[A-List] Global Economy

[Mark Jones <markjones011@xxxxxxxxxxxxx>]

[Here, for accessibility and the archive, is Henry's entire text, which
should be required reading for anyone who wants to understand what the
roots of the New Depression are. Mark]







Perils of the debt-propelled economy
By Henry C K Liu

Economics is a complex subject. Any subject, however complex, if looked at
in the right way, will become even more complex. This fact baffles many
experts who tend to avoid small errors meticulously while sweeping on to
grand fallacy.

One of the shortcomings of economics is the inadequate attention paid to it
as a behavioral science. The problem can be traced to the neoclassical
concept of the economic man who is supposed to act rationally in his own
interest which in a money economy is generally defined rather
simplistically as financial gain. Economics is obviously more than finance,
and economic well-being is not synonymous with financial gain. Modern
economics of course deals with the problem of human behavior with some
sophistication, albeit always through the back door, and always equating
self-interest with rational individual response to pricing. A market
economy is coordinated through the price system operating on the principle
of marginal utility.

Economists construct indifference curves to show consumer preferences. In
economics, the effect on consumption of a pure change in price is shown in
an income-compensated demand curve (also known as a Hicksian demand curve
after economist John Hicks - 1904-89). A Marshallian demand curve (after
economist Alfred Marshall - 1842-1924) is based on the concept of marginal
utility. Marginal utility is observed only through choices. Marginal
utility in consumption is simply a problem of choosing the bundle of goods
that maximizes a buyer's utility, subject to the income constraint - the
requirement that the bundle the consumer chooses costs no more than the
buyer's disposable income.

Yet the demand for goods is affected by human behavior. A good whose
consumption increases when its price goes up is called a Giffen good, after
Robert Giffen, a 19th-century English statistician, who noted that Irish
peasants bought more potatoes when the price of potatoes rose. This
contradicted the law of demand, one of the basic laws of economics. For the
poor Irish peasants, potatoes, as the main staple, took up a huge share of
their income. If the price of potatoes went up, the share of their income
available to purchase other foods would shrink markedly, forcing them to
consume more potatoes to make up the difference.

Giffen goods are also necessary for conspicuous consumption. When
high-price items go up further in price regularly, such as art objects,
more buyers will enter the market, bidding up prices even more. Tulip bulbs
during the speculative bubble in Holland in the 17th century were
overpriced Giffen goods. The stock market is full of Giffen goods. When a
share price goes up, it attracts more buyers. Real estate is often a Giffen
good, particularly in places like Hong Kong where the real-estate market is
fundamentally controlled by the government through control of the supply of
land.

When housing prices rise over long periods, more buyers enter the housing
market. The increased demand created by anticipated price appreciation more
than offsets the fall in demand caused by price increases. And price
deflation in housing creates a downward spiral of shrinking demand, a
phenomenon easily observed in recent years all over Asia, from Tokyo to
Hong Kong to Singapore. Public health and commercial medicine have
characteristics of Giffen goods. When the price of medicine rises, more
people tend to get ill due to less preventive use of medicine, causing
aggregate demand for medicine to rise.

An inferior good is a good that one buys less of when one's income rises,
because one can afford a superior good by comparison, even if the inferior
good may also rise in price. During periods of prosperity, when income
rises generally faster than prices, inferior goods are separated from
Giffen goods. During periods of recession, when income falls generally
while prices remain the same or continue to rise, inferior goods and Giffen
goods tend to merge. A Giffen good must be an inferior good, but most
inferior goods are not Giffen goods.

Credit drives the economy, not debt. Debt is the mirror reflection of
credit. Even the most accurate mirror does violence to the symmetry of its
reflection. Why does a mirror turn an image right to left and not upside
down as the lens of a camera does? The scientific answer is that a mirror
image transforms front to back rather than left to right as commonly
assumed. Yet we often accept this aberrant mirror distortion as uncolored
truth and we unthinkingly consider the flawed reflection in the mirror as a
perfect representation.

Similarly, we reflexively accept as exact fidelity the encrypted labels
assigned to our thoughts by the distorting mirror of language. Such
habitual faulty acceptance is consequential because it is through language
that ideas are transmitted and around language that culture develops.

In the language of economics, credit and debt are related but not the same.
In fact, credit and debt operate in reverse relations. Credit requires a
positive net worth and debt does not. One can have good credit and no debt.
Too much debt lowers credit rating. When one understands credit, one
understands the main force behind the modern economy, which is driven by
credit and stalled by debt. Behaviorally, debt distorts marginal utility
calculations and rearranges disposable income. Thus debt turns more
commodities into Giffen goods and creates what US Federal Reserve Board
chairman Alan Greenspan calls "irrational exuberance", the economic man
gone mad.

Human behavior is complex beyond the measurement of price. Price alone is
not sufficient to influence market behavior. Karl Marx dealt with the
concept of fetish as a factor in demand as expressed in price.

