Economic Domino Theory in the Eurozone, Part 2

On Wednesday, the Dow Jones Industrial Average surged 490 points, almost 5% in response to the announcement by the Federal Reserve that it was initiating a secondary capital injection in the European market.  This was the largest one-day jump since March of 2009, but was it enough to salvage the economic quagmire that is the European Union?

As the European dominoes have continued to fall—due mainly to the inability of those countries to maintain a sustainable level of debt—financial institutions across the world have developed strategies to limit the crisis and prevent the spread of this fiscal cancer.  With the interrelated nature of the worldwide financial system, this is not just a European problem; it is a problem for East Asia, the Middle East, and it is a problem for the United States.

The first step for the heads of the US financial system was to assess the exposure of American banks to European debt.  Last Wednesday, Ben Bernanke, Chairman of the Federal Reserve, announced that US banks would undergo a “stress test” over the course of the next few weeks.  This is, in essence, an effort to analyze the books of the six dominant financial institutions and determine the amount of European debt present.

These institutions—Bank of America, JPMorgan Chase, Citigroup, Wells Fargo, Goldman Sachs, and Morgan Stanley—currently hold approximately 66% of the US GDP, or about $9 trillion.  Most of them have engaged in complex transactions known as foreign exchange swaps, which are defined as “an agreement to exchange stipulated amounts of one currency for another currency at one or more future dates.” 

These transactions allow for more flexibility in financial dealings and serve as a hedge against future alterations in the exchange rate, but they also increase exposure to international debt.  A source at the Treasury Department revealed that initial estimates of US exposure range from $1-$2 trillion and could reach as high as $3.5 trillion; the most vulnerable are Bank of America, JPMorgan Chase, Citigroup, and Goldman Sachs. 

In terms of American institutions, the only solution available to them is to play the confidence game.  On Tuesday, in response to this stress test, Standard & Poor’s, one of three ratings agencies on Wall Street, downgraded the credit rating on all of these banks and many of their European counterparts.  As they seek to maintain some level of confidence, one strategy has been to constantly move money throughout the market as a means of reducing the actual debt and European exposure present on their balance sheets.  The financial confidence game is a fickle beast. 

While the American banks seek to maintain confidence, the Treasury Department and Federal Reserve, in tandem with their worldwide counterparts, have sought to address the crisis at its core.  European countries are being crushed under a mountain of debt and they lack the necessary liquidity to write-down their debt; as a result, their credit markets are practically frozen stalling any economic activity. 

The lynchpin of European economic activity is France—specifically the French banks.  All the major European nations—particularly Germany—and the United States have large sums of money in these institutions.  Moody’s, another of the three ratings agencies, originally announced that they would be downgrading both the French banks and France itself today, which would have led to the nightmare scenario. 

A simultaneous downgrade of France and its financial sector would result in a large-scale run on the banks in which major financial institutions, such as American and European banks, as well as countries themselves, such as Germany and the United States, would attempt to withdraw their money at the same time.  Since the current financial system is built on leverage and no bank in the world has enough liquid capital to return the money of all of their investors, the entire system could potentially collapse.

On Wednesday, the Federal Reserve in collusion with the European Central Bank (ECB), the Bank of England, and the central banks of Canada, Japan, and Switzerland announced an immediate process of quantitative easing.  Since Europe as a whole, and France in particular, needs to increase liquidity to write-down their debt, this process would involve an infusion of capital in the market.

According to the source at the Treasury, since the Federal Reserve cannot legally lend directly to France, they have lent money at a 0% interest rate to the European Central Bank which will then loan to the International Monetary Fund which will loan to France.  This capital injection will allow France to write-down a substantial percentage of their debt and potentially stave off a cataclysmic financial event. 

Moody’s announced on Wednesday that it will hold off on downgrading the credit rating of France and its banks for 10 days, meaning the complete process of loan and write-down must take place over that period.  The capital injection was the only legal action the Federal Reserve could take.  It is now up to the European Union nations to handle this fiscal crisis in a responsible way, but in many ways the damage may already be done. 

There is a perspective broader than economics in which the Eurozone crisis may have dangerously destabilized the worldwide geopolitical balance.  The European Union has been brought to the precipice of financial ruin and is still hanging by a thread.  In many ways, it has always acted as a constraint on the power of individual nations within it and surrounding it. 

The destabilization of the EU has created an excuse for Germany to possibly drop the euro and leave the Union altogether.  It has, by default, strengthened the geopolitical positions of nations like Russia and China and created a relationship of dependence, evident by the fact that exports from China to Europe have dropped precipitously over the last month.  Russia’s increased strength has the potential to simultaneously result in further destabilization in the Middle East as their influence in countries north of Afghanistan grows. 

None of these scenarios are in America’s interest.  The geopolitical balance in the world over the last decade has been tense, but it has been a balance nonetheless.  The US government and the US financial institutions have done all they can to maintain confidence and liquidity in the worldwide financial markets.  Now it is up to the Eurozone to ultimately fix the problem they have created.

Economic Domino Theory in the Eurozone, Part 1

In 1992, the thirteen nations of the European Communities met in Maastricht, Netherlands to sign the Maastricht Treaty.  By doing so, these nations, which included Italy, France, West Germany, the United Kingdom, and Greece, bound themselves in an association known as the European Union, now comprised of 17 nations.  In the process they created a unified currency—the euro—which forever linked the fortunes of these economies, whether good or bad, in an essentially unbreakable chain.

