A golden age, and other things they wish they'd never said.

 

Mr Brown and Mr Cameron couldn't flatter financiers enough. Now they're scrambling to reposition themselves in a world of bust

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• • Andrew Rawnsley
  • The Observer,
  • Sunday October 19 2008
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  • Article history

When a politician claims that he always saw the storm on the horizon, it is often more informative to read what he was saying when the sun was still shining. Before I listened to the latest thoughts from Gordon Brown and David Cameron on the crisis of capitalism, I first reminded myself what they were saying before the boom went bust.
 
Let's start with Gordon Brown in June 2005 giving the Chancellor's annual speech to the City at the Mansion House. Addressing the bow-tied ranks of money-changers, he paid lavish homage to 'your unique innovative skills, your courage and steadfastness'. They had his personal thanks 'for the outstanding, the invaluable contribution you make to the prosperity of Britain'. Though even the financiers may have wondered what courage had to do with it, they clapped long and hard.
Having hosed them with adulation every time he visited the City, Gordon Brown surpassed himself when he returned in 2007 to deliver his final Mansion House speech as Chancellor before he moved into Number 10. 'A new world order has been created,' he proclaimed. Britain was 'a new world leader' thanks to 'your efforts, ingenuity and creativity'. He congratulated himself for 'resisting pressure' to toughen up regulation of their activities. Everyone needed to follow the City's 'great example', emulate this 'high value-added, talent-driven industry'. 'Britain needs more of the vigour, ingenuity and aspiration that you already demonstrate.' Thanks to their 'remarkable achievements', we had the huge privilege to live in 'an era that history will record as the beginning of a new Golden Age'.
 
Or, as it turns out, an era that history will record as ending in the Great Crash of 2008. Their 'ingenuity' engineered the most seismic financial crisis in 80 years. Their 'aspiration' has destroyed swaths of their own industry and the rest of the economy. Their 'vigour' is propelling us into recession. What he then hailed as a 'Golden Age', the Prime Minister now deplores as an 'Age of Irresponsibility'.
 
David Cameron has had some fun at the expense of the Prime Minister. Which might make you assume that the Tory leader had foreseen, as Gordon Brown had not, that it would all turn to dust. So here is Mr Cameron in June 2006, offering his thoughts on 'the new global economy'. He trumpeted 'the victory of capitalism, privatisation and liberalisation'. Not to be out-grovelled by Gordon Brown when talking about bankers, the Tory leader lauded the 'highly innovative' City as 'the biggest international finance centre in the world'. Mr Cameron happily noted that 'there are more than 550 international banks and 170 global securities houses in London', numbers that may now be subject to downward revision. The Cameron of this pre-bust vintage gave the credit for all that reckless - sorry, 'innovative' - trading to 'critical Conservative decisions' when the Tories were in government. It proved that 'light regulation' and 'low regulation' were 'keys to success'.
 
Just over a year ago, in September 2007, Mr Cameron made a speech at the London School Of Economics. The financial markets were already experiencing what was then politely termed 'turbulence', but the Tory leader chose to amplify his thesis about the ascendancy of unconstrained capitalism. In a section entitled 'The End Of Economic History?', he answered the question by declaring that: 'The debate is now settled.' 'Liberalism' had prevailed. The left's silly idea that markets required tight regulation had been thoroughly discredited. 'The result? The world economy more stable than for a generation.' He drizzled sycophancy on the heads of the bankers, drooling that 'our hugely sophisticated financial markets match funds with ideas better than ever before'. What a pity the casino got so sophisticated that it traded trillions of dollars of toxic bets that no one understood, including the gamblers themselves.
 
I could fill every column until Christmas with the foolish eulogising of the animal spirits of ungoverned markets by the Prime Minister and the Leader of the Opposition. I could probably fill this entire newspaper with embarrassing quotes from senior politicians about the erstwhile masters of the universe. A generation of leaders, here and in much of the rest of the world, fell under the thrall of high finance. The commanding heights of politics were surrendered to the bankers. Right-leaning politicians did so from ideological conviction, left-leaning politicians did so because they came to believe that it was the only way to power. The markets were allowed to set the rules for the politicians. Leaders couldn't tax wealth more than the markets were prepared to allow. They couldn't spend, borrow, intervene or regulate without the permission of the gods of the dealing rooms. When Bill Clinton was in the White House, he would rage about the way in which his presidency was dictated to by 'a bunch of fucking bond traders'. One of his senior aides, James Carville, joked: 'I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.'
 
This side of the Atlantic, Tony Blair and Gordon Brown took a short spoon to supper with the devil. He seemed such a seductive fellow when the financial sector was growing four times as fast as the rest of the economy. The credit boom kept house prices rising, shop tills ringing, tax revenues flowing, the country feeling prosperous and voting Labour. The financial alchemists of the City appeared to have invented a perpetual motion machine for producing cheap money. No one in government wanted to ask awkward questions about ballooning debt and obscene bonuses that incentivised ever more reckless bets. Mr Brown made his wildly hubristic claim to have abolished 'boom and bust'. In so much as the Tories raised an objection, it was that Labour was over-constraining the 'wealth creators' with bureaucratic red tape.
 
Vince Cable was alone when he wandered the battlements of the City of Gold crying his warning that it would all end in tears. That the Lib Dem has been proved utterly correct doesn't seem to be doing his party much good in the polls, but at least it has made him Britain's most popular politician.
Gordon Brown and David Cameron are meanwhile scrambling to reposition themselves for the world of the bust. The Prime Minister would prefer we forgot that drivel about a 'Golden Age' and look out those of his old speeches in which he argued for a global surveillance system of financial markets. Mr Cameron would be obliged if we'd pretend we hadn't heard him extolling the gamblers and concentrate on his more recent call for 'economic responsibility'.
 
