[A-List] New economy bull

["Keaney Michael" <Michael.Keaney@xxxxxx>]

Here's another fine article from A-lister Henry.


Creative accounting and the destructive risk
By Henry C K Liu
Asia Times, April 3, 2002

Alan Greenspan, chairman of the US Federal Reserve Board, frequently
credits US growth in the 1990s to a rise in productivity made possible
by advances in technology. Yet studies have shown that computerization
did not simulate much rise in industrial productivity in the 1990s.
Industrial computerization was essentially in place long before 1995.
The 1990s boom in the US was not an industrial boom but a financial
boom. This was made possible by three developments: the deregulation of
financial markets, the computerization of trading of financial
instruments, and globalization, particularly financial globalization.

The entire structured finance (derivatives) phenomenon would not be
possible without any one of the above mentioned developments. Structured
finance in essence allowed an unprecedented explosion of credit, by
unbundling risks for a wide range of risk-takers who sought
corresponding compensatory returns. While hedging initially provided
protection against volatility to individual market participants, it soon
became a profit center for financial institutions. This led to the
institutionalization of volatility as a market opportunity. Financial
institutions actually sought volatility in the system to provide a
continuous profit stream.

Creative accounting, whose peculiar logic evolved from structured
finance, also made the traditional debt/equity ratio immaterial. Ways
were devised for the large market participants to structure debt as
hedges, through swaps that avoided taxes and balance-sheet liabilities.
Swaps enabled borrowers legally to book loan proceeds as current
operating income and loan liabilities as future capital expenditure that
could be kept off the balance sheet, inflating current earnings.
Circular counterparty risks suddenly became neutralized risk, and cash
flow from swaps became net revenue. These practices are now known as
Enronitis.

On the macro level, the global finance game has become a sure win for
those who use dollars, especially those whose government issues dollars
by fiat. The world market has become a place where the United States
makes dollars and the rest of the world makes what dollars can buy. But
after the Asian financial crisis of 1997, the whole world essentially
adopted dollarization, if not directly, at least through hedges, albeit
sometimes at prohibitive cost.

At that point, the US economy suddenly began to lose its exclusive
dollar hegemony advantage because US entities were no longer the only
ones with access to dollars nor could US transnationals avoid non-dollar
revenue. To maintain the "strong dollar" monetary policy instituted by
US treasury secretary Robert Rubin at the beginning of the Bill Clinton
presidency, the US Federal Reserve progressively tightened dollar money
supply throughout most of the 1990s. But this did not slow the US
economy because structured finance permitted debt to expand without a
corresponding expansion of equity. A strong dollar gave the US economy a
boom in low-cost imports, while the US trade deficit merely forced
foreign exporters to hold dollar reserves to finance the US debt bubble
through a US capital account surplus. Japan did this for a whole decade,
pushing its own economy into permanent recession while its dollar
reserves mounted. Mainland China, Hong Kong and Taiwan took up the slack
from Japan by 1995 and the three Chinese economies together now hold
more dollar reserves than Japan does. China, starved for capital for
domestic development, thus finds itself stuck with US$200 billion in US
Treasury bills that pay 5 percent while it is forced to offer foreign
direct investment high double-digit returns. The annual interest gap
alone is in excess of $20 billion, which amounts to half of China's
current annual foreign-capital inflow.

Growth in the 1990s came from a structural shift of the US economy from
industrial capitalism to finance capitalism. Through financial
globalization, the US shifted labor intensive manufacturing off US soil
to low-wage locations, thus lowering the cost of manufactured products.
Financial products and services and intellectual property valuation
constituted most of the growth, making the US a consumer market of last
resort for the whole world. London, Frankfurt, Paris, Tokyo, Hong Kong
and Singapore became financial outposts of New York, sucking up dollar
reserves to support the US debt bubble.

This game is ending, as the US consumer market becomes saturated and
condemned to low single-digit growth, regardless of business cycles. The
wealth effect from a tripling of equity value did not double consumption
in the US, because aggregate demand is constrained by a widening income
disparity. The rich have bought all the manufactured products they need
and the working poor cannot afford to buy all they want. The wealth
effect did double investment globally, reflected in the phenomenal rise
in market capitalization of US transnationals and financial
institutions, particularly in the so-called New Economy. The competition
for credit favored double-digit growth markets in the developing
countries, but the US continued to dominate global finance through its
sophistication and innovation in finance and through dollar hegemony.

The problem is that all unregulated markets eventually self-destruct.
Weak competitors are naturally forced off the market, leading to
monopolies that are the result of market failure of competition. Yet
regulation cannot cure the problem preemptively because remedial
regulation only makes sense after disasters, never before.

There is increasing evidence that the real threat to China is not
democracy or the market economy per se but the peculiar US version of
these institutions. The 19th-century industrial capitalism that Marx
observed no longer exists. Finance capitalism is a system in which
capital is only a notional value upon which to build a gigantic mountain
of hidden debt. Representative democracy and unregulated market
fundamentalism in the US mode now work as legalized constitutional
devices to disfranchise the poor and weak, both locally and globally.

Greenspan acknowledged this in his semiannual monetary policy report to
the US Congress, before the Committee on Financial Services on February
27: "From one perspective, the ever-increasing proportion of our GDP
[gross domestic product] that represents conceptual as distinct from
physical value-added may actually have lessened cyclical volatility. In
particular, the fact that concepts cannot be held as inventories means a
greater share of GDP is not subject to a type of dynamics that amplifies
cyclical swings. But an economy in which concepts form an important
share of valuation has its own vulnerabilities." He was of course
referring to Enronitis.

Greenspan's observation about the vulnerabilities of conceptual
valuation was on target, although his warning of vulnerability was
disproportionately misplaced. Even after the Enron and Global Crossing
controversies, Greenspan continues to resist regulation, preferring to
rely on market discipline. The risk is much higher than he admits.

Past records do not reliably project future vulnerability risk. Any risk
manager knows that accidents are always waiting to happen. The fact that
it has not happened in the past does not mean it will not happen in the
future. In fact, with each passing day without an accident, the risk of
borrowed time increases. Low probability is only a source of comfort if
the impact is not fatal.

Also, what Greenspan did not say, but admitted by implication, was that
finance capitalism is operating with less and less reliance on capital.
Capital has become a notional value in structured finance. Credit is no
longer anchored by equity but by circular hedges. Debt-to-equity ratio
is no longer a relevant consideration. Practically all US major
businesses nowadays, with their high debt leverage, would have negative
real equity if the price/earning (P/E) ratio were to return to
historical norms. Blue chips are being shut out of the unsecured
short-term commercial paper market. Corporate credit ratings are
inflated by exorbitant market capitalization value, which in turn
reflects irrational P/E ratios. Even now, during what many on Wall
Street contend to be a savage bear market, the Standard & Poor's 500
Index yields 25 times earnings. It would have to fall by another 41
percent to reach the median valuation prevailing since 1957.

Such a decline can happen in a period of days in this age of program
trading and socialized risk, even with circuit breakers and trading
curbs. When that happens, structured finance will be a sea of dead and
wounded in counterparty casualties, regardless of who won and who lost.

Full article at:
http://www.atimes.com/global-econ/DD03Dj01.html

Michael Keaney
Mercuria Business School
Martinlaaksontie 36
01620 Vantaa
Finland

michael.keaney@xxxxxx