Panic Fallout

by Steve H. Hanke

The panic of 2008 has sent the political classes into fits of hyperactivity. Their favorite ploy has been to scare the public into supporting gigantic interventionist policies designed to inflate government budgets and re-regulate economic activity.

These scare tactics were on display as world leaders prepared for the London meeting of the Group of 20 on April 2. The countries represented in this grouping account for two-thirds of the world's population and 90% of its gross national product.

After failing to predict a slow-down, let alone a panic, the International Monetary Fund finally issued a scary forecast on March 19 — just in time for the G-20 meeting. This forecast allowed the IMF to peddle its prescriptions. Once the G-20's communiqué was released, doom and gloom were temporarily swept aside. The political classes had just struck a mother lode.

The G-20 winner was the IMF. The IMF's managing director Dominique Strauss-Kahn — a seasoned French socialist politician — could hardly believe the IMF's good fortune. At a press conference on April 2, Strauss-Kahn had this to say:

"Maybe some of you were in the IMF press conference at the end of the Annual Meeting last October. And if some of you were there, then you may remember that what I said at that time is that IMF is back. Today you get the proof when you read the communiqué, each paragraph, or almost each paragraph — let's say the important ones — are in one way or another related to IMF work."

If the G-20 summiteers come through with their pledges, the IMF's resources will be increased by over $750 billion (USD).

To put that in perspective, consider that the IMF's credits and loans outstanding at the end of 2008 were only $27 billion. As politicians confront a new crisis, the opportunists are playing the system and exploiting it for their own ends.

Much of the growth of government in the US and elsewhere occurs as a direct or indirect result of national emergencies such as wars and economic slumps. Laws are enacted, bureaux are created and budgets are enlarged. In many cases these changes turn out to be permanent.

As Robert Higgs verified in his 1987 classic, Crisis and Leviathan, crises act as a ratchet, shifting the trend line of government's size and scope up to a higher level. History provides many illustrations of how damaging this fallout can be.

Take the Great Depression. At that time, the organized farm lobbies, having sought subsidies for decades, took advantage of the crisis to pass a sweeping rescue package, the Agricultural Adjustment Act, whose title declared it to be "an act to relieve the existing national economic emergency."

Seventy-six years later, the farmers are still sucking money from the rest of society and agricultural policy has been enlarged to satisfy a variety of other interest groups, including conservationists, nutritionists and friends of the third world. Indeed, even though agricultural prices hit record highs last year, the river of government farm subsidies kept flowing.

Then, during the second world war, when government accounted for nearly half the US's gross domestic product, virtually every interest group tried to tap into the vastly enlarged government budget.

Even bureaux seemingly remote from the war effort claimed to be performing "essential war work" and to be entitled to bigger budgets and more personnel.

Even smaller crises have sent the opportunists into feeding frenzies. Let us return to the classic case of ever-opportunistic IMF. Established as part of the 1944 Bretton Woods agreement, the IMF was primarily responsible for extending short-term, subsidised credits to countries experiencing balance-of-payments problems under the postwar pegged-exchange rate system.

In 1971, however, Richard Nixon, then US president, closed the gold window, signalling the collapse of the Bretton Woods agreement and, presumably, the demise of the IMF's original purpose. But since then the IMF has used every so-called crisis to expand its scope and scale (see the accompanying chart).

The oil crises of the 1970s allowed the institution to reinvent itself. Those shocks required more IMF lending to facilitate, yes, balance-of- payments adjustments. And more lending there was: in the 1970-1980 period, IMF lending increased by 123%.

With the election of Ronald Reagan as US president in 1980, it seemed the IMF's crisis-driven opportunism might be reined in. Yet with the onset of the Mexican debt crisis, more IMF lending was "required" to prevent future debt crises and bank failures.

That rationale was used by none other than President Ronald Reagan, who personally lobbied 400 out of 435 congressmen to obtain approval for a US quota increase for the IMF. IMF lending ratcheted up again, increasing 108% in real terms during Reagan's first term in office. With the fall of the Soviet Union in 1991, the IMF reinvented itself again. According to the IMF, a temporary lending facility was needed "to facilitate the integration of the formerly centrally planned economies into the world market system."

