Identity – National or Cultural?

Mr. Kotkin offers a powerful warning for US politics. In a world where the nation-state and national sovereignty are the organizing principles of global politics, a national identity is the necessary glue that holds democracies together and strengthens them against chaotic change. Multiculturalism and identity group tribalism only weaken democratic societies.

America’s Future Depends on Believing in a Shared National Identity.

 By Joel Kotkin

City Journal, August 7, 2019

This week, the troubled state of American democracy was on display in the reactions to the mass shootings in Texas and Ohio. To the establishment Left, led by the New York Times, the El Paso shooter operated as if he were a white nationalist acting on orders from Donald Trump. Some on the right, meantime, linked the Dayton shooter’s actions to Antifa. In a healthy political environment, Americans, regardless of political views, would consider these tragedies the heinous actions of disturbed people, motivated mostly by a dangerous combination of madness and ideology. But in our warped political climate, everyone assumes that their enemies want to kill them.  

Our political polarization reflects a decline in the notion of American identity. Tribalism on the left has supplanted foundational ideals of citizenship. Representative Ayanna Pressley recently insisted that blacks, Hispanics, gays, and members of other minority groups must promote identity-first politics over any notion of the common good; failure to do so, she suggested, is a betrayal of the group. In addition, progressive Democrats have effectively championed open borders, advocating the removal of criminal penalties for border-crossers, who also would get free health care not readily available to most American citizens. Such views represent the triumph of identity politics over the civic ideal of E Pluribus Unum.

The Left’s positions, according to Jeh Johnson, Homeland Security secretary under Barack Obama, are “unworkable, unwise,” and lack support of “a majority of American people or the Congress.” And yet our press, cultural institutions, and universities—all controlled by progressives—amplify those views each day, shaping an angry younger generation with little use for citizenship, free speech, open dialogue, democracy, or capitalism. Some 40 percent of millennials, for example, favor limiting speech deemed offensive to minorities—well above the 27 percent that prevails among Gen Xers, 24 percent among baby boomers, and just 12 percent among the oldest cohorts. Many millennials also dismiss basic constitutional civil rightsand support socialism over free markets.

While progressives seek to impose their agenda, some populist conservatives are understandably resentful at being told by 1 percenters like Beto O’Rourke that they are beneficiaries of “white privilege” and are members of the “male patriarchy.” Most Republicans, according to Pew, worry that foreigners are remaking and undermining the country’s identity. Considering the country’s demographic trajectory, this politics has a limited shelf life. A return to 1950s America is no more likely than the mass expulsion of Trump’s white “deplorables.”

Fighting for a robust and inclusive American identity won’t be popular with our corporate elite. “Transnational class formation”—long linked by various parts of the industrial and financial aristocracy—is becoming more pronounced. The late Peter Drucker, considered the father of management thinking, suggested that national citizenship may no longer be “meaningful” in a world connected by digital technology and global markets. Many top firms including Amazon, Apple, Chevron, and General Electric refuse even to identify as American companies. Like feudal lords loyal to the European Christianitas, not their locale, this corporate elite increasingly identifies with global markets and a cosmopolitan, post-national worldview. Since Trump’s election, many companies, including Google, have grown reluctant to work with the U.S. military, immigration agencies, and police departments, while assisting the surveillance agenda of  authoritarian China.

Given their post-nationalist inclinations, it’s not surprising that many corporate powers—notably in tech—prefer unlimited immigration. This partly reflects the non-native share of the tech workforce, which has reached 24 percent nationwide, compared with 16 percent for the rest of labor force. In Silicon Valley, it’s roughly 40 percent. Though they defend open borders, tech leaders express little concern for the native-born, largely white middle class. Immigrants, suggests Steve Case, former CEO of AOL, should replace our troubled, indigenous working class.

Such positions invite backlash from those who live outside the charmed circle. After all, if uneducated migrants want to enter the country, they won’t settle in Malibu, posh parts of San Francisco, or the Upper East Side, but instead in working- and middle-class neighborhoods. They’ll compete for housing and jobs in hardscrabble neighborhoods, but they won’t bid up the price of houses in exclusive enclaves or threaten well-paid jobs in the executive suite or at universities.

Our present trajectory is ruinous; it will exacerbate political antagonism and likely produce even more politicized violence. The only solution to greater polarization lies in reestablishing the norms of a civic nationalism that transcends identity politics of all kinds.

Developing a renewed sense of American identity won’t be easy. As a lifelong Democrat, I saw nothing remotely unpatriotic in the rhetoric of George McGovern—a World War II hero—and certainly not from Jimmy Carter or Bill Clinton. Yet today, according to Gallup, only 22 percent of Democrats today say that they are “proud to be Americans,” down from 65 percent in 2003, when the widely disliked George W. Bush was in the White House. Modern progressives generally reject any thought of American exceptionalism, maintaining, in the words of Pete Buttigieg, that America was “never as great as advertised.”

It’s hard to build a positive agenda without some sense of national pride and shared culture. Fortunately, America’s founding principles—rule of law, protection of minority rights, market-based capitalism—are not dependent on race and heritage. Unlike Europe, we don’t have one great historic tradition that we must embrace or lose. By contrast, America, based on ideas that transcend race, boasts a remarkable record of incorporating newcomers, first from Ireland and Germany, then Italy and Eastern Europe, and more recently from Latin America and Asia. These generations of new Americans constitute the secret sauce that makes this country work and could sustain it in the future.

This expansive civic nationalism also represents an economic imperative. Due to sharply lower birthrates, most of our prime competitors—the EU, Japan, and even China—are on the verge of demographic collapse. Europeans may need immigrants, but their welfare states, slow growth, and lack of cultural cohesion will make absorbing these newcomers problematic at best. Most Asian countries have little interest in large-scale immigration.

America’s future will depend on believing in a shared mission. Calling progressives “Communists” or conservatives “fascists” gets us nowhere. Convincing young people, particularly young men, that they have no future won’t dissuade them from authoritarian views—or even violence. The road to sanity starts with a renewed embrace of a shared American identity that transcends all others.

China and the dangers of unbalanced growth


The article below reiterates one of the basic economic truths explained in Political Economy Simplified, which is that growth requires a cyclical balance between consumption and savings; borrowing and investment. China is producing more exports than the world can consume, especially by the de-leveraging developed economies. China’s growth path is essentially too steep to keep up and so will correct to a more sustainable path. This is what happened with the credit bubble in the US as well. China is attempting to turbo-charge both consumption and investment at the same time by excessive borrowing, just like the US did in the 2000s.

Fundamentally, the economy runs on four wheels: consumption, saving, investment and production. If either of these gets out of sync with the others, the vehicle will sputter and crash. Interest rates are normally what keeps it all together, but we’ve been distorting those worldwide for the past two decades. Such mismanagement will demand a reckoning, and more of the same merely delays the inevitable.

From the WSJ:

China Has Its Own Debt Bomb

Not unlike the U.S. in 2008, China is at the end of a credit binge that won’t end well.


Six years ago, Chinese Premier Wen Jiabao cautioned that China’s economy is “unstable, unbalanced, uncoordinated and unsustainable.” China has since doubled down on the economic model that prompted his concern.

Mr. Wen spoke out in an attempt to change the course of an economy dangerously dependent on one lever to generate growth: heavy investment in the roads, factories and other infrastructure that have helped make China a manufacturing superpower. Then along came the 2008 global financial crisis. To keep China’s economy growing, panicked officials launched a half-trillion-dollar stimulus and ordered banks to fund a new wave of investment. Investment has risen as a share of gross domestic product to 48%—a record for any large country—from 43%.

