November 21, 2008

Mr. Paulson¹s Deceptive Speech

Michael Hudson

Yesterday, November 20, Treasury Secretary Henry Paulson presented so deceptive a speech at The Ronald Reagan Presidential Library in Simi Valley, California, that was that its false framing of Washington's financial giveaway to Wall Street deserves to be enshrined in the annals of Orwellian doublethink.

What prompted the speech seems have been Congressional criticism of Mr. Paulson¹s bait-and-switch transfer of public funds to Wall Street, and the Federal Reserve¹s transfer of an amount twice as high as Congress's $700 billion. His most urgent aim was to ward off accusations that the Treasury and Federal Reserve have acted illegally. Federal law, and in particular the Anti-Deficiency Act, prohibits Treasury from spending money, lending money, and guaranteeing or buying assets without Congressional approval. The Federal Reserve can and does lend on a secured basis, but only if it expects not to realize losses. (Italics added.)

But Congress did not approve the Treasury's $250 billion of preferred stock investments in Wall Street banks. The happy recipients, their stockholders and officers evidently worried precisely that this "investment" would end up taking losses. That is why the Treasury stands in
back of bona fide creditors. That is why preferred stock was preferred by existing stockholders to loans and guarantees (which have priority in case of bankruptcy), not to mention the conditions that Congress thought it had laid down calling for these institutions to renegotiate mortgages to bring them in line with the debtor's ability to pay.

The Fed has refused to let Congress know any details ­ any details at all ­ about its cash-for-trash swaps with these institutions. This is what has concerns Congress, and what has prompted Bloomberg to bring a lawsuit in order to discover and publicize the details. It is not hard to'see why this curiosity exists. The only reasonable explanation as to why investment banks, American International Group (A.I.G.) and commercial banks apparently headed by Citibank (whose shares plunged yet another 30 percent during Wednesday and Thursday) have turned over a trillion dollars worth of illiquid mortgage securities, junk bonds and who knows what other junk to the Fed is to avoid taking a loss on these bad loans and investments. As Mr. Paulson explained matters, ³the Federal Reserve has statutory authority to lend against a pool of mortgage loans on a fully secured basis. The Fed was able to assist the JPMorgan purchase because they believed that there was a reasonable prospect of avoiding losses.

What time frame are we talking about here? Evidently one in which Mr. Paulson will have left the administration, sticking his successor with the losses and, presumably, the blame.

Everything seems to have been unexpected to Mr. Paulson ­ as if ignorance is a defence. When I came to Washington in 2006, he reminisced, markets were benign. We were still in Alan Greenspan's idea that inflating asset prices on credit constitutes wealth creation. At that time I myself was only one of many who warned that the real estate market had come to rest on a foundation of junk mortgage lending. Every banker with whom I spoke at the time knew this. But most were still seeking to make hay while the making was good, and it was still quite good ­ for the banks, that is. Matters were not benign for the increasingly debt-ridden U.S. economy, but at least they were rosy for Wall Street. Bank executives were paying themselves enormous
salaries and even larger stock options. Meanwhile, the smarter money managers were beginning to shift their funds out of the U.S. economy in a wave of capital flight of a magnitude not seen since Russia in the mid-1990s.

Acting as if all this could not have been foreseen, Mr. Paulson assured his mistake-friendly audience, There was no playbook for responding to a once or twice in a hundred year event.² A kind of random historical earthquake seems to have been at work, a financial San Andreas fault. Mr. Paulson then trivialized this, however, with the euphemism "housing correction."

The key is, what is to be corrected? Is it not the financial market itself?

Mr. Paulson then set about dissembling the character of the U.S. and global financial system. "Our financial system," he claimed, "is built on the hard work of our citizens; it is built on the savings of our citizens."

This is where he seeks to spread the disinformation that the explosion of debt that now burdens the U.S. economy has not been the case of Americans saving. It is the result of autonomous credit-creation by the commercial banking system. The basic financial principle of modern banking is that loans create deposits. The bank loan comes first ­ then the deposit or saving.

