text:
Addie Card, 12 years old, anemic little spinner in North Pownal Cotton Mill, Vermont.
Girls in mill say she is ten years. She admitted to me she was twelve; that she started during school vacation and would "stay."
Ilargi: The US government throws 30 billion more pearls before the swine at AIG, and the markets scream loud and clear, one more time, that they're on to this game, and have lost all faith in Washington. AIG shares went up a little, just about all others are down with a vengeance, with the DOW at 6700 for a 300 point loss. This is not a coincidence, this is investors telling Obama and Bernanke that the game is up. AIG will choke on its insurance file of mortgage backed securities. I still see AIG TV ads for life insurance, and they make me wonder who'll buy a policy that may take 40-50 years to pay out, from a company that is for all intents and purposes lying in its grave.
A few more people will start to understand what is going on, that a 3.2% GDP growth rate in 2010, as projected in the Obama budget presented last week, has nothing that resembles reality. Which makes it a dangerous number to publish. As long as people think you're hallucinating, you will not inspire confidence. The markets say you can't do it, and your voters will catch on. You're walking backwards.
For those of you who have followed us in the past few years, it will be increasingly obvious that it's nonsense to say that nobody could have seen this coming. Stoneleigh and I have told you about what you see unfolding for a long time. I hope you have used this information to your advantage, and I don't mean to make profits, though good on you if you have, and the donation line is always open, but indeed to save yourselves from the (worst) kinds of misery that you might otherwise have fallen into. For those of you who are relatively new here, do keep reading every day. We're not done yet.
The downturn is nowhere near over, or at a bottom, or anything like that. It will not be one straight line down, but the trendline is certain. Many pundits now claim that a Dow at 5000 is some sort of bottom, but don't count on it. As for home prices, they will keep tumbling and lose at least 80% of their peak values.
The reason is very simple. The world's major banks are enormously over-leveraged, and need to delever on average some 50%. They can do this by attracting more equity, but who in his right mind will invest in them? The only -other- option they have is to diminish their loan portfolio's. So that's what they must and will do. Not that it will save the banks, the majority of them will close their doors. In the meanwhile, the deleveraging process will suck 99% of all remaining credit out of the marketplace, for governments, businesses and individuals alike. There will be a temporary relief for national governments in bond sales, but the amounts needed are so mind-boggling that the sovereign debt markets will end up eating their own tails.
And then the world as you know it, or as you might recognize, will be over. And it won't come back.
Stocks Drop Worldwide, Treasuries Gain on Concern Economies Are Worsening
Stocks fell worldwide, sending the Dow Jones Industrial Average below 7,000 for the first time since 1997, and Treasuries rose after Warren Buffett said the economy is in "shambles" and American International Group Inc. reported a $61.7 billion loss. Berkshire Hathaway Inc. retreated 5 percent after reporting the worst annual drop in book value since Buffett took control in 1965. HSBC tumbled 17 percent after announcing a rights offering, driving down lenders such as Bank of America Corp. BHP Billiton Ltd., the world's largest mining company, lost 3.9 percent as copper and nickel fell and oil slid 6.6 percent.
"The bear market has only begun," said Robert Prechter, the founder of Gainesville, Georgia-based Elliott Wave International Inc. who is famous for predicting the 1987 stock market crash, said on Bloomberg Radio. "I don't see the clear weather yet." The Dow average decreased 104.18 points, or 1.5 percent, to 6,958.75 at 10:03 a.m. in New York. The Standard & Poor's 500 Index dropped 1.6 percent to 723.09. Treasuries rose as investors sought a haven, driving the yield on 10-year notes down to 2.96 percent from 3.01 percent.
The MSCI World Index of stocks in 23 developed nations fell 2.7 percent and dropped as low as 727.59, the lowest intraday level since the Iraq War began in March 2003. The MSCI Emerging Markets Index slid 3.8 percent, while Hungary's forint dropped after European Union banks spurned aid pleas for eastern Europe. U.S. stocks have fallen for three straight weeks as the government rescued Citigroup and drugmakers fell on President Barack Obama's health-care plan. The S&P 500 is off to its worst start to a year with a 20 percent loss. Options investors are paying twice this decade's average to protect against losses in U.S. stocks through 2011, signaling the bear market that already wiped out $10.4 trillion of equity value may last two more years.
"There's a real panic in the markets, with some people wanting to buy long-term insurance at any price," said Peter Sorrentino, who helps manage $16 billion, including $130 million in options at Huntington Asset Advisors Inc. in Cincinnati. "People have lost hope." Contracts to protect against a drop in the S&P 500 for two years cost $15,160 on the Chicago Board Options Exchange at the end of last week, compared with $6,875 in 2007, according to price-adjusted data compiled by Bloomberg. That shows traders expect the benchmark gauge for U.S. equities to fluctuate twice as much in the next two years as it has since 2000.
Berkshire Hathaway Class B shares lost 5 percent to $2,367.78 in Germany. Fourth-quarter net income fell 96 percent to $117 million on the falling value of holdings including derivative bets. The 9.6 percent drop in Berkshire's book value last year compares with the 37 percent retreat in the S&P 500, including reinvested dividends, the best relative performance since 2002. Buffett said the economy will be "in shambles" this year, and perhaps longer, before recovering from the reckless lending that caused the worst "freefall" he ever saw in the financial system. HSBC tumbled 17 percent to 409.5 pence. Europe's largest bank by market value said it plans to raise 12.5 billion pounds ($17.7 billion) in a rights offer, increasing concern that banks need more capital.
PNC Financial Services Group Inc. dropped 3.2 percent to $26.48. The fifth-largest U.S. bank by deposits slashed its dividend 85 percent, to 10 cents from 66 cents, to save $1 billion amid "extreme market deterioration." Raw-material producers in the MSCI World Index lost 2.4 percent, a decline that was second only to financial institutions among 10 industries. The measure of banks, brokerages and insurers slid 4.8 percent. BHP, the world's largest mining company, declined 3 percent to 1,073 pence. The Reuters/Jefferies CRB Index of 19 commodities fell 2 percent. Oil fell for a second day, losing 6.6 percent to $41.80 in New York.
AIG advanced 14 percent to 48 cents. The insurer deemed too important to fail will get as much as $30 billion in new government capital in a revised bailout after posting a record fourth-quarter loss. The market remained lower even after the Institute for Supply Management's factory index unexpectedly climbed to 35.8 in February from 35.6 the prior month. A reading of 50 is the dividing line between growth and contraction. "The situation is very difficult and economic data isn't stabilizing," said Guillaume Duchesne, Geneva-based equity strategist at Fortis Private Banking, which oversees about $117 billion. "That justifies the negative spiral in the stock market."
US Stocks Dropping Below New Set Of Milestones
U.S. sharemarket benchmarks were dropping past another set of milestones on Monday as stocks succumbed to a broad and deep selloff amid fears that a recovery for the global economy may be a long way off. The Dow Jones Industrial Average was recently off about 229 points at 6824. The benchmark slid under 7000 on an intraday basis for the first time since Oct. 28, 1997. The Dow last closed below 7000 on May 1, 1997. All 30 of the Dow's components sank as investors sold heavily in every sector. Financials slid, with Bank of America dropping 14% and Citigroup and J.P. Morgan Chase falling 16% and 6%, respectively. Alcoa and Caterpillar also sank, as did shares of General Electric, which dropped more than 7% to fall below $8 a share.
The broad selloff pushed the Standard & Poor's 500 Index down roughly 3.5% to 709, moving near its levels of December 1996, when former Federal Reserve Chairman Alan Greenspan delivered his famous "irrational exuberance" speech. The energy and financial sectors each declined about 6%, while its industrial and basic materials categories were lower by more than 5%. Last week, stocks dropped to the lowest levels in eleven and a half years, and there has been no break in the selling pressure. Friday, the Dow industrials fell nearly 120 points, leaving the benchmark down 11.7% for February - its worst performance for the month since 1933, when it fell 15.6%. "It's like an unending nightmare," said Kent Engelke, managing director at Capitol Securities Management in Glen Allen, Va.
Other market benchmarks were also weaker Monday. The Nasdaq Composite Index fell 2.8% in recent trading, helped by more mild losses for the technology sector. The small-stock Russell 200 Index was down more than 4%. The Chicago Board Options Exchange Volatility Index surged 11% to about 51. For more than five months since the meltdown of Lehman Brothers Holdings, the financial industry's bellwethers haven't been able to right themselves, even after government bailouts in every major industrialized economy, layoffs, and dividend cuts. While many traders acknowledge that those steps will help over the long term, they aren't yet willing to declare an end to the industry's crisis.
HSBC Holdings shares were down almost 20% after the bank reported a deep loss and said it plans to raise $18 billion through a rights issue. HSBC's moves triggered another round of selling among its U.S. rivals, as Wells Fargo fell by 13% and Morgan Stanley fell 10%. PNC Financial Services Group, which said it was slashing its dividend by 85%, was down by more than 5% recently. Traders and analysts are hoping the Treasury Department will announce this week new details about how it will value the underwater mortgage bets that are clogging many banks' books. Many are frustrated that such information hasn't already been released - a silence that many market participants say is key to the slide seen in recent weeks. "People are just abandoning the financial sector," said strategist Marc Pado, of the brokerage Cantor Fitzgerald. "Until the government tells these banks what their assets are worth, they just can't lend."
American International Group shares soared about 14.3% to 48 cents a share, though its revised government rescue package did little to ease unease about the broader financial sector. American Express fell 5.6% amid reports detailing the credit-card issuer's renewed efforts to focus on well-heeled clients who are able to pay off their balances every month. The company is suffering from its previous, ill-timed efforts to expand to riskier borrowers. "If we had known this was coming, we would have ratcheted back some of our investment and put tighter guardrails on our credit decisions," said Alfred Kelly, AmEx's president. A rising dollar helped to keep commodity prices in check. Oil futures fell $4.25 to $40.51 a barrel in New York. The broad Dow Jones-AIG Commodity Index was off more than 3%. Treasury prices rose as investors sought safe havens. The two-year note rose 3/32 to yield 0.939%. The 10-year note rose 30/32 to yield 2.912%. New economic data on Monday were mostly glum. U.S. manufacturing activity and construction spending declined, though personal consumption showed a surprising rise.
How Low Can The Market Go?
On days like today, it helps to look at the silver lining. Here it is: The farther stocks fall, the cheaper they get--and the higher the expected long-term return becomes. Unfortunately, that doesn't mean we don't have a long way to go on the downside. There were four massive stock bubbles in the 20th Century: 1901, 1929, 1966, and 2000. During each of these bubble peaks, the S&P 500 neared or exceeded 25X on professor Robert Shiller's cyclically adjusted P/E ratio.* After the first three of these peaks, the S&P 500 PE did not bottom until it hit 5X-8X. We're still in the middle of the last one.
The most recent bubble peak, 2000, was by far the most extreme we have ever experienced. In 2000, the S&P 500 by prof. Shiller's measure exceeded 40X (it had never before exceeded 30X). With the S&P 5000 hitting 700 today, the PE has now fallen back to 12X. (See chart above.) Three major bubbles are not enough historical precedent to confidently conclude where the S&P 500 will bottom this time around, but it seems reasonable to conclude that the trough will be in line with--or below--the preceeding lows (Given that we just had the highest peak in history by a mile, it doesn't seem absurd to think that we might be headed for the lowest trough in history by a mile.)
So where are we now? Based on Professor Shiller's latest numbers, we're at about a 12X P/E. (Prof. Shiller's last update was at 805 on the S&P 500, which produced a 14X P/E. Plugging in today's 700 on the same earnings number, we get about a 12X P/E). The 12X PE compares favorably to the long-term arithmetic average of 16X, but it's still way above the historical troughs of 5X-8X. So where would the S&P bottom if we hit the previous trough PE lows? It depends how we get there. If the stock market stops falling and earnings eventually begin to grow again, we would be close to the bottom: The market could simply move sideways for 5-10 years while earnings growth gradually reduced the PE to the 5X-8X range. This is what happened in the 1970s. Alternatively, the market could just keep dropping, as it did in the early 1930s. Using Professor Shiller's latest earnings data, here's where the numbers would fall out if the market just kept dropping and 10-year average earnings didn't grow from today's level:
In short, if the S&P fell straight to the high-end of its previous trough range (8X PE, or 460), it would fall another 35% from today's level (700). If the S&P fell straight to the low-end of its previous trough range (5X PE, or 300), it would fall another 55+% from today's level. Here's hoping we don't set a new low on the downside.
* Shiller's "cyclically adjusted" PE takes an average of 10 years of S&P 500 earnings instead of using a single year's. Why? Because the business cycle makes single-year earnings misleading. In boom times, profit margins are high, and P/Es look artificially low (and stocks look misleadingly cheap). In busts, profit margins collapse, and P/Es look artificially high (and stocks look misleadingly expensive--as is the case this year). Shiller's cyclically-adjusted PE mutes the effect of the business cycle and, therefore, provides a much more informative and predictive PE ratio.
Beginning Now: The Panic Phase of the Collapse
Just as the Obama Administration launches a triple tirade of new initiatives — a record stimulus package, a bigger round of rescues, and the largest deficit financing of all time … Just as the Treasury Department doubles down on its bailouts for sinking giants — Fannie Mae, Freddie Mac, AIG, General Motors, Chrysler, and Citigroup … And precisely when the government has raised hopes for a recovery in 2010 … The panic phase of this collapse is about to begin. The panic phase is an acceleration in the economic decline … a chain reaction of debt explosions … a free-fall in the financial markets … and a series of rude awakenings that will accelerate the decline even further:
Rude Awakening #1: In a Collapse, Washington's Economic Forecasting Models Are Worthless.
Economists rely on computer models designed to forecast gradual, continuous, linear changes, such as economic growth. But these models are incapable of handling sudden, discontinuous, structural changes, such as housing market collapses, mortgage meltdowns, megabank failures, credit market shutdowns, or stock market crashes. Already, as explained by the New York Times on Saturday, "The fortunes of the American economy have grown so alarming and the pace of the decline so swift that economists are now straining to describe where events are headed, dusting off a word that has not been indulged since the 1940s: depression."
They're a bit late. Three months ago, in "Depression, Deflation and Your Survival," we warned you that we were sinking into America's Second Great Depression. And today, that's precisely what's happening. But with no other model to turn to, most economists continue to forecast the future in terms of moderate, incremental changes. In the panic phase now unfolding, a growing number will begin to realize how wrong they've been. They'll see that this crisis represents a clean break with the past, rendering their forecasting models worthless. Some already see the light. It's only a matter of time before they admit it in public.
Rude Awakening #2: The Economy Is Sinking Three to Five Times Faster Than Expected.
Every single step taken by the Bush and Obama administrations has been based on the flawed assumptions embedded in their economic models. They assume that:
- the world economy is not collapsing …
- the banking system is not broken …
- corporations, investors, consumers and entire nations will not take drastic action to protect their own interests, and, therefore …
- we will not see widespread factory shutdowns, wholesale layoffs, mass dumping of assets, or major new trade barriers.
They assume that none of this is happening or will continue to happen. They assume that the six-decade growth cycle that began after World War II remains largely intact. They think, talk and act as though we were still living in an era that's now over.
Each of these assumptions is, on the face of it, patently false. And yet, it's based on these assumptions that our government continues to spend, lend or guarantee TRILLIONS of dollars. Starting right now, however, we can begin to see the first signs of a rude awakening in that realm as well:
- The New York Times reports "a sense of disconnect between the projections of the White House and the grim realities of everyday American life."
- Economist Allen Sinai calls the White House's economic forecasts "a hope, a wing and prayer."
- Even Obama advisor Paul Volcker admits this crisis is swifter and broader than that of the Great Depression — something that, at this juncture, most Obama advisers refuse to admit.
Despite all these doubts, however, the average GDP forecast of most private economists differs only marginally from the rosy forecasts of the White House. Specifically …
In 2009, the White House predicts the economy will contract by a meager 1.2 percent, while private economists predict a decline of only 2.0 percent.
The grim reality:
- The 6.2 percent plunge in the fourth quarter — plus a similar decline estimated for the current quarter — shows the economy is now sinking three to five times faster than they're forecasting for the year.
- There is absolutely no sign that the decline is ending and every sign that it's accelerating.
- Thus, to contain this year's decline to the meager 1 or 2 percent that the government and private economists are projecting would require a comeback in the second half that's nothing short of a miracle.
In 2010, the White House says the economy will grow 3.2 percent, while private economists say it will grow 2.1 percent.
The grim reality:
- In America's First Great Depression, the financial collapses beginning in 1929 led to GDP declines of 8.6 percent in 1930, 6.4 percent in 1931 and 13 percent in 1932.
- But in this cycle — America's Second Great Depression — the financial collapses that we saw in 2008, such as Bear Stearns, Lehman Brothers, Fannie and Freddie, Washington Mutual, Wachovia, AIG, Citigroup and many others, were markedly worse than those of 1929.
That doesn't necessarily mean that the GDP declines in 2009, 2010 and 2011 will be worse than those of the early 1930s. But it does mean that the 2 or 3 percent growth now forecast by private and government economists for 2010 is clearly a pipedream. In the panic phase now unfolding, some prominent economists are now beginning to recognize their forecasts may be full of holes. It's only a matter of time before they admit it in public.
Rude Awakening #3: The Dangerous, Unintended Consequences of the Government's Rescue Efforts Can Only Deepen, Broaden and Prolong the Economic Decline.These include:
- The dangerous and inevitable surge in government borrowing. Even with its fairy-tale forecast of a meager 1.2 percent decline in the economy this year, the White House projects a 2009 federal budget deficit of $1.75 trillion. If you assume the average private forecast of a 2 percent GDP decline, the deficit automatically grows beyond $2 trillion. And the only neutral assumption for GDP — no deceleration or acceleration in the 6.2 percent rate of decline now underway — leads you to a deficit that makes the above projections look puny by comparison.
- The dangerous and inevitable surge in borrowing costs. Even in the government's unrealistic rosy scenario, the explosion in government borrowing must drive real rates of interest sharply higher. There is simply no other conceivable scenario.
- The dangerous and inevitable damage caused by higher interest rates. When interest rates go up, they go up for nearly everyone, sweeping across the economic landscape into every home, business, or government. Result: Even a rate rise of just a few percentage points can quickly neutralize and overwhelm any benefits derived from the government's stimulus spending, banking bailouts or expansive budget plans.
- A dangerous and inescapable two-tiered market for credit.What happens when the government pumps money into defaulting households or failing banks even while nearly all other interest rates are rising? The answer is simple: The lucky few who get government aid are able to borrow at lower interest rates. But the vast majority, not eligible for government money, must pay much higher rates than they'd pay otherwise.
- A dangerous diversion of precious capital from strong hands to weak hands. With government money pouring into the weakest households and companies, precious resources are diverted from strong hands — those who could best help bring about a recovery — to weak hands, including those who were most responsible for the bust. Already, companies like Berkshire Hathaway, despite triple-A ratings, are paying record high spreads to borrow … while banks and others which get government guarantees can borrow far more cheaply, despite abysmal credit ratings and balance sheets.
In the panic phase of the crisis now unfolding, a minority of Washington and Wall Street experts is beginning to fear these dangerous consequences. It's only a matter of time before they openly confess their real concerns. Sadly, though, confession is one thing; action is another. And sadly, each of these unintended consequences deepens the depression, spreads the pain, prolongs the crisis, and weakens the eventual recovery.
Rude Awakening #4: Investors Who Fail to Take Protective Action Could Lose as Much as 90 Percent In Virtually Every Asset Imaginable.In an economic collapse of this magnitude, the only predictable bottom in the value of most assets is zero. In that context, any value investors can squeeze out of their assets that's significantly above zero must be counted as a blessing.
Here are my forecasts for each major investment sector …
Stocks: Eight months ago, in our July 2008 Safe Money Report headlined "Major U.S. Bear Market Just Beginning to Unfold," we set our medium-term target for the Dow Jones Industrials at 7200. Now, that target has been reached. Then, three months ago, in our December 2008 Safe Money headlined "Starting Now: America's Second Great Depression," we set a new target at 5500 on the Dow. And three weeks ago, based on the fundamental measures provided by Claus Vogt, editor of the German edition of our Safe Money Report, we have further revised that forecast to
- 5000 on the Dow
- 500 on the S&P 500, and
- 900 on the Nasdaq.
Today, Dow 5000 may seem far away. But with the Industrials closing at 7063 on Friday, it's actually relatively close: All that's needed to reach 5000 is another 29 percent decline — a modest move in contrast to the massive wipeouts already witnessed in the shares of our nation's largest banks.
And in America's Second Great Depression, the averages could easily fall to even lower levels.