Even more staggering is the amount of credit that China unleashed to finance this investment boom. Since 2007, the amount of new credit generated annually has more than quadrupled to $2.75 trillion in the 12 months through January this year. Last year, roughly half of the new loans came from the “shadow banking system,” private lenders and credit suppliers outside formal lending channels. These outfits lend to borrowers—often local governments pushing increasingly low-quality infrastructure projects—who have run into trouble paying their bank loans.

Since 2008, China’s total public and private debt has exploded to more than 200% of GDP—an unprecedented level for any developing country. Yet the overwhelming consensus still sees little risk to the financial system or to economic growth in China.

That view ignores the strong evidence of studies launched since 2008 in a belated attempt by the major global financial institutions to understand the origin of financial crises. The key, more than the level of debt, is the rate of increase in debt—particularly private debt. (Private debt in China includes all kinds of quasi-state borrowers, such as local governments and state-owned corporations.)

On the most important measures of this rate, China is now in the flashing-red zone. The first measure comes from the Bank of International Settlements, which found that if private debt as a share of GDP accelerates to a level 6% higher than its trend over the previous decade, the acceleration is an early warning of serious financial distress. In China, private debt as a share of GDP is now 12% above its previous trend, and above the peak levels seen before credit crises hit Japan in 1989, Korea in 1997, the U.S. in 2007 and Spain in 2008.

The second measure comes from the International Monetary Fund, which found that if private credit grows faster than the economy for three to five years, the increasing ratio of private credit to GDP usually signals financial distress. In China, private credit has been growing much faster than the economy since 2008, and the ratio of private credit to GDP has risen by 50 percentage points to 180%, an increase similar to what the U.S. and Japan witnessed before their most recent financial woes.

The bullish consensus seems to think these laws of financial gravity don’t apply to China. The bulls say that bank crises typically begin when foreign creditors start to demand their money, and China owes very little to foreigners. Yet in an August 2012 National Bureau of Economic Research paper titled “The Great Leveraging,” University of Virginia economist Alan Taylor examined the 79 major financial crises in advanced economies over the past 140 years and found that they are just as likely in countries that rely on domestic savings and owe little to foreign creditors.

The bulls also argue that China can afford to write off bad debts because it sits on more than $3 trillion in foreign-exchange reserves as well as huge domestic savings. However, while some other Asian nations with high savings and few foreign liabilities did avoid bank crises following credit booms, they nonetheless saw economic growth slow sharply.

Following credit booms in the early 1970s and the late 1980s, Japan used its vast financial resources to put troubled lenders on life support. Debt clogged the system and productivity declined. Once the increase in credit peaked, growth fell sharply over the next five years: to 3% from 8% in the 1970s and to 1% from 4% in the 1980s. In Taiwan, following a similar cycle in the early 1990s, the average annual growth rate fell to 6%.

Even if China dodges a financial crisis, then, it is not likely to dodge a slowdown in its increasingly debt-clogged economy. Through 2007, creating a dollar of economic growth in China required just over a dollar of debt. Since then it has taken three dollars of debt to generate a dollar of growth. This is what you normally see in the late stages of a credit binge, as more debt goes to increasingly less productive investments. In China, exports and manufacturing are slowing as more money flows into real-estate speculation. About a third of the bank loans in China are now for real estate, or are backed by real estate, roughly similar to U.S. levels in 2007.

For China to find a more stable growth model, most experts agree that the country needs to balance its investments by promoting greater consumption. The catch is that consumption has been growing at 8% a year for the past decade—faster than in previous miracle economies like Japan’s and as fast as it can grow without triggering inflation. Yet consumption is still falling as a share of GDP because investment has been growing even faster.

So rebalancing requires China to cut back on investment and on the rate of increase in debt, which would mean accepting a rate of growth as low as 5% to 6%, well below the current official rate of 8%. In other investment-led, high-growth nations, from Brazil in the 1970s to Malaysia in the 1990s, economic growth typically fell by half in the decade after investment peaked. The alternative is that China tries to sustain an unrealistic growth target, by piling more debt on an already powerful debt bomb.

Storms on the Horizon

We’ve created a game where the winning strategy is to convert debt into real assets as fast as one can accumulate that low-priced debt. The losers will be holding those worthless pieces of debt paper when the music stops. Those who own and control real assets bought with cheap debt will rule the world, if they can keep it. And we call this progress? Red sky at morning, sailors take warning…

Excerpted from the WSJ: (subscription req’d)

Why There Will Be No New Bretton Woods

China has built up an astounding mountain of monetary reserves: $3.3 trillion, approximately 60% of which comprises U.S. government securities. The U.S. has accumulated the world’s largest international debt: $15.9 trillion. Each government eyes the trajectory of the two stockpiles with trepidation—the Chinese fear a collapse in the global purchasing power of their dollar hoard, the Americans a collapse in funding for their debt. The U.S. accuses China of “manipulating” its currency, keeping it artificially low to stimulate exports and discourage imports, while China blames U.S. profligacy and lax monetary controls.

Many hope that the International Monetary Fund, created at Bretton Woods, can be the catalyst for a new cooperative monetary architecture. Yet history suggests that this won’t occur until the U.S. and China come to the conclusion that the consequences of muddling on, without the prospect of correcting the endemic imbalances between them, are too great.

Meanwhile, trade tensions may grow much worse—as they did in the 1930s, during the last great international currency war. China’s recent bilateral agreements with Japan, Brazil, Russia and Turkey to pursue trade without dollars could be a worrisome harbinger, insofar as each would be more likely to undertake global trade discrimination in order to balance its bilateral trade than to stockpile other currencies. The U.S. had sought to eliminate this damaging stratagem permanently at Bretton Woods; it may soon re-emerge.

The Currency Manipulators


This is another source of worry for the free world. Central bankers will never be able to withstand the winds of political and economic conflict from gross trade imbalances made worse by currency manipulation. And just imagine trying to get one nation’s taxpayers to pay for the mistakes of another nation’s politicians. Never happen. The historical result is a complete collapse of international cooperation. And sometimes world war. These guys are throwing gas on the flames.

Rumors of (Currency) War

G-7 finance ministers lament the rise of the monetary nationalism they all practice.

These days there’s not a market in the world that some regulator somewhere doesn’t want to meddle in. The big exception, curiously enough, is the currency market.

The finance ministers for the Group of Seven economic powers released a statement Tuesday washing their hands of responsibility for the value of their currencies: “We, the G7 Ministers and Governors, reaffirm our longstanding commitment to market determined exchange rates.” The intention was to calm global currency markets, but the result was even more turmoil.

And no wonder. Start with the basic fact that there is no such thing as a free market in paper currencies. Money is a commodity whose monopoly supplier is the state. Markets trade currencies—trillions of dollars every day—but governments and central banks have the biggest influence on their value by controlling their supply.

The G-7’s look-Ma-no-hands pose is fooling nobody who actually trades currencies, which is why exchange rates jump or fall these days based on the merest eyebrow twitch by Ben Bernanke, Mario Draghi or the other maestros of global money.

The G-7 statement goes on to say, “We are agreed that excessive volatility and disorderly movements in exchange rates can have adverse implications for economic and financial stability.” That’s another beauty. If the G-7 really wanted to return to stable exchange rates, they could do something about it. Their statement is a feeble attempt at open-mouth monetary operations that is a poor substitute for real policy.

The immediate cause of this G-7 eruption is Japan’s recent decision to join the rest of the world in monetary devaluation. New Prime Minister Shinzo Abe has been brow-beating the Bank of Japan to reduce the value of the yen, which had appreciated by more than 25% against the dollar from 2009 to late 2012. The yen has since fallen sharply, alarming Japan’s trading partners in South Korea and Europe.