Here's how it works. A bank's marketing department seeks to drum up customers for debt. A borrower will go into a bank and sign a promissory note, and the bank then creates a checking account in the amount that is stipulated. The note calls for a specific rate of interest to be paid ­ a
rate much higher than that which the bank can borrow from the Federal Reserve or in the money market in general. One benchmark global rate to bankers is the London Interbank Borrowing Overnight Rate (LIBOR), and the other is the Federal Reserve's discount rate to banks. (Japanese banks also provided loans to large financial institutions at under 1% per year,
spurring the international carry trade, borrowing cheap in yen and then converting the funds into other currencies and lending at a higher rate.)

None of this involves saving. It involves credit creation in which banks have a legal monopoly, with funding monetized by the U.S, Japanese and other major foreign central banks. This free credit creation is at the root of the problem, not the natural growth of savings.

What have banks done with this credit-creating privilege? Nearly all their loans have been to enable buyers to purchase assets (real estate, stocks and bonds or entire companies) already in place, or to enable hedge funds to play the mathematical games that have come to characterize today¹s casino capitalism. Mr. Paulson depicts the resulting financial system as being essential for the good functioning of "Main Street." But surely he must know some lawyer who might explain to him that only very, very wealthy speculators are allowed to play the hedge fund game of financial derivatives that lies at the heart of today's financial breakdown and negative equity
for banks that have made bad gambles. The legal reality is that in order to invest in hedge funds and similar casino capitalism gambles (or in Broadway plays and other high-risk ventures, for that matter), prospective financiers must sign releases attesting to the fact that they can afford to lose their money.

"If the financial system were allowed to collapse,"Mr. Paulson warned, "it is the American people who would pay the price. This has never been just about the banks; it has always been about continued prosperity and opportunity for all Americans." Not really. Wall Street hardly is so altruistic. It has increasingly made its money off Americans, by engaging in increasingly predatory, extractive lending to the economy. That is what has caused the U.S. debt burden to soar so far ahead of the ability of debtors to pay. It also is what is now diverting spending away from consumption and (for companies) new capital investment to pay creditors.

Not content with misrepresenting how the U.S. economy works, Mr. Paulson then drew a picture of the global economy that also is a travesty. "The world was awash in money looking for higher return," he explained, "and much of this money was invested in U.S. assets."

Well, not exactly. The world economy has been awash in the U.S. payments deficit, which has swollen the reserves of central banks in the creditor nations from Asia to Western Europe. These central banks have recycled $4 trillion their dollar inflows to the United States under dollar
hegemony. Rather than seeking a "higher return," central banks have found themselves o liged to invest in low-yielding U.S. Treasury securities, or somewhat higher Fannie Mae and Freddie Mac securities. These returns are much lower than U.S. investors have sought in buying up foreign companies and their stocks, whose price appreciation far exceeded the rate that foreign economies were able to recoup on their dollar recycling to the United States.

Mr. Paulson wants above all to deter foreign economies from breaking away from this dysfunctional system. The second important priority, he explained to his Reagan Library audience, must be continued reform of the International Financial Institutions like the World Bank and the IMF to allow for greater participation of developing nations.² The aim here is to make the financial sector's lobbying control over the world¹s financial system global. A final reform priority must be consistent liberalization of policies on trade and investment, with an emphasis on avoiding new protectionist measures and achieving a breakthrough in the Doha
round of global trade talk.

New protectionist measures! Even as U.S. auto companies are advocating special subsidies for the U.S. auto industry in Detroit and pursuing beggar-my-neighbor financial policies (let foreign banks and economies absorb the financial loss from playing in the Wall Street casino),
foreign countries are not to develop a financial system more highly regulated, an agriculture more aimed at feeding their own people. They are not to block capital outflows from the United States based on ³free² credit creation to buy out their commanding heights as the IMF imposes austerity plans and forced privatization sell-offs on Third World and post-Soviet countries while cutting taxes at home in the face of an escalating U.S. trade deficit and rising foreign military spending.

Mr. Paulson's speech looks like a major salvo in the Bush Administration's attempt to make both the Wall Street bailout and the U.S. predatory finance irreversible, while the government replaces public debt (Treasury bonds) for Wall Street's bad gambles. His errors are calculated to
misinform, as are most lobbying efforts by the banking and financial sector. One can only hope that Congress will question his testimony that has repeatedly followed this line with more acumen than prompted its earlier acceptance of the Treasury's bailout act. It's time to clean up this act.

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