The Prime Minister's strategy is to try to internationalise not just the solutions to this crisis, but also the culpability for it. He would have us blame those greedy bankers who were once his heroes and the America that he once so admired. Mr Cameron is conversely keen to localise the blame around the Prime Minister. The Tory party has been uncomfortable supporting the government and unnerved by the sight of Gordon Brown feted as some sort of superhero. The Tory leader has been reassuring worried colleagues: 'I will pin the tail on the donkey.' Hence his speech on Friday which broke the pseudo truce by heaping culpability on the Prime Minister.
 
This parochial blame game takes place in the context of a much more important global realignment of the balance of power between finance, government and the rest of society. The barons of capital have been devoured by their own excesses. Forced to go running to the state for help, large chunks of their firms now owned by the taxpayers they previously treated with contempt, the bankers are now the supplicants to the politicians. Humiliation has been visited not just on the individual chief executives and chairmen who have lost their jobs; an entire class has been discredited in voters' eyes. High finance will not vanish, but its numbers, glamour and power will shrink. Charles Leadbetter, always an insightful analyst, draws a useful comparison with what happened to the trades union leaders. Those barons grew over-mighty in the Sixties and Seventies until they met their nemesis in the shape of Margaret Thatcher. They are still with us, but they lost their ability to mesmerise politicians and intimidate everyone else. High finance has similarly been dethroned.
 
There is no appetite, beyond the denuded ranks of revolutionary socialists, for a command economy anything like the model so discredited by the experiment with the Soviet Union. Governments have taken over banks out of necessity not ideological conviction. But there has been a shift. The intellectual and political climate now favours those sceptical about the more exaggerated claims made for markets. George Bush has been forced to nationalise banks. It looks increasingly likely that he will be succeeded by Barack Obama governing with the help of big Democrat majorities in Congress. David Cameron, who as recently as his party conference was inviting us to regard him as the son of Thatcher, is now denouncing 'irresponsible capitalism'. Gordon Brown has rediscovered a purpose for his premiership and a potential legacy in the reform and regulation of global finance.
 
The full extent and shape of this power shift will take time to become clear. This much is already certain. Political leaders will not fawn before money as they once did. The era of uncritical awe for financiers is over. The epoch of blind faith in the market is done with. When our leaders go to the City in future, they will no longer take knee pads with them.

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Exchange rate movements as explained by dealers

 By Tiffany Hutcheson

1 Introduction

Theoretically, the value of a currency is determined by the economic fundamentals of its country, such as interest rates, inflation rates and national income. These fundamentals have an effect on trade and capital flows and hence the demand and supply of the currency. However, there have been many well-known episodes when real exchange rates have moved contrary to these fundamentals for lengthy periods of time (Krugman, 1989). Attempts using empirical models to test economic fundamentals as a basis for predicting exchange rate movements have not been very successful especially over the short run (Taylor, 1995). Furthermore, market practitioners have successfully developed and implemented profitable trading strategies, which do not rely on economic fundamentals. One reason for the poor performance of trading activities based on fundamental analysis could be the behaviour of practitioners trading in the foreign exchange market (Krugman, 1989). For example, some practitioners may trade tactically in a way that forces an exchange rate to move away from its fundamental value. These practitioners would then establish a currency position that becomes profitable once general market trading moves the exchange rate back towards its true value (Rankin, 1999).

To gather information on the factors influencing traders, dealers in the Australian foreign exchange market were asked to complete a questionnaire survey. Their responses can be used to gauge the degree to which economic fundamentals influence the trading behaviour of dealers and hence exchange rates. As the majority of currency trading occurs through dealers, they are an ideal group to survey (Carew and Slayter, 1994). In order for their trading to be profitable they need to pay attention to any factor or event they consider will influence exchange rates. Consequently their responses can be used to obtain information on the relative importance dealers place on various factors considered to influence exchange rates. This information will contribute to the continuing debate on exchange rate determination. It may identify areas other than those previously studied, such as purchasing power parity, which could be researched in order to provide additional explanations for exchange rate movements.

The survey also included questions on the market's trading environment, such as the use of electronic broking, bid-ask spread size and the degree of competition in the market. The dealers' responses to these questions were analysed in an earlier paper (Hutcheson, 2001).

The paper is organised as follows. The preparation of the survey questions and the collection of the survey data are discussed in part two. The impact of changing economic fundamentals on exchange rates is investigated in part three while the influence of non-fundamental factors, impact of economic announcements and predictability of exchange rate movements are analysed in parts four, five and six respectively. Part seven contains some concluding observations about the survey responses.

2 The Survey Data

Each of the institutions licensed by the Reserve Bank of Australia, as at 12th July 1999, to deal in foreign exchange received a copy of the survey. A high response rate was achieved with 39 of the 59 surveys mailed out being completed and returned (1). Consequently, the survey responses should be representative of the views of the majority of dealers trading in the market. As explained in an earlier paper on this survey, most of the survey respondents held senior positions in the foreign exchange section of their institution's treasury department (Hutcheson, 2001). The comprehensive knowledge and market experience of these respondents should ensure the survey responses are a fairly accurate description of events in the market.