Douglas J. Elliot, a Senior Fellow at the Brookings Institute, wrote on CNN Money that “the road into the Eurozone ran only one way.”  What he meant was that the Eurozone countries made it almost impossible to dump the euro without leaving the European Union; there is no mechanism in place for such an act.  The fear was that if a country like Greece were to dump the euro as its currency, they would set a weaker exchange rate leading to a run on their banks and a domino effect rushing through the Eurozone. 

At this moment, however, the very foundations of the European Union are buckling under the weight of debt and instability.  The governments of Greece and Italy have both been ousted after promising substantial austerity packages.  The euro itself is in danger of folding and the nations of the Eurozone watch as each domino continues to fall.  How bad is it?  Simon Wolfson, the CEO of European retailer NEXT is offering a $400,000 prize for a plan to break up the euro peacefully.  

The root cause of this crisis is essentially government debt, a prescient warning for American technocrats. The Maastricht Treaty mandated that annual government deficits not exceed 3% of GDP while government debt not exceed 60% of GDP.  Most European nations, however—particularly Greece and Italy—used complex currency and credit derivatives to mask the realities of their debt situation. 

Currently all the major Eurozone nations have debt to GDP ratios over 60%: the United Kingdom (77.8%), Germany (75.7%), France (83%), Italy (118.9%), and Greece (140.2%).  These staggering ratios—particularly those of Italy and Greece—have strained the relationships between banks and clients, investors and business, government and business, and government and citizens.  As a quick aside (and a story for another day), the American debt to GDP ratio is 99.6% for the year and ironically crossed the 100% plateau on Halloween according to projections by the International Monetary Fund. 

German Chancellor Angela Merkel and French President Nicolas Sarkozy have led the efforts by the more structurally sound European nations to maintain stability and find a long-term solution.  But experts worry that they are playing a losing hand.  The fiscal monstrosity that is the Greek and Italian bond market, combined with their astounding levels of government debt, has led some to fear the “doomsday scenario.”  

On Tuesday, the yield on 10-year Italian government bonds reached 7.039%, a rate at which economists believe the refinancing of Italy’s debt becomes unsustainable.  Were Italy and Greece unable to refinance their debt and default, economists and heads of state alike worry that the domino effect will spread through Europe and beyond—quickly.  Spain and Portugal would fall, followed by Ireland, and eventually the cancer would reach France. 

While France may not be a dominant geo-political power, they do dominate the banking sector of the Eurozone.  Germany, the most reliable of the bunch, houses almost all of its capital in French banks.  France also holds approximately $1 trillion in American money.  Meanwhile, the French banks have overleveraged themselves in the unpredictable Eurozone market resulting in France’s rocky fiscal infrastructure and dim economic outlook.  As rating agency Standard & Poor’s stated in downgrading the French banking sector, “we see weaker economic prospects for Europe, including the peripheral countries to which some French banks are significantly exposed.” 

Eurozone leaders have taken action.  At a summit in October, they decided to write down—essentially reduce in value—the Greek debt held by the private sector by 50%.  Meanwhile, Lucas Papademos has replaced George Papandreo as interim Prime Minister of Greece and promised a strong effort to pass a significant austerity package. 

Last week in Italy, the Parliament voted to approve an austerity package—which includes cutting 300,000 public sector jobs, increasing the retirement age for government benefits, simplifying the tax code, creating incentives for venture capital investment, and reintroducing the property tax—paving the way for Silvio Berlusconi to resign as Prime Minister. 

But there are flaws to these measures.  The write down of Greek debt makes very idyllic assumptions.  An article in The Economist after the deal was struck commented that the Eurozone’s main rescue fund, the European Financial Stability Facility, “does not have enough money to withstand a run on Italy and Spain” while other sources of liquidity—Germany and the central bank—have ruled out further bailouts.  The Italian austerity package is vague—such as when it outlaws deficit spending “except in the case of exceptional events” and fails to define “exceptional events”—and the country itself currently lacks a government. 

As the dominos continue to fall, the worry shifts from the collapse of the European bond market and banking sector to the impact on American markets.  The universality of the worldwide financial system means that the economic domino effect does not stop at the water’s edge. 

America, the Case For Hope

Writings about our country have long been dominated by benign, soporific eulogies to the greatness of America past.  We are the country that evicted the domineering, imperialistic behemoth that was the British Empire.  We successfully created a representative democracy outlined in the redoubtable words of the longest lasting constitution in world history.  We settled the west, fought for equality for all, defeated totalitarianism in Europe and Asia, went to the moon, and invented the microchip, the internet and a cure for polio.  But…

The malaise of the last few years has set in so that every comment about the greatness of America past ends with a “but”.  But now we are in a lost decade.  But now capitalism has failed and our economy cannot recover.  But now our political system is defunct, never to regain its ideal form.  But our people have lost their moral core.

These are all valid concerns and valid challenges.  Our economic recession, resulting from the financial crisis of 2008 which illuminated serious flaws in the financial system and its inter-related relationship with government, has now spanned three years.  A lost decade like Japan’s 1990s is not out of the question.  The hyper-polarized nature of our political system, which culminated in the debt ceiling debacle this summer, has done harm to our external political reputation and our internal political confidence. 

Americans, however, are a people of resilience.  As political philosopher Alexis de Tocqueville commented, “the greatness of America lies not in being more enlightened than any other nation, but rather in her ability to repair her faults.”  In our history, we faced the challenges of economic disaster and emerged stronger than before.  We confronted atrocities abroad and emerged victorious.  We foresaw the changing landscape of the turn of the millennium and developed the greatest technologies in the world.  And we can do it again.