Education is a classic dilemma. Economics literature has never dealt
satisfactorily with education, being unable to decide whether it is
consumption or investment or both. It has done similarly with health care
and environmental preservation. If these endeavors are consumption, the law
of scarcity dictates that society cannot afford too much of them. If they
are investment, then supply-side theory would conclude the more the better.
If they are both consumption and investment, there should be a limitless
upward spiraling supply/demand symbiosis. One could not possibly have an
over-educated society or over-healthy population or an over-clean
environment, if being more educated, more healthy and more clean is deemed
economically productive and thus financially profitable.

It is obvious that debt changes human behavior. A little debt reinforces
responsibility. The US social system of private property is built on the
notion that homeowners with a life-long mortgage are better citizens than
renters. People tend to take better care of their homes and plant roots in
their communities if they "own" their homes, even though 90 percent of the
purchase value is in debt that is not expected to be paid off until three
decades later.

On the other hand, it is clear that excessive debt encourages
irresponsibility. The borrower may develop an irresistible incentive to
walk away from his debt if he perceives the debt to be beyond his ability
to repay, or the cost of the debt to exceed its benefits. Even a central
bank, which is the domestic lender of last resort, is wary of the problem
of moral hazard, that commercial banks within its system would lend
irresponsibly if they knew that their lending errors would be bailed out by
the central bank.

The US bankruptcy regime is designed to give trapped debtors a fresh start
from distressed debt to reestablish credit. Unlike European precedents, one
cannot be jailed in the United States for failing to pay one's debt, unless
criminal fraud is involved. In fact, there is a legal concept of lender
liability, based on which a distressed debtor can sue the lender for
damages for lending money irresponsibly that led the debtor into financial
trouble.

Lender liability is embodied in common and statutory law covering a broad
spectrum of claims surrounding predatory lending. It is a key concept in
environmental-cleanup litigation. If a lender knowingly lends to a borrower
who is obviously unable to make reasonable beneficial gain from the use of
the funds, or causes the borrower to assume responsibilities that are
obviously beyond the borrower's capacity, the lender not only risks losing
the loan without recourse but is also liable for the financial damage to
the borrower caused by such loans. For example, if a bank lends to a trust
client who is a minor, or someone who had no business experience, to start
a risky business that resulted in the loss not only of the loan but of the
client trust account, the bank may well be required by the court to make
whole the client.

In the United States, although predatory lending is not defined by federal
law, and various states define abusive lending differently, it usually
involves practices that strip equity away from a homeowner, or equity from
a company, or condemn the debtor into perpetual indenture. Predatory or
abusive lending practices can include making a loan to a borrower without
regard to the borrower's ability to repay, repeatedly refinancing a loan
within a short period of time and charging high points and fees with each
refinance, charging excessive rates and fees to a borrower who qualifies
for lower rates and/or fees offered by the lender, or imposing new
unjustifiably harsh terms for rolling over existing debt. Predation breaks
the links between an economy's aggregate resource endowment and aggregate
consumption and between the interpersonal distribution of endowments and
the interpersonal distribution of consumption.

The choice by some to be predators decreases aggregate consumption, both
because the predators' resources are wasted and because producers sacrifice
production by allocating resources to guarding against predators. Much of
welfare economics is based on the concept of Pareto Optimum, which asserts
that resources are optimally distributed when an individual cannot move
into a better position without putting someone else into a worse position.
In an unjust global society, the Pareto Optimum will perpetuate injustice.

Now, there is a close parallel in most Third World debts and International
Monetary Fund (IMF) rescue packages to the above predation examples where
sophisticated international bankers knowingly lend to dubious schemes in
developing economies merely to get their fees and high interest, knowing
that "countries don't go bankrupt", as Walter Wriston of Citibank famously
proclaimed. The argument for Third World debt forgiveness contains large
measures of lender liability and predatory lending. Debt securitization
allows these bankers to pass the risk to the credit markets, socializing
the potential damage after skimming off the privatized profits.

Credit is reserved financial resources ready for deployment. Debt basically
is unearned money secured with a promise to repay the principal sum plus
interest with optimistically anticipated earned money in the future,
assuming, for example, that the borrower will not become unemployed through
no fault of his own or a business will not be adversely affect by
unanticipated shifts in business paradigm, or an economy will not be
destroyed by global financial contagion.

Paying down debt with new debt is a Ponzi scheme - the likelihood of its
exposure is inversely proportional to its scale of operation. More and more
critics are calling the Enron debacle a Ponzi scheme, in that the company
filed for bankruptcy even though, for almost a decade up to a few weeks
before its bankruptcy filing, many in high places were hailing Enron as the
new innovative business model.

Neoliberal economist Paul Krugman publicly hailed Enron as a shining
example of free-market entrepreneurship in what he called "a love letter to
free markets". He served on its prestigious advisory board for a annual fee
of US$50,000. Neoconservative Weekly Standard editor Bill Kristol received
$100,000 from the same Enron advisory board, while contributing editor
Irwin Stelzer praised Enron for "leading the fight for competition".