Mr. Abe’s political intervention into central-bank independence is regrettable, but he’s merely joining the queue. Since the financial crisis, every major central bank has let itself become an agent of domestic economic policy. Mr. Bernanke’s Fed has led the trend, embracing near-zero interest rates for more than four years plus repeated “quantitative easing.”

The Fed is supposed to be the steward of the dollar, which is still the world’s reserve currency. But since the crisis Mr. Bernanke has all but declared that the rest of the world can take care of itself. So as the Fed has flooded the world with dollars, the rest of the world has had to ease as well to keep their currencies from rising too fast. Mr. Bernanke is the band leader in this round of monetary nationalism.

In the 42 years since the collapse of Bretton Woods—the postwar international monetary system anchored to the U.S. dollar—world leaders have played more or less the same game. The more respectable countries have insisted they believe in the virtues of a strong currency, while often secretly hoping for a weaker one to boost exports. The rest have simply resorted to devaluation when convenient, without the pretense of virtue.

Control of the money supply has only grown in importance as the size of government has increased: You have only to look at Greece to see what happens when you combine fiscal incontinence with a currency (the euro) that Greek politicians can’t manipulate. In the U.S. and U.K., a major side benefit for politicians of near-zero interest rates and bond purchases is that they help to finance huge government deficits at rock-bottom rates.

Fixed or more-stable exchange rates would impose a discipline on government spending that few politicians of any stripe really want. Thus the G-7’s putative defense of market-determined exchange rates is in part a veil for state manipulation of money in the hope of “managing” the economy. That hasn’t done all that much for growth in the past five years, so it’s no surprise that beggar-thy-neighbor devaluations look increasingly appealing to politicians.

It’s nice that the G-7 appreciates the dangers of currency war, but its Tuesday statement that “we will not target exchange rates” is a policy abdication. If the ministers really want to prevent “excessive volatility and disorderly movements” in currency markets, they would work together to coordinate their monetary policies to produce more stable exchange rates.

But that would require financial leadership, especially from the U.S. Treasury. If his Senate confirmation hearing is any indication (see nearby), Obama nominee Jack Lew is a babe in the monetary woods. He’s likely to continue the real G-7 policy, which is every currency for itself, the weaker the better.

John Taylor on Monetary Policy

In this WSJ article , Mr. Taylor explains the imbalances of world capital flows and the inevitable consequences. This is the primary source of our periodic financial crises. There is a crippling human cost to this policy that Taylor politely declines to address: those who rely on capital and the income it generates in retirement will be devastated by the excessive risks they’ve been forced to take. As I have mentioned elsewhere, excessively low interest rates are the signal of a very sick economy and not a cure.

Monetary Policy and the Next Crisis

Low interest rates and international capital flows, not a ‘saving glut,’ were to blame for the 2008 crash.


At its annual meeting of the world’s central bankers in Switzerland last week, the Bank for International Settlements—the central bank of central banks—warned about the harmful “side effects” of current monetary policies “in the major advanced economies” where “policy rates remain very low and central bank balance sheets continue to expand.” These policies “have been fueling credit and asset price booms in some emerging economies,” the BIS reported, noting the “significant negative repercussions” unwinding these booms will have on advanced economies.

The BIS emphasizes the view that international capital flows stirred up by monetary policy were a primary factor leading to the preceding crisis and that these flows would lead to the next one. This is in stark contrast to the “global saving glut” hypothesis—which says that the funds pouring into the U.S. in the previous decade originated largely from the surplus of exports over imports in emerging market economies.

The BIS should be taken seriously. It warned long in advance about the monetary excesses that led to the financial crisis of 2008.

The capital-flow story starts during extended periods of low interest rates, as in the U.S. Federal Reserve’s low rates from 2003 to 2005 and its current near-zero interest rate policy, which began in 2008 and is expected to last to 2014. These low interest rates cause investors to search elsewhere for yield, and they buy foreign securities—corporate as well as sovereign—for that reason. Global bond funds in the U.S. thus shift their portfolios to these higher-yielding foreign securities and investors move to funds that specialize in such securities.

Low U.S. interest rates also encourage foreign firms to borrow in dollars rather than in local currency. U.S. branch offices of foreign banks play a key part in this process: As of 2009, U.S. branches of over 150 foreign banks had raised $645 billion to make loans in their home countries, making special use of U.S. money-market funds, where about one half of these funds’ assets are liabilities of foreign banks.

This increased flow of funds abroad—whether through direct securities purchases or through bank lending—puts upward pressure on the exchange rate in these countries, as the foreign firms sell their borrowed dollars and buy local currency to expand their operations and pay workers. That’s when foreign central banks enter the story. Concerned about the negative impact of the appreciating currency on their country’s exports or with the risky dollar borrowing of their firms, they respond in several ways.

First, they impose restrictions on their firms’ overseas borrowing or on foreigners investing in their country. But the differences in yield provide strong incentives for market participants to circumvent the restrictions.

Second, central banks buy dollar assets, including mortgage-backed securities and U.S. Treasurys, to keep the value of their local currency from rising too much as against the dollar. One consequence of these purchases is a foreign government-induced bubble in U.S. securities markets, as we saw in mortgage markets leading up to the recent crisis, and as we may now be seeing in U.S. Treasurys.

The flow of loans from the U.S. to foreign borrowers is effectively matched by a flow of funds by central banks back into the U.S. There is no change in the current account, and no role for the so-called savings glut.

Third, in order to discourage the inflow of funds seeking higher yields—which would drive up the exchange rate of their own currency—foreign central banks hold their interest rates lower than would be appropriate for domestic economic stability. There is much statistical evidence for this policy response, and, when you roam the halls of the BIS and talk to central bankers, as I did last week, you get even more convincing anecdotal evidence. Call it the lemming effect: Central banks tend to follow each other’s interest rates down.

This is what happened in the lead up to the 2008 financial crisis, and it has helped fuel Europe’s current debt crisis. In the 2003-2005 period, low interest rates led to a flow of funds into U.S. mortgage markets as foreign central banks bought dollars, aggravating the housing boom and the subsequent bust.

Moreover, the European Central Bank’s interest rate moves during 2003-2005 were influenced by the Fed’s low rates. By my estimates, the interest rate set by the ECB was as much as two percentage points too low, which also had the effect of spurring housing booms in Greece, Ireland and Spain. Ironically, the European debt crisis, which originated in the booms and busts in Greece, Ireland and Spain, now has come around to threaten the U.S. economy.

The Fed’s current near-zero interest rate policy, designed to stimulate the U.S. economy, has made it harder for other central banks to combat credit and asset price booms. A group of 18 emerging market central banks—including Brazil, China, India, Mexico and Turkey—held their interest rates on average as much as five percentage points below widely used policy benchmarks—and global commodity prices doubled from 2009 to 2011, a boom rivaling the excesses leading up to the 2008 financial crisis. This global, loose monetary policy was likely a big factor pushing up commodity prices. The current sharp slowdown in most emerging markets coincides with an inevitable bust of this easy-money induced boom, and the decline of foreign demand for American goods is now feeding back to the U.S. economy.

The Fed needs to pay closer attention to global capital flows and the reactions of other central banks to its decision to set interest rates very low for long periods of time. This does not mean taking one’s eye off the U.S. economy, but rather preventing booms and busts abroad from slowing growth at home precisely when we need it most.