On the great seal of the United States are three Latin phrases.  Novus Ordo Seclorum, translated as “a new order for the ages,” represents the unique nature of the American experiment.  This experiment combined the political philosophies of ancient Greece and Rome, a Judeo-Christian legal foundation, and the practicalities of the British Parliamentary system into a government never before seen in world history. 

Annuit Coeptis, translated as “providence, [or God], favors our undertaking,” represents the spiritual foundation of the American experiment.  We are an inherently spiritual people, bolstered in our spiritual foundation by the success God has shined upon us in our history. In some ways, we have lost our spiritual fervor, but the moral infrastructure is still in place, ingrained in every aspect of public life.  Tocqueville stated that “Americans combine the notions of religion and liberty so intimately in their minds that it is impossible to make them conceive of one without the other.”  It may not always seem to be the case but I still honestly believe that it is. 

The third phrase on the great seal is E Pluribus Unum, translated as “out of many, one.”  The diverse nature of the American population has always been a sign of the great success of the American experiment.  Greater yet, however, is the fact that through that diversity has come one voice, one rallying cry for the values on which this nation was founded: freedom, liberty, unity,  suffrage, morality, leadership.  These values have been challenged—as they were during the Civil War—but the strength of American convictions has always been sustained.

As the challenges of the Civil War commenced, the dome of the US Capitol, the great exclamation point on the temple of American liberty and deliberation, sat unfinished.  With the future of the Union unknown, President Lincoln ordered the dome to be finished, stating “if people see the Capitol going on, it is a sign we intend the Union shall go on.” 

The future of our American Union may be unknown, but as Lincoln ordered in the 1860s, we should continue to seek and strive for a “more perfect Union.”  Discussions of America should no longer be benign, soporific or elegiac.  If history has revealed anything, it is that there is no challenge we cannot face, no conflict we cannot overcome, no task we cannot complete. 

The Great Seal of the United States cannot and will not be broken.  We are one nation born from many peoples, religions, ideologies, and cultures.  Our diversity makes us stronger and it will make our successes greater.  The success and consistency of our history changed the world forever.  In the next few years, we can and we will do it again.  It may not yet be morning in America, but the dawn is not far off.    

Jobs, Taxes, and the Republican Primary

Economic factors are always paramount in presidential elections.  But in a year when the unemployment rates remains above 9% and the Eurozone debt crisis looms, the importance expands exponentially.  With the first Republican primary less than two months away, each of the potential candidates has outlined a tax and jobs plan that will, according to them, bring the United States out of this recession and restore it to its once great position as the only viable superpower.

Mitt Romney, the unflappably stagnant former governor of Massachusetts, introduced his 49 point jobs plan last month in Las Vegas.  It entails cutting corporate tax rates from 35% to 25%, eliminating the estate tax, and extending the so-called Bush Tax Cuts.  He also recommends reducing the regulatory burdens on business by repealing Obamacare and Dodd-Frank (the financial reform bill) and expanding drilling in areas such as the Gulf Coast, the Plain States and Alaska. 

Texas Governor Rick Perry, the unflappably flappable candidate, introduced his tax and jobs proposals in recent weeks.  His jobs plan focuses mainly on increased energy production in oil and natural gas which he states will “unleash 1.2 million American jobs through safe and aggressive energy exploration at home.”  His tax plan proposes creating an opt-in flat tax, meaning those who choose to do so, can have their taxes reduced to a flat rate. 

Former Godfather Pizza Executive Herman Cain, the ever-present attention seeker, has infamously proposed his 9-9-9 plan to reform the tax code.  It would throw out the existing tax code and replace it with a 9% corporate tax rate, 9% individual income tax, and 9% national sales tax.  Cain has not explained his plan much beyond that except to say that his advisors have crunched the numbers and it will be deficit neutral.

Former Utah Governor and Ambassador to China Jon Huntsman (disclaimer, I volunteer on Huntsman’s campaign) has proposed a tax and jobs plan that synthesizes many aspects of Romney, Perry and Cain’s proposals.  He calls for tax reform in which loopholes and deductions for corporations and the rich are eliminated and the base is broadened.  The corporate tax rate would then be reduced from 35% to 25% and the personal income tax would be reduced to flatter, fairer rates of 8%, 14%, and 23%.  He has also called for expanded oil and natural gas exploration, regulatory reform, free trade expansion, and stronger relationships with foreign nations.

Other candidates have made various similar and sometimes outlandish proposals.  Rick Santorum, has proposed cutting the tax rate for manufacturing to 0%, an interesting thought.  Ron Paul has proposed eliminating the Departments of Education, Commerce, Energy, Interior, and Housing and Urban Development.  Michelle Bachmann has not been able to formulate a sentence that does not end with “repeal Obamacare.” 

Many of these proposals are seriously flawed.  Romney’s tax plan leaves the existing tax code, loopholes, deductions, and all, in place allowing for companies like GE to continue to make billions of dollars and pay no income taxes.  Perry’s tax plan also leaves the existing loopholes and deductions in place because those benefiting from them will not choose to opt-in to the proposed flat tax.  Cain’s plan is simply simplistic; as a tax lobbyist I spoke to recently put it, “I have serious questions about a tax policy that can be summed up in a catch phrase.”