Real Estate: Chief economist Mark Zandi of Moody's Economy.com forecasts a possible "mild depression" scenario, in which the average price of a home — already down 27 percent from its peak — could fall another 20 percent. What he does not tell us how far home prices could fall in a worst-case, 1930s-type depression scenario. But I will: As much as 80 or even 90 percent from peak to trough. Meanwhile, commercial real estate prices could fall with equal speed. As Mike Larson reported this week, the issuance of commercial mortgage-backed securities plunged 95 percent last year … S&P expects their delinquency rates to triple this year … and the resulting credit shutdown is already driving prices into a tailspin.
Bonds: While Zandi forecasts a possible mild depression, his own colleagues at Moody's Bond Rating division are forecasting bond default rates that denote an inevitable severe depression. Indeed, Moody's announced last week that
- It expects the number of defaults on high-yield bonds to triple this year to about 300, the worst since the early 1980s when the high-yield bond market first emerged …
- The default rates on those bonds could reach 15 percent, higher than that registered during the Great Depression …
- And default rates could rise even further — to 20 percent — if the economy deteriorates more than currently expected.
Even assuming Moody's less pessimistic forecast, a 15-percent default rate will gut the price of nearly all corporate bonds, regardless of rating. Add the inevitable surge in interest rates driven by massive government borrowing, and you can see how most corporate bonds could lose anywhere from half to 90 percent of their current market value.
Banks: Last week, the Federal Deposit Insurance Corporation (FDIC) announced that
- The number of troubled banks jumped from 76 at year-end 2007 to 252 at year-end 2008.
- The assets held by problem banks jumped to $159 billion, up more than seven-fold from $22 billion a year earlier.
But it appears that most of the large banks that have already failed or been bailed out by the government — IndyMac, Washington Mutual, Citigroup and Bank of America — were never on their list to begin with. And based on our own lists of weak banks, the number in jeopardy is many times larger than the FDIC indicates. This raises immediate questions about the FDIC's ability to flag problem banks. And it raises fundamental questions regarding the government's future ability to guarantee the deposits of millions of Americans. My forecast: Expect to lose at least half and possibly up to 90% of your money in uninsured deposits of failing banks. And although it is not an immediate concern, in America's Second Great Depression, even insured depositors could lose money.
Worst US job losses in 60 years expected
The recession tightened its grip on U.S. businesses and consumers in February, according to economists, who are predicting the largest one-month job loss in almost 60 years. "Pink slips continue to fly," said Meny Grauman, an economist for CIBC World Markets. With output still falling at a dizzying rate, most companies are shedding unneeded workers and cutting back the hours of those remaining. Strapped by debt and seeing their paper wealth evaporating, many consumers are spending as little as they can. "The economic patient is still in critical condition, with little medication to relieve the pain," wrote economists Brian Bethune and Nigel Gault of IHS Global Insight. "We will have to bite the bullet."
The first week of the new month brings two of the most important economic indicators: the ISM index and the nonfarm payrolls report. Both are expected to be very grim news. First, on Monday, the Institute for Supply Management reports back from purchasing managers at manufacturing firms across the nation. Although few people outside of the financial markets or the economics profession know what it is, the ISM is probably the best single leading indicator marking the end of a recession. The ISM is a diffusion index that measures the breadth of economic distress or success across firms. It asks key executives to judge whether business is getting better or worse.
Once the ISM -- and especially the new-orders component -- turns up decisively, the expansion is typically one to four months away, although in some cases it has turned up as much as a year before the end of a recession. The ISM plunged to 32.9% in December -- a level only seen at the depths of the very worst recessions -- but it bounced back to 35.6% in January, giving some hope that we'd seen the bottom. Unfortunately, the ISM is expected to dip back to 34% in February, according to the median forecast of economists surveyed by MarketWatch, as global export markets worsened and U.S. capital spending remained weak.
The key components to watch will be new orders, export orders and inventories. Manufacturers' own inventories are too high, and they judge that their customers' inventories are too high as well. Once customer inventories are worked down, factories can get back to work. If the ISM is forecast to be awful, the nonfarm payrolls report is expected to be horrendous. The Labor Department is slated to report the figures Friday. Economists expect payrolls to plunge 630,000 in February, slightly more then the 598,000 lost in January and the 597,000 lost in November. The unemployment rate is expected to climb to 7.9% from 7.6%, breaking through the 7.8% peak in the 1991 recession to the highest level since 1984.
It would mean that a record 4.2 million jobs will have been lost since the recession began in December 2007, with no end in sight. "Employment losses have deepened considerably in recent months," wrote economists for Wachovia, who expect total losses for the recession to top 6.5 million. "With total revenue declining at its worst pace since the late 1950s, many businesses and governments are in survival mode and have no choice but to cut jobs," Wachovia economists said. The main evidence for a worsening job market has been the rise in unemployment benefits. First-time claims have risen decisively over 600,000, nearly double the level at the beginning of the recession. Continuing claims are at an all-time high. Consumer surveys also show extreme pessimism about finding a job.
While some forecasters think job losses in February stayed in the ballpark of about 590,000, a few economists think the labor market got much worse in February and are expecting losses of 650,000, 700,000, or in one case, even 800,000. The report is "likely to be the weakest to date," wrote economists for Barclays Capital, who expect payroll losses of 675,000 and an unemployment rate of 8%. "February was the worst month yet," said Global Insight's Bethune and Gault, who are predicting payroll losses of 750,000 and an employment rate of 8%. Others have a slightly less dire view, if a loss of 625,000 could be considered upbeat. "Our sense, admittedly based mostly on anecdotes, is that labor market conditions remain dismal but are not necessarily accelerating to the downside," wrote Stephen Stanley, chief economist for RBS Greenwich Capital.
Economists expect the number of hours worked to continue plunging as more workers are forced into part-time shifts. In January, 7.8 million workers wanted to work full time but could only get part-time work. Average weekly earnings likely rose 0.3% again, as the lowest-paid occupations took a larger share of job losses. If the economy did shed 630,000 jobs in February as expected, it would be the third largest monthly loss on record, dating back to 1939. The record was set in September 1945, when nearly 2 million people lost their jobs after the Allies won the most destructive war in history and industry was retooling for peacetime, sending "Rosie the Riveter" back to her knitting. In October 1949, 834,000 jobs were lost when almost all the nation's steelworkers went on strike in the final month of a brutal but short recession.
Another strike in July 1956 cost 629,000 jobs, but the next month saw 678,000 jobs regained. Of course, the size of the workforce is much larger today than it was in 1949 or 1956. But as a proportion of the workforce, this recession also is moving up in the record books. If 630,000 jobs were lost in February, it would bring total losses in this recession to just over 3% of payrolls, close to the 3.1% lost in the recessions of 1982, 1954 and 1949 (excluding the strike). Next on the list: 4% in 1958 and 6.9% in 1945. If Wachovia economists are right that 6.5 million will lose their jobs by the end, employment will have fallen by 4.7% in this recession. And remember: These forecasts assume the Federal Reserve will slowly be able to get credit flowing again, and that the recently approved fiscal stimulus will give a significant boost to the economy.
Deficit of realism. America assumes a lot in its road map to recovery
The US economy is in an even worse state than we thought. The response to the stimulus plan signed off last week by President Obama was pretty negative, and the plight of the big US banks remains as dire as ever. But the sheer pace of the plunge of the economy, coupled with the extraordinary scale of the US budget deficit, may well change the profile of the global downturn. And if so, that will affect all of us. The GDP figures for the final quarter of last year were revised down to an annual rate of 6.2 per cent, the worst for 26 years. But it is unlikely the decline can carry on at that pace for long, because the driver of the fall, a collapse in consumer purchases, is so sudden that it has to rebound.
People can put off buying that new car for a few months but eventually it makes financial sense to use the amazing discounts on offer to replace the present one, particularly if the new car is more economical. Also, the downward revision of the figures, which came out earlier in the month, was down to a recalculation of stocks. Since these were lower than first thought, there is less slack in the supply chain than originally assumed. Conclusion: the economy will doubtless have carried on shrinking in the first quarter of this year, but probably at a slower rate. That said, as you can see from the graph, the recession is now well embedded.
There are also no green shoots yet to suggest a turning point. There is, for example, very little sign of a recovery in the US housing market – in fact none at all. Inasmuch as you can generalise about such a vast country, US homes are pretty much back to fair value in terms of their affordability. But the uncertainty is such, and the overhang of unsold homes so huge, that prices are still falling. Confidence is lower than it was during the recessions of the 1980s, 1990s and early 2000s, as you can see from the other graph. The question that arises then is whether the new US budget will change things. The boost is huge. The budget deficit is projected to rise to 12.5 per cent of GDP. That is higher than at any time since the Second World War. It is double the size, relative to GDP, of Franklin D Roosevelt's New Deal in the 1930s. It is larger than the fiscal deficits run by Japan during the 1990s, which is not an encouraging precedent since they pretty much failed – though arguably Japan's so-called "lost decade" would have been even more lost without them. Finally, it is even larger than the proposed deficit that our present Government plans to run here.
So what should we make of it? I suppose I fear this administration is making the same mistake with fiscal policy that the previous one made with monetary policy. Remember how the Federal Reserve cut US interest rates way below the rate of inflation to pump up the economy after the collapse of the internet bubble? It succeeded in boosting demand. People borrowed like crazy, savings plunged, the housing boom took off, and the economy recovered. But the growth was artificial and could not be sustained. The argument at the time was that the impact was not inflationary, and that was right for prices were held down by the imports of cheap goods from East Asia. And the credit boom was not risky as the banks were able to spread their risks by securitising their debts. In any case those debts had AAA ratings. But the lack of inflation (and those AAA ratings) lulled people into a false sense of security and we all know what happened.
The argument now is that the loss of output from recession is so huge that it makes sense for the state to borrow to reverse it. You could say the economy is a bit like an airline or a hotel – the revenue from a seat or a bed not filled is lost forever. So better to borrow now, get demand up, and claw back the borrowing later. To some extent this must be right, provided the fiscal position is indeed brought back into kilter. President Obama's plan holds that the deficit will be back to 3 per cent of GDP by the end of his term. If that were the case, it might be just about acceptable. Trouble is, the assumptions on which this deficit-reduction profile are made look to me to be quite unrealistic. GDP growth next year of more than 3 per cent? Huh?
There is a further concern. This programme assumes the US government can finance it. Now at the moment the dollar is riding high, with government assets seen as a safe haven in the storm. The current account deficit is narrowing and the Chinese are perceived to have no option but to keep investing in the US.
So for the time being the deficit can be financed, or so it would appear. But the mood of financial markets is fickle and at some stage it will turn. There have been runs on the dollar before. You could envisage a nightmare scenario where the flow of funds into the US reverses, long-term interest rates shoot up, the US fiscal position fails to improve and there is a global dollar crisis. Even without that, the debts will be a burden for a generation. The seeds of the next downturn are being sown now.
Meanwhile the US banks still have to be nursed back to health. There has been a lot of criticism of the new US Treasury Secretary Tim Geith-ner, either for lacking clarity in his bank rescue plans or perhaps for rescuing them at all. Citigroup shares collapsed on Friday when the bail-out plans was announced. I really feel this is unreasonable. You cannot rescue banks well; you just have to rescue them well enough. It is now established that the major American banks won't be allowed to fail; the mistake made over Lehman Brothers won' be repeated. As a result the money markets are starting to function again, though not very well for that takes time. So the necessary (but insufficient) conditions for an economic recovery are being put in place. Until credit is flowing, there can be no growth. You pump in money and it disappears; it does not feed through into demand.
Given that lending ought to start again by the summer and given the sheer scale of the fiscal plan, it seems reasonable to expect some sort of bounce in the US come the autumn. But will it be sustained? I'm concerned it may not. So a new letter in the alphabet soup of recessions comes to the fore, the W. You know the point. Will the recession, plotted in a graph, look like a V, a U or a W? A few months ago the probability looked like a shallow U. More recently, given the pace of the plunge, it has begun to resemble a V. But if there is a bounce in the autumn, followed by another dip through next winter, that will be a W. The real recovery will have to wait until well into 2010. Of course this is speculation, but it seems plausible, and more plausible given what happened last week.
Eastern European economic freefall was not in the EU brochureThe run of success in Eastern and Central Europe has come to a halt and Western Europe is being asked to pick up the tab. As elsewhere there are two problems, a banking and an economic one. But there are two further twists. One is that huge borrowings in euros are being serviced in local currencies; the other that some countries are exposed to the problems of Russia and Ukraine.
On Friday the World Bank, the European Investment Bank and the European Bank for Reconstruction and Development combined to lend more than £20bn to finance banks and small companies across the region. But that is not nearly enough.
The core of the problem is that people borrowed in euros to get a lower interest rate – a policy that seemed sensible at the time as the new EU members were converging fast on the eurozone. But their currencies have fallen by up to 50 per cent since last summer, vastly increasing the burden of debt. If this is a problem for the countries concerned, it is almost as big an issue for some eurozone banks, particularly Austria's, which have debts that probably can't be repaid. It's Europe's equivalent of the US sub-prime crisis, made worse because a lot of the new member state banking services are provided by eurozone-based banks. (Mercifully this seems to be one banana skin that British banks avoided.)
The banking problem will be fixed but the economic one will remain. One aspect has been a sharp fall in demand from Western Europe, but the Baltic countries, Ukraine and to a lesser extent Romania have been hit by the mayhem in Russia. The inevitable result has been a fall in GDP and rising unemployment. So there will have to be further support, with the IMF and the EU stepping in. And there is still the wider problem of the euro, which is being under- mined by fears (I think unfounded) of government defaults in Greece or Ireland. The region will recover,: but the path from here to there will not be easy. This was not in the EU brochure when these countries joined.
Don't hold your breath waiting for the recovery
by Martin Feldstein
The massive downturn in American's economy will last longer and be more damaging than previous recessions, because it is driven by an unprecedented loss of household wealth. Although the fiscal stimulus package that President Obama recently signed will give a temporary boost to activity sometime this summer, the common forecast that a sustained recovery will begin in the second half of 2009 will almost certainly prove to be overly optimistic.
Previous recessions were often characterized by excess inventory accumulation and overinvestment in business equipment. The economy could bounce back as those excesses were absorbed over time, making room for new investment. Those recoveries were also helped by interest rate reductions by the central bank.
This time, however, the fall in share prices and in home values has destroyed more than $12 trillion of household wealth in the United States, an amount equal to more than 75% of GDP. Previous reactions to declines in household wealth indicate that such a fall will cut consumer spending by about $500 billion every year until wealth is restored. While a higher household saving rate will help to rebuild wealth, it would take more than a decade of relatively high saving rates to restore what was lost. The decline in housing construction has added to the current shortfall in aggregate demand. The annual number of housing starts has fallen by 1.2 million units, cutting annual GDP by an additional $250 billion. While this will eventually turn around as the inventory of unsold homes shrinks, the recovery will be slow.
So the U.S. economy faces a $750 billion shortfall of demand. Moreover, the usual automatic stabilizers of unemployment benefits and reduced income tax collections will do nothing to offset this fall in demand, because it is not caused by lower earnings or increased unemployment. Although the recently enacted two-year stimulus package includes a total of $800 billion of tax reductions and increased government spending, it would be wrong to think that this will add anything close to $400 billion a year to GDP in each of the next two years. Most of the tax reductions will be saved by households rather than used to finance additional spending.
Moreover, a substantial part of the spending will be spread over the following decade. And some of the government spending in the stimulus package will replace other outlays that would have occurred anyway. An optimistic estimate of the direct increase in annual demand from the stimulus package is about $300 billion in each of the next two years. The stimulus package would thus fill less than half of the hole in GDP caused by the decline in household wealth and housing construction, with the remaining demand shortfall of $450 billion in each of the next two years causing serious second-round effects. As demand falls, businesses will reduce production, leading to lower employment and incomes, which in turn will lead to further cuts in consumer spending.
To be sure, an improvement in the currently dysfunctional financial system will allow banks and other financial institutions to start lending to borrowers who want to spend but cannot get credit today. This will help, but it is unlikely to be enough to achieve positive GDP growth. A second fiscal stimulus package is therefore likely. However, it will need to be much better targeted at increasing demand in order to avoid adding more to the national debt than the rise in domestic spending. Similarly, the tax changes in such a stimulus package should provide incentives to increase spending by households and businesses.
Although long-term government interest rates are now very low, they are beginning to rise in response to the outlook for a sharply rising national debt. The national debt held by U.S. and foreign investors totaled about 40% of GDP at the end of 2008. It is likely to rise to more than 60% of GDP by the end of 2010, with the debt-to-GDP ratio continuing to increase. The resulting increase in real long-term interest rates will reduce all forms of interest-sensitive spending, adding further to the economy's weakness.
So it is not clear what will occur to reverse the decline in GDP and end the economic downturn. Will a sharp dollar depreciation cause exports to rise and imports to fall? Will a rapid rise in the inflation rate reduce the real value of government, household, and commercial debt, leading to lower saving and more spending? Or will something else come along to turn the economy around. Only time will tell.
Just send them checks
Martin Wolf, senior financial editor at the Financial Times, worries that all measures taken so far make everything worse, not better.
GM Needs Global Aid in Worst Auto Market Since 1945
General Motors Corp., surviving with U.S. federal loans, needs government help worldwide to get through the worst automotive market since the end of World War II, Vice Chairman Robert Lutz said. The slump is forcing GM to undergo changes it has needed to make for years, such as reviewing the future of its Hummer, Saab and Saturn brands, Lutz said today in a Bloomberg television interview from Geneva. Lutz, who rejoined GM in 2001 to help revitalize its auto designs, will retire at the end of this year.
"We will go through a rough spot as will every other automobile company," said Lutz, 77. "We will get through and come out the other end stronger and more competitive than ever before." GM has received $13.4 billion in U.S. aid and is seeking more to keep its operations in its home market running through this month. The Detroit-based company last week said it will need help in Germany and other countries to restructure its European operations, with the focus on the Opel brand. The largest U.S. automaker would like to maintain "technical and operational" control of Opel as it seeks 3.3 billion euros ($4.2 billion) in aid from Europe and $1.2 billion in cost cuts, Lutz said.
Why AIG can't fail
What happened
Insurance giant AIG and the U.S. government agreed to a fourth bailout for AIG, which is reporting a $62 billion loss Monday, the largest quarterly loss in history. The new deal involves another $30 billion in federal dollars—the U.S. already owns almost 80 percent of AIG, after putting up $150 billion over five months. The government will get stakes in two profitable AIG life insurance subsidiaries. (The New York Times)
What the commentators said
The "astounding amount" of taxpayer dollars needed to keep AIG from the consequences of its own malfeasance "should make your blood boil," said Joe Nocera in The New York Times. But we're not just keeping AIG from going bust—we're also rescuing the companies whose toxic assets AIG insured. Essentially, AIG has the entire Western banking system "by the throat."
Then the entire Western banking system needs to "share the pain" with us, said Lauren Silva Laughlin and Richard Beales in BreakingViews.com. AIG was supposed to reimburse U.S. taxpayers by selling off units, but it hasn't been able to, or has been forced to sell at bargain prices, because nobody has money to buy, and who's going to offer "top dollar" when the seller has to sell?
Clearly "putting more taxpayer money at risk is unlikely to be palatable," said Lilla Zuill and Kristina Cooke in Reuters, but the U.S. had to act, and fast. Moody's and Standard & Poor's were set to downgrade AIG's debt to junk status Monday, if the government hadn't stepped in. If AIG's credit rating fell, the resulting chain reaction would be "too big a shock to already fragile global markets."
AIG Lost $670 Million Every Day
No company has ever lost as much as AIG did last quarter. All told, it lost almost $100 billion last year, with $61.7 billion of those losses in just the last quarter of 2008. Few companies have ever been worth that much, or been able to put anything like that much at risk. It's almost unfathomable. Let's see if we can break it down into a more reasonable number.Every day AIG lost: $670 million.That's more like it. It means that every six and half seconds, AIG loses the equivalent of the median household income in the US.
Every hour AIG lost: $27.9 million.
Every minute AIG lost: $465 thousand.
Every second AIG lost: $7,750.
Shattered AIG Is Breaking Up
Too big to fail, too complicated to succeed. American International Group on Friday reported a record $61.7 billion quarterly corporate loss and received a new dollop of U.S. taxpayer aid as part of a plan to break the company into smaller, easier-to-manage units. The struggling insurance company has received $30.0 billion in new federal assistance, indicating policy makers still believe AIG is too big to fail. Chief Executive Edward Liddy said the company has become "too complicated, too unwieldy and opaque" to be run as a single business, according to TradeTheNews.com.