The 1990s ended with the Asian Financial crisis (among others) — one that was misdiagnosed and made worse by the IMF's medicine. Never mind. The Asian crisis was yet another justification for more funding. During the 1990- 1999 period, IMF lending increased by 99% in real terms.

Not surprisingly, the events of September 11, 2001 did not catch the IMF flat-footed. On September 18, Paul O'Neill, the then US Treasury Secretary, had breakfast with Horst Kohler, the then IMF's managing director, to discuss the financial needs of coalition partners.

The IMF received a bit of a post-September 11 bounce. Then the IMF experienced a free fall, when the Federal Reserve (along with other central banks) pushed interest rates to record lows. The flood of new global credit was drowning the IMF until the credit bubble burst. That is when the IMF seized its opportunity.

The ratchet, of course, has many deleterious dimensions that reach well beyond public budgets. For example, on the same day the G-20 met in London, the US Financial Accounting Standards Board caved in to pressure exerted by the US Congress and altered the accounting rules for banks and other financial institutions.

Instead of valuing assets at prices they can fetch in the market (mark-to-market), banks will be allowed to use their own valuation models to value assets.

This accounting change brings to mind the fallout from another panic — the US panic of 1873. It was then that the publication of bank statements was suspended on the hope that "what you don't know won't hurt you."

Let's hope the current tidal wave of interventionism fades and a modicum of reason kicks in.

Obama's AIG Panic

The AIG Beltway bonfire continued yesterday with the spectacle of Ed Liddy, AIG's government-appointed CEO, enduring the wrath of Congress for embarrassing the Members with post-bailout bonuses. What we now have is a full-blown political panic ignited by no less than President Obama himself that is threatening to engulf his attempts to revive the financial system, and is undermining confidence in his leadership. This is no way to promote an economic recovery.

As recently as Sunday morning, White House economist Larry Summers was saying the bonuses were regrettable but there wasn't much that could be done to stop them. "We are a country of law. There are contracts. The government cannot just abrogate contracts," he said, with great good sense. Assorted Congressmen then did what comes naturally, which is declare their mock outrage. Rather than keep his legendary cool, Mr. Obama and the White House panicked as well and joined the braying pack.

Speaking on Monday of the $165 million paid to members of AIG's Financial Products division, the President asked, "How do they justify this outrage to the taxpayers who are keeping this company afloat?" Treasury Secretary Tim Geithner, who had known about the bonuses, was also trotted out to express his "outrage" and declare that Treasury would somehow try to claw back the bonuses. By shouting "greed" in a crowded and panicky Washington, our supposed financial stewards thus gave license to everyone in the media and Capitol Hill to see who could claim to be most shocked and appalled at AIG.

We've now got a full-fledged mob on our hands, with Congress looking to string up bankers in whatever bunker they can be found. Senators Chuck Grassley and Max Baucus want to double the current income tax on these bonuses, to 70% from 35%, and that's one of the more reasonable proposals. Congresswoman Carolyn Maloney, the Democrat from silk-stocking Manhattan, wants to tax it all -- at 100%.

Senator Chris Dodd, down in the 2010 election polls after his sweetheart Countrywide mortgages, is busy rewriting the TARP compensation limits he only recently stuck in the stimulus bill. His last-minute measure explicitly exempted from compensation limits bonuses agreed to prior to the passage of the stimulus bill: "The prohibition required under clause (i) shall not be construed to prohibit any bonus payment required to be paid pursuant to a written employment contract executed on or before February 11, 2009 . . ." So Senator Hedge Fund is suddenly morphing into Huey Long to save his career.

This is all too much even for Rep. Charlie Rangel, the House's chief tax writer, who says the tax code shouldn't be deployed as a "political weapon." He's right. AIG's managers may be this week's political target of choice, but the message to every banker in America, indeed every business in America, is that you could be next. At least we haven't yet seen the resolution that was proposed in the English parliament, in 1720 in the aftermath of the South Sea bubble, that bankers be tied in sacks filled with snakes and tipped into the Thames. But it's still early days.

One consequence will be that every bank executive in America will try to repay his Troubled Asset Relief Program, or TARP, money as rapidly as possible. The political punishment for accepting public money is becoming higher than the benefits of the extra capital cushion. According to Wells Fargo Chairman Richard Kovacevich, "If we were not forced to take the TARP money, we would have been able to raise private capital." On Tuesday, Bank of America CEO Ken Lewis joined the rush for the TARP exits, saying he hoped to pay back the $45 billion BofA has received by 2010 if not sooner. It's hard to argue with the sentiment.