 Santorum’s proposal concerning tax rates on manufacturing is intriguing but has little chance of success in Congress.  Paul’s proposals are simply ludicrous; maybe in a perfect world we could do away with five Executive Agencies and be fine, but that is not this world.  Huntsman’s jobs and tax plan was called “big and bold” by Reuters and “as impressive as any to date in the GOP presidential field, and certainly better than what we’ve seen from the front-runners.”  Because of my stake in the Huntsman campaign I will let you decide for yourself.

What is clear is that the Republican candidates for president have displayed many similarities and many differences in these proposals.  The distinctions may seem minute, but they are clear and integral in this time of economic woe.  The candidates now have approximately eight weeks to distinguish themselves from each other and from President Obama.  It should be interesting to watch.  

Putin in Power: Continuity and Complexity

The amiable yet complex diplomatic relationship between the United States and Russia has taken another turn in the last week.  Former Russian President and current Prime Minister Vladimir Putin has announced that he will seek reelection in 2012 to the Presidential office, which he held from 2000 to 2008.

Putin, a former KGB operative and Communist Party member, has maintained a love/hate relationship with the United States during his time in public office. American representatives and leaders have perceived a Cold War attitude from the post-Cold War presidency.

Over the past few years, United States Presidents and President Putin have butted heads over issues such as the unofficial reunification of Soviet bloc countries, the use of natural resources—particularly natural gas—to detach Germany from the Atlantic Alliance, and the Russian invasion of Georgia in 2005 for which former President Bush called the Russian leader “cold-blooded.” 

Putin has also been criticized for instances which many considered violations of human rights.  In 2009, Russian attorney and anti-corruption activist Sergei Magnitsky suffered a gruesome death after being in police custody for 358 days.  In 2003, billionaire Mikhail Khodorkovsky was arrested and charged with fraud, embezzlement and money laundering after giving financial support to multiple opposition parties. 

Putin seems to be attempting to adapt to 21^st century geopolitical realities while remaining a Cold War leader at heart.  Ralph Peters of the Washington Post maintains that Putin is a successful leader in that he has somehow mastered this balance.  “Not one of his international peers evidences so profound an understanding of his or her people, or possesses Putin’s canny ability to size up counterparts.” 

Peters goes on to lay out Putin’s general strategy—which he calls genius—of reconciling the tactics of the Soviet Union and the realities of the current world.  “You need control only public life, not personal lives.”  In other words, the KGB has been replaced by the Press Service.  While the instances mentioned above may prove to be counterarguments to that statement, Putin’s successful reign as President and Prime Minister are evidence of his competent leadership. 

In 2008, Putin was disallowed from running for reelection in Russia due to their mandated term limits.  He was replaced by Dmitry Medvedev who subsequently appointed Putin Prime Minister leading to the belief that Medvedev was merely a puppet of the former President.  Walter Russell Mead, in American Interest, describes Putin’s announced run for president as the “Russian decision to take off the Medvedev mask and put Prime Minister Putin back in the top spot.”

Putin’s efforts to become president once again have put the United States in a difficult position.  There are diplomatic conflicts with Russia and there are personal conflicts with Putin.  But there are also areas of agreement and mutual benefit.  Neither the United States nor Russia wants China to dominate Eurasia.  Neither wants Islamic fundamentalists to destabilize the region. 

Russia, led mainly by Putin, has used its excess of natural resources to gain influence with multiple Western countries.  As Peters states, “seduced by Kremlin policies—from oil and gas concessions to cynical hints of strategic cooperation—Western leaders have too many chips in the game.”  The United States and other Western countries are now dependent on Russia for natural resources, geopolitical stabilization, and United Nations support.  But they must now deal once again with Vladimir Putin.

Putin’s popularity in Russia is more one of image than policy.  According to Peters, he has “renewed Russia’s confidence in the country’s greatness.”  He is loved and admired because he is a nastoyashi muzhik, a “real man.”  A Putin presidency may be great for Russian morale, but is it good for the world? 

9/11, Ten Years Later

Sunday marks the 10^th anniversary of the terrorist attacks on September 11, 2001.  As Christopher Hitchens stated recently in Slate, “10 years ago in Manhattan and Washington and Shanksville, Pa., there was a direct confrontation with the totalitarian idea, expressed in its most vicious and unvarnished form.” On that day, as W.H. Auden put it in 1939, “the unmentionable odour of death/ Offend[ed] the September night.”  

It is important in this time of reflection and introspection to both honor the memories of those lost and contemplate where we’ve been and where we’re going.  Much has changed in the last ten years, both in the United States and abroad; the future success or failure of our country will be determined by the decisions made in the next few months and years. 

In September, 2001 the American economy was recovering from the bursting of the dot com bubble but still remained on a solid financial and political foundation.  The housing and construction industries were booming, corporations were enjoying substantial liquidity, and inflation and unemployment remained low.  Although the 2000 presidential election was as contentious as any in recent history, the government enjoyed a budget surplus and relative bipartisan enthusiasm.

During the Clinton years and the beginnings of the Bush Administration, the United States enjoyed stability in foreign affairs, disrupted only by small-scale conflict in Bosnia, Kosovo, and Iraq. 

But the world has drastically changed in the last ten years.  In technological terms, the United States has almost entirely completed the transformation from an industrial power to an economic system dominated by technological innovations, financial dealings, and hyper-compartmentalized knowledge industries. 

