing the labor force instead looking for solutions from the pathetic Democratic Party?

Hudson: The credit crisis derives from "the magic of compound interest", that is, the tendency of debts to keep on doubling and redoubling. Every rate of interest can be expressed as a doubling time. (See the "Rule of 72".) No "real" economy's production and economic surplus can keep up with this tendency of debt to grow even faster. So the financial crisis would have occurred regardless of wage levels.

For example, in today's economic march into debt peonage, running up mortgage debt to afford the inflated price of home ownership tends to absorb all the homebuyer's disposable personal income. If wages would have risen more rapidly, the price of housing would simply have risen faster, because employees would have had more take-home pay to pledge to carry larger mortgages. The silver lining of stagnant wages was to help keep the price of houses down to merely stratospheric levels, not ionospheric ones.

Labor unions haven't been much help in solving the housing crisis. In Germany where I am right now, unions have sponsored co-ops at low membership costs, as they used to do in New York City. So housing only absorbs about twenty percent of German family budgets, compared to twice that in the United States.

Imagine what could be done if pension funds had put their money into housing for their contributors instead of into the stock market to buy and bid up prices for the stocks that CEOs and other insiders were selling. "Labor capitalism" via pension-fund capitalism (which seems to be a "final stage" of finance capitalism) has been a failure, especially now that you see private and public-sector pension funds folding. The idea that pension funds could help workers by promoting finance capitalism in destroying industrial capitalism and its employment functions was one of the great deceptions of our epoch.

Whitney: When politicians or members of the foreign policy establishment talk about "integrating" Russia or China into the "international system"; what exactly do they mean? Do they mean the dollar-dominated system governed by the Fed, the World Bank, the IMF, and the WTO? Do countries compromise their national sovereignty when they participate in the US-led economic system?

Hudson: "Integrating" means absorbing - something like a parasite integrating a host into its own control system. WTO and IMF rules prohibit other countries from getting rich in the way that the United States did in the 19th and early 20th centuries. Only the United States is permitted to subsidize its agriculture, thanks to its unique right to grandfather in its price supports. Only the United States is free from having to raise interest rates to stabilize its balance of payments, so that only it can devote its monetary policy to promoting easy credit and asset-price inflation. And only the United States can run a military deficit, obliging foreign central banks in dollar-recipient countries to give it a free ride. In other words, there is no free lunch for other countries, only for the United States.

Other countries do indeed give up their national sovereignty by joining the US-sponsored globalization institutions as they become more neocon and neoliberal. The United States never has adjusted its economy to create equilibrium with other countries. But to be fair, this is simply because only the United States is acting fully and totally in its own self-interest. Other countries simply are not "playing the game". That is the problem. They are not acting as real governments. When one party gets a free ride it takes two to tango - an enabler as well as an abuser. The leading foreign governments have become enablers of US economic aggression.

Whitney: What do you think the Bush administration's reaction would be if a smaller country, like Switzerland, had sold hundreds of billions of dollars of worthless mortgage-backed securities to investment banks, insurance companies and investors in the United States? Wouldn't there be litigation and a demand that the responsible parties be held accountable? So, how do you explain the fact that China and the EU nations, that were the victims of this gigantic swindle, haven't boycotted US financial products or called for reparations?

Hudson: International law is not clear on financial fraud. Caveat emptor is still the rule. Foreign investors took a risk in trusting a deregulated US financial market that makes it easiest to make money via financial fraud. Ultimately, foreign countries joined their US counterparts in putting their faith in neoliberal deregulation.

England is now in the same mess. Financial accountability was supposed to lie with US accounting firms and credit rating agencies. But what they wanted was to maximize profits, and this was done by "giving the customers what they want". And they wanted to promote the economic fiction of solvency, just as the United States wants to pretend that foreign dollar holdings are payable, while cities and states here pretend that they can pay the pensions they have offered their public-sector workers. Foreign investors were so ideologically blinded by free market rhetoric (imposed at gunpoint in countries like Chile where the free-market boys had the strongest hand) that they actually believed the fantasies being promoted about "self-regulation" and self-regulating markets tending toward equilibrium, rather than the real-world tendency toward financial and economic polarization in which fraud was the fastest way to wealth and "Behind every great fortune is a great crime", as Honore de Balzac put it.