On November 13, 2001, two weeks before Enron filed bankruptcy on December
2, the Baker Institute honored Greenspan with its Enron Prize, which the
official press release said "gives recognition to outstanding individuals
for their contributions to public service. The prize is made possible by a
generous gift from the Enron Corp ... one of the world's leading
electricity, natural-gas and communications companies. Among the previous
recipients of the Enron Prize are Colin Powell, current US secretary of
state; Mikhail Gorbachev, former president of the Soviet Union; Nelson
Mandela, the first black president of South Africa; and Georgian President
Eduard Shevardnadze."

Enron officials have since acknowledged that the company has purposely
overstated its profits by billions of dollars since 1997 and has disguised
billions in debt as revenue through structured finance via offshore
special-purpose vehicles. Top Enron executives cashed out more than $1
billion in company stocks when they were near their peak price of more than
$80. In addition, nearly 600 employees deemed critical to Enron's
operations received more than $100 million in bonuses in November 2001
while the company was on the brink of bankruptcy. Some commitment to public
service.

On the corporate level, debt inevitably alters management behavior.
Leverage increases profit margin on successful business plans. As Henry
Kravis, king of the leveraged buyout, famously said: "Debt can be an asset.
Debt tightens a company." To less creative minds, debt is still a
liability, not an asset. But debt also exaggerates losses when business
plans fail. In the US financial system, bankruptcy is a legal if not
painless way to refute debt. The comfort to lenders is that equity
investors are wiped out first before the lenders' various collateralized
positions are endangered.

Banks used to be the sole intermediaries of debt. For this reason, a
central bank was formed to supervise and provide liquidity to the banking
system. Thus a central bank came into existence in the United States in
1913 on the assumption that the existence of a healthy banking system is in
the national interest. And to protect the national interest, the central
bank, which in the US version is a government institution privately owned
by the banks in the Federal Reserve system, is allowed to act as lender of
last resort to the nation's commercial banks with public money, or more
accurately, through government authority to create fiat money.

Thus regulation on banks is a fair quid pro quo, a social contract. Bank
deregulation without corresponding raising of the threshold for
central-bank bailout is a direct breach of this social contract. If for the
good of the nation banks cannot be allowed to fail, they should also not be
allowed to deregulate.

More ominous, the US credit system has broken through the banking system -
the bulk of debt now is intermediated through the unregulated credit
markets by debt securitization. Securitization acts as more than just
providing a vehicle for investment in debt instruments. It restructures
simple debt into complex, hybrid instruments sliced infinite ways until the
original debt is beyond recognition.

Debt securitization is guerrilla warfare against a sound credit system.
Debt proceeds can be disguised as current income, distorting the financial
performance of the debtor. In these brave new credit markets, the
government is generally only an interested bystander, so far quite
unwilling to regulate even over-the-counter (OTC) derivative trading by
banks, which are suppose to be regulated, with an "if I don't smoke,
someone else will" mentality.

OTC derivatives are traded off exchanges, directly between counterparties,
and as such are not subject to disclosure rules. Adding estimated data from
the Bank for International Settlements for OTC derivatives to published
figures for exchange-traded derivatives, the total notional principal
balance of the reported derivatives market in June 2001 was $119 trillion,
about four times the gross domestic product (GDP) of the Organization of
Economic Cooperation and Development (OECD) countries and twice the value
of global trade. The amount unreported remains unknown.

This shows that derivatives performed more than a hedge function, as
apologists claim. Derivative trading has become a profit center for banks
and non-bank financial institutions. True, the notional principal amount is
never at risk, because no principal payments are exchanged. The interest
payments that are linked to that notional principal amount are at risk. A
loss on a derivative contract becomes possible when (a) interest rates or
commodity prices move in a direction that makes the contract more or less
valuable, and (b) the counterparty on the other side of the contract
defaults. Derivatives credit exposure is the present value of the cost of
restoring the economic value of a contract should a counterparty default.

All kinds of street rumors are flying at this very moment that one of the
world's biggest banks is exposed to derivative trades that would cause
serious counterparty credit problems if the market capitalization of this
bank should fall below a triggering level, or the price of commodities or
interest rates should move against its derivative positions. Because there
is no way to dispel or confirm such rumors, and the bank involved remains
tight-lipped about its true financial conditions, the uncertainties weigh
down on the economy.

There is ample evidence that the level of interest rates does not always
control the aggregate level of debt in an economy, popular expectations
notwithstanding. When interest rates are high, they often merely reflect
the systemic credit-unworthiness of borrowers as a group or the high risk
assumed by lenders collectively. High interest rates in fact create more
incentive for both lenders and borrowers to take higher risk to shoot for
the higher returns needed to meet higher interest cost. High interest rates
also direct money to more desperate borrowers. As William Zeckendorf, the
bankrupt real-estate tycoon, once said: "I'd rather be alive at 30 percent
interest than be dead at 3 percent."

However, interest rates do affect the distribution of credit in the
economy. When rationed by interest rates, debt actually puts money to work
for those who need it most desperately, and not necessarily the highest and
best use in the economy, or where it is socially needed most. Debts at high
interest rates can only be justified by high risk, which tends to
destabilize the economy. Debt securitization actually lowers systemic
credit quality by socializing risk across the whole system rather than
concentrating it on singular, isolatable defaults.