As New York Times columnist Thomas Friedman whimsically stated on Meet the Press, ten years ago “Facebook didn’t exist.  Or for most people it didn’t exist.  Twitter was a sound.  The Cloud was in the sky.  4G was a parking place.  Linkedin was a prison.  Applications were something you sent to college.  And, for most people, Skype was a typo.”

In many ways, the attacks on 9/11 have altered the military fabric of the world in a way analogous to the way technological innovations have completely altered the social fabric of our country.  They are obviously not equivalent in their ramifications, but understanding the extensive challenges we are facing is crucial, else we are deemed to repeat the mistakes of the past.

We are still mired in conflicts of astounding financial and personal cost.  The American political system is in a constant state of gridlock, our bond rating has been downgraded, and the budget deficit has skyrocketed in the past ten years.  We are at a crossroads; our leaders are, at this moment, debating if and how we can break out of this funk. 

Republican presidential candidates, such as Jon Huntsman and Mitt Romney, have proposed their own jobs plans—including capital gains cuts, tax reform, increased drilling and free trade agreements—and President Obama proposed his plan on Thursday.  They have also discussed and debated multiple perspectives on the foreign entanglements in Iraq and Afghanistan.

We can debate amongst ourselves the ideal solution to the issues we face.  Does government have the ability and the responsibility to solve this economic crisis through more stimulus spending, infrastructure projects and education investment?  Does the private sector have the main responsibility and greatest aptitude to create jobs and alter our economic system?  Should the United States completely end its involvement in the wars in Iraq and Afghanistan?

What is unacceptable as a country is to do nothing.  Al Qaeda sought, on September 11, to disrupt and destroy the American military, political, and financial sector while simultaneously inflicting the most significant loss of life possible.  The effects were disastrous, but the fabric of our country survived, for a time. 

Lacking decisive action, our country is on a path toward failure—and by extension victory for al Qaeda—but we still have hope.  Al Qaeda is driven by a totalitarian, anti-American ideal which Hitchens describes as “the big lie.”  Abraham Lincoln commented that “America will never be destroyed from the outside.  If we falter and lose our freedoms, it will be because we destroyed ourselves.”  

Now, ten years after that tragic event, is our opportunity to once and for all declare victory.  The attacks on September 11^th “reordered and distorted the decade that followed” as David Remnick put it in The New Yorker.   The best way we can honor the memories of the fallen and defeat the “big lie” of totalitarian hate is for our politicians to set us on a path toward financial, military and political sustainability in the decade to come.  All that is required is political will.     

Winners and Losers from the GOP Presidential Debate

Wednesday night’s debate was the much anticipated debut of newly crowned Republican front runner Rick Perry.  From the beginning, two things became obvious.  First, it is not only the press but the rest of the Republican field that views Perry as the frontrunner, evident by the constant barrage of criticism from the other candidates.  Second, the main competition, for better or for worse, is and will continue to be between Perry and Mitt Romney.

From the get go, Romney and Perry engaged in a political pissing/spitting contest about their records as governors and their plans for job creation.  Perry touted his record as the 4^th ranked job creator among governors in the United States and Texas’ record as the top job creating state during the current recession.  He then criticized Romney’s record as the 47^th ranked job creator among US governors during his tenure.

Romney responded by explaining the difficulties the state of Massachusetts faced at the start of his term and the positive steps he took as governor, creating jobs at a faster rate than the national average.  He also touted his private sector experience in creating and optimizing companies around the world.  He then pointed out that a large percentage of the jobs created in Texas are the result of their surplus of natural resources, not Perry’s policies or leadership, and that Texas has the highest rate in the country of jobs at or below the minimum wage. 

Jon Huntsman, the former governor of Utah and perennial voice of reason, chimed in that Utah was the 1^st ranked job creating state during his tenure, but that did not detract from the Romney/Perry rivalry. 

By the end of the debate, the hierarchy of candidates became much more clarified.  Romney and Perry maintained and even solidified their position as the top tier of candidates.  Considering the setting and the crowd, they both presented strong arguments in favor of conservative positions on jobs, immigration, health care and defense.  They were both winners of the debate and will now attempt to spin the results more in their own favors using it as a springboard to future debates and appearances in Iowa, New Hampshire, South Carolina and around the country.

Michelle Bachmann and Ron Paul presented strong arguments but failed to make a statement in terms of policy positions or memorable rhetorical flourishes.  Both, in my opinion, did more harm than good.  Paul further reduced himself to the periphery by arguing that the FDA, TSA and Air Traffic Control are unnecessary government agencies.  Bachmann was simply outshined in her conservative, Tea-Party message by Perry who is now funneling her support to his own campaign.

Rick Santorum and Newt Gingrich are most likely on the verge of dropping out of the race.  They simply do not have the financial and electoral support to continue the rigorous process of campaigning for elected office.  Gingrich, by making multiple attempts to claim unity among the candidates and defend against supposed efforts by the media to divide them, gave off the impression that he was above criticizing his fellow candidates and ready to get behind the eventual nominee.  This is not the attitude a real player in the Republican primary should have.

The two remaining candidates, Jon Huntsman and Hermain Cain, are both polling in the low single digits but made positive strides on Wednesday night.  Cain articulated coherent policy positions (whether or not they would be beneficial or passable is another story) and Huntsman continued to position himself as holding the rational middle ground.  Unlike some of the other candidates, however, Huntsman sounded more presidential; he did not stoop to the personal attacks and criticisms like the other candidates did and he made real, useful references to his past experiences as Ambassador and government official in four presidential administrations.  Because of the financial support both maintain, they are likely to remain in the race at least through the New Hampshire primary and have the potential to gain support in the next few months.