A Dangerous World

I’m not a gold bug, though I can appreciate it’s insurance value against bad government. Nevertheless, this Barron’s interview provides a good overview of what we face in the international economy.

Going for Gold in a Dangerous World


Eidesis Capital’s Simon Mikhailovich on why physical gold outside the world’s banking system is the safe place to be. Understanding the Philadelphia problem.

Simon Mikhailovich knows a thing or two about financial weapons of mass destruction. With a wealth of experience in structured credit, he co-founded Eidesis Capital in 1998 with Michael Sollott, after they completed a buyout of the collateralized-debt-obligation business of St. Paul Travelers.

The new firm focused on distressed CDO investing. Its latest such private equity-style fund, the $180 million Eidesis Special Opportunities III, had a net internal rate of return of 17% from July 2009 through June 2011, when it decided to lock in gains and return most of investors’ capital.

Mikhailovich, who emigrated to the U.S. from the Soviet Union in 1979 with just $100 in his pocket, issued early warnings in 2007 about the impending collapse of the derivatives market, and the coming financial crisis. Convinced the worst is yet to come, Eidesis, which also is managed by Jim Wang, now invests mostly in gold bullion in various locations around the world outside of the banking system. To understand why, read on.

Barron’s: What’s your view of the current macro picture?

Mikhailovich: The U.S. has so far succeeded in going slowly to allow an orderly deleveraging of financial assets. But the policy measures—essentially zero interest rates—are like antibiotics. The effectiveness wears off over time, you need to take more and more to achieve less and less, and eventually they stop working. Our concern is that excessive indebtedness around the world is driving governments to try to perpetuate a protracted deleveraging, because short-term deleveraging is very painful. But there are some natural limitations. Interconnectedness in markets—now higher than it has ever been—has been created by disruptive new technologies, which aren’t very well understood.

Try us.

One technology is securitization, such as CDOs, where high-risk debt is recharacterized into investment-grade securities. The other is over-the-counter credit derivatives, which are basically grossly under-reserved insurance. When you combine the government policies with the level of interconnectedness in markets, it creates a recipe for disaster.

What are the short-term chances that we see a meltdown comparable to 2008?

Chances are high. Although there’s faith in the U.S. and its ability to help Europe navigate this situation financially, the U.S. itself has a big pending problem of the debt ceiling, of automatic tax increases, of the presidential election. There’s tremendous uncertainty. Many things have to go right in the short term to delay the eventual resolution, if you will. Based on recent precedent, it’s clear the politicians have no incentive to act unless they are faced with some sort of existential threat. A compromise will only delay the problem, because it’s a problem of excessive indebtedness and you can’t solve a balance-sheet problem without solving it, except by delaying it.

So the risks are greater than 2008?

Yes. The disruptive technologies and government policies have created an extremely highly correlated environment with all financial markets and all financial institutions. The risks were manifest in 2008, but rather than defuse them, government policies have since increased the interconnectedness. Too big to fail is now too bigger to fail. Northern European countries have been trying to figure out how to bail out Southern European countries, which increases their interdependence. The Federal Reserve is opening credit lines to the European Central Bank, and essentially supporting the ECB and providing liquidity to the European banks. Rather than enable a quick but extremely painful deleveraging, Western governments are trying to delay it by borrowing significant amounts to supplement economic activity. Debt increases the risks by increasing the interconnectedness of financial institutions and governments. Correlation is a measure of risk. That poses threats that have never existed before to the stewards of capital.

What can the government do?

My approach is what investors should do to protect themselves from the consequences. Investors need to examine old ideas about diversification, and to realize that both bonds and stocks have become much more highly correlated than ever. Investors should look for alternative sources of uncorrelated assets or assets whose value is less correlated, as opposed to simply looking at the price of those assets. The hidden cost of deleveraging proceeding without a blowup is that it transfers value from savers to debtors. It creates perverse incentives because it breaks the price mechanism, which is the most important signal in a free-market economy. We don’t know the real cost of misallocation of capital. Meanwhile, people are making valuation decisions based on these bad signals.

Where do you allot assets if you are concerned about correlated risk?

There are two roles of uncorrelated sources of returns, or reserves, in a central banking sense. Reserves are essentially hedges or protections, they’re monies or some value that is sitting on the sidelines that can be pressed into service if something happens and you need to rely on these stores of value, for two reasons. One is to protect the value of part of the portfolio, and the other is to have access to liquidity during market disruptions when you can profit by being able to buy when others do not have access to liquidity. We concluded such an asset is physical gold bullion—not paper or derivative instruments—held securely outside the financial system, which is potentially subject to a disruption like we saw in 2008, and geographically diversified to provide access to various markets, where the hope is that at least one or some of them would be liquid. That is a very intelligent way to allocate part of your portfolio to this sort of reserves.

Central banks all have gold reserves, and they’ve been increasing them. Recently, the Swiss National Bank announced that it holds its reserves in diverse locations around the globe. A spokesman explained that the main reason is to protect against a crisis scenario.

They aren’t comfortable storing their assets in their own country?

A cardinal rule of risk management is, don’t put all your eggs in one basket. If anybody is an expert in safe-haven assets, it is the Swiss National Bank. The U.S., for example, holds its gold reserves outside the financial system, at Fort Knox and at West Point.

We came up with a vehicle that enables investors to do the same thing. Our specialty is structured credit, and credit derivatives are mispriced because the rates are at zero and are subject to potential significant disruptions. We have just seen an example of that. Despite the fact that JPMorgan Chase was lauded as the most capable risk-management institution, it is facing potentially very large losses. Their trade wasn’t a hedge. It was a very specific bet on a very specific set of outcomes that is not panning out.

Can you imagine another Lehman event?

It’s just a matter of time. This financial system is completely unsustainable. The level of interconnectedness, the level of misapplied incentives is again unprecedented in history. If you were offered a game of chance where when you win, you win, and when you lose, you are given another chance to throw the dice, then, of course, everybody would play that game and essentially that is where the financial system is. That isn’t capitalism. That creates distortions, misallocation of capital, and mismanagement of risk, and we are seeing it time and time again.

Should the U.S. break up the big banks?

The most important thing for the government to do is admit the truth: that we have all participated in overspending through various means and that our standard of living exceeds our ability to pay for it. As with any emergency, this requires a tremendous amount of leadership. Before you can solve the problem, you have to admit you have a problem. And it is critically important to restore the confidence of the population in the fact that the system is not rigged.

It’s absolutely disgraceful that 2008’s consequences haven’t been the same as, let’s say, savings and loans in the 1990s. Unquestionably, things were done that were illegal in many cases, certainly grossly negligent. By various fiduciary and criminal standards, we should have seen a tremendous number of prosecutions and successful lawsuits. The U.S. system was built on a very simple premise: if you take a chance and succeed, you reap the rewards of your success. If you take a chance and fail, you have to take the consequences of your failure. When you disconnect greed and fear, greed runs rampant.

What’s the endgame for the euro?

I don’t know; nobody knows. If we step back from everything that is going on in the U.S., and in Greece and Europe, one can say that the endgame ultimately is devaluation of financial assets. It is almost as if these disruptive financial technologies enabled overproduction of financial assets. They increased productivity and they created oversupply, and that excess supply needs to be liquidated. But the liquidation is what governments don’t want to allow. So they are trying to support the prices of goods and services that have been overproduced, which are financials. That is the endgame. Greece has overproduced credit…. There is a huge vulnerability. What about Spain? What about Portugal? What about Ireland? These are irreconcilable issues, and the only way they can be reconciled is by printing more money for the moment. The ability of governments to sustain the unsustainable ultimately rests on their ability to maintain faith in their creditworthiness, and faith is something that takes a long time to crumble. But once it goes, it can go very quickly. Here is the paradox: Governments are borrowing more and more, and the spreads of government securities are getting tighter and tighter. So the creditworthiness is getting worse and the cost of funding is getting better.