The US Federal Reserve's fixation on interest-rate policy as the sole tool
of regulating monetary policy is increasingly taking on the look of shadow
boxing, with declining effect on the economy. As chairman Greenspan is fond
of saying: "Bad loans are made in good times." As interest rates are
artificially raised by Fed action to tighten money supply, distressed
borrowers with bad loans made in good times will need to borrow more, thus
enlarging the credit pool, defeating the Fed's purpose of a tight monetary
policy. As interest rates are artificially lowered by Fed action to
stimulate a slowing economy, banks raise their credit threshold to
compensate for the narrowing of rate spread, thus reducing the number of
qualified borrowers and shrinking aggregate loan volume. This is known as
the Fed pushing on a credit string.

Credit rationed by interest rates also discourages economic democracy,
since the poor generally find it much harder to obtain or afford credit.
The poor also do not have the sophistication to participate in structured
finance. There is much truth is the saying that it is not how much you own,
it is how much you owe that measures how rich or financially powerful you are.

Debt also encourages carelessness with money, since lending implies faith
in the borrower's ability to repay in the future. People tend to be more
careful with money they earned in the past in the form of savings because
they remember how hard they had to work for it. In contrast, debt is based
on future earnings, which is deemed easier money by the existence of debt
itself. High interest rates also encourage high risks to justify the high
cost of money.

The problem with debt is that it needs to be serviced regularly (except
zero coupons, which are discounted from the principal sum at the outset and
cost more and are monitored with bond covenants and triggers to activate
automatic foreclosure). Unlike a credit-driven economy, a debt-propelled
economy will inevitably reach a point where its ability to service the
growing debt is exceeded, unless inflation stays ahead of interest charges,
in which case the banking system will fail. Thus runaway systemic debt
frequently leads to hyperinflation.

Bankruptcy only relieves the debtor, not the economy. If, as economist
Hyman Minsky claimed, money is created whenever credit is extended, then
the erasure of debt destroys money and shrinks the economy.

There is a circular link among deregulation, debt, overcapacity and
bankruptcy. Deregulation has created a havoc of bankruptcy in the airline,
health-care, communication, energy and finance sectors. Deregulation
permits predatory pricing in the name of competition, which often leads to
monopolistic consolidation within industries. The surviving giants then
take on massive debt to acquire vanquished competitors and to expand
capacity in anticipation of increased demand and soon reach a point where
increased sales do not increase net revenue to offset low margin. Once a
company is trapped in the whirlpool of debt, a downward spiral of low
prices and shrinking revenue will push the cost of debt beyond
sustainability, leading to bankruptcy. This is known as the bursting of the
debt bubble.

In March 1980, the Depository Institutions Deregulation and Monetary
Control Act (DIDMCA) was enacted in the United States. It was a
deregulation initiative by the administration of president Jimmy Carter
aimed at eliminating many of the distinctions among different types of
depository institutions and ultimately removing interest rate ceiling on
deposit accounts. Authority for federal savings and loan associations to
make risky ADC (acquisition, development, construction) loans was expanded,
which ended up with the savings and loan (S&L) crisis five years later.
Deregulation of airlines also began under Carter, leading to recurring
waves of bankruptcy.

Conventional wisdom suggests that a good credit rating is necessary to
borrow. But the financial world works differently in reality. A good credit
rating is first necessary to issue credit. Without the ability of some
entity to issue credit, no one can borrow. And since no modern financial
institution lends its own money, lenders must first secure funds wholesale
to lend to retail borrowers. For that, a lender must maintain a good credit
rating.

Banks are protected from this requirement by their discount window at the
central bank, which is backed by the full faith and credit of the nation,
and by Federal Deposit Insurance Corp (FDIC) insurance. Still, central
banks and the Bank of International Settlement (BIS) set capital and
reserve requirements for commercial banks to assure risk prudence.

GE, the world's largest non-bank financial conglomerate that incidentally
also manufactures, issues credit at the retail level through vendor
financing, to capture sales for GE products. It gets its funds wholesale
from the commercial paper market, which GE dominates because it has a good
credit rating. When GE credit rating was downgraded recently, it faced
being frozen out of the commercial paper market, and had to revert back to
costly bank credit lines that adversely affected its interest rate spread
and profitability.

When a government issues currency and circulates money through the banking
system, it is in essence issuing credit to the economy that it is entitled
to receive back in taxes. Government then spends the tax money on goods and
services that the public provides. The surplus money that is not returned
by taxes is government credit floating around the economy to keep it
operating financially.

It is important to understand that money issued by the government, unlike
private money, is not IOUs from the issuer. Money, when issued by
government as a legal tender, is a credit from the government good for the
payment of taxes, and for settling "all debts, public and private", as
printed plainly on all Federal Reserve notes. A US dollar is a Federal
Reserve note that entitles its holder to exchange it at any of the six
Federal Reserve Banks for another Federal Reserve note of the same face
value, no more and no less, at least since 1971 when the late president
Richard Nixon took the dollar off the gold standard.