The government said the purpose of the aid was to stabilize and reduce the size of the company, which it believes it poses a risk to the financial system. It was for that reason that the United States acquired 79.9% of AIG in an $85.0 billion September bailout. In November, the company was allowed to increase its borrowings to $150.0 billion. The decision came as AIG announced it lost $61.7 billion during its fourth quarter, surpassing the $54.2 billion record set by Time Warner in the first quarter of 2002. Liddy said his company was in a much dire condition than expected. He also said that the deal with the government keeps a difficult economic situation from deteriorating further by making sure the company survives, but he couldn't guarantee AIG wouldn't need more federal aid.
Despite the loss, the company's credit rating appears to remain intact, at least for now. Fitch Ratings said the government's support overrides the quarter's loss for most of the company's ratings. AIG's stock rose 16.7%, or 7 cents, to 49 cents in morning trading. Ironically, the report send the rest of the stock market tumbling, finally pushing the Dow Jones industrial average below 7,000 points. AIG has lost almost all of its market value over the past year, falling a remarkable 99.0%. In the last three months of 2008, the New York-based firm lost $22.95 per share. It lost $5.3 billion, or $2.08 per share, in the previous year's corresponding period. Sales fell to negative $23.8 billion, as the company had to reverse gains it recorded from investments in past quarters.
The dramatic reshaping of AIG (nyse: AIG - news - people ) is similar to drastic steps being taken at Citigroup to shore up its operations. Earlier this year, Citi announced plans to hive off a mountain of bad loans, shed noncritical businesses like U.S. mortgage lending, and refocus on its traditional commercial, retail, and private banking operations globally. It will even change its name back to Citicorp. On Friday, the U.S. government agreed to convert $25.0 billion of its preferred equity stake in Citigroup to common shares, giving it a 36.0% stake in Citi and helping the bank restructure its capital base in the face of mounting losses from bad loans and other assets. Citi so far has taken $45.0 billion in new capital from the government's TroubledAsset Relief Program and gotten federal guarantees on $300.0 billion of assets.
Stocks plummeted to fresh lows in New York Monday, on the heels of the government's latest crutch for American International Group and a mixed bag of economic data.The Treasury Department and Federal... AIG is also seen splitting itself up to preserve healthy business units. The firm announced that it plans to form a general insurance holding company to be called ATU Holdings, which will combine its U.S. and foreign property-casualty insurance operations into a new unit. About 20.0% of the new company would be sold to the public. The government has been intent on preventing the collapse of another major financial institution after the bankruptcy of Lehman Brothers in September crippled the credit markets. AIG, while not a bank, is seen as too big to fail because of its interconnectedness with other financial firms worldwide.
The new administration in Washington is also scrambling to fix the problems it inherited, with a fresh round of economic stimulus and a financial stability plan that revises some of the work done on the Troubled Asset Relief program, an emergency bank industry rescue plan that was passed hastily last fall after the collapse of Lehman. Part of AIG's problem is that it has been trying to sell parts of its global operations as the economy falters. That has put many potential buyers on the sidelines, making it harder for AIG to raise the funds to repay government loans. AIG has previously tapped the TARP program to the tune of $40.0 billion and it has $150.0 billion in government loans, giving Uncle Sam a 79.9% stake in its fortunes.
In the deal cobbled together this weekend, the Federal Reserve will reportedly take equity stakes in two companies AIG had put out for bidding with little success, American International Assurance and American Life Insurance. That will go toward repaying the Fed the $37.8 billion in credit lines AIG tapped last year. Originally AIG was to repay that credit line in cash. The Treasury and the Fed are also supplying $30.0 billion in fresh TARP capital as a standby letter of credit that could be drawn down as AIG has continued to bleed money. AIG's staggering losses haven't come out of its insurance businesses, but from its units devoted to derivatives products, especially those that insured mortgage-backed securities and other debt.
AIG Gets More Aid After Record $61.7 Billion Loss
American International Group Inc., the insurer deemed too important to fail, will get as much as $30 billion in new government capital and relaxed terms on its loans after posting the worst loss by a U.S. corporation. The fourth-quarter loss widened to $61.7 billion from $5.29 billion in the year-earlier period, the New York-based insurer said today in a statement. The new agreement deepens the U.S. commitment to saving AIG and may put more taxpayer funds at risk, with the Treasury and Federal Reserve saying that the cost of inaction "would be extremely high." The agencies cited AIG's role as insurer for 100,000 companies, municipalities and retirement plans, potentially affecting 100 million Americans, and as counterparty to some of the biggest financial companies.
"The government has accepted all the downside with little chance of upside," said Phillip Phan, professor of management at the Johns Hopkins Carey Business School in Baltimore, before the announcement. "They are trying to protect the global financial system from a complete meltdown." The insurer, first saved from collapse in September with a package that grew to $150 billion last year, had to ask for help again after failing to sell enough subsidiaries to repay the government. The company may need more support if financial markets don't improve, the Treasury and Federal Reserve said in their separate statement.
Banks relied on AIG to back more than $300 billion of assets through derivative contracts as of Sept. 30, making the company a "systemically significant failing institution" that has to be propped up, according to the Treasury. AIG will pay down the federal loan, valued at about $38.9 billion on Dec. 31, partly by turning over its two largest international life insurance units, which will be put in trusts. The company will also give the government rights to the cash flow from tens of thousands of life insurance policies. The insurer gained 10 cents to 52 cents at 8:11 a.m. in early New York trading. AIG has plunged 99 percent in the past 12 months on the New York Stock Exchange.
The role of the U.S. has shifted from that of short-term lender -- entitled to interest at the 3-month London interbank offered rate plus 8.5 percent for a two-year loan under the first bailout -- to a longer-term equity investor. Former AIG CEO Maurice "Hank" Greenberg had said terms of the original loan were too expensive to allow the company to recover. "We priced their capital punitively and forced them to sell things fast; that hasn't worked either so we're having to pump in more capital," said Haag Sherman, who helps oversee $8 billion as chief investment officer of Houston-based Salient Partners. "This probably won't be the last time AIG has to come to the trough."
AIG wrote down the value of assets including credit-default swaps and commercial mortgage-backed securities by $25.9 billion and had costs of about $6.9 billion tied to repaying the government in the quarter. The firm also took a charge of about $21 billion related to taxes. For the year, AIG lost $99.3 billion, compared with profit of $6.2 billion in 2007. The fourth-quarter result eclipses AOL Time Warner Inc.'s $44.9 billion fourth-quarter loss in 2002, then the largest in history, according to Howard Silverblatt, senior index analyst at Standard & Poor's. The company had to write down the value of America Online and its cable systems by $45.5 billion.
AIG will also separate the division that provides property and liability coverage for commercial clients and may sell a stake to the public, the company said in a separate statement. That business, which was previously intended to be the core of AIG after the U.S. rescue, may get a new brand to distance itself from AIG. The U.S. agreed to accept a lower interest rate on loans to AIG and to exchange its $40 billion in preferred stock for new non-cumulative preferred shares that "resemble common equity," the Treasury and Fed said. With cumulative preferred shares, the dividends continue to accrue even if an issuer doesn't pay on time. AIG was paying a 10 percent dividend on the preferred stock and nothing on the common.
Treasury Secretary Timothy Geithner and Federal Reserve Chairman Ben S. Bernanke concluded AIG's latest rescue was the least costly of several alternatives the U.S. had to prevent an economic collapse caused by the firm's failure, said a person familiar with the situation. AIG sought a revised bailout after the global decline in financial firms thinned the pool of potential buyers for units, increasing the chance that auctions wouldn't raise enough money to pay back AIG's loans. Under the new plan, AIG will be under less pressure to divest assets as it continues to seek buyers for operations including an aircraft-leasing business, an auto insurer, and a retirement-services operation.
The insurer had been in talks in the past week with regulators to restructure its bailout to stave off credit-rating downgrades that would have caused further costs tied to credit- default swaps. AIG got an $85 billion credit line in September after credit-rating downgrades left the company facing more than $10 billion in potential payments to debt investors who bought swaps from the insurer to protect against losses. Downgrades by Moody's Investors Service and Standard & Poor's would force AIG to post more than $7 billion in collateral to counterparties, the insurer said in a November filing.
AIG's plane-leasing unit, International Lease Finance Corp., is no longer eligible to participate in a federal program that buys short-term debt from financial firms because its credit rating was cut, the insurer said in a regulatory filing today. Chief Executive Officer Edward Liddy, appointed by the government to run AIG in September when the insurer agreed to turn over an 80 percent stake to the U.S., had struck deals to raise about $2.4 billion through asset sales. Under Liddy's plan, revealed in October, AIG was to emerge as a firm mostly providing property-casualty coverage to businesses. Liddy said AIG was on the "road to recovery" after securing a bailout valued at $150 billion in November. That package included the $60 billion credit line, a $40 billion capital investment and $50 billion to reduce liabilities tied to mortgage-backed securities the insurer owned or backed through swaps. Liddy said then that terms of the original rescue, disclosed a day after Lehman Brothers Holdings Inc. collapsed, were unsustainable.
AIG is winding down the trades and closing the unit that sold the swaps. The unit is under investigation by the U.S. Department of Justice, the Securities and Exchange Commission and U.K.'s Serious Fraud Office. The U.S. probes involve how AIG executives valued its swap portfolio and disclosed information about the contracts to investors, AIG said in a November regulatory filing. AIG will be subject to the most severe of compensation limits on companies getting government aid, according to a person familiar with the situation, who asked not to be identified. Those restrictions were strengthened in the $787 billion stimulus bill enacted last month. Limits on pay may reduce AIG's "ability to retain its highest performing employees," the company said in its annual report today.
AIG, once the world's largest insurer, operates in more than 100 countries, providing protection to individuals and businesses. It insures against some of the biggest risks, covering planes and commercial shipping and providing protection against terrorist attacks. The biggest insurers in North America posted more than $150 billion in writedowns and unrealized losses linked to the collapse of the mortgage market from the start of 2007, with AIG representing more than a third of that total. The company has units that insure, originate and invest in home loans. The U.S. Senate's banking committee has scheduled a hearing for March 5 to discuss AIG's bailout and the government involvement. New York Insurance Superintendent Eric Dinallo and Donald Kohn, vice-chairman of the Federal Reserve Board of Governors, were scheduled to testify.
How Bank Regulation Helped Destroy AIG
What ever changes we make to our financial regulations, hopefully we'll ensure that we can never have another AIG putting the entire global financial system at risk. Unfortunately, our track record of building regulations is terrible. In fact, in many ways the last round of regulatory reform helped cause the disaster in AIG. How could AIG's destruction have been caused by banking regulation? Most people wil probably be surprised by the very idea. After all, they've been told that what really happened to AIG involved unregulated credit default swaps, insurance contracts on bonds that AIG sold across the world. They suspect AIG might have been caused by too little regulation.
In fact, much of AIG's problem was caused by credit default swaps and regulation. After Hank Greenberg was ousted from AIG, the company began to get heavily involved in the credit default swap market. That market was growing in large part because of banking regulation. How the regulations created a demand for CDS. Banks around the world operate under rules that determine how much capital they must hold in reserve. The rules say that a riskier the assets held by a bank, the larger the reserve they have to maintain. One way to reduce the riskiness of your assets was to buy insurance on them. This created a huge demand for credit default swaps as a kind of regulatory arbitrage, banks trying to comply with regulations while maximizing their own profits.
Let's use an example. Say you are running a bank in Europe. You have a bunch of deposits you want to invest, and you want to invest those in assets that will give you the highest return with the lowest risk. If you buy a bunch of high-yield loans, that is counter-productive. Even if you earn more for each dollar you invest, the reserve requirements will tell you that you can't invest as much. Now if you throw a credit default swap on, which you can buy cheaply from AIG, you can invest more of your depositors money in highly rated securities. In effect, you get extra-credit for the swap when calculating your reserve requirements.
But isn't it insane for banks to keep buying insurance policies from a company that obviously couldn't pay them back? After all, AIG sold $527 billion of these. There's no way it could make good on even a tiny fraction of them. But bankers didn't see it that way. They didn't expect to ever collect on the insurance policies. The main reason they bought them was because the regulations rewarded them for buying them, allowing them to hold less money in reserve and invest more. In a sense, the credit default swaps were more like 'regulatory compliance policies' than 'insurance policies.'
This wasn't some nefarious secret. AIG sold hundreds of billions of credit default swaps to European banks for precisely this regulatory reason. And it wasn't shy about it. It revealed in its annual statement that about $379 billion of the $527 billion in AIG's default swap portfolio "represents derivatives written for financial institutions, principally in Europe, for the purpose of providing them with regulatory capital relief rather than risk mitigation." This story, about how banking regulations helped create the demand for a financial product that now another reason to be cautious about building a new regulatory framework. You never quite know what monsters you could be creating.
AIG's Liddy Says Former CEO Greenberg Responsible for Losses
American International Group Inc. Chief Executive Officer Edward Liddy said ex-CEO Maurice "Hank" Greenberg, credited with building the company into the largest insurer, was partially to blame for the firm's woes. Greenberg was at the helm during the formation of AIG's financial products unit, which sold derivatives that cost the company more than $30 billion in writedowns and prompted a government rescue, Liddy, 63, said today on Bloomberg Television. New York-based AIG today reported the biggest loss by a publicly traded U.S. firm and announced that it reached an agreement to restructure the bailout.
Greenberg, who led AIG for almost 40 years before being forced to retire in 2005, has said Liddy is not equipped to run the company and called the sale of the firm's insurance units to repay the government a "tragedy." Greenberg told Congress last year that risk controls he put in place were weakened or eliminated after he left. "I think he's responsible" for some of the insurer's struggles, Liddy said today in the interview. "The formation of the AIGFP unit, which has literally brought us to our knees, that happened on his watch. The compensation systems that have gone astray, happened on his watch. I don't think it's as clean and simple as sometimes Hank would like to portray."
Liddy, the former CEO of home and auto insurer Allstate Corp., was appointed in September to run AIG after the insurer agreed to turn over an 80 percent stake to the government in exchange for an $85 billion loan. The financial products unit was profitable until after Greenberg left, his spokeswoman, Liz Bowyer, said in a statement today. The losses "never would have happened - and in fact did not happen," while Greenberg was in charge, Bowyer said. "Under Mr. Greenberg's leadership, AIG grew from a modest enterprise into the largest and most successful insurance company in the world. Its market capitalization increased approximately 40,000 percent between 1969, when AIG went public, and 2004, Mr. Greenberg's last full year as chairman and CEO." AIG gained 3 cents to 45 cents in New York Stock Exchange composite trading at 3:16 p.m. after the U.S. committed as much as $30 billion in additional capital. The insurer, which posted a fourth-quarter loss of $61.7 billion, has plunged 99 percent in the past 12 months.
The financial products unit was founded in 1987 by ex- employees of Drexel Burnham Lambert, the securities firm that helped popularize "junk-bond" investing. It was headed by Joseph Cassano, who built the business into one that provided guarantees on more than $500 billion of assets at the end of 2007, including $61.4 billion in securities tied to subprime mortgages. Cassano stepped down in March 2008, agreeing to stay on as a consultant earning $1 million a month until U.S. lawmakers lambasted the arrangement in October.
Liddy was appointed by the U.S. to run AIG after it needed an $85 billion federal loan to stave off bankruptcy in September. He is AIG's third CEO since Greenberg, who was forced to retire four years ago amid state and federal probes into accounting and sales practices. Greenberg denies any wrongdoing in a New York State civil lawsuit filed against him in May 2005, which is still pending. Then-New York Attorney General Eliot Spitzer dropped portions of the lawsuit in 2006 that included four other allegations tied to the investigation. Greenberg still controlled the largest stake of AIG shares before the government takeover through personal holdings and investment firms C.V. Starr & Co. and Starr International Co.
FDIC: $19 billion now backs over $4.8 trillion
Yesterday I used a GMAC ad to illustrate a point about publicly-funded deposit insurance—we should do away with it. It encourages depositors to shop for high interest rates rather than healthy banks; it forces onto the public the cost of risks taken by imprudent individuals; and it massively misdirects society's resources by underpricing the cost of government-backed insurance. Why are taxpayers now pumping hundreds of billions into a bailout of Fannie and Freddie? Because the government guaranteed their debt essentially for nothing.
Had the government's guarantee been priced properly, investments in Fan and Fred would have been far less remunerative. We offered trillions of $ worth of free lunches and now we have to pay for them. The same is true of public deposit insurance. Why are Treasury and the Fed moving mountains to save failing banks? Because taxpayers offered trillions of $ of free lunches to depositors for which we now are being forced to pay. There's nearly $5 trillion worth of insured deposits in the American banking system. But the FDIC's Deposit Insurance Fund (DIF) is less than 1% of that total: $18.9 billion. And it's falling fast, down from $52.4 billion (-64%) at the end of 2007.
FDIC doesn't have the resources to bail out the depositors of even one large failed bank, much less the entire banking system. And let's not kid ourselves: The entire banking system remains very much at risk. To put the $18.9 billion figure in perspective, consider FDIC's estimate for insured deposits at the two major banks closest to collapse—Citi and BofA: $103 billion and $449 billion respectively. And those figures understate the total because they don't include "temporary" increases in deposit insurance coverage to $250,000 per account per bank from $100,000.*
To be sure, should those banks fail, the FDIC would be able to sell seized assets in order to fund deposit guarantees. So the DIF wouldn't have to pay back depositors dollar-for-dollar.** Nevertheless, the total cost will, like the Fannie and Freddie bailout, run into the hundreds of billions of $ or more. Because FDIC has an open line of credit on the Treasury, taxpayers would be responsible. [By the way, bank deposits aren't the only assets guaranteed by FDIC. As part of the government's October bailout efforts, FDIC now backs certain debt issues for financial companies. As of mid-January, companies had issued $232 billion under the program...]
FDIC Chairwoman Sheila Bair is taking a quixotic step in the right direction. This week she announced that FDIC will charge a special assessment on banks in order to raise $27 billion for the Deposit Insurance Fund. Give her points for effort, sure. Unfortunately, $27 billion is a meaningless figure when compared with the pool of deposits that are being bailed out. As you can see from the second chart, the Deposit Insurance Fund has always been a tiny fraction of total insured deposits; it hasn't been above 1.5% since the 60s. We let the banking system expand without expanding protections against its failure. Another $27 billion now hardly makes a difference.
FDIC argues that bank failures will only cost the DIF $65 billion over the next five years. In reality, bank failures have cost us far more than that already. TARP and the Fed's various lending arrangements are backdoor methods meant to rescue banks that would otherwise have to be rescued by FDIC via the front door. And they have little choice. The front-door method would likely be impossible without igniting major inflation and/or crashing Uncle Sam's balance sheet. "Printing" excess reserves and lending them directly to banks "sterilizes" that lending's inflationary impact. Banks take more capital onto their balance sheets, but that money doesn't flow into the economy.
Instead, banks hoard it in order to repair their capital base, which is absolutely necessary given their insane leverage ratios. Bailing out depositors directly might be impossible to begin with as FDIC has no money to do so. Could Treasury borrow in one shot the multiple trillions of $ it might need if the banking system collapsed outright? Not to mention that if it actually gave those trillions to individuals, they would likely spend it quickly, igniting massive inflation. If we want to avoid financial crises in future, we need to stop encouraging excess credit creation via "free" government guarantees…
*The increase in the deposit insurance limit to $250,000 from $100,000 is scheduled to expire at the end of this year. It will most likely be rolled over indefinitely. Incidentally, since FDIC isn't including "temporarily" insured deposits in its total for individual banks, I wonder if it includes them in the total amount of insured deposits?? My guess is no, that the $4.9 trillion figure is calculated using the $100k threshold per depositor.
Citi may need more capital despite government move: Deutsche
Citigroup Inc may need to raise additional capital despite the U.S. government's move to bolster its capital base, said an analyst at Deutsche Bank, who sees a 2009 loss of about $4.5 billion for the company excluding any preferred share dividend payments. Citigroup shares fell as much as 7 percent to $1.39 in trading before the bell Monday, after Friday's close of $1.50 on the New York Stock Exchange.
"There is still a good chance that Citi will be required to raise additional capital, possibly due to demands from regulators or simply due to its deteriorating credit quality and balance sheet," analyst Mike Mayo wrote in a note to clients. The U.S. government said on Feb. 27 it will boost its equity stake in Citigroup to as much as 36 percent through the conversion of up to $25 billion in preferred shares to common stock. This was the third attempt by the government to prop up Citigroup in the past five months.
"There is unusual uncertainty related to capital needs, normalized earnings, and operating mode with new government ownership that make any investment in Citi stock an abnormally risky one that could just as easily see its stock double as it could get significantly reduced," Mayo said. He estimates that Citigroup will suffer a cumulative loss of $85 billion on a lifetime basis, given expected loan losses of $65 billion and capital market write-downs of $20 billion. He maintained his "hold" rating on Citigroup shares and has a price target of $3. The analyst said his target reflects uncertainty in the bank's earnings prospects over the next two years.