How do you explain it?

Very simple. It is faith. It is muscle memory. It’s normalcy bias, a psychological phenomenon that prevents people from seeing unconventional threats. People overestimate their previous experience and they underestimate future experience…. But there may come a moment when it doesn’t work, and then what’s a safe haven? lt is gold. It’s silver, diamonds, Rembrandts, Picassos, real estate. It’s agricultural land. It’s the means of production.

But you have to consider the Philadelphia problem. In the movie Trading Places, the hero is trying to sell his very expensive Swiss watch at a pawn shop in Philadelphia, and he is told that in Philadelphia it’s worth 50 bucks. The benefit of land and of paintings and other stores of value is that they are not financial assets and they do preserve value over an extended period. But they are not liquid during times of disruption. You can’t get a fair price; they’re unique, whereas gold is ubiquitous. It’s divisible. It’s measurable. It’s testable. There is a global market for it. So you will never have the Philadelphia problem. You may not like the price, but it is never going to be a rip-off.

So, gold is going to rise over time.

The price of gold never rises. It is the value of financial assets that declines. Gold is a store of value. Gold is not an investment. However, in the current environment, gold can produce tremendous real returns because it’s an asset that doesn’t produce any cash flow. Its valuation is driven exclusively by supply and demand. In the 10 years through 2010, a study has shown, 80% of physical demand for gold came from emerging markets and only 20% from the developed world, and half of that was for jewelry. Developed markets that are the repositories of most of global financial wealth have had de minimis demand for physical gold. If this devaluation of financial assets proceeds apace and the moment of clarity comes for many investors in the West who realize they need to diversify into assets that can protect against devaluation, demand for physical gold has the potential to rise dramatically.

What about commodities?

It is very difficult to own commodities physically, and therefore you are subject to market disruptions and counterparty risk. MF Global’s clients thought they owned commodities. They even thought they owned U.S. Treasuries, and they ended up being paid 70 cents on the dollar for their Treasury holdings. Lehman clients couldn’t get full value for assets they didn’t think were at risk. They thought they were simply in custody of Lehman Brothers. That raises another problem with financial technology—re-hypothecation—where banks make money by lending out collateral. Every asset and every dollar that is in custody in a bank, unless specific legal arrangements are made, is re-lent, and as we saw with MF Global and with Lehman, ultimately it is the customer or the investor who bears the counterparty risk.

Do you have any of your money in a bank?

Of course. But I try to diversify. This isn’t about the end of the world. Armageddon is a physical end of the world, financial disruption is financial disruption. Many countries have gone through financial disruptions and had their currencies devalued and had all sorts of economic problems, even in the last 20 years. Russia, Argentina, Brazil—it didn’t extinguish life in those countries.

But you’re talking about a greater correlation between the financial system and these financial weapons of mass destruction.

They destroy money, not lives. Human history ultimately is the history of ebbs and flows of wealth, and the ability to preserve wealth over time requires a very proactive approach. Secular changes that disrupt technologies are traditionally very, very difficult, and many will lose. But some people will win. Tremendous wealth was created during the Great Depression. The idea is to position oneself to survive financially and potentially enhance one’s position.

Democracy and the Euro or “The Greek Stand-off”

Hold on folks, it looks like Greece may turn out to be the Lehman Bros. of public debt. Moral hazard on a national scale. No wonder markets are nervous.

Greeks have to face the consequences of their own political choices.

One way to look at this week’s events in Greece is as George Papandreou’s revenge. As Prime Minister last November, he proposed that Greeks vote on whether they could live with the conditions the EU and IMF were imposing in return for a bailout. The idea sent markets into a tizzy, Mr. Papandreou lost his job, and the referendum never occurred.

But Greek voters are having their say anyway. On Tuesday Greek President Karolos Papoulias called a new election for next month, after no party could put together a majority following this month’s splintered election.

The far-left Syriza coalition, which finished second in the voting, is rejecting the bailout terms and demanding an end to fiscal restraint and economic reform. Presumably the Greeks will now have a no-holds-barred debate about the consequences of their policy choices, including possible ouster from the euro zone.

The rest of Europe may find this inconvenient, but this strikes us as progress and in any event was inevitable. That was the wisdom behind Mr. Papandreou’s stillborn idea. Like every other country in the EU, Greece is still a democracy. Greek voters reserve the right to say no to Brussels, or even to elect those willing to abrogate agreements made in their names by former governments.

For decades, the European conceit has been that voters would gladly cede their national right to democratic accountability in return for Continental peace and prosperity. This worked as long as there was prosperity. But now that pan-European governance includes painful policy choices imposed from afar, the national publics want their franchise to mean something.

Angela Merkel may want to enshrine fiscal rectitude for all time in a fiscal pact. The German Chancellor may even be right as a policy matter to want to do that given that her taxpayers will otherwise have to pay. But the fatal flaw in her vision is that she can’t control the course of democratic events outside Germany’s borders. All the more so when she has become arguably the main issue in Greek politics, complete with demagogic posters of her in Nazi garb.

In a sense the Greeks are using their elections as a way to renegotiate the terms of their most recent €130 billion bailout by the rest of Europe. They assume that if they refuse to go along, the Germans and the European Central Bank will give in and ease the terms of fiscal retrenchment and reform.

The belief, at least on the Greek left, is that the country will be able both to stay in the euro and keep its generous welfare state, albeit with some mild adjustment. Syriza leader Alexis Tsipras is even proposing to hire 100,000 more public employees.

European leaders will be doing everyone a favor if they make clear that there is no such easy way out. If Greeks want to continue being rescued by the rest of Europe, they must meet European terms. If Greeks can’t manage that, then Athens will get no more bailout cash and will have to find the money to pay its own bills.

And if Athens fails to do so, then default and ouster from the euro zone are likely, with all of the predictably terrible consequences for Greek living standards following the return of the drachma and devaluation. Instead of staying as part of modern Europe, Greece will slide toward a Third World future.

European leaders need to deliver this message not as a threat, but as the reality of what Greeks are risking if they reject reform. At least this is a choice Greeks will be making for themselves. The lesson will not be lost on voters elsewhere in the euro zone.

Europe’s leaders can’t repeal democracy on the Continent, and therefore they can’t ask countries in the euro zone for more than their politicians can deliver or their populations can take. This means admitting that the bailout model that Europe adopted for Greece two years ago has failed and is increasing political polarization across Europe, and not only in Greece.

The euro zone was conceived as a currency union among countries adhering to certain basic fiscal rules. Had it stuck to that vision in this crisis—rather than turn it into a fiscal or debt union—and let Greece face the consequences of its economic mismanagement from the beginning, Greece might have defaulted and stayed within the euro.

Now so much damage has been done that it’s hard to see such an outcome. Trying to turn the euro into a larger political union has put the entire euro zone in jeopardy.

Barron’s Interview with John Taylor

Fiscal Follies, Monetary Mischief


Stanford Prof. John Taylor believes that government economic policies should be constrained and predictable rather than ad hoc and discretionary. In particular, he is extremely leery of stimulus spending, and the looming possibility of QE3.

Stanford University economics professor John Taylor is perhaps best-known as the creator of the “Taylor Rule,” which seeks to determine the Federal Reserve’s interest-rate target according to a simple formula. He has also become an outspoken critic of both fiscal and monetary policy as practiced over recent years.

