11 US banks having collapsed since January

Foreign Exchange Currency Outlook : The Fed left rates on hold yesterday, on a unanimous vote, evidently thinking that “targeted emergency loans” are a more refined and direct way to deal with the credit crisis than a wholesale rate cut for everyone. While we may say this is a sensible way to address things in a crisis, it also opens the door for discrimination and special favors, or crony capitalism. It puts tremendous power in an institution that may not be equipped to handle it.

Power corrupts.

At what point does the Fed get the kind of oversight such power warrants? Neither the executive nor the legislative branches have shown themselves capable of overseeing the Fed. Think of those Congressmen totally transfixed (deer in the headlights) and paralyzed by Mr. Greenspan’s obfuscations. It’s no match at all. Structurally, giving the Fed this kind of power is the biggest threat to sovereign foreign investment. We have no evidence the Fed is now or will soon become corrupt and abuse its power. We have faith in the good intentions and noble ideals of Mr. Bernanke. But just wait. Charges of unequal treatment are sure to follow, and in our lifetime.

This sad observation leads us to wonder what other unforeseen consequences are lucking in the bushes. When Thailand set off the Asian credit crisis in 1997, nobody foresaw that Brazil and Russia were next and that the Russia situation would crash Long Term Capital. This time the logical deduction is that credit losses and write-downs will indeed reach the $1 trillion mark originally estimated by the IMF last year. According to Bloomberg, write-downs and losses add up to $516 billion, with 11 US banks having collapsed since January. “Corporate bond sales in the U.S. and Europe have slumped 42% from a year ago.” We are back to dreading hearing the sound of other shoes dropping.

Again thinking about confidence in the US, what does it say about it that the largest broker Merrill Lynch, the largest savings bank Washington Mutual and the largest insurance company AIG are all in trouble and needing rescue at the same time? More US debt has to be the outcome. You have to wonder what the ratings agencies will make of the vast new debt being taken on by the government. Unlike Japan, the US government can’t be assumed able to tax its way out of it. We said at the time Japan’s ratings were downgraded that it was an erroneous understanding of the will of the Japanese people. Just as they were prepared to defend Japanese soil with pitchforks near the end of WW II, they would allow themselves to be taxed to death before they would allow a sovereign default.

Not so in the US.

Could the US take on so much debt that taxpayers would revolt?

Yes.

If Newt Gingrich was happy to have the US default to make some petty political point during the Clinton administration, imagine what could happen today when the debt burden per capita is so much higher… Foreign investors in US paper, including especially the Chinese and Middle Easterners, are very smart people. They will not miss this potential. Yesterday’s TICS report is perhaps just a harbinger of things to come. The US needs capital inflows of about $60 billion per month, whether long-term or short-term, to cover the current account deficit. What happens if the money doesn’t flow in? In the old days, governments would sell gold or other reserves, but that doesn’t seem possible today for lots of reasons, including the appearance of desperation. The country suffering a deficit without offsetting capital inflows can issue more debt, and so far foreign buyers like US paper as a safe haven, but these are crisis times. It’s not guaranteed to last. The third option is devaluation to the point where every US asset is a screaming buy.

This is the doomsday scenario long hawked by the fear-mongers we normally disdain. Well, today we disdain the scenario at our peril. The probability of the extreme-devaluation outcome is no longer really tiny. It’s still less than 50%, but not nearly zero. The problem, as always, is where do the world’s savers put their money if not the US?

Name a nice safe place. Well, there’s always Switzerland.

Or perhaps we are just feeling gloomier than usual today out of disappointment at the bad behavior of just about every player in this drama. Individual greed won, and society loses. Worse, the very people who caused or allowed the problems are still in charge of fixing it, not least Mr. Paulson and the Fed, along with just about everybody else on Wall Street and Washington. And worse again, the public blames Wall Street and Washington instead of blaming itself. Blame must attach to all those people who bought houses knowing full well in their heart if not their mind that they couldn’t afford them. Everybody winked and looked away from the inflation of house prices and subprime shenanigans. Flipping houses became the subject of their own TV shows, for crying out loud. We still watch them, too. It’s a crisis of morals and ethics that is not being seen for the higher drama of big-shots going down in flames. The only upside we can see is that the housing price crisis may be ending next year and throughout all of this, US citizens may start getting the idea that saving a little is not a bad idea and spending everything and beyond is a bad idea.

The whole point of modern enlightened “modified” capitalism was that the extremes of cyclical ups and downs would be muted. The business cycle has indeed seemed tamer than in previous decades before the war, and certainly since before the Fed was established. The crises of the 19th century were disastrous. This time we had the institutions and the well-educated managers, but lost the moral compass. Regulations are not a substitute for morals, but it’s all we have. Just as Russia collapsed when raw free-market capitalism was introduced without adequate safeguards against abuse of power and corruption, the US economy is collapsing inward. It won’t fail like Russia did, but it’s the same situation in essence. Still, get ready for contraction. The economy will contract if savings rise, and will contract on the reduction in credit capacity. Economists are already talking about the drop in GDP to come by year-end as a result of the financial sector.

So far we are sticking to the strong US Dollar exchange rate story but we admit it’s on crutches.

A reversal is all too possible.

If you are risk-averse, stay away until some of the dust settles.

Bye for Now

Barbara Rockefeller

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