Even before 1971, while an ounce of gold was officially pegged at $35 by
president Franklin Roosevelt on January 31, 1931, a domestic holder of a
dollar note could only exchange it at a Federal Reserve Bank for another
dollar note, since US citizens were forbidden by law to own gold. Only
foreigners could demand gold for dollar up to 1971.

A government bond, which on the surface looks like a government debt, is
merely a call on government credit previously issued, withdrawing dollars
from the money supply by providing a government bond. Government bonds are
the living proof that money is not an IOU from the government, otherwise
when government sells or redeems bonds, it is perpetrating a Ponzi scheme
of paying off old debt with new debt, rather than exchanging debt
instruments (bonds) with credit instruments (dollars).

Sovereign debt is fundamentally different from corporate debt. A corporate
bond entitles its holder to claim its face value in dollar notes that the
bond-issuing corporation cannot create by itself. It must earn dollars with
the bond proceeds to pay interest on the bonds. At the time of redemption,
if the corporation already spent the bond proceeds, it must then earn back
or sell assets or borrow the dollars from somewhere to redeem the bond.

In contrast, a government bond entitles its holder to claim from a Federal
Reserve Bank its face value in dollars that the government can print at
will, even if it already spent the bond proceeds. The interest on the bond
is also paid with dollars of which the government has an unlimited supply.
Part of the dollars that the government spends will come back from the
public in the form of taxes. The rest will stay in the economy to finance
its operations.

So if the government runs a surplus, meaning it takes in more tax money
than it spends, it drains money from the economy, forcing the economy to
contract. A budget deficit is in essence an injection of more government
credit into the economy.

Private citizens can own assets, but whenever such assets are monetized
with dollars, one trades those assets for credit from the US government
that other market participants in the economy will accept because, aside
from its status of legal tender as defined by law, it is good for
negotiating tax liabilities.

Technically, a government never borrows. It issues tax credit in the form
of money. So when former president Ronald Reagan said the government does
not make any money, only the private sector does, he was merely mouthing
conventional wisdom, with no clear understanding of the true nature of
money and credit. In fact, money is all that government makes. Thus any
government that takes on foreign-currency debt or allows its economy to do
so is taking unnecessary risk.

The main function of sovereign debt is not to make up for any shortfalls in
government funds. Such shortfalls cannot exist by definition. Rather,
sovereign debt instruments act as fundamental collateral for the nation's
credit market. The Fed Open Market Desk buys and sells government
securities to maintain the Fed funds target rate set by the Federal Reserve
Board. The repo (repurchase agreement) market, which provides overnight and
short-term funds for banks, operates with government securities as collateral.

Thus IMF conditionalities of reducing sovereign debt by imposing budget
surpluses and price deflation as a cure for a distressed credit market of
excessive foreign debt is merely adding gasoline to fire.

As a sovereign bond is redeemed with cash, it is in essence replacing a
call instrument on government credit with government credit. When
government securities are withdrawn and cash floods the economy, the debt
market shrinks because the amount of collateral shrinks and the amount of
cash increases, reducing the need for credit, and the economy contracts
with cash inflation, unless the cash is immediately recirculated as private
debt or investment.

The reason that the market monitors the Fed funds rate as an indication of
Fed policy is that the Fed funds rate closely tracks another rate, the repo
rate, that the Fed Open Market Desk actively influences during most market
days. Every business-day morning at 11:45 Eastern Standard Time, the Fed
announces what it intends to do (buying or selling government securities
with an agreement to reverse the transaction later) in the repo market to
keep the repo rate close to the Fed funds target rate set by the Fed.
Changes in the repo rate are normally quickly followed by changes in the
Fed funds rate. Thus, indirectly, the Fed appears to influence the federal
funds rate through its impact upon the repo rate.

Non-monetarists subscribe to the view that Fed easing means the Fed lowers
interest rates. But they are not specific about how these rates are lowered
are how the Fed should go about doing this. There are often periods (such
as 1990-91) when interest rates dropped but money growth also fell.
Non-monetarists (and market participants) view periods like this as Fed
easing episodes, while monetarists argue that these are (implicitly)
periods of Fed tightening. Thus it is clear that interest rates by
themselves do not always determine the money supply.

Since all private debts in a money economy are anchored by government
credit, through what economists called high-power money (money created by
the Fed through the increase of the total reserves in the banking system,
so called because it would be multiplied manifold through the
money-creation power of commercial bank loans), credit in an economic
democracy should not be rationed by interest rates to the highest bidder,
but by national purposes or social needs.

Credit in fact is a financial public utility, much like air and water, and
it should be equally accessible to all, not just the rich. Government loan
guarantees for students and house mortgages for low- and moderate-income
groups and loans to small business are based on this principle.

For example, the US National Housing Act was enacted on June 27, 1934, as
one of several economic-recovery measures of the New Deal. It provided for
the establishment of a Federal Housing Administration (FHA). Title II of
the Act provided for the insurance of home mortgage loans made by private
lenders, taking the risk in lending to low income borrowers off the private
lenders. Title III of the Act provided for the chartering of national
mortgage associations by the administrator. These associations were to be
independent corporations regulated by the administrator, and their chief
purpose was to buy and sell the mortgages to be insured by the FHA under
Title II.

