Everyone has his day and some days last longer than others.

Sir Winston Churchill

A good cause

What’s wrong with the economy?

Thursday late afternoon , January 15, 2009.

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Its been 30 long years since chairman Deng Xiaoping decided to open China’s economy to the world, ending a period of dozens of years of China’s 1.3 billion population seclusion from the rest of the world. I can still remember chairman Deng’s unequivocal words in support of free trade to a group of American businessmen visiting China, “If you need white mice, they will be white, [but] if you need them black, we will provide them too.”

Since then, Walmart has grown from some 30 odd stores to over 1,500 worldwide. Sam Walton’s original secret was to discover the price of chinese goods, and the next, to transfer these savings to US consumers. And China has grown to become an economic powerhouse, not only in manufacturing, but painfully for us, it’s also an increasingly sophisticated player in the services sector as well—Bill Gates has only kind words for his Microsoft R&D team in China.


Paul Volcker at Columbia University. Feb 20.
Courtesy of Bloomberg News

It’s hard to put a finger on who’s to blame, globalization has brought us all closer, and labor is extremely cheap not only in China, but India, Malaysia, Thailand, Vietnam, and many other countries. We cannot blame the European or US companies for outsourcing their work, if they don’t, their competitors will.

Also, some 15 years ago, executives from Morgan’s brokerage arm gathered in Boca Raton, to brainstorm their way out of a sluggish sales season. In that meeting, someone had the brilliant idea to sell debt insurance. They repackaged it into a financial (not an insurance regulated) product known as the Credit Default Swap (CDS), and virgin territory and all, it sold like hot cakes, to the tone of $62 trillion by December, 2007.

From a monetary standpoint, there are two ways in which the economy of the US may unfold: the deflationary or the inflationary road. The former may be better explained by what happened during the great depression, in three words: loss of jobs. I prefer the latter, our standard of living deteriorates because the prices of goods increase through inflation.

In other words, our western free market society’s answer to the Asian threat was to finance our way into the greatest liquidity our economic history has ever known. Banks literally were unbridled to increase their lending without limit, their loans were guaranteed by insurance coverage, no need to stick to the old and proven reserve requirement limits.

As a matter of fact, the business of selling debt insurance was so good, that most banks started to sell it themselves. But, was it really that good? Apparently not, as in the case of the subprime real estate loan fiasco, the lender was negligently too far distanced from the borrower, or the insurance company from the insured. Hence, thousands of bad loans were made on both fronts, but the latter was by far the more toxic mistake for banks.

Why? Let’s stop for a moment to revisit the $62 trillion CDS debt insurance situation. The best analogy I can come up with is the following. Let’s say you were able to take an $85 monthly premium to cover the $200,000 debt of your house. Let’s suppose that your neighbors could also take the same insurance and collect the insurance if something happened to—your— house. Let me run some quick numbers, if the house caught fire after 6 months, your neighbors would be sitting pretty to collect the $200,000 after having invested (in premium payments) only $510—that’s an whoping 392 times profit on the investment, or for every $1000 invested you would get $800,000 yearly, not bad, not bad…

Wouldn’t your neighbors be tempted to throw matches at your house every time they walked past it? Sure they would. And, that’s exactly what some hedge funds did to some weak companies, they shorted their stock to aggravate their already debilitated financial position, making money all the way down, and collecting a king’s ransom when the company would declare bankruptcy, as Lehman did.

From a monetary standpoint, there are two ways in which the economy of the US may unfold: the deflationary or the inflationary road. The former may be better explained by what happened during the great depression, in three words: loss of jobs. I prefer the latter, our standard of living deteriorates because the prices of goods increase through inflation.

Fortunately, under Ben Bernanke’s Fed patronage, our country has taken the inflationary —print dollars—way out of the economic woes we are facing.

So, if you feel like the ground your stepping on is caving under you, now you know why.

You may also want to take a look at Elizabeth Warren’s excellent 57 minute video lecture at UCTV to get another perspective on the problem, or my short version. Elizabeth teaches contract law, bankruptcy, and commercial law at Harvard Law School. She is an outspoken critic of America’s credit economy.