In other words, most foreign investors lack a realistic body of economic theory to match that of French novelists a century ago. The United States may simply argue that they should take responsibility for their bad investment, just as US pension funds and other investors are told to do.

Whitney: The Congress recently passed a bill that gives Treasury Secretary Henry Paulson the unprecedented authority to use as much money as he needs to keep Fannie Mae and Freddie Mac solvent. Paulson assured the Congress that he wouldn't need more than $25 billion but, the 400 page bill allows him to increase the national debt by $800 billion. How will the Fannie/Freddie bailout affect the dollar and the budget deficit? Are interest rates likely to skyrocket because of this action?

Hudson: Interest rates are not going to skyrocket, because the Fed can flood the economy with money, Alan Greenspan-style, and other countries don't want to see the market value of their bonds and stocks reduced by high discount rates. At this point nobody really knows what will happen to FNMA and Freddie Mac's stock, but their bonds and packaged mortgages will be supported. The Fed already has provided over $5 trillion of credit guarantees, as I've explained in my Counterpunch articles. In conjunction with the $2 to $3 trillion costs of the Oil War in Iraq, this attempt to reflate real estate and financial markets should put in perspective the government's absurd claims that there is no money to pay Social Security because in another half century or so the system will run up a (mere) $1 trillion deficit.

That being said, it looks like the mortgage and financial crisis will get much, much worse over the coming year. We are just heading into the storm where adjustable-rate mortgages (ARMs) are scheduled to reset at higher rates, and where US banks have to roll over their existing debts in a market where foreign investors fear (quite correctly) that these banks already have no net worth left.

The principle at work here is "Big fish eat little fish". Wall Street will be bailed out, and banks will be allowed to "earn their way out of debt" as they did after 1980, by exploiting retail customers, above all credit-card customers and individual borrowers. There will be many bankruptcies, and people will suffer more than ever before because of the harsh pro-creditor bankruptcy law that Congress (under Joe Biden's sponsorship, along with that of McCain advisor Phil Gramm) passed at the behest of the bank lobbyists.

Whitney: A few months ago, the Wall Street Journal ran an editorial which said that they could imagine two nightmare scenarios if the current credit crisis was not handled properly; either there would be a run on the dollar causing a sudden plunge in its value, or the unexpected failure of a major financial institution could send the stock market crashing. Last week, the former head of the IMF Kenneth Rogoff triggered a sell-off on Wall Street when he said, "We're not just going to see mid-sized banks go under in the next few months, we're going to see a whopper; we're going to see a big one - one of the big investment banks or big banks". What happens if Rogoff is right and Merrill, Citi or Lehman go belly up? Is that enough to send the stock market freefalling?

Hudson: Not necessarily. Citibank could well be nationalized, then sold off. The principle should be that if a bank is "too big to fail", it should be broken up. Even Citibank shareholders think that it has a greater breakup value than overall market value at this point.

Reform should start with a repeal of the Clinton Administration's repeal of Glass-Steagall. "Small is beautiful" is as true for the financial sector as for the rest of the world.

Lehman Brothers may be given the Bear Stearns treatment and sold off, probably to a hedge fund. Merrill is much larger, but it also could be parceled out. The stock market's financial index would plunge, but not necessarily industrial stock prices.

Whitney: According to MarketWatch: "In the three months from April to June, banks posted their second worst earnings performance since 1991 ... Earnings for the quarter totaled just $5 billion, compared with $36.8 billion a year ago, a decline of 86.5%". Also, according to a front page article in the Wall Street Journal: "financial institutions will have to pay off at least $787 billion in floating rate notes and other medium term obligations before the end of 2009".