Global policy shortcomings will cost us dear
Virtually every policy response to the crisis, on both sides of the Atlantic, seems to be falling short. My colleague, Martin Wolf, and the editorial column of the Financial Times have argued that the Obama administration's financial sector rescue plan is dangerously inadequate. I would like to make the additional observation that the tendency to disappoint applies to almost every single policy decision by almost every government. Let us briefly take stock of some of the policy decisions and proposals in the European Union.
Faced with an economic contraction of at least 3 per cent this year, according to my estimate, the EU has agreed an effective stimulus of some 0.85 per cent of gross domestic product for the current year, as calculated by David Saha and Jakob von Weizsäcker, two economists at Bruegel, a Brussels-based think-tank. The stimulus was also not well co-ordinated, which limits its economic impact. EU governments reacted to the acute phase of the crisis with mostly voluntary state recapitalisation schemes and debt guarantees. But there is not a single country where the schemes seem to be solving the problem of insufficiently capitalised banks, able and willing to lend to businesses and consumers.
Last week's much awaited report about the future of European banking regulation and supervision was another example of a policy proposal failing to meet even the lowest expectations. The committee, headed by Jacques de Larosière, a former governor of the Bank of France and managing director of the International Monetary Fund, could not agree on the need for a single supervisor for Europe's 45 cross-border banks. Instead, it recommended leaving national regulators in charge and creating two new institutions – one at the macro level and one at the micro level – with the job of mediating between national governments and regulators.
When asked why he did not opt for an EU-wide supervisor, Mr de Larosière responded: "We might have been accused of being unrealistic." I got the sense – but maybe this is a misperception – that he wanted to push harder for more centralisation, but that there was no consensus. Another fitting example of policy complacency is the response to the central and east European (CEE) currency crisis. This was on the agenda of Sunday's informal European summit, which concluded after this column was written. The proposals that were discussed ahead of the summit included a stabilisation fund. This is desirable and necessary, no doubt, but it is not at all clear how this is sufficient to ward off a speculative attack against all peripheral CEE currencies. I argued last week that euro-isation is the way to go.
Where tragedy turns into farce is the string of policy proposals by Angela Merkel, German chancellor. At one time, she advocated a United Nations Economic Council as a co-ordinating body for global finance – an economic equivalent to the UN Security Council. At the recent Group of Four European summit, she pushed ahead with a proposal to regulate hedge funds and tax havens. Most recently she said that countries should co-ordinate the timing of their bond issues. All this would imply that the crisis was caused by hedge funds, by policy failures due to a lack of international organisations, and by the fact that the Americans and Europeans issue their bonds on the same day of the week. I shudder to think what she might propose next.
Why this extraordinary complacency? One reason is that policymakers are not sufficiently alarmed about the immediate economic catastrophe. To them, this is still what US economists call a "garden-variety recession". They must have been told that global trade has been in freefall for four months now, contracting at a faster rate than during the Great Depression. Yet they still appear to believe that the economy will miraculously recover in the second or third quarter, which is when their stimulus packages will kick in. But these plans are nowhere near big or good enough to stop such a massive decline so quickly. As for Ms Merkel and her colleagues from France, Spain and Italy, they seem to be overwhelmed by what is clearly the wrong type of crisis for them.
That cannot be said of Mr de Larosière. For all my criticisms of his committee's recommendations, his analysis of the global financial crisis is spot on. His team was afraid to make proposals that, in his estimate, had no chance of being adopted. I have no illusions about the enthusiasm among governments for a single EU banking supervisor. But if nobody puts up a fight, we should not be surprised that the only policy actions we get are the ones we get. This is no longer a banking crisis. It is a policy crisis of the first order. Speculators, once more, are getting ready to deconstruct a European edifice, as they did in 1992, but this time it will be one on a bigger scale.
How Washington can prevent 'zombie banks'
Beginning in 1990, Japan suffered a collapse in real estate and stock market prices that pushed major banks into insolvency. Rather than follow America's tough recommendation – and close or recapitalise these banks – Japan took an easier approach. It kept banks marginally functional through explicit or implicit guarantees and piecemeal government bail-outs. The resulting "zombie banks" – neither alive nor dead – could not support economic growth. A period of feeble economic performance called Japan's "lost decade" resulted. Unfortunately, the US may be repeating Japan's mistake by viewing our current banking crisis as one of liquidity and not solvency.
Most proposals advanced thus far assume that, once confidence in financial markets is restored, banks will recover. But if their assumption is wrong, we risk perpetuating US zombie banks and suffering a lost American decade. Evidence – a mountain of toxic assets, housing market declines, a sharp economic recession, rising unemployment and increasing taxpayer exposure through guarantees, loans, and infusion of capital – strongly suggests that some American banks face a solvency problem and not merely a liquidity one. We should act decisively. First, we need to understand the scope of the problem. The Treasury department – working with the Federal Reserve – must swiftly analyse the solvency of big US banks. Treasury secretary Timothy Geithner's proposed "stress tests" may work. Any analyses, however, should include worst-case scenarios. We can hope for the best but should be prepared for the worst.
Next, we should divide the banks into three groups: the healthy, the hopeless and the needy. Leave the healthy alone and quickly close the hopeless. The needy should be reorganised and recapitalised, preferably through private investment or debt-to-equity swaps but, if necessary, through public funds. It is time for triage. To prevent a bank run, all depositors of recapitalised banks should be fully guaranteed, even if their deposit exceeds the Federal Deposit Insurance Corporation maximum of $250,000 (€197,000, £175,000). But bank boards of directors and senior management should be replaced and, unfortunately, shareholders will lose their investment. Optimally, bondholders would be wiped out, too. But the risk of a crash in the bond market means that bondholders may receive only a haircut. All of this is harsh, but required if we are ultimately to return market discipline to our financial sector.
This is not a call for nationalisation but rather for a temporary injection of public funds to clean up problem banks and return them to private ownership as soon as possible. As president Ronald Reagan's secretary of the Treasury, I abhor the idea of government ownership – either partial or full – even if only temporary. Unfortunately, we may have no choice. But we must be very careful. The government should hold equity no longer than necessary to restructure the banks, resume normal lending and recoup at least a portion of taxpayer investment. After replacing bank management with new private managers, the government should have no say in banks' day-to-day operations. The FDIC can assist. Just this year, it has placed more than a dozen American banks – admittedly all small – into receivership.
We might also consider setting up something akin to the Resolution Trust Corporation, created in 1989 to liquidate the assets of failed savings and loans. The RTC eventually disposed of almost $400bn in assets of more than 700 insolvent thrifts. To avoid bank runs and contain market disruption, the Treasury should announce its decisions at one time. Washington will also need to co-ordinate its actions with other major capitals, especially in western Europe and east Asia. At best, this will encourage other countries to take similar steps with their own banking systems. At a minimum, other governments can prepare for the financial turmoil associated with the announcement.
This approach is not pretty or easy. It will cost a lot of money, with the lion's share coming from US taxpayers, at least in the short to medium term. But the alternative – a piecemeal pumping of more public money into insolvent banks in the vague hope that things will improve down the road – could truly be historic folly. Eventually our banks and economy will start to recover. When they do, we would be wise to avoid another Japanese mistake – raising taxes. To counter mounting debt created by government stimulus packages, Japan increased taxes in 1997. Consumption dropped and the country's economy collapsed. Our ad hoc approach to the banking crisis has helped financial institutions conceal losses, favoured shareholders over taxpayers, and protected senior bank managers from the consequences of their mistakes.
Worst of all, it has crippled our credit system just at a time when the US and the world need to see it healthy. Many are to blame for the current situation. But we have no time for finger-pointing or partisan posturing. This crisis demands a pragmatic, comprehensive plan. We simply cannot continue to muddle through it with a Band-Aid approach. During the 1990s, American officials routinely urged their Japanese counterparts to kill their zombie banks before they could do more damage to Japan's economy. Today, it would be irresponsible if we did not heed our own advice.
Median Home Price In Detroit: $7,500
Everyone knows that Detroit is screwed six ways from Saturday, but that doesn't mean you can't still be shocked. For example, abandoned buildings with plants growing in them are shocking no matter what. And learning that the median home price is $7,500, according to this Chicago Tribune article, is still pretty eye-popping. To put that in perspective, it's the same amount that AIG lost every second of the day in Q4.
We're curious, can you even get a mortgage for a house like that? Could Clusterstock go there, put $1,500 down, and stretch the remaining $6,000 over the course of a 30-year loan? Cause if so, that's a pretty good time horizon for the city's eventual turnaround as a green tech mecca. Other amusing tid-bits in the article include the various candidates for mayor and their ideas to fix the city. They include: "Bulldoze large parts of the city and turn them into windfarms", "grow your own food", and the best one: "procreate like there's no tomorrow." *Disclosure: The author was born in Detroit and hopes to see the city turn aroun
U.S. Manufacturing Drops for 13th Straight Month
Manufacturing in the U.S. contracted in February for a 13th consecutive month as factories cut production to match collapsing sales.
The Institute for Supply Management's factory index rose to 35.8 last month from 35.6 in January. Readings less than 50 signal contraction. Another report showed consumer spending rose more than expected in January after six straight declines as Americans took advantage of post-holiday discounts. Factories are cutting jobs and scaling back on output and investment as the housing and credit crises squeeze global demand for everything from cars to appliances. President Barack Obama last month announced a stimulus package to jolt the economy out of what may become the worst recession in seven decades and introduced a record $3.55 trillion budget designed to chart a path toward long-term growth.
"Manufacturing is struggling and certainly the indication we have right now is it will continue to struggle for months to come," Norbert J. Ore, chairman of the ISM's manufacturing survey said on a conference call with reporters. "Manufacturing is still operating at relatively low rates." The median estimate of 67 economists surveyed by Bloomberg was for an ISM reading of 33.8. Forecasts ranged from 30 to 37. The ISM's gauge of new orders fell to 33.1 from 33.2 the prior month. ISM's export orders gauge held at 37.5. The gauge of inventories dipped to 37 from 37.5. The group's employment index fell to 26.1, the lowest since record-keeping began in 1948, from 29.9 in January. The recession has already cost 3.6 million job losses since December 2007 and more cuts are in the pipeline.
Earlier today, the Commerce Department said consumer spending rose 0.6 percent in January after declining for a record six consecutive months. Incomes increased by 0.4 percent. ISM's gauge of prices paid held at 29. Economists had projected that the measure, which averaged 66 in 2008, would rise to 33.5. A measure of goods imported by factories fell to 32, the lowest since records for that gauge began in 1989. Consumer spending, which dropped at a 4.3 percent rate in the fourth quarter after a 3.8 percent decline in the prior three months, may slip through the first six months of this year, according to economists surveyed last month. Purchases have not shrunk for four straight quarters since records began in 1947.
The recession that began in December 2007 will probably persist at least through the first half of this year, according to economists surveyed, which would make it the longest downturn since 1933. The economy shrank at a 6.2 percent pace in the fourth quarter of last year, the biggest contraction since 1982, and business investment fell at a 21 percent rate. In Obama's first address to a joint session of Congress on Feb. 24, he said the staggering economy has left "confidence shaken" and the credit freeze paralyzing the banking system will need to be fixed or "our recovery will be choked off before it even begins."
Obama signed his $787 billion stimulus into law on Feb. 17 and his administration has unveiled measures to boost housing and banks. Also, the Federal Reserve has flooded markets with cash. Among manufacturers, carmakers have been the hardest hit. Detroit-based General Motors Corp. last week reported the second- biggest quarterly loss in its 100-year history, as Chief Executive Officer Rick Wagoner asked the Treasury for $16.6 billion more in loans to survive through 2009. Whirlpool Corp., the world's biggest appliance maker, said Feb. 9 that profit will probably fall for a second straight year as the recession and a plunge in home construction stifle demand. Appliance sales in the U.S. will decline 10 percent this year, Chief Executive Officer Jeffrey Fettig said on a conference call.
Companies that rely on exports are also hurting. Honeywell International Inc., the world's largest maker of airplane-cockpit controls, last week said 2009 sales will be lower than previously projected because of slowing demand in China and India and "weakness" in commercial aerospace. New Jersey-based Honeywell has cut jobs and frozen hiring because of the global slowdown. "We have been preparing for the downturn for two to three years," Chief Executive Officer David Cote said during a Webcast presentation. "We knew it was coming."
Forget inflation—deflation is the real worrier
To paraphrase Winston Churchill, never have so many billions of dollars been pumped out by so many governments and central banks. The United States government is pumping $789 billion into its economy, Europe $255 billion, and China $587 billion. The US Federal Reserve increased its stock of base money in 2008 by 97%, the European Central Bank by 37%. The Federal funds rate in the US is practically zero, and the European Central Bank's main refinancing rate, already at an all-time low of 2%, will likely fall further in the coming months. The Fed has given ordinary banks direct access to its credit facilities, and the ECB no longer rations the supply of base money, instead providing as much liquidity as banks demand. Since last October, Western countries' rescue packages for banks have reached about $4.3 trillion.
Many now fear that these huge infusions of cash will make inflation inevitable. In Germany, which suffered from hyper-inflation in 1923, there is widespread fear that people will again lose their savings and need to start from scratch. Other countries share this concern, if to a lesser extent. But these fears are not well founded. True, the stock of liquidity is rising rapidly. But it is rising because the private sector is hoarding money rather than spending it. By providing extra liquidity, central banks merely reduce the amount of money withdrawn from expenditure on goods and services, which mitigates, but does not reverse, the negative demand shock that hit the world economy.
This is a trivial but important point that follows from the theory of supply and demand. Think of the oil market, for example. It is impossible to infer solely from an increase in the volume of transactions how the price of oil will change. The price will fall if the increase resulted from growth in supply, and it will rise if the increase resulted from growth in demand. With the increase in the aggregate stock of money balances, things are basically the same. If this increase resulted from an increase in supply, the value of money will go down, which means inflation. But if it resulted from an increase in demand, the value of money will increase, which means deflation. Obviously, the latter risk is more relevant in today's conditions.
If the underlying price trend is added to this, it is easily understandable why inflation rates are currently coming down everywhere. In the U.S., the annual inflation rate fell from 5.6% in July 2008 to 0.1% in December 2008, and in Europe from 4.4% in July 2008 to 2.2% in January 2009. At the moment, no country is truly suffering deflation, but that may change as the crisis deepens. Germany, with its notoriously low inflation rate, may be among the first countries to experience declining prices. The most recent data show that the price index in January was up by only 0.9% year on year. This deflationary tendency will create serious economic problems, which do not necessarily result from deflation as such, but may stem from a natural resistance to deflation. In each country, a number of prices are rigid, because sellers resist selling cheaper, as low productivity gains and wage defense by unions leave no margin for lower prices.
Thus, deflationary pressure will to some extent result in downward quantity adjustments, which will deepen the real crisis. Moreover, even if prices on average exhibit some downward flexibility, deflation necessarily increases the real rate of interest, given that nominal interest rates cannot fall below zero. The result? An increase in the cost of capital to companies, which in turn, lowers investment and exacerbates the crisis. This would be a particular problem for the US, where the Fed allowed the Federal funds rate to approach zero in January 2009. The only plausible inflationary scenario presupposes that when economies recover, central banks do not raise interest rates sufficiently in the coming boom, keeping too much of the current liquidity in the market. Such a scenario is not impossible. This is the policy Italians pursued for decades in the pre-euro days, and the Fed might one day feel that it should adopt such a stance.
But the ECB, whose only mandate is to maintain price stability, cannot pursue this policy without fundamental changes in legislation. Moreover, this scenario cannot take place before the slump has turned into a boom. So, for the time being, the risk of inflation simply does not exist. Japan provides good lessons about where the true risks are, as it has been suffering from deflation or near-deflation for 14 years. Since 1991, Japan has been mired in what Harvard economist Alvin Hansen, a contemporary of Keynes, once described as "secular stagnation."
Ever since Japan's banking crisis began in 1990, the country has been in a liquidity trap, with central bank rates close to zero, and from 1998 to 2005 the price level declined by more than 4%. Japanese governments have tried to overcome the slump with Hansen's recipes, issuing one Keynesian program of deficit spending after the other and pushing the debt-to-GDP ratio from 64% in 1991 to 171% in 2008. But all of that helped only a little. Japan is still stagnating. Not inflation, but a Japanese-type period of deflationary pressure with ever increasing public debt is the real risk that the world will be facing for years to come.
Dollar Rises to Highest Since 2006 as AIG Spurs Safety Demand
The dollar rose to the highest level since April 2006 against the currencies of six major U.S. trading partners as investors sought safety after American International Group Inc. got more U.S. government support. The Dollar Index, which the ICE uses to track the U.S. currency, climbed to highest in almost three years after European Union leaders vetoed Hungary's proposal for a 180 billion euro ($227 billion) loan to eastern European economies. The Swedish krona fell to a record versus the euro on speculation the Baltic region's borrowers may default, and the British pound and Polish zloty tumbled. "Risk aversion is providing support to the dollar, in particular against the euro," said Adam Boyton, a senior currency strategist in New York at Deutsche Bank AG, the world's largest foreign-exchange trader.
The dollar increased 0.7 percent to $1.2580 per euro at 12:09 p.m. in New York, from $1.2669 on Feb. 27. It reached $1.2546, the strongest level since Feb. 19. The euro dropped 1 percent to 122.35 yen from 123.61. The yen traded at 97.24 per dollar, compared with 97.57. The Dollar Index, which tracks the greenback versus the euro, yen, pound, Swiss franc, Canadian dollar and Swedish krona, climbed to 88.969. The index rose 1.8 percent last week, the biggest gain since mid-January, as investors bought the world's reserve currency. The Federal Reserve's trade-weighted dollar index, which is updated weekly, rose to the highest since October 2004 on Feb. 20.
New Zealand's currency slid as much as 1.9 percent to 49.13 U.S. cents, the weakest level in 6 1/2 years, after its Treasury Department said the economy may contract more this year than forecast in December. Policy makers will lower the 3.5 percent official cash rate by 0.75 percentage point on March 12, according to the median forecast of 11 economists surveyed by Bloomberg News. The Swedish krona declined as much as 1.6 percent to 11.6152 versus the euro, the weakest level since the European currency's debut in 1999. Sweden holds at least half of cross-border bank lending to Estonia, Latvia and Lithuania, according to Brown Brothers Harriman & Co., which cited fourth-quarter data from the Basel, Switzerland-based Bank for International Settlements. The pound declined 2.3 percent to $1.3987 as U.K. house prices dropped the most since at least 2001, according to a report today from Hometrack Ltd. Prices declined an annual 10 percent last month as rising unemployment and fewer loans discouraged buyers.
The U.S. currency strengthened as global equities slumped, with the Dow Jones Industrial Average falling below 7,000 for the first time since 1997. AIG will get as much as $30 billion in new government capital in a revised bailout after posting the worst loss by a U.S. corporation. The dollar also advanced on speculation the deepening global financial crisis is spurring banks to restrict lending abroad. Stephen Hester, chief executive officer of Royal Bank of Scotland Group Plc, said Feb. 26 that the U.K.'s largest government- controlled bank will cut back or withdraw from 36 of 54 countries where it operates to focus on its "heartland." The Hungarian forint led eastern European currencies lower today, falling 3.1 percent to 243.86, while Poland's zloty lost 3 percent to 3.7796. The forint fell to a 6 1/2-year low of 246.32 on Feb. 17 as Moody's Investors Service said it may cut the ratings of several banks with units in eastern Europe. The zloty touched 3.9151 the next day, the weakest since May 2004.
EU leaders spurned Hungary's request for aid at a summit in Brussels yesterday. Growth in Poland, the biggest eastern European economy, will slow to 2 percent, the slackest pace since 2002, the European Commission forecasts. "There was a bit of a disappointment that the EU didn't adopt a systemic plan to rescue eastern Europe," said Todd Elmer, a New York-based currency strategist at Citigroup Global Markets. "But there have been indications they'll be willing to provide bailouts on a case-by-case basis, and that's why we think the pressure on Europe is a bit overdone." The European Central Bank will cut its main refinancing rate to a record low of 1.5 percent on March 5 to spur economic growth, according to the median forecast of 55 economists surveyed by Bloomberg. The yen gained 0.8 percent to 61.82 against the Australian dollar and 0.8 percent to 75.83 versus the Canadian dollar today on speculation central banks will lower interest rates, discouraging Japanese investors from buying overseas assets.
Australia's central bank will lower the cash target by a quarter-percentage point to 3 percent at a meeting tomorrow, according to the median forecast of 18 economists surveyed by Bloomberg News. Policy makers are forecast to lower the Bank of Canada's rate by a half-percentage point to 0.5 percent. Japan's target is 0.1 percent. The yen weakened 7.9 percent versus the dollar in February, the worst month since August 1995, on concern the deepening recession in Japan undermined the currency as a haven. The two-year U.S. Treasury notes' yield was 0.51 percentage point higher than the comparable Japan security today. When the spread was that wide on Feb. 12, the yen traded at 90.94 per dollar, or 7 percent stronger than today's level. "Investors are taking a step back to judge if the move in the yen is overdone," said Paresh Upadhyaya, who helps manage $50 billion in currency assets as a senior vice president at Putnam Investments LLC in Boston. "The rate differential will support the yen to outperform going forward."