Taylor writes a lively blog called “Economics One,” and, early this year, published the book First Principles: Five Keys to Restoring America’s Prosperity. Professor Taylor recently sat down with us for an interview at our offices in New York. Here are some edited excerpts:

Barron’s: What’s the best case you can make on behalf of those who defend the recent fiscal stimulus?

Taylor: The case that has been made for the discretionary fiscal stimulus is based on quite conventional Keynesian theory. It is basically that, if the government gives people a lot of extra money on a one-time basis, they will spend it. Not all of it, but most of it. Similarly, when the federal government gives money to states and localities as part of the temporary fiscal stimulus, it will be spent in such a way as to boost gross domestic product. And that will greatly help when economic activity is otherwise either contracting or stagnant.

My own view is that the theory is flawed, and the evidence that the fiscal stimulus achieved the desired result is practically nonexistent. The surge in federal spending only increased the burden of the already burdensome federal debt.

Start with the evidence.

The attempt to stimulate consumer spending in 2009, or the earlier attempt under President Bush in ’08, showed the expected rise in consumer income as government payments were made, but little or no response from consumer spending. Inconveniently for the advocates, consumer spending actually declined in some of the calendar quarters when it was supposed to have been stimulated. If you use statistical analysis to take into account the factors that would have brought increases or decreases in consumer spending, you find virtually no boost to spending from the stimulus.

As for the money sent to states and localities, economist John Cogan and I found that the funds were either put into financial assets or used to reduce borrowing. The hoped-for increase in infrastructure spending was negligible.

What is also inconvenient for the advocates: According to the national income and product accounts, state-and-local government purchases were lower every quarter in 2009 and 2010 than in 2008.

And you would expect these results from the standpoint of economic theory?

Let’s start with consumer spending. It’s basic economic theory that most people look beyond the very short-term. To expect them to rush out and consume more when the government cuts them an extra check on a temporary basis is not realistic. Instead, they will bank most of the extra money or use most of it to pay down debt. There are exceptions, of course. Some people will feel so pinched, they will need to spend the money. But the data show that the exceptions don’t dominate the story.

It has been argued, however, that the Reagan tax-cuts of 1981 were an example of effective fiscal stimulus.

The Reagan tax cuts were not temporary or targeted, which are defining characteristics of discretionary fiscal stimulus packages. The Reagan tax package was meant to be permanent, and a permanent tax cut can certainly influence consumer behavior for the same reason that a temporary tax cut does not. Consumers can rely on the extra income and might boost spending accordingly. Businesses might then respond by expanding capacity, because they feel they can rely on the extra sales. And the permanently lower tax rates will encourage more hiring and investment.

But let’s even imagine that, with temporary tax cuts, consumers do spend all the extra money at the malls. Can we expect business to respond by hiring more workers on a lasting basis? Of course not. Businesspeople will know better than anyone that the pop in spending won’t last.

The Obama administration’s “cash-for-clunkers” program did seem to have the desired effect, however. Consumers in possession of a qualified clunker could trade it in for an inflated rebate, and then apply that government-funded rebate to the purchase of a new car. And yet that was a temporary stimulus.

It certainly was, and it taught us the unsurprising lesson that if you offer consumers a financial incentive to buy a new car, people already planning to do so will take advantage of that incentive and make the purchase sooner rather than later.

It also taught us something else about the problem with temporary-stimulus programs: Even when they work, there is payback shortly afterward. Cash-for-clunkers caused a pop in new-car sales for only a month or two, soon followed by a downside correction.

Let’s return to your point about the states failing to spend the fiscal stimulus money on infrastructure. One theory in support of such policies is that they depend on competent people implementing them, and in this case, we just didn’t have enough competent people. So more competence will make that kind of fiscal stimulus work.

But the competence you are assuming is based on the unrealistic idea that we have a completely different federal-state political system. For example, some observers think China’s government was recently successful in boosting infrastructure spending to spur economic activity. We don’t know for sure, but let’s assume they’re right. There is no lesson in that for the U.S. because we can’t choose China’s system—and wouldn’t want to even if we could.

For one thing, local governments in China have no access to capital markets. They basically take what they get from the central government, and spend what they get. And since they always have a list of projects on the shelf, all the central government need do is lower the hurdle for what is a good project, and suddenly the project gets implemented.

By contrast, we have a decentralized system in which state and local governments do have access to borrowed funds. That is what you have to take largely as a given.

You are saying we don’t really have shovel-ready projects that can be quickly implemented by government?

Back in the 1970s, the Carter administration made stimulus grants to the states, and that did not work, either. There are some who say: Just use the military—they can always spend the money somewhere. But how useful, or politically realistic, is that? It would probably be worthwhile to have more information technology in medicine, and better record-keeping. Part of the stimulus went to that. But how could that possibly stimulate the economic recovery from recession, when it should all be planned and implemented carefully over time?

Government officials imagined they had a little textbook model. You boost the “G” that stands for government spending, and voilà, it works. But that is not the reality.

But if, as you say, consumers and local government used to the money to reduce borrowing and pay down debt, could that be a completely bad thing?

It can’t be bad to reduce the debt of consumers and of state and local government. But it can’t be good to boost federal debt in the process by the same amount. So that’s a wash. It’s really hard for me to see it as a net positive.

Is there any part of the huge increase in the federal deficit during this period that you do not oppose?

Absolutely—the part that is normally referred to as “automatic stabilizers.” When the economy contracts or barely grows, certain fiscal responses happen automatically. Revenues from taxes decline, as profits, capital gains, and wages and salaries decline or barely grow. Spending also increases—on welfare programs, unemployment insurance, and when some people retire earlier than planned and claim Social Security payouts. So you automatically get a decline in revenue and increase in spending.

I emphasize the “automatic” quality of these events. They are predictable, and they occur in a timely fashion. What is unpredictable and not timely is the futile attempt to engage in proactive, discretionary fiscal policy.

Right now, the Federal Reserve’s official interest-rate target on federal funds is 0% to 0.25%. Is that where the target should be according to the Taylor Rule?

No, the interest-rate target would be at 1%, or a little higher. That is based on starting with a multiple of the inflation rate, and then adjusting up or down for the growth rate of the economy compared with its potential growth rate. Right now, the growth-rate part of the formula would call for a downward adjustment, so you end up around 1%.

The Taylor Rule is based on empirical research about what tends to work best for the short-term interest rate. It is far from perfect. It just works better over the long run than the discretionary tinkering of imperfect human beings. And in fact, through most of the period from the early 1980s through 2002, when the economy performed relatively well, the central bank’s interest-rate target tracked the Taylor Rule fairly closely.

But not since then. You have said that during the period from 2003 through 2005, the fed-funds rate violated the Taylor Rule by being too low.

Yes, at times by as much as three full percentage points. And that helped cause the financial crisis, as I have argued in my book Getting Off Track.

Federal Reserve Chairman Ben Bernanke, who was a Fed governor under Chairman Alan Greenspan when this policy was implemented, has responded publicly to your criticism. What would you say is his best argument?

His argument has been that, at the time, they were forecasting a slowdown in the rate of inflation. And that if you used this forecast, the target they maintained would have been consistent with the Taylor Rule.

And what’s your response?

My main response is that the Taylor Rule does not, and should not, depend on forecasts. Forecasts are subjective—and therefore too discretionary. Based on what was known at the time about inflation and economic growth, the target was far too low.

Bernanke once claimed that economists generally agree that the Fed’s policies in 2003 and ’04 did not contribute to the housing bubble.