Survey data has been used in the past to obtain feedback from foreign exchange dealers (2). Some of the questions used in this survey are based on questions included in surveys undertaken by Cheung, Chinn and Marsh (1999), Cheung and Wong (2000) and Cheung and Chinn (2001). However, the questions are asked in a different way to the other surveys. Consequently, it is difficult to directly compare the responses to all the similar questions across the surveys.

3 Fundamental Movements in Exchange Rate

Market participants known as fundamental analysts adopt the notion that exchange rate movements are determined by the economic fundamentals of the countries represented by the exchange rate. They argue that the market regards a currency, as being under or over valued if it does not reflect these fundamentals thus creating a profitable arbitrage opportunity. In a floating exchange rate regime, where central banks do not intervene, arbitrageurs would buy undervalued currencies and sell overvalued currencies. This trading would force the currency's value to move quickly back towards its true value (Neely, 1997). According to fundamentalists if all currently available information on economic fundamentals is correctly priced into an exchange rate it will only change when new information becomes available.

Regrettably daily and intra-day exchange rate movements are not well explained by fundamental analysis (Singleton, 1987). In fact there have been times when it has appeared as though dealers have simply disregarded economic fundamentals and are merely overreacting to news and rumours (Shleifer and Summers, 1990). As shown in table 1 the majority of respondents believe that intra-day exchange rate movements do not reflect changes in the fundamental value of an exchange rate. They feel that changing fundamental values are reflected a lot more in the movements that occur within a period of six months or greater. These responses reinforce the finding from other surveys that fundamental analysis became more important as the time horizon increased (Taylor and Allen, 1992; Cheung, Chinn and Marsh, 1999; Cheung and Wong, 2000; Cheung and Chinn, 2001).

4 Non-Fundamental Movements in Exchange Rate

The respondents indicate in Table 2 that excessive speculation and manipulation by hedge funds are the main factors preventing exchange rates from reflecting their fundamental value. Excessive intervention by central banks was the next most heavily supported factor while views taken by major trading banks and slowness of dealers to respond did not receive as much support. Whilst speculation has for some time been seen as a force that can potentially destabilise exchange rate movements, only in recent years have hedge funds been one of the factors held responsible for unpredicted swings in exchange rates.

Cheung and Wong's (2000) survey on dealers trading in Hong Kong, Tokyo and Singapore and Cheung and Chinn's (2001) survey on dealers trading in the United States also found that excessive speculation and hedge fund manipulation were regarded to be the major forces behind exchange rate movements.

4.1 Speculation

It has been argued that speculative forces can destabilise currencies and prevent them from reflecting a country's economic fundamentals (Neely, 1997). However, as shown in Table 3, the survey respondents do not unanimously support speculation as a destabilising force with 55.6% indicating that speculation mainly moves exchange rates towards their fundamental value while 44.4% indicate that it moves them away. This is consistent with the finding by Cheung and Wong (2000) for the Hong Kong, Tokyo and Singapore markets. On the other hand 70.67% of the respondents to Cheung and Chinn's (2001) survey of United States dealers considered speculation to be a force that moved exchange rates in the direction of their fundamental values.

The stabilising nature of speculation arises because speculators buy currencies whose value they expect to increase and sell currencies whose value they expect to decrease. When a currency's value moves in the expected direction the speculator will reverse their currency position and profit. As speculators reverse buying positions when exchange rates are increasing and reverse selling positions when exchange rates are decreasing, you would expect their trading to offset large upward and downward pressures on the value of a currency. However, there have been several speculative episodes since currencies began to be floated in the 1970s when excessive speculation has been blamed for driving exchange rates away from their true values. During these episodes exchange rates increased or decreased by more than was supported by economic fundamentals (Krugman, 1989). In particular the exchange rate movements did not support the relationships between exchange rates and changing relative inflation rates and interest rates between countries as explained by purchasing power parity and uncovered interest parity respectively. In other words it was the speculative trading that was causing the exchange rate to move rather than changing market fundamentals. Consequently, when speculators eventually reversed their position it was some time before exchange rates moved back towards their true value. Particularly if dealers who did not normally speculate started to imitate the trading behavior of speculators, a phenomenon known as herding behavior, without regard to whether or not their behavior is supported by economic fundamentals (Banerjee, 1992). It would take these dealers longer to reverse their positions than the large speculators and so exchange rates would continue to be driven away from their true value.

Excessive speculation has been one of several trading strategies adopted by a recently developed type of investment vehicle known as hedge funds. Hedge funds are typically made up of a group of wealthy investors who employ a manager to achieve the maximum return in particular asset classes. As managers are generously rewarded for their achievements, they can choose to adopt aggressive trading strategies (Chicago Mercantile Exchange, 1995). In foreign exchange markets hedge funds have been known to gradually build up very large positions in particular currencies and then reverse these positions rapidly. If their reversal generates excessive exchange rate movements they are able to earn large profits. By building up the positions gradually their impact on exchange rates is only really felt when they reverse their positions. However, only a small number of hedge funds are large enough to create market positions sizeable enough to generate such movements (Reserve Bank of Australia, 1999).

The survey respondents would have recently experienced the destabilising impact of hedge funds on the Australian dollar in mid 1998. Between December 1997 and March 1998 hedge funds were said to have built up large short positions in the Australian dollar using borrowed funds (Rankin, 1999). During this period the Australian dollar was already experiencing a downward trend following the unfavorable impact of the Asian crisis on Australia's trade and capital flows. Consequently, the effect of hedge funds selling the Australian dollar went largely unnoticed. However, as the Australian dollar approached US60 cents, hedge funds began to sell more aggressively and generated uncertainty among other currency traders about what exchange rate the Australian dollar should trade at (Rankin, 1999). Significant Reserve Bank intervention was required in early June 1998 to stop this aggressive selling from continuing (Reserve Bank Bulletin, 1998).