How are the banks going to pay off nearly $800 billion ($200 billion by December!) when they only earned a measly $5 billion in the quarter! And how can the Federal Reserve keep the banking system functioning when earnings don't even cover current liabilities? Do the banks have some secret source of revenue we don't know about or is the system headed for disaster?

Hudson: The banks don't have a secret source of revenue. It's right out in the open. They will take their junk mortgages to the Federal Reserve and borrow the money at full face value. The government will be left with the junk.

In this way the traditional way to pay debt is with yet MORE debt. The interest due is simply added on to the principal, so that the debt grows exponentially. This is the real meaning of "the magic of compound interest". It means not only that savings left to accumulate interest keep on doubling and redoubling, debts do too, because the savings that are lent out on the "asset" side of the creditor's balance sheet (today, that of America's wealthiest ten percent) become debts on the "liabilities" side of the balance sheet (America's "bottom ninety percent").

The government can either take over an insolvent bank, as the Bank of England did with Northern Rock when it went bankrupt early this year, or it can let the bank "earn" money by stiffing its customers some more. Guess which solution the lobbyists are paying Congressmen to approve!

Whitney: From 2000 to 2006, the total retail value of housing in the United States doubled, going from roughly $11 trillion to $22 trillion in just six years. For the last 200 years, housing has barely kept pace with the rate of inflation, usually increasing two to three percent per year. The Federal Reserve's low interest rates were the main cause of this unprecedented housing bubble and, yet, ex-Fed chief Alan Greenspan still denies any responsibility for what The Economist calls "the largest bubble in history". Did Greenspan understand the problems he was creating with his "loose" monetary policies or was there some ulterior motive to his actions?

Hudson: Greenspan simply didn't care about the financial depth charges he was laying. He saw his job as what it had been when he was a Wall Street consultant-for-hire: a cheerleader for special interests seeking to get rich fast. These had been his major clients in his years on Wall Street, and he saw himself as their servant, like a pilot fish for sharks.

Mr Greenspan's idea of "wealth creation" was to take the line of least resistance and inflate asset prices. He thought that the way to enable the economy to carry its debt overhead was to inflate asset prices so that debtors could borrow the interest falling due by pledging collateral (real estate, stocks and bonds) that were rising in market price. This required an official Fed policy of asset-price inflation - a financial free ride. To Mr Greenspan's petty bourgeois Ayn-Rand view of the world, any given way of making money was as economically and socially productive as any other way of doing so. Buying a property and waiting for its price to inflate was deemed as productive as investing in new means of production. If balance-sheet assets rose faster than debts, then net worth rose - "wealth creation".

Ever since his days as co-founder of NABE (the National Association of Business Economists), Greenspan has looked at GNP and the national balance sheet as the two key economic indicators. Alas, they are fatally "value-free". This is his intellectual and conceptual limitation. He wanted to provide a way for savvy investors to get rich, and the easiest way to get rich is to be passive and get a free lunch. His ideology led him to believe the "free market" patter talk about the financial sector being self-regulating and hence acting honestly. The reality is that he opened the floodgates to financial crooks. His set of measures did not distinguish between Countrywide Financial getting rich (Mr Mozilo became the seventh-highest paid CEO in America) and Enron getting rich, as compared to General Motors or other industrial companies expanding their means of production. The economy was being hollowed out under his watch, but this didn't appear in the measures he watched from his perch at the Federal Reserve.

So just as journalists and the mass media proclaim every market downturn as "surprising" and "unexpected", Mr greenspan was as clueless as a lemming running headlong over the cliff. It's an inherent instinct for free-market boys. To see a problem is like being a "premature anti-fascist" was in the 1930s - not what team players want to do.

Whitney: The housing market is freefalling, setting new records every day for foreclosures, inventory, and declining prices. The banking system is in even worse shape; undercapitalized and buried under a mountain of downgraded assets. There seems to be growing consensus that these problems are not just part of a normal economic downturn, but the direct result of the Fed's monetary policies. Are we seeing the collapse of the Central banking model as a way of regulating the markets? Do you think the present crisis will strengthen the existing system or make it easier for the American people to assert greater control over monetary policy?