Yes, but Bernanke mainly cited himself or the Fed board staff, and did not cite others who concluded just the opposite: that the Fed’s policies did help fuel the housing bubble. More recently, Bernanke has retreated from that position. He now says there is no consensus among economists about the Fed’s role. I regard that as progress.

On another important component of Fed policy, what do you think of quantitative easing?

I opposed the large-scale asset purchases of QE1 and QE2, and believe it’s unfortunate that the central bank is still publicly considering a QE3. They were ineffective, and potentially harmful.

These massive purchases of mortgages and medium-term Treasuries were aimed at lifting the value of these fixed-income securities, and thereby bringing down the relevant interest rates. At best, that was the short-term effect. But how long can such an effect last? What basically determines these interest rates are expectations about future interest rates, which in turn are partly determined by inflationary expectations.

You don’t believe purchases by the Fed have any long-lasting influence?

Let’s suppose something even more misguided: For QE3, the Fed decides to buy the stock of publicly traded companies in order to lift stock prices. Equity prices would rise. But how long could that last, unless the earnings of these companies rise proportionately? Price-earnings ratios would become unsustainably high, and the market would soon correct for the Fed’s aberrational influence. The same dynamics work for the bond market.

Apart from not helping, quantitative easing has also hurt?

Speaking of the stock market, notice that stock prices have become sensitive to whether or not the Fed will implement QE3. I see no reliable relationship between equity prices and quantitative easing, but the fact that many people believe in it is at least a source of concern. Another important concern is just how the Fed will manage to sell off all the mortgage-backed securities and medium-term government bonds it now holds on its balance sheet without causing disruptions in the market.

But my real worry is that quantitative easing may become a pillar of Fed policy. If the economy speeds up, you do less of QE; if it slows down, you do more. Quantitative easing may become not just the wave of the present, but of the future, which could be very damaging.

What’s the basic lesson for both fiscal and monetary policy?

Both policies should be predictable, not discretionary and unpredictable. It is always possible that some brilliant policy maker can do something unpredictable that will yield a better outcome. But history has shown us repeatedly that this usually yields worse outcomes. My new book, First Principles, names “policy predictability” as one of five key principles.

And the other four?

Rule of law, strong incentives, reliance on markets, and a clearly limited role for government.

Thank you, John.

Default and the Nature of Government

Instructive history. After reading, see the explanatory graphic from Political Economy Simplified: The Credit-Debt Machine.

From the WSJ:

Because governments always promote government debt and can pressure banks into buying it, future sovereign debt crises are inevitable.


Twenty-first century economists, financial actors and regulators blithely talked of the “risk-free debt” of governments, and European bank regulators set a zero-capital requirement on the debt of their governments. The manifold proof of their error is that banks and other investors are now taking huge credit losses on their Greek government bonds.

The only question is why anybody would be surprised by this. The governments of country after country defaulted on their debt in the 1980s, a mere generation ago. In a longer view, Carmen Reinhart and Kenneth Rogoff count 250 defaults on government debt from 1800 to the early 2000s. As Max Winkler wrote in his instructive 1933 book, “Foreign Bonds: An Autopsy”: “The history of government loans is really a history of government defaults.”

Winkler chronicled many examples of government defaults and repudiations of debts up to 1933, including those of Austria, Bolivia, Brazil, Bulgaria, Canada, Chile, Ecuador, Costa Rica, Germany, Greece, Guatemala, Latvia, Mexico, Peru, Romania, Russia, Turkey and Yugoslavia—as well as those of a dozen U.S. states.

Among the financial history lessons now forgotten is the European sovereign debt crisis of the 1920s. The losers of World War I were flat broke. But the winners, principally the governments of Britain and France, had vast debts they could not pay.

Simply put, the theory of the Versailles Peace Treaty at the end of the war was that Germany would be forced to pay reparations, a form of debt, so that France could pay its debt to Britain and the United States, and Britain could pay its debt to the United States. There was a slight problem, of course: Germany probably could not, and certainly would not, make the payments as decreed by the treaty, so no one could pay off their debt.

By the mid-1920s, it was obvious that the expected repayments were not happening and could not happen. The debt crisis gave rise to complex international negotiations and an agreement that included the restructuring of German obligations, along with new lending to Germany. This was considered at the time a landmark success. The similarity to the recent fevered negotiations in Europe is clear.

The 1920s negotiations were carried out by the international Dawes Committee, resulting in the then-famous Dawes Plan of 1924. The effort was chaired by Charles Dawes, who was elected U.S. vice president later that year and was awarded the Nobel Peace Prize in 1925 for the plan.

Under the Dawes Plan, German payments were reduced and restructured. The French military occupation of part of Germany, part of a plan to enforce payments, would end. Foreign creditors were to have oversight of the Reichsbank, Germany’s central bank—and the creditors were to have as collateral German customs duties, taxes on tobacco, beer and sugar, and revenue from alcoholic spirits.

But can you enforce your rights to such collateral if a powerful government decides not to pay? You can’t.

New loans from the U.S. would make Germany’s planned payments possible. Americans would lend Germany money, so it could pay France and Britain, so they could pay the U.S. One might imagine that this pattern of making new loans to pay old obligations was not sustainable, and it wasn’t.

But the German External Loan of 1924 that followed to implement the Dawes Plan was considered by many to be “a brilliant success.” As late as 1930, with 19 years left to maturity, these 7% Dawes loan bonds traded above their face value, at 109. “The Dawes Loan opened the eyes of American investors to the romance of buying foreign securities,” wrote Charles Kindleberger and Robert Aliber in their classic “Manias, Panics and Crashes.” Foreign government bonds became popular in the new financial capital of the world, New York City.

But it was a disappointed romance. In 1934, the German government announced it was no longer paying on Dawes bonds. By 1936, 35% of the sovereign bonds floated in New York in the 1920s were in default—an experience similar to defaults on subprime mortgages in our own time. The vast majority of the sovereign debt that had been created by World War I also defaulted.

In 1933, Winkler predicted that “All will at last be forgotten. New foreign loans will again be offered, and bought as eagerly as ever.” And then: “Investors will once again be found gazing sadly and drearily on foreign promises to pay.” A brilliant forecast.

As European banks and other investors today gaze sadly on government promises to pay, it is essential to ask: Who promotes loans to governments?

The answer is that governments promote loans to governments. They have an obvious self-interest in promoting loans to themselves and to other governments they wish to help or influence. Banks are extremely vulnerable to pressure from governments—the more regulated they are, the more vulnerable. Employees of government bureaucracies have an incentive to encourage loans to their political employers—an inherent conflict of interest.

In addition to promoting their own debt to all possible buyers at all times, governments promoted the World War I loans to the Allies; loans to Germany in the 1920s; loans to developing countries in the 1970s, which defaulted in the 1980s; loans to Fannie Mae and Freddie Mac until they failed; and loans to fellow governments in the European Union up to today.

Because governments always promote government debt and can induce or pressure banks into buying it, future sovereign debt crises are inevitable.

The Vatican’s Calls for Global Financial Reform

The bishops are right on the money (!) with their diagnosis of the problem, but seem a bit off in advocating for centralized authority over globalization. Seems to go in exactly the wrong direction. We need more democratic and market transparency and accountability. (Admittedly, not the Church’s strong point.)