While the respondents do not unanimously support speculation as a stabilising force, most of them felt it increased exchange rate volatility and improved market efficiency and liquidity (see Table 3). The increased volatility can be partly explained by speculators adopting trading strategies differing from those of other market participants. That is they could be buying or selling currencies at a time when other market participants are trading in the opposite direction or not trading very actively. The ability for speculation to improve market efficiency can be accounted for by the tendency for speculators to commence trading when they perceive that current and expected market fundamentals have not been correctly priced into the existing exchange rates (Blundall-Wignall et al., 1993). They will then trade in a manner that forces a currency's value to change until it reaches its true value. This increase in efficiency could also be accompanied by increased market liquidity as previously inactive dealers and dealers who normally trade for other reasons will enter the market to profit from the impact of speculative trading on the exchange rate.

4.2 Intervention by the Reserve Bank

Central banks intervene in foreign exchange markets if they consider volatility to be excessive or currencies to be under or overvalued. In Australia the timing and size of the intervention undertaken by the Reserve Bank has varied across several periods since the Australian dollar was floated in December 1983 (Andrew and Broadbent, 1994). This variation has been due to a wide range of factors such as the severity of exchange rate volatility being experienced and how the intervention will affect other government policies. However, whatever the reason for the intervention most of the respondents feel that the Reserve Bank normally intervenes at the appropriate moment with only 14.3% feeling that its timing has been inappropriate (see Table 4). In recent years the Reserve Bank has seen the need to intervene several times. However, prior to 1997 the Reserve Bank had not intervened since November 1993.

72.7% of the respondents feel that Reserve Bank intervention has been successful in moving exchange rates towards their fundamental values. In fact, 76.55% of the respondents believe that Reserve Bank intervention achieves its goals. These responses support a study undertaken by Andrew and Broadbent (1994) on the effectiveness of Reserve Bank intervention. They argue that intervention will be successful if the Reserve Bank makes a profit from supporting a depreciating Australian dollar by buying at low exchange rate levels and an appreciating Australian dollar by selling at high exchange rates. Their study found that the Reserve Bank's foreign exchange operations had been profitable over most of the periods when intervention was taking place. While the Reserve Bank's trading on behalf of its clients, principally the Commonwealth Government, may have generated some of this profit, the continued finding of profitability over long periods does lend some support for judging intervention to be successful.

The respondents are equally divided on the impact of Reserve Bank intervention on volatility with 50% feeling it decreases volatility and 50% feeling it increases volatility. This appears to be contradictory to the notion that successful intervention should be stabilising. However, volatility is more likely to decrease over the long term, as successful intervention begins to calm down market behavior (Andrew and Broadbent, 1994). On the other hand intra-day volatility would increase when dealers did not correctly anticipate the intervention undertaken by the Reserve Bank, as they would now need to trade out of their current market positions.

5 Impact of Economic Announcements

Whilst the survey respondents maintain that changing economic fundamentals mainly have an impact on long-term exchange rate movements. Unexpected economic announcements made by governments can influence intra-day exchange rate movements. When determining a currency's value market participants will take into consideration the existing and expected economic fundamentals of the currency's country. So when government announcements of the actual fundamentals differ from market expectations, dealers will trade in a way that causes exchange rates to change, if dealers do not react before or at the same time as other dealers any profitable opportunity that exists will be traded away. Several studies using intra-day data have concluded that new economic announcements take only a few minutes to have an impact (Almeida et al., 1998; Kim, 1998). Table 5 reveals that dealers tend to react within less than a minute when announcements from the major developed countries on domestic inflation, unemployment, trade deficit, current account, interest rates, retail sales and gross domestic product differ from what was expected.

Several respondents claimed that in Australia the Australian dollar/United States dollar spot market reacted instantaneously to announcements by the Australian government whilst the reaction time in other spot market currency pairings was more delayed. The market also did not react as quickly to announcements made by countries other than Australia. This may be partly because the overseas announcements, such as announcements from the United States of America, are made while Australian financial markets, other than the market for foreign exchange, are closed. Consequently, foreign exchange dealers may not fully adjust their trading position until they see the response to the announcements from other Australian financial markets when they open the following day (Kim, 1998). For example, dealers may wait to see how the domestic market for interest rate securities responds to changes in overseas interest rates.

Respondents are asked to select the economic announcement from Australia and the United States of America that they consider has the biggest impact on the Australian foreign exchange market. Table 6 shows that five years ago respondents regarded interest rate announcements made by the Reserve Bank of Australia had the biggest impact followed by announcements on the current account, inflation and then trade balance. Today interest rate announcements still have the biggest impact but inflation and unemployment and then the current account and trade deficit now follow it. The strong support for interest rates announcements is expected as the direction and magnitude of international capital flows is affected by changes to relative interest rates between countries. A reason for dealers providing greater support for inflation announcements today than they did five years ago could be due to their growing concern about the ease in which the direction of international capital flows can change. The sudden capital reversals experienced by several Asian countries in the late 1990s made dealers aware of the speed in which the direction of these flows can change. As the Reserve Bank of Australia will place upward pressure on interest rates when inflation increases

above a target range, changing inflation can be seen as a factor influencing capital flows (Reserve Bank of Australia, 1996). Consequently, dealers expect international capital flows will be fairly responsive to announcements of higher inflation. There is still a close link between the current account and trade balance and the Australian dollar, as the majority of Australian exports are commodities priced in foreign currencies (Gruen and Kortian, 1996). Consequently, changes to world commodity prices affect export revenue and hence exchange rates.