For the larger banking system, however, this is exactly the wrong time to be shedding capital. The main point of the TARP was to backstop the financial system against systemic failure. Treasury botched the roll out and the execution, but with the economy still in recession and housing prices still falling, banking losses will surely grow. Mr. Geithner has projected the need for more than $1 trillion more in public capital, and the FDIC has asked Congress to increase its credit line to as much as $500 billion.

If we're lucky, the banks will be able to use today's steep yield curve to earn their way out of this mess, but no one can be sure and before this is over the FDIC and Treasury are going to need more public capital to protect depositors of failed institutions. The last thing we need is for this year's political panic to recreate the circumstances for another financial panic like the one we had last fall.

The Beltway's banker baiting seems to increase in direct proportion to the government's incompetence in nurturing a financial recovery. Anger rises when Americans learn after three bailout revisions that they haven't been told the truth that the AIG nationalization was a conduit to save counterparties, and even hedge funds, that gambled on housing. Only two weeks ago, Federal Reserve Vice Chairman Donald Kohn told Congress he couldn't disclose who AIG's counterparties were. Americans also wonder why taxpayer guarantees should be provided to Citigroup, a three-time loser, but with little accountability for the board and managers who brought the company low.

Reviving a financial system is a long process that requires a combination of capital support, workout ability and discipline for mistakes. The public has to believe the end result will be a better, sturdier system in return for taxpayer support, while at the same time being assured that gamblers aren't saved from their own mistakes.

If this balance is beyond the ability of Mr. Obama's current economic team, he needs a better team. The worst mistake he can make is to deflect attention away from government's mistakes by joining the attack on the very bankers he needs to lead an economic recovery. That's how a deep recession becomes a Depression.

Stocks Drop Worldwide

Stocks Drop Worldwide, Treasuries Gain on Concern About Economy

March 2 (Bloomberg) -- Stocks fell worldwide, sending the Dow Jones Industrial Average below 7,000 for the first time since 1997, and Treasuries rose after Warren Buffett said the economy is in “shambles” and American International Group Inc. posted the largest corporate loss in U.S. history.

Berkshire Hathaway Inc. retreated 7.8 percent after the steepest annual drop in book value in Buffett’s career at the company. Bank of America Corp. and Citigroup Inc. tumbled more than 14 percent as AIG posted a $61.7 billion quarterly loss and HSBC Holdings Plc said it will raise $17.7 billion, triggering the biggest decline in U.K. bank stocks since at least 1985. Exxon Mobil Corp., the world’s biggest company by market value, fell as oil slid 10 percent and General Electric Co. sank below $8 for the first time since 1994.

“You have almost no reason to own a bank stock,” Keith Wirtz, who helps oversee $20 billion as chief investment officer at Fifth Third Bancorp in Cincinnati, told Bloomberg Television. “There is too much turmoil.”

The Dow average decreased 243.8 points, or 3.5 percent, to 6,819.13 at 1:43 p.m. in New York. The Standard & Poor’s 500 Index dropped 4 percent to 705.69. Europe’s Dow Jones Stoxx 600 Index tumbled 4 percent, its steepest loss of the year. Treasuries rose as investors sought a haven, driving the yield on 10-year notes down to 2.9 percent from 3.01 percent.

The MSCI World Index of stocks in 23 developed nations fell 4.6 percent to 716.13, the lowest intraday level since the Iraq War began in March 2003. The MSCI Emerging Markets Index slid 4.8 percent, while Hungary’s forint dropped after European Union banks spurned aid pleas for eastern Europe.

Worst Start to Year

The deepening global recession, a third government rescue for Citigroup Inc. and dividend cuts at companies from General Electric Co. to JPMorgan Chase & Co. have dragged the MSCI World Index to three consecutive weeks of declines. The benchmark has fallen 22 percent this year, adding to last year’s 42 percent slump.

Options investors are paying twice this decade’s average to protect against losses in U.S. stocks through 2011, signaling the bear market that already wiped out $10.4 trillion of equity value may last two more years.

“There’s a real panic in the markets, with some people wanting to buy long-term insurance at any price,” said Peter Sorrentino, who helps manage $16 billion, including $130 million in options at Huntington Asset Advisors Inc. in Cincinnati. “People have lost hope.”