Only one association was ever formed under this authority on February 10,
1938, as a subsidiary of the Reconstruction Finance Corp, a government
corporation. Its name was National Mortgage Association of Washington, and
this was changed that same year to Federal National Mortgage Association
(Fannie Mae). By amendments made in 1948, Title III became a statutory
charter for Fannie Mae.

Before the Great Depression, affording a home was difficult for most people
in the United States. At that time, a prospective homeowner had to make a
down payment of 40 percent and pay the mortgage off in three to five years.
Until the last payment, borrowers paid only interest on the loan. The
entire principal was paid in one lump sum as the final "balloon" payment.

During the 1920s boom time in real estate, a rudimentary secondary mortgage
market was established. The stock-market crash of 1929 ended the
real-estate boom and forced many private guarantee companies into
insolvency as home prices collapsed. As economic conditions worsened, more
and more people defaulted on mortgages because they couldn't come up with
the money for the final balloon payment or to roll over their mortgage
because of low market value of their homes.

To help lift the country out of the Depression, Congress created the FHA
through the National Housing Act of 1934. The FHA's insurance program
protected mortgage lenders from the risk of default on long-term,
fixed-rate mortgages. Because this type of mortgage was unpopular with
private lenders and investors, Congress in 1938 created Fannie Mae to
refinance FHA-insured mortgages.

As soldiers came home from World War II, Congress passed the Serviceman's
Readjustment Act of 1944, which gave the Department of Veterans Affairs
(VA) authority to guarantee veterans' loans with no down payment or
insurance premium requirements. Many financial institutions considered this
arrangement a more attractive investment than war bonds.

By revision of Title III in 1954, Fannie Mae was converted into a
mixed-ownership corporation, its preferred stock to be held by the
government and its common stock to be privately held. It was at this time
that Section 312 was first enacted, giving Title III the short title of
Federal National Mortgage Association Charter Act.

By amendments made in 1968, the Federal National Mortgage Association was
partitioned into two separate entities, one to be known as the Government
National Mortgage Association (Ginnie Mae), the other to retain the name
Federal National Mortgage Association (Fannie Mae). Ginnie Mae remained in
the government, and Fannie Mae became privately owned by retiring the
government-held stock. Ginnie Mae has operated as a wholly owned government
association since the 1968 amendments. Fannie Mae, as a private company
operating with private capital on a self-sustaining basis, expanded to buy
mortgages beyond traditional government loan limits, reaching out to a
broader income cross-section.

By the early '70s, inflation and interest rates rose drastically. Many
investors drifted away from mortgages. Ginnie Mae eased economic tension by
issuing its first mortgage-backed security (MBS) guarantee in 1970.
Investors found these guaranteed MBSs highly attractive. Also in 1970,
under the Emergency Home Finance Act, Congress chartered the Federal Home
Loan Mortgage Corp (Freddie Mac) to buy conventional mortgages from
federally insured financial institutions. The legislation also authorized
Fannie Mae to purchase conventional mortgages. Freddie Mac introduced its
own MBS program in 1971.

In the early 1980s, the US economy spiraled into deep recession. Interest
rates and housing prices were high, while income growth was stagnant. The
US economy faced a dual problem of income deficiency and money devaluation.
In this poor housing environment, Ginnie Mae, Fannie Mae and Freddie Mac
all created programs to handle adjustable-rate mortgages. The Ginnie Mae
guaranty is backed by the full faith and credit of the United States.
Today, Ginnie Mae guaranteed securities are one of the most widely held and
traded MBSs in the world. Ginnie Mae has guaranteed more than $1.7 trillion
in MBSs. Historically, 95 percent of all FHA and VA mortgages have been
securitized through Ginnie Mae. Ginnie Mae is a guarantor, a surety. Ginnie
Mae does not issue, sell, or buy MBSs, or purchase mortgage loans.

Fannie Mae operates under a congressional charter that directs it to
channel its efforts into increasing the availability and affordability of
home ownership for low-, moderate- and middle-income Americans. Yet Fannie
Mae receives no government funding or backing, and it is one of the
nation's largest taxpayers as well as one of the most consistently
profitable corporations in America. The company has evolved to become a
shareholder-owned, privately managed corporation supporting the secondary
market for conventional loans. It continues to operate under a
congressional charter with oversight from the US Department of Housing and
Urban Development and the US Treasury.

Fannie Mae has two primary lines of business: Portfolio Investment, in
which the company buys mortgages and MBSs as investments, and funds those
purchases with debt, and Credit Guaranty, which involves guaranteeing the
credit performance of single-family and multi-family loans for a fee.

Its Portfolio Investment business includes mortgage loans purchased
throughout the US from approved mortgage lending institutions. It also
purchases MBSs, structured mortgage products and other assets in the open
market. The corporation derives income from the difference between the
yield on these investments and the costs to fund these investments, usually
from issuing debt in the domestic and international markets. Fannie Mae has
$3.46 trillion in MBSs outstanding today.