Of the announcements covering economic conditions in the United States, the announcements that have the biggest impact on the Australian foreign exchange market today as well as five years ago are those for interest rates and employment. Current account and trade deficit announcements from the United States have very little impact, as they are not seen to be strong indicators of economic and financial conditions in the United States.

6 Predictability

The ability to successfully predict exchange rate movements has been questioned by both academics and dealers. In Table 7 the respondents give very little support for exchange rate movements being either always predictable or never being predictable. The majority of respondents felt that if anything they were more likely to be sometimes predictable. They give slightly more support for intra-day exchange rate movements being sometimes predictable than they do for periods of less than six months and periods longer than six months.

Although the respondents do not regard exchange rate movements as being very predictable, they do believe that several factors can be identified as having a major influence on exchange rates depending on the time horizon in question. In Table 8 respondents maintain that intra-day exchange rate movements are mainly determined by order placements followed by over-reaction to news, speculative forces, bandwagon effects and technical trading. The confidential nature of inter-dealer trades makes it very difficult to obtain data on the volume and price of individual trades. Consequently, the disclosure by respondents that order placements have a major influence on intra-day exchange rate movements indicates that studies of order flows should be able to reveal information on trading behavior.

However, as the time horizon increases the respondents indicate that economic fundamentals have a growing impact on exchange rate movements while the other factors become less significant, particularly over periods greater than six months. Order placements and over-reaction to news only seem to have an impact on intra-day exchange rate movements. Speculative forces and bandwagon effects, where dealers adopt the trading trends of other dealers, have the same degree of impact intra-day and over the medium run. Technical trading, which involves historical exchange rates being used to forecast future trends in exchange rate movements, has its greatest influence on medium run exchange rate movements. However, unlike economic fundamentals, technical trading has little impact on long-run exchange rate movements.

7 Conclusion

This paper analyses the responses provided by Australian foreign exchange dealers to a questionnaire survey on the factors influencing exchange rate movements and hence trading behavior. Dealers will have experienced periods when exchange rates movements were regarded as being normal as well as circumstances deemed to be irregular. Consequently, their responses to the survey questions should be able to provide information on the factors generating movements in exchange rates. While the dealers do differ in their responses to several of the survey questions, a majority response was recorded for most of the questions.

The survey respondents do agree with the theoretical argument that exchange rate movements can be explained by changing economic fundamentals. However, they believe this explanation holds mainly over the longer term. Although when announcements of Australian economic fundamentals are different from what the market expected, dealers are seen to react within less than a minute to correctly price the anomaly into current exchange rates. The economic announcement having the biggest impact both today and five years ago is interest rates.

Speculative behaviour is regarded to be the main factor that prevents exchange rates from reflecting their fundamental value. However, there was no unanimity among the respondents on whether or not speculation was a stabilising force. In fact speculation was seen to both increase exchange rate volatility and improve market efficiency. Excessive intervention by central banks also received considerable support as a factor behind non-fundamental exchange rate movements. Intervention by the Reserve Bank of Australia tends to successfully move exchange rates towards their fundamental value and is conducted at the most appropriate time, according to most respondents.

The respondents did not feel that speculative forces fully explained intra-day exchange rate movements. Factors considered to have a greater influence on moment-to-moment movements in exchange rates were order placements by clients and overreaction of market participants to events. Technical trading was considered to make an impression on medium term exchange movements.

Whilst this survey has been able to identify factors respondents believe influence exchange rate movements, it also found that most of the respondents do not feel that exchange rates can be accurately predicted. In fact they see exchange rate movements as being only sometimes predictable over all time horizons.

An American Padmavyuh

 

Full convertibility was Manmohan's mantra. Thank god they failed.