Contracts to protect against a drop in the S&P 500 for two years cost $15,160 on the Chicago Board Options Exchange at the end of last week, compared with $6,875 in 2007, according to price-adjusted data compiled by Bloomberg. That shows traders expect the benchmark gauge for U.S. equities to fluctuate twice as much in the next two years as it has since 2000.

‘Freefall’

Berkshire Hathaway Class B shares lost 7.8 percent to $2,365. Berkshire, which owns stakes in companies from Coca-Cola Co. to American Express Co., posted a fifth-straight profit drop, the longest streak of quarterly declines in at least 17 years, on losses from derivative bets tied to stock markets.

Buffett said the economy will be “in shambles” this year, and perhaps longer, before recovering from the reckless lending that caused the worst “freefall” he ever saw in the financial system.

Financial stocks in the MSCI World Index dropped 6.8 percent, leading all 10 industries lower.

HSBC Raises Capital

HSBC tumbled 19 percent to 399 pence, sending a measure of U.K. bank shares down 16 percent, the biggest one-day decline since the index was created in 1985. Europe’s largest bank by market value said it plans to raise 12.5 billion pounds ($17.7 billion) in a rights offer, increasing concern that banks need more capital.

PNC Financial Services Group Inc. dropped 5.3 percent to $25.88. The fifth-largest U.S. bank by deposits slashed its dividend 85 percent, to 10 cents from 66 cents, to save $1 billion amid “extreme market deterioration.”

Aggregate dividends by S&P 500 companies will fall 23 percent this year, the biggest decline since 1938, S&P predicts. More than 288 U.S. companies cut or suspended payouts last quarter, the most since S&P records began 54 years ago.

GE, once the S&P 500’s biggest dividend payer, slid 10 percent to $7.64. The only company left in the 30-stock Dow Jones Industrial Average from its founding in 1896 is adding to investor pessimism as credit analysts threaten to reduce its AAA rating. GE cut its quarterly dividend by 68 percent, to 10 cents from 31 cents, last week. GE Chief Executive Officer Jeffrey Immelt bought 50,000 shares at $8.26 a share today.

AIG’s Loss

AIG advanced 14 percent to 48 cents. The insurer deemed too important to fail will get as much as $30 billion in new government aid in a revised bailout after posting a record $61.7 billion fourth-quarter loss.

Raw-material producers and energy stocks in the MSCI World Index slid more than 5 percent. The Reuters/Jefferies CRB Index of 19 commodities fell 4.8 percent as oil retreated 10 percent to $40.11 a barrel on the New York Mercantile Exchange, the biggest intraday decline since Jan. 20.

Raymond James Financial Inc. cut its forecast for the average price of oil in 2009 by 28 percent to $43 a barrel as the worldwide economic slump cuts consumption.

Exxon, the world’s biggest oil producer, fell 2.7 percent to $66.05. Freeport-McMoRan Copper & Gold Inc., the world’s largest publicly traded copper producer, sank 12 percent to $26.77.

Eastern Europe Concern

The MSCI EM Eastern Europe Index slumped 3.8 percent to 88.48. The forint dropped as much as 2.7 percent against the euro, the most since Dec. 26. European Union leaders rejected requests for a region-wide aid package, bowing to German concerns that it would put too much pressure on budget deficits in western Europe as the economy slumps.

Deere & Co. and Caterpillar Inc. declined more than 8 percent after a government report showed spending on U.S. construction projects fell in January more than twice as much as forecast.

The 3.3 percent decline followed a revised 2.4 percent drop the prior month that was larger than previously reported, the Commerce Department said. Economists had forecast construction spending would decrease 1.5 percent, based on a Bloomberg survey of economists.

The market remained lower even after the Institute for Supply Management’s factory index unexpectedly climbed to 35.8 in February from 35.6 the prior month. A reading of 50 is the dividing line between growth and contraction.

“At the beginning of year, everyone expected recovery in the second half of the year,” said Kevin Shacknofsky who helps manage $1.8 billion at Alpine Mutual Funds in Purchase, New York. “The negative news coming out of the financial sector, the continue weakness in the housing market and disappointment with government policy is pushing the recovery date beyond the second half of year.”

Gerald Celente - Predicts Panic '08