From Foreign Affairs:

The Future of the Church in the Financial Order
Samuel Gregg
February 7, 2012

Last October, a bold proposal to reform the global financial system came from an unexpected source: the Catholic Church. As the eurozone teetered on the brink of economic chaos, the Pontifical Council for Justice and Peace — a body of the Roman Curia that advises the pope on economic justice, peace, and human rights — issued “Towards Reforming the International Financial and Monetary Systems in the Context of Global Public Authority” (more simply called the “Note”). The Council’s goal in publishing it was explicit: the Church wanted to attract the attention of world leaders as they assembled to discuss ongoing turmoil in financial markets at the G-20 Summit in Cannes and to add its voice to those arguing for capital controls (such as the “Tobin tax”) to discourage international financial speculation. Then, early last month, during his keynote speech for the New Year to diplomats accredited to the Holy See, Pope Benedict XVI reinforced the call for ethics in the global economy. The Pope’s words echoed the Note’s urgent call for new, even radical thinking about the rules and institutions governing the global economy.

The Note argued that the root cause of today’s economic woes is the growth of excessive credit and monetary liquidity in the past few decades, which, in turn, inflated asset bubbles and set off a succession of debt and confidence crises. It also held that the lack of regulatory controls on international finance exacerbated the problem — in other words, that the pace of economic globalization has been out of control. The resulting instability and economic inequality means that the world now requires “a system of government for the economy and international finance.” Once world leaders recognize, the Council argued, that increasing global interdependence is forcing countries to move beyond a Westphalian, or state-based, international order, they will be more prepared to cede their own sovereignty in the interests of global humanity’s common good.

On the one hand, the Church advocates a world authority that manages globalization in the interests of economic justice. Yet it is equally committed to open markets, also as a matter of economic justice. Reconciling these two commitments will be a major test for Catholic social doctrine.

Considering the Church’s history and its social doctrine, its call for a supranational authority is hardly a surprise. The Church has long viewed nation-state sovereignty as a challenge to its autonomy. Historically, it was far more comfortable operating in more fluid internationalized settings, such as during the Holy Roman Empire or Medieval Christendom. The devastation of World War II convinced senior European Catholics that the power of nation-states had to be tamed. This helps to explain why the Church was such an advocate of European unification. Indeed, prominent Catholics such as the former French Prime Minister Robert Schuman were central players in the processes set in motion by the 1957 Treaty of Rome. Six years later, Pope John XXIII endorsed the idea of a world authority, a call reiterated in all subsequent popes’ social teachings. The Church has avoided identifying such a body specifically with the United Nations. And it has tended to describe such an authority’s functions in very general terms such as “coordination.” But the logic is that if the conditions that facilitate human flourishing increasingly transcend national boundaries, the modern state’s claim to be the highest political authority capable of coordinating such conditions is unwarranted. In practical terms, some Church officials calculate that a world authority would be easier for the Church to navigate than a global order of sovereign nation-states.

Yet a world authority could pit the economic interests of Catholics in developed countries against those in developing nations, creating challenges for how the Church presents its teachings about economic issues to Catholics throughout the world. Many countries throughout Latin America, Africa, and Asia are in a fundamentally different economic and geopolitical place from those of the ailing EU. The Church must thus deepen its appreciation of how the global operation of economic factors such as comparative advantage, incentives, and tradeoffs has different impacts upon Catholics living in very dissimilar economic circumstances. But this also has implications for the Church’s position concerning the economic functions to be assumed by a world authority. Such responsibilities, for example, could primarily concern promoting greater economic integration through removing obstacles to trade. This, however, would be incompatible with the Note’s theme that a world authority’s economic functions should be focused upon securing greater control over the pace of change through international regulations that, if implemented, would significantly impede the free movement of people, goods, and capital.

While the Church’s senior leadership is disproportionately European in composition, the Catholic Church’s epicenter in raw numbers has shifted to the developing world. According to statistics contained in the Vatican’s 2011 Annuario Pontificio, European Catholics now account for just 24 percent of the world’s 1.18 billion Catholics. In 1948, the equivalent was about 49 percent. Today, almost 50 percent of all Catholics live in the Americas, and most of them south of the Rio Grande. Demographically, the European Church has stagnated for three decades. But its expansion in Africa, Asia, and Latin America in the same time period has been staggering. Between 2005 and 2009 alone, the number of African Catholics grew from 135 million to approximately 158 million.

These realignments parallel changes in the economic path pursued by many of the developing nations in which most of the world’s Catholics live. In recent years, economic growth has taken off in many developing countries at a pace that dwarfs European growth rates. Over the last three decades, many such countries (Chile and Brazil being prominent Catholic examples) have gradually moved away from top-down economic planning toward greater openness to global markets as a primary way to diminish poverty and spur economic growth. Within Catholic social teaching, there is considerable support for such market-oriented paths. Since 1991, Catholic social doctrine has re-emphasized that developing nations have a right to freely access networks of global exchange. The free trade and anti-protectionist implications of this principle were spelled out in John Paul II’s encyclical Centesimus Annus and reiterated in Benedict XVI’s 2009 Caritas in Veritate. How this fits, however, with the Church’s ongoing emphasis on the need for a world authority — and, more immediately, with the Note’s call for capital controls — needs to be clarified.

Moreover, the Church’s teaching on these matters is grappling to accommodate the growing divergence between the immediate economic expectations of Catholics in developed European nations and those living in emerging economies. For Catholics in developing countries, economic globalization is a way out of poverty. This helps explain why some traditionally Catholic countries such as Colombia, Guatemala, Mexico, and Panama have pushed for free trade agreements with the United States, while others, such as Brazil, have pursued trade agreements within Latin America. Likewise, African countries with large Catholic populations, such as Kenya, Rwanda, Tanzania, and Uganda, have pursued regional trade agreements as steppingstones to wider entry into global markets.

By contrast, many Catholics in Western Europe see the same forces released by economic globalization as creating pressures to lower their countries’ regulatory barriers, reduce their wages, phase out subsidies, and rethink the high tax levels needed to pay for strong welfare states. Not surprisingly, many Europeans are reluctant to go down paths that represent a departure from postwar policies.

The tension between these two groups presents the Catholic Church with three significant and interrelated challenges. First, it must ensure that its emphasis on supranational institutions as a way of managing globalization is not interpreted as reflective of a desire to protect EU states from increasing competition from developing nations. Any appearance of protecting wealthy Europeans at developing countries’ expense would be considered inconsistent with the Church’s stated commitment to social justice and would risk alienating many Catholics in developing nations.

Second, the Holy See will increasingly find itself lobbied by European leaders as well as those of developing nations to lend its influence to the realization of incompatible economic objectives. What stance, for example, should the Church adopt toward agricultural subsidies? Many Europeans see subsidies as ways to protect European farmers from economic extinction. Africans and Latin Americans, however, are inclined to view the same EU subsidies as measures designed to blunt developing countries’ increasingly competitive edge in agriculture. In such debates, who will the Church end up supporting?

Third, the Church’s leadership faces an intellectual challenge. On the one hand, the Church advocates a world authority that manages globalization in the interests of economic justice. Yet it is equally committed to open markets, also as a matter of economic justice. Reconciling these two commitments will be a major test for Catholic social doctrine. Open global markets certainly need rules. But how would a world authority engage in top-down global economic management without significantly compromising the competition that flows from open economic and financial markets?

The Catholic Church is not in the business of exercising “hard power.” But it certainly shapes people’s minds, whether through the daily preaching of thousands of Catholic clergy, the formation imparted by its countless educational institutions, or the unique bully pulpit it possesses with the papacy. This is no guarantee that predominately Catholic countries will simply fall into line with the Church’s teaching on global economic governance issues. The Church is, however, in a position to shape millions of people’s attitudes. In an increasingly global public square, the influence exercised by a Church whose name means “universal” and which, as a religious organization, possesses an unrivaled worldwide presence means that when it makes pronouncements about global economic reforms, it should consider making requests that are consistent with its own future.