Very little was said in the debate that was at all novel.  It was simply part of the process of whittling down the field and creating a coherent message for the coming months.  Tonight is the Democrats’ turn, with President Obama giving his jobs speech, but it’s also opening night for the NFL…

Why College Students Should Support Jon Huntsman

Today’s jobless numbers are worrying.  According to the report released by the Bureau of Labor Statistics, the American economy added no net jobs in the month of August and the unemployment rate remains at 9.1%.  President Obama and Republican frontrunner Mitt Romney are set to release their jobs proposals next week, but one candidate has already done so, Jon Huntsman.

As college students, there are three broad issues pertinent to our interests.  The first is jobs.  Many of us have parents who are out of work, siblings unable to find work or will be looking for jobs ourselves in the next year or so.  Huntsman, the former governor of Utah and Ambassador to China, has outlined a 4 part plan for economic recovery. 

First, he proposes comprehensive tax reform which includes simplifying tax brackets and lowering rates, eliminating capital gains taxes, reducing corporate rates and eliminating corporate and personal loopholes and deductions.  Second, he proposes expansive regulatory reform including the repeal of Obamacare and Dodd-Frank (the financial regulatory bill), reigning in the EPA and FDA, and enacting patent reform.  Lastly, he emphasizes the need for energy independence, through expanding drilling rights and natural gas capabilities, and enacting free trade agreements.

Some of these things may seem obvious, but believe it or not, they have not been outlined by any politician or presidential candidate until now.  These are all market-based solutions that will make American companies competitive with foreign corporations, reduce regulatory instability and give individuals and families more money in their pocket.  The stabilization of the economy and the stimulation of the jobs market is in our best interest as students soon to graduate. 

The second pertinent interest as college students the long-term sustainability of government, specifically in terms of spending.  We are still young but at the rate the government is spending, programs like Social Security and Medicare are on a path to destruction while the basic ability of the government to sustain its constitutionally mandated role becomes more and more hazy.  With the debt we have built up, and will continue to build up, will be able to respond to natural disasters?  Will we be able to respond to an attack on our country?  Will we be able to support law enforcement, education, infrastructure twenty years down the road?

Huntsman has been a rational voice in a sea of irrationality during these last few months of debate.  While Republicans have decried any revenue increases or defense cuts and Democrats have decried any changes to entitlements, the former governor has clearly stated that decisive action must be taken.  We must curtail entitlement spending; we must end costly foreign entanglements; we must reform the tax code. 

This is our future at stake; shouldn’t we support a candidate who has our best interests in mind rather than a candidate who caters to special interests (whether they be the anti-tax lobby or the pro-entitlement force, or the pro-military shop)?

The third pertinent issue (and this is by no means and exhaustive list but rather a general summary) that is important to college students includes social and environmental policy.  We care about equality, about clean air and clean water, about climate change.  Huntsman has been one of the most forward looking members of the Republican Party in all of these respects. 

Huntsman recently stated in an interview with ABC’s Jake Tapper that “in a center-right country, I am a center-right candidate.”  He also described himself as holding the “sensible middle ground.”  Of all the Republican candidates, he is the most reasonable in his politics, personable in his approach and experienced in both foreign and domestic affairs.  Right now, the sensible middle ground is exactly what America needs.

Understanding the 2008 Financial Crisis, part 2

In 2005 and 2006, housing prices began to fall.  This, combined with the fact that the mortgages from 2003 and 2004 were reaching the end of their two-year fixed interest rate and spiking, led to defaults in record numbers.  The fuse had been lit, the dominoes began to fall; use whatever metaphor you want here, it was bad and only going to get worse. 

In March, 2007 Bear Stearns, the 5^th largest investment bank in the country, was unable to meet its financial obligations.  They had invested heavily in mortgage-backed securities and CDOs and had even sold some credit default swaps.  As their shares plummeted, the Treasury Department, led by Treasury Secretary Hank Paulson (the former CEO of Goldmann Sachs), took action to attempt to stabilize the financial sector.  They negotiated a merger in which Bear Stearns was bought by JP Morgan Chase for $2 a share with the government guaranteeing $30 billion in toxic assets. 

The markets stabilized for a time but the underlying problem of housing defaults continued.  The type of large-scale crisis that occurred in September 2008 was the result of these defaults combined with the shady bookkeeping of Wall Street firms.  The actual liquidity of investment banks like Lehman Brothers, financial conglomerates like CitiGroup, and insurance companies like AIG was relatively unknown. 

When Wall Street firms posted almost across the board losses in the 3^rd quarter of 2008 resulting from the investment in mortgage backed securities and CDOs all of the dominoes began to fall.  Lehman Brothers (the 4^th largest investment firm in the country), whose stock had been trading at $66 a share, plummeted to $2 a share in a matter of months (as pictured below).  While Lehman CEO Richard Fuld expected the Treasury Department to give them the same deal they gave Bear Stearns, Secretary Paulson sought a private sector solution (meaning rather than the government guaranteeing Lehman’s toxic assets, the other investment firms would). 

But after the deal with Bank of American fell through (they eventually bought Merrill Lynch) and British regulators killed the deal for Barclays to buy Lehman, Lehman was forced to declare bankruptcy on a Sunday night as an attempt to stabilize the markets opening on Monday.  It did not.  When Lehman declared bankruptcy, British regulations mandated that the personnel at Lehman’s London office leave the premises.  When this occurred, investors who sought to withdraw their money from Lehman’s accounts were not able creating panic and a run not only on that one bank but on every investment bank in the world. 