S. GURUMURTHY

On March 18, 2006, Prime Minister Manmohan Singh told a global audience in Mumbai that the Reserve Bank of India would prepare a roadmap on full capital account convertibility to fully integrate the Indian financial system with the global. But now, on September 30, '08, Dr Singh has done a U-turn. He now says "the foremost challenge is to insulate India from the ill-effects of the international financial crisis". Why this shift from "integration" in 2006 to "insulation" in 2008? Simple. The Wall Street-innovated global financial architecture is like the padmavyuh in the Mahabharata which, like Abhimanyu, a nation can only enter, but never come out of. The global financial padmavyuh of today is the US-patented model. It is several thousand times more toxic now than at the time of the Asian crisis in 1998. Just take one aspect, the monumental growth in virtual money, or derivatives. The outstanding over-the-counter derivatives (OTC) in banks was $100 trillion in 2002 and $596 trillion in 2007—a rise of 496 per cent in five years. This does not include exchange-traded derivatives. Both aggregated might be several hundred times the actual global trade. This false money had helped banks and shadow banks to leverage their equity 50-70 times, to make super profits. Six years back, Warren Buffet had equated derivatives to financial weapons of mass destruction. It is this WMD that has now carpet-bombed financial markets all over. How did this virus spread? In the 1990s, after the collapse of the socialist model, the US sincerely believed—and the rest in the West and in the East seemed to accept—that Washington had become the new Rome; the Washington Consensus the new Bible; and the IMF, World Bank, WTO and the like the new evangelists. The US financial system thus became the benchmark for the world. Every nation, India included, was queuing up to copy its rules and models, to become like the US itself. But suddenly, the US has now U-turned, bewildering those still standing in the queue. The America of today seems to look to the state capitalist USSR of yesterday to tackle the financial tsunami on Wall Street. It is no global crisis. It is a crisis exported to the world by the US. The question is: is it just a slowdown, or a recession, or a depression that torments the US and the West, and courtesy them, the whole world? It seems more than all these and not just a systemic fall. It seems—the impending, but un-admitted—collapse of an economic model. Under its increasing influence, the most stable unit of human civilisation, the family, is bankrupted and nationalised and the insolvent government is privatised through corporates. Take the United States. Its family savings—which used to be 80 per cent of total savings in the '80s, and some 60 per cent in the '90s, has become negative 20 per cent. Meanwhile, corporate savings—which was 20 per cent of total savings in the '80s, and 40 per cent in the '90s—has become 120 per cent of the national savings now. Result: families bankrupted, corporates enriched. But the US corporates which had grabbed the savings of families and had $600 billion in cash would not pump in a single dollar into the system, contrary to former US Fed chairman Alan Greenspan's view that they would, to ease credit. Finally, the Fed had to work its dollar printing presses to attempt to save America. The $700-billion rescue platform of the US is not to be raised on taxpayers' money, but from the electronic printers of the US Fed. The American Fed printed $400 billion from 1863 to 1995, but added some $400 billion more in the 10 years to 2005. The present package is thus financed by electronic cash, not tax money. Back in India, the US-led crisis has put on hold all that the 'MMC' threesome—Manmohan, Montek and Chidambaram—would otherwise have sold as further reforms to India, the forex, financial and banking sector reforms.In the past, they had dismissed those who resisted them as Neanderthal minds. The Indian financial media too was singing in tune with them. But, if anything saves India today, as during the Asian crisis in 1998, it is the failure of the threesome in liberating the Indian financial system from Indians, and handing it over to Wall Street. Let the Indians thank God for their failure—and celebrate that they cannot do it easily hereafter. (S. Gurumurthy is convenor of the Swadeshi Jagaran Manch)

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10 things to know before confessing to an affair

If you've had sex with someone other than your partner and are thinking of spilling the beans, read this first

Suzi Godson

1. Infidelity is not as common as you might think. A 2006 online survey of 46,000 people revealed that one in five married men and one in ten married women had committed infidelity during their marriage (BBC's UK Lovemap).
2. If there is no way that your partner will find out about a one-off misdemeanour on a business trip, and you want your relationship to survive, honesty is not necessarily the best policy.
3. Crippled with guilt or need advice? Respect your partner and talk to a neutral third party rather than confiding in a friend. Relate offers telephone counselling for £45 an hour on 0300 1001234. Or call the Samaritans on 08457 909090.
4. If the affair is ongoing and there is a chance that someone else will tell your partner, come clean. A one-night stand might just be excusable; lying never is.
5. Nor is compromising your partner's sexual health. If you were dumb enough to have unprotected sex, get tested for STIs. Some STIs can't be picked up for two weeks or more, and HIV has a three-month dormancy period. So even if your initial results are clear, you may need to tell your partner the truth so that he or she can get tested too.
6. When you tell your partner your motive should be a genuine desire to improve or, if necessary, gently terminate your relationship. Don't confess to ease your own guilt, vent anger or get even.
7. Infidelity is often a symptom, not a cause, of trouble in a relationship, and confessing may force you to address the underlying issues. For example, if you were drunk or high when your infidelity happened, drugs and alcohol may be the real problem.
8. Frank Pittman, a psychiatrist and relationship expert, says there are four types of infidelity: accidental infidelity (an unintended act of, usually drunken, carelessness); the romantic affair (you meet somebody wonderful while you are going through a big crisis in your life); the marital arrangement (comfort while you avoid dealing with a marriage that won't die and won't recover); and the philanderer (men who continually need their masculinity affirmed, women who are the daughters or ex-wives of philanderers).
9. Extra-marital affairs remain the biggest cause for divorce, according to the UK management consultants Grant Thornton.
10. Only 3 per cent of 4,100 high-powered, but unfaithful, men divorced their wives and married their lovers (Dr Jan Halper, the author of Quiet Desperation: The Truth About Successful Men). And the divorce rate among those who marry their lovers is 75 per cent (Frank Pittman).

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In its 13 years, Outlook has honed a peculiarly Indian take on secular fair play that opens its pages to diversity and dissent

MUKUL KESAVAN
Outlook is now 13 years old. For a Jewish boy, his thirteenth birthday is the time he comes of age; an English-speaking Indian child is likely to be told that she (or he) is now a teenager, an otherwise alien time of life for most Indian children. What 13 means in the life-cycle of a magazine is less obvious because the average life expectancy of an English magazine in India is hard to reckon.

If we were to use the Illustrated Weekly of India as a precedent (which began life in 1880 as the weekly edition of the Times of India and kept going up to 1993 by which time it was a hundred and thirteen years old), Outlook would be a child with a century of vigorous life ahead of it. On the other hand, if we take as our guide one of India's most promising newsmagazines, Sunday, which began publishing in 1973 and died (along with the twentieth century) in 1999, Outlook would be in the middle of its mid-life crisis, with just another 13 years to look forward to.

On the whole, though, there's reason to take the long view. Successful magazines of news and opinion tend to keep going for a while. Time, the prototype for most modern newsmagazines, opened shop in 1923, and while it isn't quite the behemoth it was in its prime, its paid circulation adds up to around 3.5 million copies each week.