US savings rate rises to 14-year high in January
U.S. households socked away most of the extra income they got in January from annual cost-of-living raises, boosting the personal savings rate to a 14-year high, the Commerce Department said Monday. Disposable real incomes rose in January at the fastest pace since May as annual pay raises and cost-of-living increases took effect, the Commerce Department said. Real disposable incomes (adjusted for inflation and after taxes) increased 1.5%, despite the third straight decline in income from wages and salaries.
Meanwhile, real (inflation-adjusted) consumer spending increased 0.4% in January, the largest increase since November 2007 and only the second increase in the past eight months. Prices increased 0.2% in January, the first increase since September. Core consumer prices - which strip out food and energy prices to get a better view of underlying inflation - rose 0.1%. Consumer prices are up 0.7% in the past year, while core prices are up 1.6%. With disposable incomes rising faster than spending, the personal savings rate rose to 5%, the highest since March 1995. At an annual rate, personal savings rose to a record $545.5 billion.
The savings rate could go even higher, with consumers trying to pay down their debts, live within their means and boost their savings to make up for their lost wealth. The savings rate "has a long way further to go," said Ian Shepherdson, chief domestic economist for High Frequency Economics. The January income report was much stronger than anticipated. Economists were looking for nominal incomes to fall 0.1%, but they rose 0.4%. Nominal spending rose 0.6%, rather than the 0.4% expected. Much of the surprise in incomes came from how the government accounts for one-time payments or increases. Pay raises for government workers and cost-of-living increases for those receiving government benefits or pensions were booked in January, boosting incomes.
Private-sector wages and salaries fell for the third straight month, held back by a subtraction for smaller-than-normal year-end bonuses. Wages and salaries fell 0.2%. Incomes from most sources fell in January, with income from transfer payments the notable exception. Supplements to wages and salaries increased 0.7%. Income from assets fell 0.3%. Proprietors' incomes fell 0.7%. Income from rents fell 0.4%. Income from transfer payments increased 3.5%. Real spending on durable goods rose 0.2% in January, spending on nondurable goods rose 0.7%, and spending on services increased 0.3%. In the past year, real disposable incomes have risen 3.3%, while real spending is down 1.6%.
China built enormous stake in US equities just before crash
The Chinese government more than tripled its investments in the US stock market to $99.5bn (£70 bn) just months before the financial crisis, it has emerged. Provisional figures from the US Treasury department showed that Beijing was holding $99.5bn of shares in June 2008, up from $29bn in 2007. Two years ago, China only held $4bn in US equities, preferring to concentrate on Treasury bills. However, economists said the latest figures suggested that China may have bought as much as $150bn of equities worldwide, or 7pc of its vast foreign exchange reserves. Brad Setser, an economist with the Council on Foreign Relations, a US think tank, said the State Administration of Foreign Exchange (SAFE), a branch of the Chinese central bank charged with looking after the foreign reserves, was responsible for the buying spree. Last year, a Sunday Telegraph investigation revealed that SAFE had built holdings of £9bn in companies listed in London.
The new figures suggest that SAFE has now become one of the largest sovereign wealth funds in the world, although it is likely to have been badly burned by falling markets during the financial crisis. The shift into riskier investments was the result of a power-struggle between China's central bank and the Ministry of Finance, both of which wanted to show they were capable of managing China's huge wealth. The Ministry of Finance runs the $200bn China Investment Corporation (CIC), the country's official sovereign wealth fund, but has been heavily criticised for taking loss-making stakes in Blackstone and Morgan Stanley. Mr Setser estimates that only $8bn of the $99.5bn of US equities were bought by CIC, with the rest being purchased by SAFE. "SAFE wanted to show that it could manage a portfolio of 'risk' assets," he said, in order to make sure that more of its funds were not passed over to CIC. However, an official from the China Banking Regulatory Committee said that SAFE had little idea of how to make overseas investments, and lacks a proper team of analysts and stock-pickers.
The head of SAFE, Hu Xiaolian, is one of the few women at the top of a major Chinese government department. However, she has little commercial experience, having spent her entire career at the central bank and graduated from the bank's own university. Nevertheless, Arthur Kroeber, an economist at Dragonomics in Beijing, said China is likely to continue buying equities despite the slumping markets. "They would have seen a considerable erosion in value by now, but I think they are absolutely playing a long game. Fundamentally, what choice do they have? What short game is there that is making money these days?" he said. "SAFE is saying: the market may be problematic, but if we buy now for the long-term, we'll probably finish up." He added that the Chinese public was relatively content with the management of the country's wealth, since SAFE does not disclose any information about its buying activities. "As long as they don't build a big stake in a high-profile company that blows up, they will be ok," he said, adding that he thought it was possible for the central bank to put as much as 10pc of its foreign reserve holdings into equities. "I would be surprised, however, if they were authorised to put more than 10pc into shares," he said.
Our financial system is not the same as "our" big financial institutions
I've just listened to NPR's recent interview of Timothy Geithner. Adam Davidson did a great job of trying to get answers from Mr. Geithner. I felt sorry, at a personal level, for our Treasury Secretary, a very smart man imprisoned in a series of talking points, desperately afraid of the consequences of holding an honest conversation. As an aside, we've come to take it for granted that policymakers ought to be circumspect for fear of provoking traumatic moves in the markets. But isn't that dumb? Markets are supposed to be about aggregating and revealing information. In what sense is it "more responsible" to hide information or ideas so that markets do not move on them? And if markets do misbehave so wildly that public officials can no longer afford to be candid because of market consequences, does that suggest an incompatibility between the kind of financial markets we have and open democracy?
Anyway. Taking for granted the constraints of the interview, what struck me most was Geithner's repeated conflation of our "financial system" and our "institutions". Mr. Geither's unspoken assumption is the fixing our financial system implies ensuring that incumbent troubled financial institutions are "strong". But that's not right. Our financial system is composed, in part, of financial institutions, but it is supposed to be larger and more robust than any specific firm. Three years ago, Mr. Geithner would have readily conceded that financial institutions are supposed to come and go, rise and fall, succeed and fail as a matter of market discipline, and that our system is made stronger by that flow of creation and destruction than it would be if some state-manged cadre of crucial banks were at its core. Of course, we all knew three years ago that some institutions had become "too big/complex/interlinked to fail", but we viewed that as unfortunate, and would have foreseen that if any of those banks got badly into trouble, the goverment would be forced to intervene and resolve the bank at some taxpayer cost, as it had in the case of earlier TBTF banks. Three years ago, no one would have suggested that the strength of our financial system and the strength of Citibank are inseparable.
We should not let this verbal slip go unchecked. The idea that certain large, politically connected private firms are essential to commonweal and must be supported at all costs by the state is quite the essence of "Mussolini-style Corporatism". Fixing our financial system is not the same as rescuing any one or several financial institutions. Household names can, do and should come and go in a capitalist economy, and it's pretty clear that quite a few familiar financials have failed the market test. What's good for Citibank is not what's good for America.
Did you catch this bit from Warren Buffett's letter?Funders that have access to any sort of government guarantee – banks with FDIC-insured deposits, large entities with commercial paper now backed by the Federal Reserve, and others who are using imaginative methods (or lobbying skills) to come under the government's umbrella – have money costs that are minimal."Lemon socialism" has costs beyond the direct cost to taxpayers of socializing losses. It prevents assets from being shifted from inefficient to efficient firms, and penalizes healthy, well-managed companies by forcing them to compete against subsidized competitors. I don't see how preventing healthy good banks from harvesting the organs of our megabanks "strengthens our financial system".
Conversely, highly-rated companies, such as Berkshire, are experiencing borrowing costs that, in relation to Treasury rates, are at record levels. Moreover, funds are abundant for the government-guaranteed borrower but often scarce for others, no matter how creditworthy they may be. This unprecedented "spread" in the cost of money makes it unprofitable for any lender who doesn't enjoy government-guaranteed funds to go up against those with a favored status. Government is determining the "haves" and "have-nots." That is why companies are rushing to convert to bank holding companies, not a course feasible for Berkshire.
Though Berkshire's credit is pristine – we are one of only seven AAA corporations in the country – our cost of borrowing is now far higher than competitors with shaky balance sheets but government backing. At the moment, it is much better to be a financial cripple with a government guarantee than a Gibraltar without one.
I think it's time to move beyond the nationalization/preprivatization debate and start talking about how to replace rather than reorganize failing firms. That doesn't mean that we would shutter all of Citi's branches. It implies having troubled banks continue to operate in a kind of run-off mode (something like Arnold Kling's #2) while the government backstops some obligations and seeks buyers for the bank's assets, operating as well as financial. In other words, it's time to move beyond nationalization and talk about state-managed liquidation. I look forward to an America with a strong financial system. I think that's more likely in a world where Citi's logo goes all retro chic like Pan Am. Frankly, I think that's all the (non-negative) "franchise value" that's left in Citi, and several of its peers.
GE Capital Credit Default Swaps Now Require Upfront Payments
General Electric Capital Corp's debt is being treated by some credit traders as if it had already been reduced below triple-A. The clearest indication of this is the sellers of insurance on the debt are demanding an upfront payment of $850,000 in addition to an annual payment of $500,000 in annual payments to insure $10 million of GE Capital debt. According to Reuters, on Friday it cost $710,000 annually, with no upfront payment. The move to selling GE Cap's debt protection on an upfront basis will mean that the swaps will sell at a fixed annual coupon plus a premium paid when the insurance in purchased. Why has the way GE Cap's CDS are sold changed? Reuters says traders are spooked by the fact that Moody's says it may still cut GE's "Triple-A" rating.
When a credit default swap contract starts trading on an upfront basis, it typically means that sellers are worried about the credit. The upfront payment means they will take less of a hit in the event the default occurs before the first principal payment. Hedge funds have dreamed up far more complicated uses for upfronts, of course, that typically involve buying and selling multiple contracts. But, at its heart, the upfront is basically downside protection for the seller of the CDS. It's rare for CDS on highly-rated debt to trade on an upfront basis. Typically, that treatment only applies to credit default swaps on large index bonds that cover a variety of capital. Lately, however, more and more companies have seen their debt protection traded on an upfront basis. GE has apparently joined the pack.
Canada's Economy Shrinks Most Since 1991 on Exports
Canada's economy contracted at the fastest pace since 1991 in the fourth quarter, adding pressure on policy makers to cut the country's benchmark lending rate to a record low tomorrow. Gross domestic product fell at a 3.4 percent annualized rate to C$1.32 trillion ($1.03 trillion) between October and December, after 0.9 percent growth in the previous quarter, Statistics Canada said today in Ottawa. Economists surveyed by Bloomberg predicted a contraction of 3.6 percent, after an initially reported 1.3 percent expansion in the third quarter. The world's eighth-largest economy will keep shrinking through the first two quarters of this year, economists predict, marking the first recession since 1992. The Bank of Canada will probably cut its key lending rate tomorrow to a record low of 0.50 percent, a Bloomberg survey of economists shows.
"This year will be tough, there's not much doubt about that," said Pedro Antunes, director of economic forecasting at the Conference Board of Canada in Ottawa. "What supported the domestic economy is going away quickly; it has basically evaporated." Canada's dollar fell to C$1.283 against the U.S. dollar at 8:41 a.m. in Toronto, from C$1.2756 late on Feb. 27. Exports fell 4.7 percent in the fourth quarter, the sixth straight decline. It was the longest slump in more than 60 years of records, Statistics Canada said. Half of the drop came from automotive shipments. Imports fell 6.4 percent, also because of lower automotive shipments. Capital investment fell 3.9 percent. Household spending fell for the first time since 1995, declining 0.8 percent, the agency said. Final domestic demand fell 1.2 percent, the first quarterly decline since 1990.
The economy shrank 1 percent in December, the most since October 1982, as manufacturing and retailing fell. The fourth quarter decline slowed Canada's 2008 growth to 0.5 percent, the least since 1991. Gross domestic product grew 2.7 percent in 2007. Statistics Canada reported last month a record job loss of 129,000 in January, and the agency's leading economic indicator fell the most since 1982 that month. "Rising unemployment, reduced working hours, wage pressures all mean that many Canadians face hard times," Toronto-Dominion Bank Chief Executive Officer Edmund Clark said on a Feb. 25 conference call. Toronto-Dominion is Canada's second-biggest bank by assets. The economy is struggling because of a global recession, which is hitting exports of Canadian automobiles, paper, metals and energy. Prices of Canada's commodity exports have plummeted 53 percent since July, Bank of Canada figures show.
Transcontinental Inc., Canada's largest printer, said Feb. 18 it will eliminate 1,500 jobs after customers canceled or delayed direct-mail projects and magazine advertising in the economic slowdown. The Bank of Canada predicted on Jan. 22 that output would shrink at a 2.3 percent pace in the fourth quarter and contract at a 4.8 percent rate in the January to March quarter. The central bank also forecast Canada's output would shrink 1.2 percent this year before rebounding in 2010 with 3.8 percent growth, the fastest since 1989. "We will continue to monitor carefully economic and financial developments in judging to what extent further monetary stimulus will be required," Carney said Feb. 10 before a parliamentary committee. The phrase echoed what the central bank said on Jan. 20 when the benchmark rate was cut by half a point to 1 percent, the lowest since the central bank was created in 1934.
The east freezes when the west catches cold
There are two types of global economic crisis: the ones that start on the periphery and worm their way inwards and those that erupt at the core and spread outwards. The first is more common, the second more dangerous. Throughout the 1990s and early years of this decade, there were plenty of scares in emerging markets. Mexico was the first country to see a run on its currency and provided the template for the Asian crisis of 1997, the Russian debt default of 1998 and the collapse of Argentina in late 2000.
As some of us said at the time, these emerging crises were warnings of trouble ahead. The global economy was akin to a middle-aged man getting pains in the chest. Despite being told by the doctor that he is eating, drinking and smoking too much, the man enjoys his life of excess and carries on regardless. In the end he suffers a massive heart attack. Failing to heed the warnings has resulted in the second sort of crisis - and from this there is no hiding place. That was certainly the case in 1929-32 - the only other occasion when economic trouble spread from core to periphery - and it is most certainly the experience of the emerging world today.
But nowhere has the impact of the global crisis been felt harder than in eastern Europe. The World Bank, the European Investment Bank and the European Bank for Reconstruction and Development announced on Friday that they would provide about €25bn (£22bn) for central and eastern Europe over the next two years, but much more will be needed. In the old Iron Curtain countries an economic catastrophe is unfolding. Russia's reliance on exports of oil and gas has been brutally exposed by the global downturn; industrial production is falling at a double digit annual rate and despite intense recessionary pressures interest rates have been raised in order to keep the rouble within its band against the dollar-euro currency basket.
In neighbouring Ukraine, things are even worse. Industrial production was more than a third lower in January than a year earlier; spending in the shops has collapsed; overnight interest rates are at 50% or so; the IMF has withheld the second tranche of a loan because the government in Kiev is failing to balance its budget. The prospect of a debt default triggering collapses around the region is acute. In Bulgaria and Romania, foreign-owned factories providing low-cost goods have been shut. Their currencies are under severe pressure and interest rates are crippling. Expect IMF involvement within weeks.
The Baltic states have suffered a double whammy; their access to western capital has been denied by the credit crunch and their main export markets - Russia and the eurozone - are struggling. Latvia and Estonia are seeing their economies contract at an annual rate approaching 10%. Financial markets in Hungary have taken a severe battering in recent weeks. This was a country that took advantage of global capital markets to fund mortgages denominated in foreign currencies. The problem with foreign-currency home loans is that your payments shoot up when the local currency depreciates and such has been the fate of the forint as overseas investors fretted about Hungary's huge current account deficit.
Slovakia's membership of the euro has meant it has escaped the worst of the financial turmoil, but it has been hit hard by the collapse in global demand for manufactured goods. Many carmakers switched production to Slovakia over the past 15 years, now VW has suspended production and Kia has cut working hours by 25%. And so it goes on. The Polish zloty has fallen sharply; industrial production in the Czech Republic has collapsed; Turkey has slashed interest rates after news that car production is down 60% on a year ago. The central banks of Hungary, Poland, Romania and the Czech Republic issued a joint statement last week saying that they were willing to intervene to defend their currencies. Eastern Europe is now on the brink of having its own version of the 1997 Asian crisis, and its prospects are bleak unless there is a rapid turn around in global demand. Given the latest data from the US, China, Japan and Germany that looks a remote prospect.
There are a couple of rays of hope. One is that the savage falls in industrial production in every continent might be part of a global stock clearing exercise and that once this process is over, firms will need to start expanding output even to meet lower levels of demand. Labour is cheap in central and eastern Europe, so it is possible that multi-national companies - seeking to save money and boost profits as they come out of the downturn - will shift production to Poland, Slovakia and Bulgaria. This, though, would not be as easy as it sounds. Taxpayers in rich countries in western Europe and North America have just spent a fortune bailing out utterly useless bankers, and do not expect to be repaid by seeing their jobs exported to other countries.
In the early 1990s, Russia and its former satellites were the laboratory mice for an experiment in fast-track capitalism; now they will provide a test of just how committed rich nations are to the fight against protectionism. The assumption is that Nicolas Sarkozy is playing a lone hand when he insists that he expects government assistance for the French car industry to save jobs in France rather in Slovakia. But a combination of welfare for Wall Street and rapidly rising unemployment suggests a tough environment for those who insist that the world must not turn its back on free trade.
For the European Union, the problems of the former communist bloc would have presented a real challenge in the best of times. But these are not the best of times. The richer countries of western Europe are going to have to dig deep to help out their less well-off neighbours to the east at a time when Germany, France, Italy and Spain are all in recession, Ireland is in the grip of a housing crash and there have been riots on the streets of Greece. Just to cap things off, Austria's banks are loaded up with dodgy loans to eastern Europe.
All this will provide the first real test of the eurozone. There are already some who believe that the strains on the euro mean that one or more countries - Italy and Greece being the usual suspects - will choose to leave the single currency. That still looks improbable, though it has to be said that many improbable things - nationalisation of large chunks of the UK banking system, for example - have happened in the past 18 months. What is certain is that a broader euro is also a weaker euro. It looks like a cast-iron sell.
'The Age of National Economic Policies in Europe Is Over'
Western European leaders rebuffed calls from some suffering Eastern states for a massive regional bailout at Sunday's emergency summit. German commentators back those calling instead for an EU recovery plan that looks at countries on a case-by-case basis. When European Union leaders gathered in Brussels on Sunday for an emergency meeting about the economic crisis they firmly dismissed calls from some Eastern European states for a regional bailout. Many countries in Central and Eastern Europe are feeling the pain, in partticularl Hungary and the Baltic States. And there are widespread concerns that Western European countries will take protectionist measures that will ultimately hurt these ailing Eastern states. Hungarian Prime Minister Ferenc Gyurcsany lead the charge, calling for a €190 billion ($240 billion) regional bailout for Eastern Europe and warned that: "We should not allow a new Iron Curtain to be set up and divide Europe."
Hungary and the Baltic States also called on the EU to make it easier for countries to join the euro, by relaxing the current criteria and shortening the two-year waiting period. Only 16 of the 27 member states currently use the euro and the currency has proved particularly stable in the turbulent currency markets. Western European, led by German Chancellor Angela Merkel, roundly rejected both calls. The euro zone countries want to protect the currency's stability and most EU leaders pointed to the very different circumstances faced by individual countries. In the end the bloc decided to follow a policy of helping individual countries on a case-by-case basis while pursuing a broader EU-wide policy of weathering the economic crisis. As the biggest contributor to the bloc's coffers, Germany is reluctant to get into the business of financing any massive regional bailout. On Monday German commentators are unanimous in their approval of the EU's response and some papers castigate Hungary for its behavior ahead of the summit.
The business daily Handelsblatt writes:
"At this point, there is no telling when we will get past this recession and which victims will be lying on the side of the road when it's all over. But we have already learned one lesson: The age of national economic policies in Europe is over. None of Europe's smaller countries has any chance of escaping the phenomenal undertow of the global financial markets by themselves. Going it alone, each and every European country -- including the biggest ones -- would get sucked under into the abyss. For Germany, quite a few economic issues are currently in play. It's hard to imagine what our companies would do without open European export markets and a stable common currency. The result would inevitably be gigantic losses of wealth for all (German) citizens. … For this reason, the federal government must do all in its power to nip all attempts at protectionism in the EU in the bud. … It is also in Germany's own interest to show solidarity with its EU partner states that are wobbling as a result of the crisis. There is no danger of the EU being split along economic lines into a rich west and a poor east, as Hungary's prime minister has claimed. The fact is that there are countries all over Europe that are losing their footing -- whether it's Ireland in the north, Latvia in the east or Greece in the south. German companies both sell and produce products in all of these countries -- for that very reason alone, Germany's federal government cannot leave any of these countries in the lurch."