As a result, the world-wide credit market was frozen; investors could not get their money out of the banks and corporations, such as GE, could not get enough liquid capital to run their day to day operations.  After choosing not to take direct action for the sake of Lehman Brothers, the government realized that they had no other option in this case. 

First, they attempted to steady AIG by buying, originally, $85 billion in toxic assets (that number would later increase to about $160 billion).  When this failed to stabilize the market and various other financial institutions neared collapse the Treasury Department sought Congressional approval for larger-scale action. 

Led by Secretary Paulson and Federal Reserve Chairman Ben Bernanke, they sought $700 billion from Congress for two purposes: continuing to buy the toxic assets poisoning the market and injecting capital into the market to return it from the brink of collapse and unlock the credit market.  While Congress originally voted down the measure (which led to a 777 point drop in the stock market, the largest in history) they eventually agreed to and passed the Troubled Asset Relief Program (TARP). 

So after years of dubious financial management and economic finagling what was the final product?  Millions of Americans defaulted on their mortgages and went into foreclosure; millions of Americans lost their jobs; the American economy lost approximately $1 trillion in value. 

And the Wall Street firms?  Well the investment banks received $125 billion in TARP money which they were supposed to, but did not, lend out; AIG was given a total of $160 billion in taxpayer money to remain solvent; Fannie Mae and Freddie Mac were taken over by the government.  On top of these taxpayer bailouts, the Obama Administration spent almost $900 billion on a stimulus package in an attempt to repair the job market. 

We have learned about the dangers of the specific instruments at play during this crisis; sub-prime mortgages, bad; mortgage backed securities, bad; CDOs, bad; credit default swaps, bad.  But the realities of the financial system have not changed.  The incentive structure remains essentially the same, evident by the record bonuses given out after the financial crisis.  The securitization chain remains in effect for various other financial instruments.  And the government has not instituted any real financial reform; Dodd/Frank was a valiant effort but lacked teeth. 

So now we wait; wait and see if Wall Street has learned its lesson.  I for one would feel better if the future of the American economy was not in the hands of those who most recently brought it to the brink of collapse.  

Understanding the 2008 Financial Crisis, part 1

If you’re like me, you have a vague understanding of what occurred in 2008 to bring the United States’ economy to the brink of ruin.  The terms subprime mortgages, mortgage-backed securities, collateralized debt obligations (CDOs) and credit default swaps were continuously thrown around on cable television and the pages of our newspapers.  But what does it all mean, and what exactly happened?  Here’s a quick (and not at all expert) explanation.

There were four main parties involved; the consumers, the mortgage lenders, the government, and Wall Street.  All bear some responsibility, to varying degrees.

Consumers, in unprecedented numbers, sought the quintessential American dream, a house of their own with a yard and probably a fountain with some odd gargoyle-like statues.  In and of itself, this was not problematic; the housing, construction and insurance industry became a booming part of the American economy and housing prices continued to rise making real estate a positive investment. 

But many Americans got greedy.  With low interest rates (the Alan Greenspan-led Federal Reserve reduced interest rates to their lowest level since World War II in the years following 9/11) and the continued rise in the value of real estate, people began refinancing their mortgages and using the extra money to buy a boat, or a car, or in some cases another house.   

Then there was the mortgage lenders.  Due to low interest rates, mortgages being guaranteed on a large scale by quasi-government agencies Fannie Mae and Freddie Mac, and the appetite of Wall Street investment banks for more mortgages to finagle into investment grade bonds, it became more profitable to sign as many subprime mortgages as possible.  Because of this, mortgage lenders such as Countrywide began lowering their lender criteria.  While, before, you needed a FICO score of 615 to get a loan, people could now get one with a score as low as 500; additionally, lenders stopped requiring down payments or occupational information.

Because the lenders sold the mortgages to Wall Street firms to be packaged into bonds, they had no incentive to be cautious.  They began creating mortgages that were almost made to default.  Many had a two-year fixed rate at 5% or 6% which would then jump after the second year to 12% and continue at a “floating rate” for the rest of the term.  Predatory lending was rampant during this period as people like a strawberry farmer Michael Lewis mentions in his book The Big Short—a fantastic read by the way—who made $15,000 a year and paid no money down on a $750,000 mortgage with a two-year fixed rate. 

If housing prices continued to rise, as they had almost uninterrupted for the previous 40 years (as seen in the graph below), people could continue to refinance their mortgage.  But, as we know, that did not happen.  Around 2005, housing prices began to fall and consumers began to default on their mortgages.  The factors discussed explain the crash in the housing market, but why did that lead to a crash in the entire financial sector?  That’s where Wall Street comes in.

Since the end of the Cold War, physicists, mathematicians and other intellectuals have been looking for a new avenue to use their skills.  Rather than creating new weapons systems and satellites, many ventured into financial markets creating complex instruments such as derivatives and securities.

In the early 1980s, Larry Flink invented Collateralized Mortgage Obligations (CMOs) as a means of creating more value in the mortgage industry.  Charles Morris, in his book The Trillion Dollar Meltdown—also a fantastic read and a great summary of the contributing factors—says that the CMO was a “genuinely important invention and had a profound impact on the mortgage industry.”  A study in the mid-1990s concluded that CMOs saved homeowners $17 billion a year. 