Hudson: What do you mean "failure"? Your perspective is from the bottom looking up. But the financial model has been a great success from the vantage point of the top of the economic pyramid looking down. The economy has polarized to the point where the wealthiest ten percent now own 85% of the nation's wealth. Never before have the bottom ninety percent been so highly indebted, so dependent on the wealthy by comparison. From their point of view, their power has exceeded that of any time in which economic statistics have been kept.

You have to realize that the economy's financial managers are trying to roll back the Enlightenment, reverse the moral philosophy and social values of classical political economy and its culmination in Progressive Era legislation, as well as the New Deal institutions. They're not trying to make the economy more equal. Their focus is short-term, because finance always lives in the short run, and their greed is (as Aristotle noted long ago) infinite.

What you see as a violation of traditional values is actually a re-assertion of pre-industrial, feudal values. The economy is being set back on the road to debt peonage. The Road to Serfdom is not government sponsorship of economic progress and rising living standards; it's the dismantling of government, the dissolution of regulatory agencies to free a new feudal-type elite from oversight.

The former Soviet Union provides a model of what the neoliberals would like to create here. Not only in Russia but also in the Baltic States and other former Soviet republics, they created local kleptocracies. In Russia, the kleptocrats founded a Pinochetista party, the Party of Right Forces ("Right" as in right-wing), with made-in-America neoliberal rhetoric and euphemisms.

For the American people or any other people to assert greater control over monetary policy, they need to have a doctrine of just what a good monetary policy is and would be. Early in the 19th century the followers of Saint Simon in France began to develop such a policy. By the end of that century most of Central Europe implemented this policy, mobilizing the banking and financial system to promote industrialization, in consultation with the government (and catalyzed by military and naval spending, to be sure). But this has disappeared from the history of economic thought, which no longer is taught to economics students. The Chicago Boys have succeeded in censoring any alternative to their free-market rationalization of asset stripping and economic polarization.

I would like to make central banks part of the Treasury instead of what it is at present - the board of directors of a rapacious commercial banking system. I think Henry Liu has come to a similar conclusion in his Asia Times articles.

Whitney: Do you see the Federal Reserve as an economic organization designed primarily to maintain order in the markets via interest rates and regulation, or a political institution whose objectives are to impose an American-dominated model of capitalism on the rest of the world?

Hudson: Shirley you jest! The Fed has turned "maintaining order" into a euphemism for consolidating power by the financial sector and the FIRE sector (Finance, Insurance and Real Estate) over the "real" economy of production and consumption. Its leaders see their job as being to act on behalf of the banking system to enable it to make money off the rest of the economy. It acts as the Board of Directors to fight regulation, support Wall Street, block any revival of anti-usury laws, and to promote "free markets" almost indistinguishable from outright financial fraud, to decriminalize bad behavior. But since Mr Greenspan the Fed's job has been to inflate the price of property relative to the wages of labor and even relative to the profits of industry. The class war is back in business.

Internationally, the Fed's job is not really to impose the Washington Consensus on the rest of the world. That's assigned to the World Bank and IMF, coordinated via the Treasury (most notoriously by Robert Rubin in Russia, under Clinton) and AID, along with the covert actions of the CIA and the National Endowment for Democracy. You don't need monetary policy to do this - only massive bribery, euphemized as "lobbying" and the promotion of democratic values via NGOs whose job is to fight any government's power to regulate or control finance. Financial power is inherently cosmopolitan and, as such, antagonistic to the power of national governments.

The Fed and other government agencies, Wall Street and the rest of the economy form part of an overall system. Each agency must be viewed in the context of this system and its dynamics - and these dynamics are polarizing, above all from financial causes. So making the "magic of compound interest" systemic involves expanding to promote "free" credit creation and arbitraging.

None of this appears in the academic curriculum. The silence of the major media to address it or even to acknowledge it means that it is invisible except to the beneficiaries who are running the system.

Bill Totten


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