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. 

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 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.  

Jobs Should Now Be the First Priority

In the past few weeks, the American political and economic infrastructure has experienced some serious blows.  Democrats and Republicans in the White House and Congress spent weeks debating a compromise on the defecit and debt ceiling.  In the end, they landed on a compromise that is neither substantial nor popular and was signed into law mere days before the impending default of the United States on its financial obligations.  

A few days after this compromise was reached, Standard & Poor's, a credit rating agency, announced that it had downgraded the United States' bond rating from AAA--the highest possible rating--to AA+.  S&P stated in their decision that they were "pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabalizes the government's debt dynamics anytime soon."  While S&P's credibility is in serious question due to their actions during the financial crisis of 2008--a story for another time--the effects of this downgrade have reverberated through the world economy.  In the last four days, the Dow Jones Industrial Average has wildly fluctuared from a high of 11,462 to a low of 10,687 with many peaks and valleys in between.

The question now becomes what is Congress and the president to do?  Both parties, and President Obama specifically, have announced a pivot from the debt debate to jobs, although this announcement has been made many times before.  While Obama will embark on a bus tour of the Midwest on Monday with stops in Minnesota, Iowa and Illinois, he will then begin a 10-day vacation in Martha's Vineyard with his family.  Congress meanwhile is out of session until September.  

Criticisms of Presidents for taking vacations and members of Congress for scheduled recesses are always overstated.  Political leaders--the president in particular--are never truly on vacation.  They have the technology and the wherewithal to conduct most items of business and make necessary contacts from any location.  That being said, our political leaders face two challanges resulting from this schedule.

First, there is an image problem.  Politicians came out publicly after finalizing the debt ceiling compromise and announced that jobs would be the new priority.  Members of Congress subsequently left Washington and returned to their district.  The reality of our political world is that little if anything could actually have been accomplished during the month of August had the members of Congress remained there; however the image of the recess is one of Congressmen and women exhausted from a self-inflicted conflict over the debt ceiling going on vacation while the unemployment rate remains above 9% and the stock market seemingly rises and falls on a whim.  Image may not be reality, but image is integral in the business of politics.

Second, there is an economic reality problem.  As I stated, theunemployment rate stands at 9.1% while the actual unemployment is upwards of 16%.  In real terms, approximately one in six Americans is out of work and as is often the case, the brunt of the burden has fallen on the most vulnerable.  Poor and lower-middle class families, African Americans, and even teenagers have had the most difficulty in finding employment.  

Government does not hold the silver bullet, the magic potion that can fix the economy and return unemployment to a more manageable level.  But it does have the ability to influence economic activity.  There are compromises on which Democrats and Republican could potentially agree; a great bargain of economic stability.  These could include the extension of the payroll tax cut, extension of unemployment benefits, tax reform, allowing corporations to bring overseas money back to the United States without a tax burden, and many other possible solutions.  

These may not solve the problem but they would be a step in the right direction.  Merely cutting government spending will not stabalize the economy and put us on a path towards consistent and substantial growth.  Our government must take further steps; all we need now is leaders who are actually in Washington and who have the political will to take a stand.