As the mortgage industry became less and less conscientious in their standards, the loans packaged into CMOs became more and more risky.  So-called “subprime loans” increased at an alarming rate and the financial instrument evolved from CMOs to mortgage-backed securities, to Collateralized Debt Obligations (CDOs) which packaged subprime mortgages together with credit card debt, student loans, car loans and anything else they could find.  The value of these securities was dependent on one very important assumption, that housing prices would continue to rise…forever.

To understand why this financial structure was created and allowed to exist we must understand the securitization chain.  Businesses and financial firms such as investment banks seek at all times to maximize profits while limiting their risk.  The securitization chain accomplished this goal for almost all the parties involved: it goes like this.

A consumer gets a mortgage on their home from one of the mortgage brokers like Countrywide.  Countrywide then sells the mortgage to a financial institution like an investment bank thus passing off the risk in the case of default.  Investment banks (Goldmann Sachs, Lehman Brothers, Merrill Lynch, etc.) would then package these mortgages, along with some other goodies, into mortgage-backed securities and CDOs and sell them to investors, thus limiting their risk. 

All the while, the rating agencies (Standard & Poor’s, Moody’s, Fitch) rated many of these mortgage-backed securities and CDOs as AAA—in financial terms an almost riskless investment—because they were either duped by the opaque nature of the security or were corrupted by the fees they were paid to rate instruments.  This was especially harmful because many investors, such as pension funds and endowments, were limited in their investments to AAA rated securities since they are “safest.”  Thus in the end, it was these pension funds and endowments that lost millions of dollars while the rating agencies explained to Congress that their ratings are “merely our opinions.” 

Investors, who were banking on a continued increase in housing value, were then most vulnerable to the risk of the market.  In order to offset their risk, some invested in another financial innovation called credit default swaps.  This is, in essence, an insurance policy.  While their mortgage-backed securities increase in value as the housing market booms, the credit default swaps pay off if the housing market busts.

Insurance companies, such as American Insurance Group (AIG), sold credit default swaps because they too were working under the assumption that a large-scale drop in the housing market was next to impossible.  They received hundreds of millions of dollars in premiums from various investors and investment banks prior to the crash and owed hundreds of billions of dollars in CDS payments after.  The whole securitization chain is pictured below.

All of these factors—the desire for home ownership, low interest rates, reduced credit standards, the securitization chain—combined with a Wall Street incentive structure which rewarded high risk/high reward behavior, created a ticking time-bomb with a single fuse: housing prices.  

What Did the Ames Straw Poll Accomplish?

On Saturday, a small percentage of the Republican electorate in Iowa flocked to the little town of  Ames for an event with no real meaning but for which candidates have spent many millions of dollars.  Only once in the last thirty years—George W. Bush in 1999—has the winner of the Ames Straw Poll gone on to win the Republican nomination and the White House.

Some candidates, such as John McCain in 2007, skipped the Iowa Caucus altogether because of its reputation as an Evangelical litmus test.  McCain had also opposed the Ethanol Tax Credit during his career in the Senate which would have killed any chance he had in the Caucus.  Mitt Romney is at least partially following this path due to the fact that his New England persona and Mormon religion do not necessarily play well in Iowa. 

While the Straw Poll has very little substantive meaning, it did help to clarify and simplify the Republican primary race which can now be viewed in three tiers. 

The top tier of candidates is now made up of Romney, Michelle Bachmann and, as of his entrance into the race on Saturday, Texas Governor Rick Perry.  This is where the real action of the Republican primary will occur.  Perry and Bachmann will now compete for the votes of the ultra-conservative, evangelical, Tea-Party types while Romney will seek to portray himself as the businessman with a plan to fix the economy and a mainstream electability. 

The second tier of candidates will now look to either increase their exposure in Iowa, working towards the Caucus in February, or focus their attention on New Hampshire and South Carolina.  In reality, these candidates—Ron Paul, Newt Gingrich, and Jon Huntsman—have little chance of making much headway in the primary, although some, such as Jon Stewart, believe Paul should be getting more press.  Huntsman, due to his strategy from the beginning of focusing on New Hampshire and South Carolina plus his financial backing has the greatest chance of becoming a spoiler but that chance is still slim. 

Herman Cain, Rick Santorum, and Thaddeus McCotter round out the Republican candidates as the third-tier.  With little support and limited funds, these candidates will likely remain in the race through the Iowa Caucus in order to “get their message out” but with little chance of making any electoral headway. 

So what does this mean for the Republican Party and for the country?  With Bachmann and Perry jockeying for position as the Conservative thoroughbreds, the chances of unseating President Obama become slimmer and slimmer.  The majority of Republican Primary voters may agree wholeheartedly with the small-government, deregulatory, social conservatism of Perry and Bachmann but the majority of the American people do not—at least not to that extent. 

The further these candidates move to the right, the more difficult it will become for them to pivot naturally to the center in the general election making a general election victory all the more difficult. 

There is still a long way to go before the general election and circumstances can change drastically.  The economy and job market will be the major factor that decides the election of 2012 and Republican would do well to remember that.  A candidate’s perspective on the role and size of government or on abortion and gay rights can be important in a Republican Primary but will be dwarfed in the general election by the issue of jobs. 

The Straw Poll is over and there are now six months before the actual Iowa Caucus.  Anything can happen—maybe if we’re lucky Jon Huntsman can get a little more traction—but more likely the first tier candidates will continue in their barrage of Conservative talking points and anti-Obama rhetoric all the way to the Republican Convention in August.