TIME Jan 6, 1936 cover

And Time is a child compared to The Economist, which started life in 1843 and successfully sells three-quarters of a million copies of every issue. Closer home, India Today, which, along with Sunday, transformed magazine journalism in India in the mid-'70s, continues to flourish. So the outlook, for Outlook at 13, is good.

But the jinx of 13 seems to have created a run of bad luck for the country Outlook reports on. The troubles in Kashmir, the explosions that seem to randomly and regularly terrorise Indian cities, the unending attacks on Christians in Orissa and Karnataka, the worldwide recession that seems to be upon us, are enough to make a rational Outlook reader triskaidekaphobic (bet you didn't know the word!).

But a little perspective will show us that the world was ever the same. Around Time's 13th anniversary, 1936, the news was considerably more ominous. Hitler's Germany tore up the Treaty of Versailles by reoccupying the Rhineland; a violently militarist politician, Koki Hirota, became the prime minister of Japan; and as if these portents of the Second World War weren't bad enough, this was also the year that the Arab revolt against British policy in Palestine and Arab resistance to Jewish migration into the region began, a conflict that festers to this day.


Bin-laden terror: The 9/13 blast at Barakhamba Road in Delhi

The Economist's 13th year wasn't much better; in 1856, it editorialised on the Crimean War that had just come to an end but the massive Taiping Rebellion in China continued, and the Second Opium War had just begun. Closer home, Britain declared war on Persia, and Wajid Ali Shah, once the Nawab of Oudh, was sent into internal exile on the eve of the great revolt of 1857.

So Outlook's 13th anniversary doesn't fall in a specially blighted year: in this world of ours, there's always enough bad news to keep newsmagazines going. What's much more interesting is the way in which a newsmagazine slants and summarises the world.


Outlook 13th anniversary

Ever since Time invented the template for the modern newsmagazine—the world summarised in dozens of short articles arranged in departments that deal with politics, religion, the arts, sport, cinema, the news told through personalities and celebrities, the weirdly uniform house style in which the news was processed—every imitator from Der Spiegel to India Today has tried to claim the mantle of objectivity. This claim is not, of course, true, which is just as well: these magazines would be unreadable if it were.

Every successful newsmagazine has had a broad ideological position. In the 35 years that Henry Luce edited Time, from 1929 to 1964, the magazine hewed closely to his conservative politics. In more recent times, Time has been accused of a liberal bias. The Economist was an ideological paper from its inception: James Wilson, its founder, was committed to laissez faire economics and the immediate provocation for setting it up was to argue against the British government's proposal to impose levies on grain import. More than a century-and-a-half later, The Economist is still busily (and profitably) arguing for low taxes and less government intervention (except in the matter of war: it supported the American invasion of Iraq as it does nearly every Western military adventure) in an anonymous house style which delights as many people as it infuriates.

Indian newsmagazines are, like their Western counterparts, ideological. It's possible, of course, to argue that all newsmagazines are the same newsmagazine, in that they all accept the mainstream presumptions of the societies in which they operate. But for the moderately alert reader, the differences in point of view are apparent too.

One of Outlook's distinguishing features is the lack of a house style. This isn't an accident: more than most other newsmagazines, Outlook carries columns, reviews and even reportage by outsiders, people who don't work for the magazine. There isn't even an attempt to tidy up the prose of its inhouse writers into a uniform idiom. As a long-time reader, this seems intentional, an attempt to create, within the constraints of a newsmagazine format, a forum for diverse and lively writing. The travel diary with which every issue ends is a remarkable and successful innovation in a genre of journalism that has traditionally shunned idiosyncratic, impressionistic writing the better to cultivate an authoritative impersonality.


From the archives, May 1846 Economist front page

But the most interesting part of Outlook's persona (or its brand identity, as marketing mavens might have it) is its commitment to a liberal and pluralist politics. Just as The Economist reports the world through a laissez faire lens, Outlook's sense of what's newsworthy in India is shaped by a peculiarly Indian take on secular fair play. Critics write that the magazine is politically skewed towards the Congress and against the BJP; if this is true, it's true only to the extent that the Congress conforms to the principles of a plural liberalism more closely than the BJP does or can. Is this unhealthy? Only if Outlook was the one newsmagazine on the stands.


Sepia tint: Roger Fenton's 1855 photo of the Crimean war

But it isn't.There are other magazines that report the news differently, that give the State the benefit of the doubt, that try, in their reportage and their comment, to explain the logic of majoritarian politics, that report India in the language of 'realism' and realpolitik. Which leaves Outlook free to open its pages to diversity and dissent. For a newsmagazine to do a cover emblazoned with a Hindu swastika and a cover story exploring majoritarian bias, as Outlook did recently, is unusual. These first years of its life have seen the idea of a plural India contested, in office and out of it, as never before, by the Hindu right. What is remarkable is that in this uncongenial political climate, Outlook has built a large mainstream readership, thrived, and is now 13.

Outlook's longevity will depend not on how it weathers ideological hostility, but how it copes with the threat of online browsing. Salman Rushdie, in a recent interview, declared that he no longer subscribed to newspapers and magazines because they were all available online. Every deadwood periodical in the world faces the danger of a young generation that has fallen out of the habit of paying for 'content', whether it be music, films or journalism. In a world where peer-to-peer sharing is eroding notions of copyright and ownership and theft, newsmagazines will have to find new ways of making money out of opinion and news. Outlook's achievement on its 13th birthday is that in this relatively short span it has found many readers who are desperate for it to succeed.