The corporation accomplishes its mission to provide products and services
that increase the availability and the affordability of housing for low-,
moderate- and middle-income Americans by operating in the secondary rather
than the primary mortgage market. Fannie Mae purchases mortgage loans from
mortgage lenders such as mortgage companies, savings institutions, credit
unions and commercial banks, thereby replenishing those institutions'
supply of mortgage funds. Fannie Mae either packages these loans into MBSs,
which it guarantees for full and timely payment of principal and interest,
or purchases these loans for cash and retains the mortgages in its portfolio.

Fannie Mae is one of the world's largest issuers of debt securities, the
leader in the $5 trillion US home-mortgage market. Fannie Mae's debt
obligations are treated as US agency securities in the marketplace, which
is just below US Treasuries and above AAA corporate debt. This agency
status is due in part to the creation and existence of the corporation
pursuant to a federal law, the public mission that it serves, and the
corporation's continuing ties to the US government. It benefits from the
appearance, though not the essence, of being backed by government credit.

Fannie Mae debt obligations receive favorable treatment from a regulatory
perspective. Fannie Mae securities are "exempted securities" under the laws
administered by the US Securities and Exchange Commission to the same
extent as US government obligations. Also, Fannie Mae debt qualifies for
more liberal treatment than corporate debt under US federal statutes and
regulations and, to a limited extent, foreign overseas statutes and
regulations.

Some of these statutes and regulations make it possible for deposit-taking
institutions to invest in Fannie Mae debt more liberally than in corporate
debt and mortgage-backed and asset-backed securities. Others enable certain
institutions to invest in Fannie Mae debt on par with obligations of the
United States and in unlimited amounts. Fannie Mae uses a variety of
funding vehicles to provide investors with debt securities that meet their
investment, trading, hedging, and financing needs. Fannie Mae is able to
issue different debt structures at various points on the yield curve
because of its large and consistent funding needs. As the Treasury retires
30-year bonds, agencies have stepped in to fill the void.

The privatization of Fannie Mae and Freddie Mac was an ideological move. It
was financially unnecessary and government credit could have funded the
entire low-, moderate- and middle-income housing-mortgage needs with no
profit siphoned off to private investors. These agency debt instruments
played a crucial role in developing and sustaining the credit markets in
the US.

In fact, the funding risk of both agencies was questioned by the Wall
Street Journal last February 20 in an editorial about Fannie Mae's and
Freddie Mac's safety, soundness and financial management, characterizing
both agencies as risky, fast-growing companies that "look like poorly run
hedge funds", "unduly exposed to credit risk with large derivative
positions", and that they "use all manner of derivatives" and "are exposed
to unquantified counterparty risk on these positions". Such concerns would
have been avoided if both agencies had been funded with government credit,
and the cost of housing to low-, moderate- and middle-income Americans
would have been lower.

A government credit economy is different from a private debt economy in its
sustainability. The Japanese economy stagnated for more than a decade
primarily because it shifted from a government credit economy to a private
debt economy in the name of financial liberalization and market
fundamentalism. The Japanese version of London's Big Bang started the
Japanese private debt bubble that subsequently infected all Asian economies.

The Big Bang in London refers to deregulation on October 27, 1986, of
London-based securities markets, an event comparable to May Day in the US,
marking a major step toward a single global financial market. May Day
refers to May 1, 1975, when fixed minimum brokerage commissions ended in
the US, ushering in the era of discount brokerage firms and the beginning
of diversification by the brokerage industry into a wide range of financial
services using computerization and advanced communication systems. This
started the offering of new genres of financial products and the emergence
of structured finance that made possible a new private-debt economy that
turned quickly into a global debt bubble. As the US reaped the fleeting
benefits of dollar hegemony, a budget surplus accompanied with sovereign
debt reduction merely pushed more debt on to the private sector to feed the
debt bubble.

The most fundamental aspect of a private-debt economy is that it cannot
sustain a slowdown, even a soft landing. If Greenspan had been better
versed in debt economics, he would have understood that a debt bubble,
unlike the conventional business cycle, cannot survive the slightest
deflation. Inflation is the oxygen for a debt bubble.

Greenspan's attempt to engineer a soft landing by raising interest rates to
fight pending inflation pre-emptively only accelerated the debt bubble's
burst. His only option was to prevent the debt bubble from forming by
tightening credit quality years ago, but he chose to rely on the market to
exercise its discipline. He rejected the suggestion of such Wall Street
gurus as Henry Kaufman to raise margin requirements. Instead of discipline,
the market gave him an insatiable appetite for addictive debt, which he had
previously called "irrational exuberance".

Once the bubble was on its way, Greenspan was on top of a debt tiger that
he could not get off without being devoured by the beast. It was not the
New Economy, it was not the unprecedented productivity that gave the US its
decade-long boom. It was debt. Without debt, there would have been no New
Economy, no dotcom industry, no telecom explosion, no structured finance,
no budget surplus and no current account deficit or its flip side, capital
account surplus.

The 1990s was the debt decade. Much of the technology was invented prior to
the beginning of the decade of finance capitalism and became widely applied
through debt in the form of vendor finance. The communication revolution
was built on debt that had been accumulated in the last decade. The
greatest invention of the 1990s was more and more sophisticated debt
instruments.