The center-right Frankfurter Allgemeine Zeitung writes:
"You know things have gotten pretty bad when you start hearing whiny, extortionist tones talking about how, 20 years after the fall of the Berlin Wall, a new Iron Curtain is being established along with a partition (of Europe). The people expressing these things are, of course, particularly the new EU member states from Central and Eastern Europe, who consider what they're hearing from … "old Europe" as being rather lacking in terms of collegiality. … In this crisis, it would be fatal if the (narrow-minded) opinion of individual nations dominates to a degree that is more than legitimate, absolutely necessary and unavoidable. And the same holds true if domestic markets turn out to only be fair-weather friends and national rescue packages come at the expense of one's own partners. In the long run, these types of rescues don't work. In the end, everyone will be forced to jointly bear the costs that cause this separation, collapse and political crisis. Moreover, it would also mean yet more damage to the idea of a pan-European community."
The center-left Süddeutsche Zeitung writes:
"The countries of Europe finally decided to find their way back to a sense of community at the summit in Brussels -- and with not a second to spare. In recent weeks, protectionist sentiments have spread through Europe like a virus. All of a sudden, more and more politicians were convinced that they could be solve this crisis using national means or with swift bilateral assistance and that, in a pinch, they could reach into the coffers of Europe's richer countries. But, in the end, when they were presented with the option of either improving cooperation or going it alone …, the leaders of Europe's states choose to pursue a common course together…. The crisis makes it abundantly clear just how intertwined (the EU) is. If one country collapses, it pulls the other ones down with it. The Europeans have no choice but to constantly renew the old pledges of solidarity and common security. And this is the case even if this crisis is going to get very expensive."
Conservative Die Welt writes:
"If there's one thing that all the countries in the European Union agree upon, it is that they are facing the largest economic crisis in the more than 50 years since the union was founded. Yet, despite the fact that the crisis might turn out to be very painful, the crisis also means that decisions will have to be made, and new decisions can also offer opportunities for a new beginning. Hungary has now demonstrated how a chance like this can be squandered. Even before the leaders of the EU member states could privately ruminate on how they might be able to combine forces to halt the economic slide, Hungarian Prime Minister Ferenc Gyurcsany had already laid down incredible demands on the table. As Gyurcsany put it, there need to be 'solidarity funds' for Eastern Europe of up to €190 billion in order to prevent 'a new Iron Curtain.' But to accuse the EU of erecting a new Iron Curtain is exactly the opposite of what Europe needs right now. That is no new beginning. And, more than anything, what it shows is a lack of solidarity -- which has to go both ways."
New 'Iron Curtain' will split EU's rich and poor
Eastern European countries gave an apocalyptic warning yesterday of hordes of unemployed workers heading west as a new Iron Curtain divides rich from poor inside Europe. Twenty years after the fall of the Berlin Wall, Western leaders were told yesterday that five million jobs could be lost in the "new" European Union countries of the East unless radical action were taken to bail them out. The spectacular collapse of some of the post-communist tiger economies led to demands at an EU summit in Brussels for a rescue fund of €190 billion (£170 billion) to stop social collapse in the Eastern nations spilling over into the rest of Europe.
The plea, led by Hungary, was rejected in a bad-tempered meeting of the 27 European leaders, dominated by fears that Western EU countries would rather prop up their own large industries and jobs at the expense of the East. Instead Gordon Brown renewed his call for a huge injection of funds into the International Monetary Fund, which has already doled out large sums to Hungary and Latvia and is soon to receive a begging letter from Romania. The Prime Minister refused, however, to say where the fresh money for the IMF would come from. As he prepared to fly off for talks with President Obama today, Mr Brown left behind an EU increasingly split between its old and new economies and lacking the unity that he hoped to present in Washington and at the G20 summit in London next month.
Ferenc Gyurcsany, the Hungarian leader, openly raised the spectre of collapse in Eastern Europe and the creation of a new Iron Curtain. "Central Europe's refinancing needs in 2009 could total €300 billion, 30 per cent of the region's GDP," he said in a paper calling for a fund of €160 billion to €190 billion to be set up by the richer EU members. "A significant crisis in Eastern Europe would trigger political tensions and immigration pressures. With a Central and Eastern European population of 350 million, of which 100 million are in the EU, a 10 per cent increase in unemployment would lead to at least five million unemployed people within the EU."
As capitalism stares into the abyss, was Marx right all along?
"Modern bourgeois society ... a society that has conjured up such gigantic means of production and of exchange, is like the sorcerer who is no longer able to control the powers of the nether world whom he has called up by his spells." Those of you with revolutionary zeal will immediately recognise these words. Penned by Karl Marx in 1848, they form part of the Communist Manifesto. Marx, like Adam Smith before him, had a historical view of society's development.
Capitalism, with its bourgeoisie, had replaced feudalism, but capitalism, according to Marx, would be replaced by communism. Capitalism was inherently unstable, as Marx noted later in the same paragraph: ".....the commercial crises... by their periodical return, put the existence of the entire bourgeois society on its trial, each time more threateningly. In these crises, a great part not only of the existing products, but also of the previously created productive forces, are periodically destroyed. In these crises, there breaks out an epidemic that, in all earlier epochs, would have seemed an absurdity – the epidemic of over-production."
Whatever else one thinks of Marx, he certainly knew a thing or two about the business cycle. Were he alive now, he would surely claim his theories were being vindicated. We are, after all, witnessing the most remarkable collapse in economic activity around the world. Take Japan. In November, industrial production fell 8 per cent. That was bad enough. In December, production dropped another 9 per cent. That was even more remarkable. January's production figures, though, are simply eye-wateringly awful, showing a further 10 per cent decline. Production, then, is down almost 30 per cent in just three months, a pace of decline unprecedented in Japanese post-war economic history.
Or how about the US, where we discovered last week that national income contracted in the final quarter of last year at an annual rate of more than 6 per cent, the biggest drop since the early 1980s. Then there's Taiwan, where exports have been in freefall in recent months. Not to mention dear old Blighty, where the economy might end up shrinking by approaching 4 per cent this year. The pace of decline in global economic output is extraordinary. On virtually any metric, we are seeing the worst global downturn in decades: worse than the aftermath of the first oil shock in the mid-1970s and worse than the early-1980s downswing, when the world economy had to cope with a doubling of the oil price, the tough love of monetarism and the onset of the Latin American debt crisis. Moreover, this time we cannot use the resurgence of inflation as an excuse for lost output: the credit crunch in all its many guises has seen to that. Instead, we have a world of collapsing output combined with falling prices: a world, then, of depression.
For many years, Marxist ideas appeared to be totally irrelevant. The collapse of the Berlin Wall in 1989 brought to an end the era of Marxist-Leninist Communism, while China's decision to join the modern world at the beginning of the 1980s drew a line under its earlier Maoist ideology. In western economies, Marxist ideas were at their most potent after the First Word War when the likes of Rosa Luxemburg could smell revol-ution in the air and as the Roaring Twenties gave way to the Great Depression of the 1930s. I'm not suggesting we're entering revolutionary times. However, it seems increasingly likely that the economic landscape in the years ahead will be fundamentally different from the landscape that has dominated the working lives of people like me who entered the workforce in the 1980s.
We've lived through decades of plenty, where incomes have risen rapidly, where credit has been all too easily available and where recessions have been mostly modest affairs. Suddenly, we're facing a collapse in activity on a truly Marxist scale. It's difficult to imagine the world's love affair with free markets being sustained under this onslaught. The extreme nature of this downswing will change our lives for decades to come. The first change relates to the allocation of capital. Increasingly, policymakers are accepting that market forces, left to their own devices, will lead to a race to the bottom. The dangers are becoming greater by the day. Interest rates are close to zero while prices and wages are in danger of declining. If deflation takes hold, real interest rates on cash will start to rise, creating perverse incentives in capital markets. Why bother to buy equities or corporate bonds if you are nicely rewarded for hanging on to an entirely risk-free piece of paper?
The efforts to stop this vicious circle are increasingly focused on bypassing the banking and financial system. As central banks widen the assets they are prepared to purchase to maintain the flow of credit to the economy at large, they are increasingly getting into the capital allocation game. They, and not the market, will at the margin decide whether companies and households are creditworthy. And as governments increase their spending plans to ward off a catastrophic loss of demand, they, rather than companies, will decide on how our savings should be allocated.
The second change relates to an increased national bias in the allocation of capital. As Nicolas Sarkozy, the French President, pushes to offer government funding to French car companies on condition they don't outsource French jobs abroad, as US Congress signs off a stimulus package with more than a hint of a "Buy American" policy, and as the UK Government pushes to encourage bailed-out banks to lend domestically as opposed to internationally, we appear to be turning our backs on the previous world of heightened cross-border trade and capital flows. While these flows have undoubtedly been volatile, they have nevertheless allowed emerging economies, in particular, to gain a foothold on the development ladder. Are we about to cast these countries asunder in our desperate attempt to fix our domestic problems?
The third change relates to interference in the price mechanism. When it comes to Sir Fred Goodwin's pension, this isn't so surprising, but the price mechanism extends far and wide. At the microeconomic level, we'll enter a world of subsidised loans with murky political undertones. At the macroeconomic level, countries may take the opportunity to manipulate their exchange rates in an attempt either to gain a competitive advantage or to "default" to foreign creditors. Some of these changes may be absolutely necessary to prevent an outright collapse in global economic activity (although the rise in protect-ionist pressures is surely a retrograde step). They also suggest, though, that there will be no return to "business as usual" for market forces.
The cost of avoiding depression is a heightened level of state intervention on a scale unimaginable for those who believe in the virtues of free markets. While such intervention may help prevent the worst ravages of economic collapse, it will ultimately do little to foster the entrepreneurial spirit and risk-taking behaviour which have, in the past, contributed so much to rising living standards. We may avoid a 1930s Depression but, increasingly, we may find the best we can hope for is a 1990s Japan. Not quite a Marxist revolution, then, but certainly a lasting sea-change in economic performance.
Currency 'Protectionism' Strengthens Dollar as Banks Focus Lending at Home
John Taylor says three decades of currency trading taught him financial turmoil prompts large banks to favor local lending, and that's why he's buying U.S. dollars for the biggest foreign-exchange hedge fund. "Whenever a banking system realizes it's in big trouble, it says, 'I have to take care of my next door neighbors and the businesses down the block," said Taylor, who manages $11.4 billion as chairman of New York-based FX Concepts Inc. "Then that currency of that country, if its banks are big in international lending like in the U.S., will strengthen."
Evidence of so-called financial protectionism surfaced last week. Stephen Hester, chief executive officer of Royal Bank of Scotland Group Plc, said Feb. 26 that the U.K.'s largest government-controlled bank will cut back or withdraw from 36 of 54 countries where it operates to focus on its "heartland." The pound and franc will also benefit from such moves, while currencies of New Zealand and other nations dependent on international banking will suffer, said Hans-Guenter Redeker, BNP Paribas SA's chief currency strategist in London. He predicts the dollar will strengthen 4.4 percent to 1.20 per euro by June 30.
Concern about home-lending favoritism follow pledges by governments around the world of more than $10 trillion to prop up banking systems. More than $1.1 trillion of writedowns and losses created the worst financial crisis since the 1930s and triggered a global recession. U.S. President Barack Obama's $787 billion stimulus plan, enacted last month, includes "Buy American" provisions. French President Nicolas Sarkozy created a fund in November to protect "strategic" companies from "foreign predators." Russia increased duties on automobile imports in December, while India limited steel imports and imposed tariffs on soybean oil.
Historians blame a trade war during the Great Depression, starting with the U.S. passage of the Smoot-Hawley Tariff Act in 1930, for deepening the worldwide economic slump. History also shows that exchange rates are vulnerable to protectionist threats, said Derek Halpenny, the London-based European head of global currency research at Bank of Tokyo-Mitsubishi UFJ Ltd. The dollar slid to a record low in April 1995 of 79.75 yen after the U.S. threatened to impose tariffs on Japan. Redeker said financial protectionism adds a layer of danger to foreign exchange markets, where trading increased to $3.2 trillion a day as international banks expanded. Loans to overseas borrowers, along with other foreign claims, totaled $31 trillion in mid-2007, up from $11 trillion at the end of 2000, the Bank for International Settlements said in a report today.
"The problem is that many banks that operate internationally have received government funds," Redeker said. Those banks will be pressured into "prioritizing local markets and withdrawing from abroad at an increasingly rapid rate. This will be quite negative for those countries that don't have a strong enough banking system on their own and have in the past relied on banking from abroad." After posting the biggest loss in U.K. history, Edinburgh- based Royal Bank of Scotland plans to boost lending to U.K. homeowners and businesses by 50 billion pounds ($71.1 billion) as part of an agreement with the government to shift 325 billion pounds of investments into a state insurance program.
Declines in the shares of financial companies helped push the Standard & Poor's 500 Index to a 12-year low last week, on concern the deepening recession will force banks to seek more government aid. The premium banks charge each other for short- term loans, a barometer of willingness to lend known as the Libor-OIS spread, was 1.02 percentage points Feb. 27, about 10 times the average for the decade before August 2007. The dollar rose to the highest in almost three years against the currencies of six major U.S. trading partners on Feb. 27 as investors sought refuge in the world's preferred reserve currency. The Dollar Index, which the ICE exchange uses to track the U.S. currency versus the euro, yen, pound, Swiss franc, Canadian dollar and Swedish krona, reached 88.490, the highest level since April 2006. It's up 8.2 percent this year.
Last month was the worst for the yen against the dollar since 1995 as Japan's currency weakened 7.85 percent. The euro depreciated versus the dollar too, losing 1.2 percent last week and New Zealand dollar declined 2.1 percent against its U.S. counterpart. The yen was little changed at 97.29 per dollar as of 7:29 a.m. in New York. The euro fell 0.9 percent to $1.2562. For Taylor of FX Concepts, who worked at Citibank until 1979, today's markets are reminiscent of the late 1970s and early 1980s. Oil prices more than doubled and the Federal Reserve lifted its target rate for overnight loans to 20 percent by March 1980 from 10 percent at the beginning of 1979, leading the U.S. into a recession that lasted from January to July 1980. The Dollar Index surged 22 percent between the end of 1979 and the close of 1981.
Damage caused by past bouts of trade restrictions may limit barriers from rising. After a January gathering in Rome, policy makers from Group of Seven nations said in a statement that they were "committed to avoiding protectionist measures, which risks exacerbating the downturn." "World leaders recognize that any kind of protectionism leads us down the same road to disaster," said Ward McCarthy, a former Fed economist who is now a principal at Stone & McCarthy Research Associates in Skillman, New Jersey. "Even though this ugly word -- protectionism -- has cropped up, it doesn't seem to be gaining any momentum as far as government economic or financial stability programs are concerned."
Citigroup Inc. CEO Vikram Pandit said in a Jan. 16 conference call that the U.S. wasn't pressuring the bank to restrict international lending. The government ratcheted up its effort to save Citigroup on Feb. 27, agreeing to a third rescue attempt that will cut existing shareholders' stake in the New York-based company by 74 percent. Kenneth D. Lewis, CEO of Bank of America Corp., the largest U.S. bank by assets, acknowledged that helping the U.S. economy goes hand in hand with accepting federal funding. "With expanded investment in our company by the federal government, we intend to play a major role in restoring the economy of United States to a healthy rate of growth," he said during a Jan. 16 conference call. "We will do this by providing credit to consumers, small and large businesses and state and local governments. Bank of America acknowledges the responsibilities of the company in the use of public funds."
The World Bank, the European Bank for Reconstruction and Development and the European Investment Bank said Feb. 27 they will provide as much as 24.5 billion euros ($30.8 billion) to help central and east European banks and businesses cope with the global financial crisis and refinance foreign-currency loans. Shares of eastern European banks touched six-year lows and the Polish zloty, Hungarian forint, and Czech koruna slid after Moody's Investors Service said in a Feb. 17 report that it may cut the debt ratings of western European banks exposed to mounting bad debts in the continent's developing economies. The South Korean won, Australian dollar, and currencies of smaller countries dependant on trade are most at risk from a rise in protectionism, said David Woo, the London-based global head of foreign-exchange strategy at Barclays Plc.
The International Monetary Fund cut its estimate for world growth to 0.5 percent in January from 2.2 percent, the weakest pace since World War II. South Korea's economy will shrink 4 percent this year, the IMF forecasts. "As governments direct significant amounts of public money to shore up the banking system and in an attempt to stabilize domestic job markets, there is increasing political pressure to appear to focus on domestic problems," said Mark Konyn, Hong Kong-based chief executive officer of RCM Asia Pacific Ltd., which oversees $11 billion in assets. "Protectionism is a threat to the recovery."
How subprime sunk the world
That horrible euphemism "subprime" has not been heard much recently, but just in case you forgot what caused all this mayhem, HSBC obliged this morning with a textbook lesson in how the financial crisis has rippled all around the world and back again. Not long ago, this Anglo-Chinese banking giant was known as "smug bank" for its ability to avoid the worst effects of the crisis. But the subprime infection is virulent: one relatively small division of HSBC in the US has eaten away at the core of this institution until it was finally forced to ask investors to back the biggest emergency cash-raising in City history.
HSBC also announced it is shutting down the troublesome US division. It has generated red ink totalling twice as much as the purchase price, so there will be few tears in Canary Wharf. Another $27bn was written off this morning and more than 100,000 customers in the US have had their loans "modified" - another euphemism to disguise the inability to pay them back. Unfortunately, that is not the end of the matter. Billions of dollars worth of shareholder assets remain exposed to the collapsing US economy. With the housing market in freefall, the chance of further write-downs must remain high. The subprime disaster has also set in train a series of related crises that are now affecting other parts of the HSBC empire.
At least it's neat: there is certain circular logic to the HSBC story that appeals to the minds of bankers. Stephen Green's statement on the financial crisis (towards the beginning of this link) is a model of clarity compared with some of the whimpering excuses doled out by other British banks recently. Two extra numbers to put this fundraising in scary context: HSBC Finance Corporation (the US arm in trouble) has $147bn of loans outstanding of which 11.2% are already in delinquency. I fear this is not the end of HSBC's subprime saga.
HSBC shares dive 20% on record £12.5 billion cash call
Shares in HSBC tumbled by 20.1 per cent by midday today as City sentiment continued to deteriorate towards a record £12.5 billion cash call by the banking giant. HSBC stock lost 98.75p to 392.5p after it released details of the rights issue to strengthen its balance sheet following a 62 per cent fall in profits over 2008 and a steep cut to its full-year dividend. HSBC said it intends to raise the money through a rights issue where investors will be offered five shares for every 12 they own at 254p each — a steep 48.2 per cent discount to Friday's closing share price of 491p. The company said that the rights issue will help its "ability to deal with the impact of an uncertain economic environment and to respond to unforeseen events".
The rights issue is the largest ever in the UK, beating last year's £12 billion cash call from Royal Bank of Scotland, the battered bank now 70 per cent owned by the UK taxpayer. HSBC shareholders will vote on the rights issue proposal on March 19. HSBC also outlined plans to close its network of US personal finance and mortgage businesses with the loss of 6,100 jobs. Over 2008, pre-tax profits at HSBC tumbled 62 per cent to $9.3 billion (£6.5 billion) last year after loan impairment charges swelled by $7.6 billion to $24.9 billion, largely as a consequence of its US business. HSBC said that it was writing off $10.6 billion from its American unit and shutting down its HFC and Beneficial brands, which wrote mortgage business including sub-prime home loans.
The bank said that 6,100 jobs would go as the 900 branches across the US stopped writing consumer business. HSBC bought Household, the US mortgage and finance company, for £10 billion six years ago. Stephen Green, the group chairman of HSBC, said: "We have a reputation for telling it as it is. With the benefit of hindsight, this is an acquisition we wish we had not undertaken." Despite Mr Green's candour, HSBC faces criticism from activist shareholders who do not want to foot the bill for failures in the American mortgage business. Knight Vinke, the investment group, told The Times yesterday that safeguards were needed to ensure that new money raised by the rights issue was not used to bail out the US sub-prime division.
Three of HSBC's most senior directors said today that they would not ask for a performance bonus amid continuing public anger over banker pay. Mike Geoghegan, the chief executive, Stuart Gulliver, the head of global banking, and Douglas Flint, the finance director, will receive no bonus and none of the bank's executive directors will receive a cash bonus. Commenting on the cash call, Mr Green said: "We are determined that HSBC should maintain its signature financial strength which is supported by a conservative balance sheet characterised by an advances to deposits ratio of 83.6 per cent.