Greenspan warned in December 1996 about "irrational exuberance" when the
Dow Jones Industrial Average (DJIA) was at 7,000, that inflation down the
road was inevitable unless the Fed started to raise Fed funds rate
pre-emptively. Yet as rates rose, the DJIA rose to 12,000 by 2000, because
inflation as measured by the government failed take into account the wealth
effect.

The reason for this was twofold. Inflation was kept low by imports and
inflation was measured mostly by rising wages but not by rising asset
value. Stock prices doubled and real-estate prices tripled, but the economy
officially did not register inflation because of low wages and cheap
imports. As stock prices rose, the price to earnings ratio skyrocketed. As
the economy inched toward technical full employment with 4 percent
unemployed, Greenspan reflexively raised the interest rate to cut off
anticipated wage-pushed inflation. The high interest rate adversely
affected the earnings of debt-ridden companies. To boost earnings,
companies cut employees, which started the downward spiral.

Since July 1997, the risks of protracted global asset deflation caused by
the aftermath of excessive private debt have become reality, first in the
emerging markets and now in the United States. Neither the IMF nor the
Group of Seven (G-7) have been able to deal effectively with the twin
problems of the artificially strong but debt-driven dollar and the
spreading manipulated devaluation of other national currencies around the
globe.

For the affected nations, the combination of mountains of foreign-currency
debt and massive short-term capital flight through stock-market collapses,
exacerbated by IMF conditionalities of high interest rates, austerity
measures that insisted on reduced government deficits and sharp currency
devaluations coupled with asset deflation, have led to tragic destruction
of hard-earned wealth and a severe drop of living standards.

Certainly market forces in a runaway-debt economy have not created Adam
Smith's "universal opulence which extends itself to the lowest ranks of the
people". The only trickling down has been poverty and misery. In a world of
6 billion people, only about 1,000 currency traders and a small circle of
rich investors in their hedge funds seem to enrich themselves further
through the unbridled manipulation of the free financial market. Even in
advanced economies, workers are misled to accept low wages as a trade-off
for stock options that become worthless when the debt bubble bursts.

Corporations seduce share owners with fantasy capital gains based on debt
to replace regular dividend payouts. When market capitalization of major
corporations inflated by debt can fall by 90 percent within a matter of
months while top executives can cash out at peak prices and resign with
severance packages worth tens of millions of dollars, there is no other way
to describe the situation than reversed Robin Hood: robbing the poor to
help the dishonest rich.

This view is now shared by increasing numbers across ideological spectrums.
Economist John Kenneth Galbraith's famous description of trickling down
prosperity was if you feed the horse enough oats, the sparrows will some
day benefit from its droppings. In finance capitalism, the poor sparrows
are crushed by the wheels of the carriage of debt that the horse pulls.

If debt is dilapidating, foreign-currency debt, mostly dollar debt, is
deadly. Thus those governments that had been misled by neoliberals to
borrow massive amounts of foreign currency unnecessarily and subsequently
dutifully implemented IMF prescriptions, such as Brazil, Argentina, Turkey,
South Korea and Indonesia, saw their economies destroyed to the point where
recovery may now take decades, if ever, and only if the poisonous IMF
medicine is quickly rejected.

The IMF has now admitted that it made a "slight mistake" in dealing with
the Asian financial crisis of 1997. It might have been slight for the IMF,
but the cost to the economies of Asia was horrendous. Trillions of dollars
of hard-earned assets and economic capacities have been destroyed, lost
forever. In fact, lives have been lost, children malnourished, families
ruined, governments fallen and ethnic animosities intensified. The
cooperative partnership among neighboring countries has been undermined and
regions destabilized. This is the direct result of predatory lending
followed by predatory IMF rescues. The operations were technically
successful but the patients died.

Since World War II, the term "capitalism" has been gradually displaced by
the more benign label of the free market. Capitalism ceased to be mentioned
in most economic literature. In the process, economists also squeezed out
of official dialogues the word "capitalism", the once-traditional name for
the market system, with its subjective connotation of class struggle
between owners, through their professional managers, and workers, through
their trade and industrial unions, and with its legitimization of the
privileges that go with various levels of wealth.

The word "capitalism" no longer appears in textbooks for Economics 101. A
Harvard economist, N Gregory Mankiw, author of a popular new textbook,
Principles of Economics, told the New York Times: "We make a distinction
now between positive or descriptive statements that are scientifically
verifiable and normative statements that reflect values and judgments." A
whole new generation of economists have grown up thinking of "capitalism"
only as a historical term like "slavery", unreal in the modern world of
market fundamentalism.

Capital, when monetized in dollars, is in essence credit from government.
Capitalism in a money economy is a system of government credits. Thus a
case can be made that in a capitalistic democracy, access to capital and
credit should be available equally to all in accordance with national
purpose and social needs. The anti-statist posture of neoliberalism is not
only logically flawed, but its glorification of a private-debt economy will
inevitably lead to self-destruction.

Henry C K Liu is chairman of the New York-based Liu Investment Group

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Sep 14, 2002
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