"We remain confident that HSBC is well-placed in today's environment and that our strength leads to opportunity. Our strategy has served us well and positions HSBC for long-term growth with attractive returns." However, the bank's dividend will be reduced by 29 per cent on a dollar basis and 15 per cent on a sterling basis to $0.64. HSBC is one of only two major UK banks, alongside Barclays, not to have sought financial help from the British Government. The cash call has been underwritten by Goldman Sachs, JP Morgan and "others", and will increase HSBC's tier one capital ratio — a key measure of a bank's financial strength — from 8.5 per cent to 9.8 per cent.
Trading in HSBC shares suspended in Hong Kong
Trading in shares of HSBC Holdings was suspended for Monday's session in Hong Kong, pending what the bank called "the announcement of a corporate action," as the company was expected to reveal a pullback from its U.S. consumer lending business. The banking giant is also due to announce its 2008 earnings report later in the day. Shares of HSBC's Hong Kong-based subsidiary, Hang Seng Bank, dropped 4% ahead of its own results for 2008. Daiwa Research expects Hang Seng's 2008 profit to drop to HK$14.06 billion from $18.24 billion in 2007.
The decline came amid steep falls in Hong Kong as well as the region after U.S. stocks extended their losses Friday. The Hang Seng Index was recently down 3.6% at 12,349.60 in Hong Kong, while Japan's Nikkei 225 Average ended the morning trading session 3.2% lower at 7,325.96. Elsewhere, China's Shanghai Composite dropped 0.3%, Australia's S&P/ASX 200 shed 2.7%, South Korea's Kospi sank 3.8%, Singapore's Straits Times Index fell 2.9% and Taiwan's Taiex gave up 2%. The Wall Street Journal reported that HSBC plans to curtail its foray into U.S. consumer lending by pulling back from key businesses. The lender is largely throwing in the towel on its 2003 purchase of Household International Inc., a $14 billion deal that saddled it with a U.S. subprime lender that has seen its results worsen amid the housing downturn, the report said.
Separately, HSBC is also expected to cut its dividend and raise more than GBP12 billion ($17 billion) in a deeply-discounted rights issue on Monday, The Sunday Telegraph reported. Analysts surveyed by FactSet Research expect HSBC to report a net income of HK$100.4 billion ($12.87 billion) for the year, down from its profit of more than $19 billion in 2007. In a recent report, Daiwa Research noted that consensus estimates on HSBC's 2008 performance varied widely, with analysts anticipating its net profit to fall anywhere between $10.9 billion and $18.4 billion. Shares of HSBC, which command a weighting of more than 11% in the Hang Seng Index, ended down 0.9% on Friday. Trading in the shares is expected to resume Tuesday.
The Auto Industry Crisis 'Is Truly Brutal'
Volkswagen CEO Martin Winterkorn speaks with SPIEGEL about government bailouts for competitors, the worldwide slump in demand for cars and VW's chances of surviving natural selection in the auto industry.
SPIEGEL: Mr. Winterkorn, should the (German) government rescue Opel?
Martin Winterkorn: The government should stay out of it. It is legitimate for the government to come to a company's aid with isolated loan guarantees, but this should only apply for a transitional period. The government cannot become a bailout organization for companies on the verge of bankruptcy.
SPIEGEL: Is Opel on the verge of bankruptcy?
Winterkorn: I cannot be a judge of that, but it would, of course, be regrettable. All I know is this: The bailout of General Motors is not easy, given the intricate web of relationships that has grown over the years. Imagine if we wanted to spin off Audi today. I don't know how Audi could survive if the VW Group were to stop supplying this subsidiary, be it with parts, technology or expertise.
SPIEGEL: General Motors and Chrysler are almost broke. Fiat's chairman has said that the company cannot survive on its own. Saab has instituted bankruptcy proceedings. Is an elimination contest taking place in the auto industry today?
Winterkorn: It looks that way. I have just returned from China, where there are still about 200 different automobile makers. A weeding-out process is also take place there.
SPIEGEL: Aren't you at least somewhat pleased by the threat of your competitors' demise, because it makes the business easier for the VW Group?
Winterkorn: Of course, if one player disappears from the field, the others will see their opportunities improve. But no one escapes this sort of crisis unscathed. It starts with the discounts with which faltering manufacturers hope to revive their sales. In doing so, they bring down prices across the board. And then there are the suppliers. If one automaker fails, Bosch, Mahle, Conti and other suppliers have a problem. Their plants no longer operated at capacity, and it becomes more difficult for VW to negotiate attractive purchasing prices. It isn't fun for anyone.
SPIEGEL: A number of governments plan to rescue the auto industry in their countries with billions in rescue funds. The United States is bailing out General Motors and Chrysler. France is helping Renault, Peugeot and Citroën. Will the companies surviving in the end be the ones that get the most support, and not necessarily the healthiest ones?
Winterkorn: That could happen, which is why I take a very critical view of such government assistance programs. They're a step back to a distance past. Who are we, after all? We are in Europe, and we have the EU. Under these circumstances, France cannot massively support its industry and at the same time require the automakers to close their plants in Eastern Europe, if any have to be closed.
SPIEGEL: The German government also wants to help the auto industry. It has already earmarked €1.5 billion ($1.88 billion) for scrapping bonuses. Doesn't this chiefly promote the purchase of small Italian and French cars?
Winterkorn: We also benefit from it, and that's why such programs are okay. They do not exclusively help the companies in one country. It is important to ensure that we too will experience a significant boost as a result. And that is the case. Normally, about 2,000 people a day order a Volkswagen in Germany. That number jumped to more than 6,000 in February. Dealerships have been staying open until 10 p.m. on Saturdays. Based on order volume, this will be the best February in many years.
SPIEGEL: But doesn't the scrapping bonus mainly improve sales of the Polo, which is made in Spain?
Winterkorn: No. Sales of the Golf, the Touran and the Passat are also up. And how many parts for the Polo do you think are made in Germany? The engine, transmission, parts of the chassis, the steering system, sheet metal parts and steel -- a total of 60 percent. That's why the scrapping bonus is clearly having a positive impact on employment. But I do not believe that the amount of money budgeted for the plan is enough. The program should definitely be extended. Besides, the government takes in as much money in sales tax revenues as it spent on the bonuses.
SPIEGEL: If the scrapping bonus is really working, that is, if your order volume is up so significantly in February, why did VW reduce working hours for its employees?
Winterkorn: We are seeing this positive development in Germany, and it's important also to talk about that in the crisis. But the negative tendencies are, of course, the dominant ones. In January, car sales declined by 37 in the United States, by 28 percent in Europe, by 20 percent in Japan, and so on. Things are in decline everywhere. That's what makes this crisis so dangerous. It is truly brutal.
SPIEGEL: You have worked in the auto industry for almost three decades. Have you ever experienced a crisis like this one?
Winterkorn: None of us has ever experienced such a tailspin. There has been excess capacity in the industry for a long time. We were able to handle it, but then came the financial crisis. Even healthy companies are having trouble getting credit from the banks. This creates an explosive mix, and no one is quite sure what else we can expect.
SPIEGEL: Governments worldwide have had to nationalize banks to save them. Some countries even face the threat of national bankruptcy. Do you believe that the political world has responded appropriately to these challenges?
Winterkorn: The grand coalition in Berlin certainly has. Chancellor Angela Merkel, Finance Minister Peer Steinbrück and the junior ministers have acted very prudently so far. And if we manage to overcome this crisis with common sense and not too much new debt, things will eventually turn around. But I am not ruling out the possibility that things could get drastically worse first. Imagine this continuing for another two or three years. Then we won't just be talking about reduced working hours.
SPIEGEL: Does VW have to lay off workers and close plants? Productivity rises by 5 to 10 percent each year. If you want to secure the 329,000 jobs within the VW Group, sales will have to grow substantially. But now sales are even shrinking.
Winterkorn: At this point, no one in our company is considering layoffs or the like. By reducing working hours, we can ensure that no cars are being produced for warehouse inventory. Besides, we have a 35-hour workweek, which we can reduce to 28 hours. This allows us to cut back production and yet hold on to our core workforce. I don't anticipate any problems in this regard for this year. We will only have to start thinking about other options if things continue to deteriorate after that.
SPIEGEL: The VW Group was still employing some 16,500 temporary workers at the end of 2008. How many will there be at the end of 2009?
Winterkorn: We will no longer employ any temporary workers. This isn't good news for those affected. But there is no way around it.
SPIEGEL: Will you now stop the construction of a new plant in the United States, where VW plans to build more than 150,000 additional cars?
Winterkorn: No, why should we? I assume that by 2011, when the plant goes online, the United States will have overcome its problems. And then the new model that will be built there will be just the right thing: a car that offers plenty of room and yet is very fuel-efficient.
SPIEGEL: Wouldn't that jeopardize the future of the Emden plant, where the Passat is produced for export to the United States?
Winterkorn: Not at all. The Passat will still be sold in the United States, as will the Jetta and the Golf. We just want to increase our sale in the US with the new model. Our goal for 2018 remains in effect, that is, to be selling 850,000 cars in the US market.
SPIEGEL: You assume that the crisis will have been overcome in two years and that worldwide automobile sales will continue to grow. But growth until now has been based on a credit bubble. Doesn't the industry have to adjust to the fact that future growth will be minimal at best?
Winterkorn: In China, for example, growth will not progress as steeply as expected, at least not initially. But it will happen eventually. Europe and the United States are weak at the moment. But the US will always be an enormous automobile market. You're lost without a car there. Or take Russia: It is a market with three million cars today, but it will eventually be one with five to six million.
SPIEGEL: And Russia has now been hard-hit by the crisis…
Winterkorn: …I know, I know, but don't be so pessimistic! A lot of things were paid for with credit in Russia. Borrowers are now paying 20 to 25 percent interest on those loans. It is clear that there are problems. But Russia has the largest reserves of natural resources, including iron and natural gas. The market will develop in the long term, and the VW Group will benefit from it.
SPIEGEL: With all due respect for your optimism, does VW have the right cars for the future? You have bet on luxury, Bugatti, Bentley and Lamborghini, on 12-cylinder engines. But now affordable and environmentally responsible cars are in demand.
Winterkorn: We proudly unveiled a three-liter Lupo 10 years ago. A few journalists showed up when we unveiled the new model. But 10 years later, when we unveiled a Bugatti model, the photographers practically trampled each other to death. And customers weren't exactly beating down our doors for those three-liter cars. The time is probably ripe for those kinds of cars today. We will unveil a new Polo that consumes 3.5 liters (per 100 km, or 68 mpg) at the Geneva Motor Show.
SPIEGEL: But aren't these just alibi cars, so that you can pursue your true passion and be able to build sports cars like the Audi R8?
Winterkorn: We do both, and I'm proud of that. There are customers who buy sports models and those who buy fuel-efficient cars. This is precisely the strength of a multi-brand group.
SPIEGEL: But the crisis has changed attitudes toward the car for many people. It is seen less as a status symbol and more as a means of transportation. Do you have to revise your model policy?
Winterkorn: We have to shift our emphasis a little. Smaller engines are in demand. One could imagine, for example, an Audi A8 with a four-cylinder diesel engine that consumes only a little more than five liters (47 mpg). That would have been inconceivable a few years ago. But, on the other hand, we will not allow the Lamborghini or Bentley product lines to die for this reason.
SPIEGEL: But their most important customers are gone, for now: the investment bankers, who used to use their bonuses to buy a Bentley or a Lamborghini.
Winterkorn: Yes, and that's why we are selling fewer of those cars, for now. But we have to ask ourselves what a car like this should look like in the future. Perhaps a Bentley has to get an aluminum body, making it 300 to 400 kilos lighter. Or a carbon fiber body for a Lamborghini. In any case, we will continue to develop these brands.
SPIEGEL: The future of another corporate brand is in jeopardy. SEAT sells cars mainly in southern Europe, and these markets are falling away. How long can the VW Group afford losses at SEAT?
Winterkorn: The Spanish car market has been cut almost in half. Instead of 1.6 million, only 800,000 cars are being sold there now. Of course, this has a very strong effect in SEAT, with its 10-percent share of the market. For now, the company is introducing two new models, and we hope that this will stabilize the brand.
SPIEGEL: Has Wendelin Wiedeking, the CEO of Porsche, the majority shareholder in VW, said how he envisions crisis management at VW?
Winterkorn: I believe that Mr. Wiedeking has no need to be concerned about his investment, given the way we approach the crisis. Porsche's investment in VW was certainly the best thing that could have happened, for everyone involved.
SPIEGEL: Would Porsche have stood a chance of surviving the crisis on its own?
Winterkorn: Porsche clearly benefits now from its ability to use technologies from the VW Group. And the benefit to us is that we have two stable major shareholders, Porsche and the state of Lower Saxony.
SPIEGEL: Other carmakers, like Daimler, would be happy to have a major shareholder. Do you think that Daimler can survive the crisis on its own, or will it have to join forces with BMW?
Winterkorn: A crisis is often the reason for two once-hostile companies to launch into a joint venture. But it's difficult even then. Audi has been part of the VW Group for the past 40 years. But the real cooperation did not begin until 1993, when Ferdinand Piëch became chief executive. There has to be someone who decides which technology will be used. Otherwise everyone will want to develop his own engine and will take every opportunity to undermine cooperation.
SPIEGEL: Can you predict which independent automakers will still be around in three years?
Winterkorn: There will be two Americans, one or two Japanese, one French company, and perhaps one large Chinese company. Daimler and BMW will exist. But so much is in flux at the moment that predictions are very difficult.
SPIEGEL: You didn't mention VW. Are you pessimistic about the group?
Winterkorn: On the contrary: I see us as solid. Of course, the crisis is not just passing us by without affecting us. However, we are in a good position, and we will certainly emerge stronger from the crisis.
UK manufacturing weakens for tenth month
The recession in UK manufacturing deepened last month after figures on Monday showed levels of production and employment fell at record rates. The Chartered Institute of Purchasing and Supply's (CIPS) index of overall activity for February came in at 34.7 - the weakest since November's record low of 34.4. It is also the 10th successive month that the industry barometer has been below the critical 50 mark, which signals industry growth. The breakdown shows employment and output at their weakest since the series began in 1992, leading CIPS to estimate around 30,000 UK factory jobs were being axed each month as firms cut costs in the face of weaker demand.
The figures also point to an annual decline in manufacturing production of around 12pc, with larger firms increasingly under pressure. CIPS director Roy Ayliffe said: "While the recession initially hit small and medium-sized companies the worst, larger manufacturers - especially those dependent on the automotive and construction sectors - are increasingly struggling. "And with bigger firms now in the equation, we are seeing jobs slashed at a record rate as firms try to survive the unrelenting market conditions." The rate of decline in new export orders accelerated sharply in February, moving back towards the record seen in December. Despite the mitigating influence of a weaker pound, firms reported reduced demand from East Asia, the eurozone, the Middle East and the United States. Factory gate price deflation was the fastest for almost seven years, reflecting stronger competition, weakening demand and lower costs.
UK mortgage lending plunges by 60%
Mortgage lending dived by more than 60 per cent during January to just one 10th of its level 12 months ago, figures showed today. Net mortgage lending was £690 million during the month, down from £1.79 billion in December, according to the Bank of England. It was the second lowest monthly total recorded by the Bank began since it began to keep statistics in this format in April 1993, and represented a steep dive from the £6.91 billion lent in January last year. Total mortgage advances slumped to £13.64 billion in January, a level last seen in July 2001. But the number of mortgages approved for house purchase remained steady at 31,000, in line with both the previous month's figure and the recent six-month average.
Estate agents have reported a pickup in interest during recent weeks as steep interest rate cuts and house price falls tempt potential buyers back into the market. But this interest has yet to translate into higher sales and, even if consumers are now more willing to buy a property, they are still likely to struggle to get the mortgage they need. Vicky Redwood, UK economist at Global Insight, said the latest lending figures showed that the housing market remained in a "pretty sorry state". She said: "While housing market activity seems to have reached a floor in the past few months, there is still very little sign that the pickup in new buyer interest is feeding through into actual purchases."
Howard Archer, chief UK and European economist, at Global Insight, was also sceptical that increased interest would lead to a marked rise in actual sales "any time soon". He said: "Although housing market activity may well now have bottomed out, it is still at an extremely low level which suggests that further significant falls in house prices are highly likely." The number of people remortgaging continued to fall during January, dropping to 34,000, less than half the 72,000 who switched home loans in October. The steep drop in remortgage numbers is likely to have been caused by lower interest rates making it cheaper for many people to remain on their lenders' standard variable rate, which they revert to at the end of a deal, rather than take out a new mortgage. House price falls of more than 20 per cent will also have eroded the level of equity many people have in their property, making it difficult for them to switch provider or qualify for the best rates.
Dutch pensions under pressure
More than 4.7 million Dutch run the risk that their pension fund will have to lower the pensions it pays out in the coming years in order to avoid collapse. This concerns (former) employees and pension recipients from large industry pension funds, such as the fund for the metal working sector, the pension fund for civil servants and teachers and several company pension funds. Social affairs minister Piet Hein Donner extended the term last week in which pension funds must get their position in order. Normally they have three years to do so after they run into trouble, as they have because of the economic crisis, that has now been extended to five years.
The sector fears that even this is not enough time. Trade union confederation FNV, which is represented on the boards of dozens of large industry pension funds, is calling for more time to avoid draconian measures. In the Netherlands, pension funds are required by law to have assets of at least 1.05 for every euro of committed pension. Pension experts say that the danger zone is from 0.90 euros and downwards – what the sector calls a coverage ratio of 90 percent (or lower). "With 90 percent or lower, an average fund cannot manage to reach 105 percent in five years' time without taking drastic measures, like raising premiums or lowering the amount of pensions paid out to recipients," says Dennis van Ek of consultancy firm Mercer.
The banks and insurers that finance minister Wouter Bos has spent billions of euros to bail out over the past months were all financially healthy, but the pension sector is in essence bankrupt. "Many pension funds" had a shortage of assets at the end of 2008. "There is a problem of solvency," social affairs minister Donner wrote to Dutch parliament. Numerous pension funds are in a position where their obligations exceed their assets. Regular companies that have an shortage of assets and can no longer raise capital simply go bankrupt. But pension funds are different.
They are like piggy banks in the Netherlands, holding a total of 600 billion euros. Capital is the least of their problems. Creditors such as pension recipients may try to have their pension funds declared bankrupt, but it is doubtful whether a court will actually do that. As the pension world and minister Donner have repeatedly assured us: the payment of pensions is not in danger. "A few hundred funds" are facing problems, Donner writes. That is half of all funds. For the sake of comparison: in the pension crisis of 2001-2003, about 200 funds were involved, a quarter of all funds at the time. That crisis thinned out the number of funds: smaller funds have since sought shelter at larger funds or at commercial insurers.
In the 2001-2003 crisis, in the wake of the internet boom, the financial position of the pension funds was poor, but not as poor as it is now. The ratio of investments to pension obligations, the coverage ratio, was at a low point for the pension sector as a whole at 99 percent (on 31 March 2003). The average coverage ratio is currently between 90 and 95 percent, Donner writes, with a few exceptions above and below this range. He is not giving any exact figures. The low point of the last pension crisis was at the end of March 2003. The Dutch stock market index AEX hit 218 points. The index has hit that same point several times over the past week.
The fall in the interest rate causes further headache, since it pushes up the current value of the pension obligations: with a low interest rate, funds now need more money in order to pay pensions later. Pension funds can insure themselves against this risk and some have done so effectively. There will not be any large-scale premium increases as during the previous crisis. Pension premiums are currently at maximum, cost-covering levels. Moreover employers are in fact cutting their costs and are not prepared to increase these with extra pension premiums.
Freezing pensions is currently the most common solution for the short term. That is also a form of economising, as in the last crisis. Minister Donner has suspended the period that pension funds are given to recover before they have to lower the pensions they pay out. For pension funds with a coverage ratio of less than 90 percent, it will be a tough upward struggle to reach 105 percent within five years. The price of recovery is a freeze on pensions for several years. That means a fall in the purchasing power of the elderly and a standstill to the pension growth of workers. Pension funds that expect that they will not reach the 105 percent will have to quickly take drastic measures, such as lowering pension entitlements.
The FNV union therefore wants to give the funds more than five years' time. Union related funds with an ageing workforce are more vulnerable to setbacks than funds with many young people who will continue to pay premiums for another few decades. At the same time as the solvency crisis, the minister wants to discuss with the sector "the tenability of the pension system in the long term." A painful revelation for politicians and for the sector: the pension legislation from 2006 presupposes there will be a crisis once in forty years. The reality is now once in six years.
France to slash GDP forecasts
France is poised to slash its economic forecasts and will soon concede that GDP is likely to fall 1.5 percent this year rather than to grow, a spokesman from the economy ministry said on Monday. France still officially forecasts economic growth of between 0.2 and 0.5 percent this year, but government officials including Economy Minister Christine Lagarde have warned of the need to revise their optimism due to deteriorating conditions. Confirming information leaked by French daily Le Figaro, the spokesman said more than 300,000 people were expected to lose their jobs in France this year as the global slowdown takes its toll on the euro zone's second-biggest economy. France's deficit as a proportion of gross domestic product (GDP) was likely to rise to five percent of GDP, well above the European Union's limit of three percent, the spokesman said. France last cut its economic forecasts in November last year, when it projected slight growth in 2009 despite the ravages of the global financial crisis. Before those revisions, it had expected the economy to expand one percent in 2009.
British military facing becoming 'second division without major spending increase'
Britain must increase its defence spending by 15 billion a year or accept that it has become a "second division" military power, a major independent report has warned. The shortfall in the armed forces' budget has reached such a critical point that the Government may soon have little choice but to scrap key orders for equipment such as aircraft carriers, armoured vehicles or even the replacement for the Trident nuclear missile programme, it claims. In a foreword to the report, Winston Churchill, the grandson of the wartime prime minister, bluntly states that if defence spending stays at its current level, Britain's armed forces will "no longer play a significant role on the world stage". He said the country will lose its seat at the "top table" of international affairs, becoming "unable to defend her wider interests". He adds that a shortfall in defence funding over the past 10 years has left the armed forces "stretched to breaking point by a combination of over-commitment and under-resourcing".
The report, published by the UK National Defence Association, comes after Britain's most decorated serving soldier, Lance Corporal Johnson Beharry VC, berated the Government for its "disgraceful" failure to provide proper mental health treatment for servicemen returning from Iraq and Afghanistan. The Government has faced persistent accusations of failing to honour its "covenant" with the armed forces since the Afghanistan conflict began in 2001. Senior officers have questioned ministers' commitment to the forces after such controversies as the failure to replace lightly-armoured Snatch Land Rovers to patrol heavily mined areas, which has led to dozens of avoidable deaths and injuries. Scandals over the state of forces housing, medical care and payments to severely injured veterans have also highlighted the lack of funding. The UKNDA, an independent body which campaigns on behalf of the armed forces, states that the cost of "repairing" the armed forces, if Britain is to continue with its current foreign policies as well as funding major orders for equipment, will be 15 billion per year. The represents a 40 per cent increase on the current 35 billion budget, but little more than the amount of money written off at a stroke to fund the recent 2.5 per cent VAT cut.
The report's author, Tony Edwards, a former head of defence export services at the Ministry of Defence, says that either Gordon Brown or his successor at the next general election faces a clear choice: either to "repair the damage" of over-stretch in Iraq and Afghanistan or to "lower our profile in the world at large". He said: "The Prime Minister could decide to continue with the current defence budget and instead lower the foreign policy and defence expectations. "Because current defence spending is out of balance with current foreign and defence policy expectations, this will involve massive reductions and cancellations of already announced programmes. "In the next five years, at current spending levels, the UK will become a middling second division military power, behind countries like India and Japan. "It is worth pointing out that repairing the armed forces, and restoring balance and morale, is probably more important than acquiring some of the new capital equipment." Among the projects which could be cut if the Government does not increase defence spending are the aircraft carriers HMS Queen Elizabeth and HMS Prince of Wales, which will cost 2 billion each; the Harrier jump jet's replacement, the F-35, which will cost 15bn, or even the replacement for the submarine-borne Trident nuclear missile, which will cost 40-70bn over 30 years.
Mr Edwards said: "The United Kingdom's armed forces have been engaged in almost continuous operations for the past 20 years. "It used to be said that Britain punched above its weight in world affairs, but more recently this has meant that our overstretched armed forces have had to punch above their budget, a far more difficult feat." Mr Edwards said the government had delayed making a decision on defence spending until after the next general election by keeping everything "in the air", such as orders for two aircraft carriers, which have been put back by two years. But, he said: "The next Prime Minister, whether it be Gordon Brown or David Cameron, will no longer be able to avoid making a decision." Gerald Howarth, the shadow defence minister, said: "We are hugely conscious that the Labour government has totally failed to provide the necessary resources to fund two wars. "We can't continue to ask the brave men and women of our armed forces to do what they are doing on the resources that have been given to them, and the Conservatives will conduct an immediate review of defence spending on entering office." The report has been endorsed by patrons including Lord Owen and the former chiefs of the defence staff General The Lord Guthrie and Marshal of the RAF Sir Peter Harding.
Some states picking economy over environment regulations
The call for economic stimulus is having an unintended side effect in places like Montana, where environmental protections are on the verge of being repealed in the name of jobs. One bill gets straight to the issue — promising to exempt hundreds of millions in economic stimulus projects from the state's landmark environmental policies. Environmentalists are ramping up lobbying efforts as a wave of measures eroding regulatory rules gain serious traction in the face of a recession and shrinking state coffers. "It is about jobs," said Sen. Jim Keane, a Democrat from the mining town of Butte. "But I think the issue is much bigger than that. All these projects also generate new taxes and revenue for the state government."
Proponents are hoping to ease the way for everything from new coal plants to electricity transmission lines. They say complex rules killed a utility's recently failed plan to build a coal-fired electricity plant near Great Falls; the utility now plans a smaller natural-gas-fired plant. Montana is not entirely alone. Some other states facing unprecedented budget shortfalls amid a deepening recession want to make sure that current or planned environmental protections don't get in the way of building projects and economic recovery. In California, lawmakers relaxed environmental laws for road projects and construction equipment in the name of economic stimulus as part of a recently approved budget package. In Idaho, lawmakers shut down new regulations for septic-tank drain fields because they feared it would hinder Idaho's economy, especially during a recession.
Utah is even considering a company's offer to take nuclear waste in exchange for needed cash. In Kansas, lawmakers are pushing for legislation that would pave the way for coal-fired power plants in the southwest part of the state — though Democratic Gov. Kathleen Sebelius has promised a veto. The move to weaken environmental protections isn't gaining steam everywhere. In Michigan, for instance, Democratic Gov. Jennifer Granholm is talking about tightening environmental regulation when it comes to coal-fired power plants. Republicans don't have the votes to impose less regulation. Montana environmentalists are on edge like they haven't been in years because of the louder cry for jobs over environmental protection.
"I do think it makes it harder," said veteran lobbyist Anne Hedges, with the Montana Environmental Information Center. "I think it makes it harder for legislators that are nervous about their constituents being nervous. And they want to tell their constituents they are doing everything they can." The conservationists are fighting back against the notion there has to be a choice between jobs and environmental regulation, saying new "green" jobs should be the future. Backers of cutting regulation argue that doing so would make it easier not only to build coal-fired plants, but to build wind farms and the new power lines needed to carry the energy to large cities.
Montana lawmakers are separately going to be looking at ways to spend federal stimulus money on some "green" jobs, such as improving the efficiency of government buildings. Some of the dozen or so bills that ease environmental permitting and restrict lawsuits and regulation will likely be killed in the coming weeks — but not all of them, Hedges said. That could leave the issue up to the state's self-proclaimed energy governor, Democrat Brian Schweitzer. He has so far been quiet on the bills — but early on in the session he met with environmentalists and urged them to keep doing battle against the "row of vultures" representing corporate interests.
"The vultures smell blood and they are going to exploit that," Hedges said. "We are going to need the governor's help." Republican Sen. Greg Barkus of Kalispell, pushing the exemption of stimulus projects from the state environmental law, said he understands environmentalists are worried. "But they don't need to be, because nobody is out to trash the environment," Barkus said. "But we need to move. This economy is scaring the dickens out of me, and a lot of other people."
How to survive the coming century
Alligators basking off the English coast; a vast Brazilian desert; the mythical lost cities of Saigon, New Orleans, Venice and Mumbai; and 90 per cent of humanity vanished. Welcome to the world warmed by 4 °C. Clearly this is a vision of the future that no one wants, but it might happen. Fearing that the best efforts to curb greenhouse gas emissions may fail, or that planetary climate feedback mechanisms will accelerate warming, some scientists and economists are considering not only what this world of the future might be like, but how it could sustain a growing human population. They argue that surviving in the kinds of numbers that exist today, or even more, will be possible, but only if we use our uniquely human ingenuity to cooperate as a species to radically reorganise our world.
The good news is that the survival of humankind itself is not at stake: the species could continue if only a couple of hundred individuals remained. But maintaining the current global population of nearly 7 billion, or more, is going to require serious planning. Four degrees may not sound like much - after all, it is less than a typical temperature change between night and day. It might sound quite pleasant, like moving to Florida from Boston, say, or retiring from the UK to southern Spain. An average warming of the entire globe by 4 °C is a very different matter, however, and would render the planet unrecognisable from anything humans have ever experienced. Indeed, human activity has and will have such a great impact that some have proposed describing the time from the 18th century onward as a new geological era, marked by human activity. "It can be considered the Anthropocene," says Nobel prizewinning atmospheric chemist Paul Crutzen of the Max Planck Institute for Chemistry in Mainz, Germany.
A 4 °C rise could easily occur. The 2007 report of the Intergovernmental Panel on Climate Change, whose conclusions are generally accepted as conservative, predicted a rise of anywhere between 2 °C and 6.4 °C this century. And in August 2008, Bob Watson, former chair of the IPCC, warned that the world should work on mitigation and adaptation strategies to "prepare for 4 °C of warming". A key factor in how well we deal with a warmer world is how much time we have to adapt. When, and if, we get this hot depends not only on how much greenhouse gas we pump into the atmosphere and how quickly, but how sensitive the world's climate is to these gases. It also depends whether "tipping points" are reached, in which climate feedback mechanisms rapidly speed warming. According to models, we could cook the planet by 4 °C by 2100. Some scientists fear that we may get there as soon as 2050. If this happens, the ramifications for life on Earth are so terrifying that many scientists contacted for this article preferred not to contemplate them, saying only that we should concentrate on reducing emissions to a level where such a rise is known only in nightmares.
"Climatologists tend to fall into two camps: there are the cautious ones who say we need to cut emissions and won't even think about high global temperatures; and there are the ones who tell us to run for the hills because we're all doomed," says Peter Cox, who studies the dynamics of climate systems at the University of Exeter, UK. "I prefer a middle ground. We have to accept that changes are inevitable and start to adapt now." Bearing in mind that a generation alive today might experience the scary side of these climate predictions, let us head bravely into this hotter world and consider whether and how we could survive it with most of our population intact. What might this future hold? The last time the world experienced temperature rises of this magnitude was 55 million years ago, after the so-called Palaeocene-Eocene Thermal Maximum event. Then, the culprits were clathrates - large areas of frozen, chemically caged methane - which were released from the deep ocean in explosive belches that filled the atmosphere with around 5 gigatonnes of carbon. The already warm planet rocketed by 5 or 6 °C, tropical forests sprang up in ice-free polar regions, and the oceans turned so acidic from dissolved carbon dioxide that there was a vast die-off of sea life. Sea levels rose to 100 metres higher than today's and desert stretched from southern Africa into Europe.
While the exact changes would depend on how quickly the temperature rose and how much polar ice melted, we can expect similar scenarios to unfold this time around. The first problem would be that many of the places where people live and grow food would no longer be suitable for either. Rising sea levels - from thermal expansion of the oceans, melting glaciers and storm surges - would drown today's coastal regions in up to 2 metres of water initially, and possibly much more if the Greenland ice sheet and parts of Antarctica were to melt. "It's hard to see west Antarctica's ice sheets surviving the century, meaning a sea-level rise of at least 1 or 2 metres," says climatologist James Hansen, who heads NASA's Goddard Institute for Space Studies in New York. "CO2 concentrations of 550 parts per million [compared with about 385 ppm now] would be disastrous," he adds, "certainly leading to an ice-free planet, with sea level about 80 metres higher... and the trip getting there would be horrendous."
Half of the world's surface lies in the tropics, between 30° and -30° latitude, and these areas are particularly vulnerable to climate change. India, Bangladesh and Pakistan, for example, will feel the force of a shorter but fiercer Asian monsoon, which will probably cause even more devastating floods than the area suffers now. Yet because the land will be hotter, this water will evaporate faster, leaving drought across Asia. Bangladesh stands to lose a third of its land area - including its main bread basket. The African monsoon, although less well understood, is expected to become more intense, possibly leading to a greening of the semi-arid Sahel region, which stretches across the continent south of the Sahara desert. Other models, however, predict a worsening of drought all over Africa. A lack of fresh water will be felt elsewhere in the world, too, with warmer temperatures reducing soil moisture across China, the south-west US, Central America, most of South America and Australia.
All of the world's major deserts are predicted to expand, with the Sahara reaching right into central Europe. Glacial retreat will dry Europe's rivers from the Danube to the Rhine, with similar effects in mountainous regions including the Peruvian Andes, and the Himalayan and Karakoram ranges, which as result will no longer supply water to Afghanistan, Pakistan, China, Bhutan, India and Vietnam. Along with the exhaustion of aquifers, all this will lead to two latitudinal dry belts where human habitation will be impossible, say Syukuro Manabe of Tokyo University, Japan, and his colleagues. One will stretch across Central America, southern Europe and north Africa, south Asia and Japan; while the other will cover Madagascar, southern Africa, the Pacific Islands, and most of Australia and Chile.
The only places we will be guaranteed enough water will be in the high latitudes. "Everything in that region will be growing like mad. That's where all the life will be," says former NASA scientist James Lovelock, who developed the "Gaia" theory, which describes the Earth as a self-regulating entity. "The rest of the world will be largely desert with a few oases." So if only a fraction of the planet will be habitable, how will our vast population survive? Some, like Lovelock, are less than optimistic. "Humans are in a pretty difficult position and I don't think they are clever enough to handle what's ahead. I think they'll survive as a species all right, but the cull during this century is going to be huge," he says. "The number remaining at the end of the century will probably be a billion or less."
John Schellnhuber of the Potsdam Institute for Climate Impacts Research in Germany is more hopeful. The 4 °C warmer world would be a huge challenge, he says, but one we could rise to. "Would we be able to live within our resources, in this world? I think it could work with a new division of land and production."
In order to survive, humans may need to do something radical: rethink our society not along geopolitical lines but in terms of resource distribution. "We are locked into a mindset that each country has to be self-sustaining in food, water and energy," Cox says. "We need to look at the world afresh and see it in terms of where the resources are, and then plan the population, food and energy production around that. If aliens came to Earth they'd think it was crazy that some of the driest parts of the world, such as Pakistan and Egypt, grow some of the thirstiest crops for export, like rice."
Taking politics out of the equation may seem unrealistic: conflict over resources will likely increase significantly as the climate changes, and political leaders are not going to give up their power just like that. Nevertheless, overcoming political hurdles may be our only chance. "It's too late for us," says President Anote Tong of Kiribati, a submerging island state in Micronesia, which has a programme of gradual migration to Australia and New Zealand. "We need to do something drastic to remove national boundaries." Cox agrees: "If it turns out that the only thing preventing our survival was national barriers then we would need to address this - our survival is too important," he says.
Imagine, for the purposes of this thought experiment, that we have 9 billion people to save - 2 billion more than live on the planet today. A wholescale relocation of the world's population according to the geography of resources means abandoning huge tracts of the globe and moving people to where the water is. Most climate models agree that the far north and south of the planet will see an increase in precipitation. In the northern hemisphere this includes Canada, Siberia, Scandinavia and newly ice-free parts of Greenland; in the southern hemisphere, Patagonia, Tasmania and the far north of Australia, New Zealand and perhaps newly ice-free parts of the western Antarctic coast.
If we allow 20 square metres of space per person - more than double the minimum habitable space allowed per person under English planning regulations - 9 million people would need 18,000 square kilometres of land to live on. The area of Canada alone is 9.1 million square kilometres and, combined with all the other high-latitude areas, such as Alaska, Britain, Russia and Scandinavia, there should be plenty of room for everyone, even with the effects of sea-level rise.
These precious lands with access to water would be valuable food-growing areas, as well as the last oases for many species, so people would be need to be housed in compact, high-rise cities. Living this closely together will bring problems of its own. Disease could easily spread through the crowded population so early warning systems will be needed to monitor any outbreaks.
It may also get very hot. Cities can produce 2 °C of additional localised warming because of energy use and things like poor reflectivity of buildings and lower rates of evaporation from concrete surfaces, says Mark McCarthy, an urban climate modeller at the UK Met Office's Hadley Centre. "The roofs could be painted a light, reflective colour and planted with vegetation," McCarthy suggests. Since water will be scarce, food production will need to be far more efficient. Hot growing seasons will be more common, meaning that livestock will become increasingly stressed, and crop growing seasons will shorten, according to David Battisti of the University of Washington in Seattle and his colleagues. We will need heat and drought-tolerant crop varieties, they suggest. Rice may have to give way to less thirsty staples such as potatoes.
This will probably be a mostly vegetarian world: the warming, acidic seas will be largely devoid of fish, thanks to a crash in plankton that use calcium carbonate to build shells. Molluscs, also unable to grow their carbonate shells, will become extinct. Poultry may be viable on the edges of farmland but there will simply be no room to graze cattle. Livestock may be restricted to hardy animals such as goats, which can survive on desert scrub. One consequence of the lack of cattle will be a need for alternative fertilisers - processed human waste is a possibility. Synthetic meats and other foods could meet some of the demand. Cultivation of algal mats, and crops grown on floating platforms and in marshland could also contribute.
Supplying energy to our cities will also require some adventurous thinking. Much of it could be covered by a giant solar belt, a vast array of solar collectors that would run across north Africa, the Middle East and the southern US. Last December, David Wheeler and Kevin Ummel of the Center for Global Development in Washington DC calculated that a 110,000-square-kilometre area of solar panels across Jordan, Libya and Morocco would be "sufficient to meet 50 to 70 per cent of worldwide electricity production, or about three times [today's] power consumption in Europe". High-voltage direct current transmission lines could relay this power to the cities, or it could be stored and transported in hydrogen - after using solar energy to split water in fuel cells.
If the comparatively modest level of solar installation that Wheeler and Ummel propose were to begin in 2010, the total power delivery by 2020 could be 55 terawatt hours per year - enough to meet the household electricity demand of 35 million people. This is clearly not enough to provide power for our future 9 billion, but improving efficiency would reduce energy consumption. And a global solar belt would be far larger than the one Wheeler and Ummel visualise.
Nuclear, wind and hydropower could supplement output, with additional power from geothermal and offshore wind sources. Each high-rise community housing block could also have its own combined heat and power generator, running on sustainable sources, to supply most household energy.
If we use land, energy, food and water efficiently, our population has a chance of surviving - provided we have the time and willingness to adapt. "I'm optimistic that we can reduce catastrophic loss of life and reduce the most severe impacts," says Peter Falloon, a climate impacts specialist at the Hadley Centre. "I think there's enough knowledge now, and if it's used sensibly we could adapt to the climate change that we're already committed to for the next 30 or 40 years." This really would be survival, though, in a world that few would choose to live. Large chunks of Earth's biodiversity would vanish because species won't be able to adapt quickly enough to higher temperatures, lack of water, loss of ecosystems, or because starving humans had eaten them. "You can forget lions and tigers: if it moves we'll have eaten it," says Lovelock. "People will be desperate."
Still, if we should find ourselves in such a state you can bet we'd be working our hardest to get that green and pleasant world back, and to prevent matters getting even worse. This would involve trying to limit the effects climate feedback mechanisms and restoring natural carbon sequestration by reinstating tropical forest. "Our survival would very much depend on how well we were able to draw down CO2 to 280 parts per million," Schellnhuber says. Many scientists think replanting the forests would be impossible above a certain temperature, but it may be possible to reforest areas known as "land-atmosphere hotspots", where even small numbers of trees can change the local climate enough to increase rainfall and allow forests to grow.
Ascension Island, a remote outpost buffeted by trade winds in the mid-Atlantic, may be a blueprint for this type of bioengineering. Until people arrived in the 17th century, vegetation was limited to just 25 scrubby species. But plantings by British servicemen posted there produced a verdant cloud forest. "It shows that if you have rainfall, forest can grow within a century," says ecologist David Wilkinson of Liverpool John Moores University in the UK, who studied the phenomenon. Even so, the most terrifying prospect of a world warmed by 4 °C is that it may be impossible to return to anything resembling today's varied and abundant Earth. Worse still, most models agree that once there is a 4 °C rise, the juggernaut of warming will be unstoppable, and humanity's fate more uncertain than ever. "I would like to be optimistic that we'll survive, but I've got no good reason to be," says Crutzen. "In order to be safe, we would have to reduce our carbon emissions by 70 per cent by 2015. We are currently putting in 3 per cent more each year."
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