Booklovers turn to Karl Marx as financial crisis bites in Germany

• Kate Connolly in Berlin
• guardian.co.uk,
• Wednesday October 15 2008 12.19 BST

Karl Marx is back. That, at least, is the verdict of publishers and bookshops in Germany who say that his works are flying off the shelves.

The rise in his popularity has of course, been put down to the current economic crisis. "Marx is in fashion again," said Jörn Schütrumpf, manager of the Berlin publishing house Karl- Dietz which publishes the works of Marx and Engels in German. "We're seeing a very distinct increase in demand for his books, a demand which we expect to rise even more steeply before the year's end."
Most popular is the first volume of his signature work, Das Kapital. According to Schütrumpf, readers are typically "those of a young academic generation, who have come to recognise that the neoliberal promises of happiness have not proved to be true."
Bookshops around the country are reporting similar findings, saying that sales are up by 300%. (Though the fact that they are not prepared to quote actual figures suggests the sales were never that high).
Literature comes and goes and it is nice to see that trends are not always driven by slick marketing campaigns. Just as Rudyard Kipling would have been delighted that his poem The Gods of the Copybook Headings which contains the apt lines: "Then the Gods of the Market tumbled, and their smooth-tongued wizards withdrew." is modish once more, so Marx would have reveled in the idea that an economic crisis had reignited interest in his works. (Not, you understand, because of the increased royalties that would be coming his way over the next few months were he still alive.)
Increasing numbers of Germans appear ready to out themselves as Marx fans in a time when it is fashionable to repeat the philosopher's belief that excessive capitalism with all its greed finally ends up destroying itself. When Oskar Lafontaine, the head of Germany's rising left-wing party Die Linke, said he would include Marxist theory in the party's manifesto, in the outline of his plans to partially nationalise the nation's finance and energy sectors, he was labeled as a "mad leftie" who had "lost the plot" by the tabloid Bild. But even Germany's finance minister, Peer Steinbrück, who must have had some sleepless nights over the past few weeks, has now declared himself something of a fan. "Generally one has to admit that certain parts of Marx's theory are really not so bad," he cautiously told Der Spiegel.
"These days Marx is on a winning streak in the charm stakes," Ralf Dorschel commented in the Hamburger Abendblatt.
But for those not quite ready to immerse themselves in Marxist theory, Marx's correspondence to Friedrich Engels at the time of an earlier US economic crisis makes more entertaining reading. "The American Crash is a delight to behold and it's far from over," he wrote in 1857, confidently predicting the imminent and complete collapse of Wall Street.

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Reversal of Fortune

 

October, 13 2008

By Joseph Stiglitz
Source: Vanity Fair

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When the American economy enters a downturn, you often hear the experts debating whether it is likely to be V- shaped (short and sharp) or U-shaped (longer but milder). Today, the American economy may be entering a downturn that is best described as L-shaped. It is in a very low place indeed, and likely to remain there for some time to come.

 

Virtually all the indicators look grim. Inflation is running at an annual rate of nearly 6 percent, its highest level in 17 years. Unemployment stands at 6 percent; there has been no net job growth in the private sector for almost a year. Housing prices have fallen faster than at any time in memory-in Florida and California, by 30 percent or more. Banks are reporting record losses, only months after their executives walked off with record bonuses as their reward. President Bush inherited a $128 billion budget surplus from Bill Clinton; this year the federal government announced the second-largest budget deficit ever reported. During the eight years of the Bush administration, the national debt has increased by more than 65 percent, to nearly $10 trillion (to which the debts of Freddie Mac and Fannie Mae should now be added, according to the Congressional Budget Office). Meanwhile, we are saddled with the cost of two wars. The price tag for the one in Iraq alone will, by my estimate, ultimately exceed $3 trillion.

 

This tangled knot of problems will be difficult to unravel. Standard prescriptions call for raising interest rates when confronted with inflation, just as standard prescriptions call for lowering interest rates when confronted with an economic downturn. How do you do both at the same time? Not in the way that some politicians have proposed. With gasoline prices at all- time highs, John McCain has called for a rollback of gas taxes. But that would lead to more gas consumption, raise the price of gas further, increase our dependence on foreign oil, and expand our already massive trade deficit. The expanding deficit would in turn force the U.S. to continue borrowing gargantuan sums from abroad, making us even more indebted. At the same time, the higher imports of oil and petroleum-based products would lead to a weaker dollar, fueling inflationary pressures.

 

Millions of Americans are losing their homes. (Already, some 3.6 million have done so since the subprime- mortgage crisis began.) This social catastrophe has severe economic effects. The banks and other financial institutions that own these mortgages face stunning reverses; a few, such as Bear Stearns, have already gone belly-up. To prevent America's $5.2 trillion home financiers, Fannie Mae and Freddie Mac, from following suit, Congress authorized a blank check to cover their losses, but even that generosity failed to do the trick. Now the administration has taken over the two entities completely, a stunning feat for a supposedly market-oriented regime. These bailouts contribute to growing deficits in the short run, and to perverse incentives in the long run. Market economies work only when there is a system of accountability, but C.E.O.'s, investors, and creditors are walking away with billions, while American taxpayers are being asked to pick up the tab. (Freddie Mac's chairman, Richard Syron, earned $14.5 million in 2007. Fannie Mae's C.E.O., Daniel Mudd, earned $14.2 million that same year.) We're looking at a new form of public-private partnership, one in which the public shoulders all the risk, and the private sector gets all the profit. While the Bush administration preaches responsibility, the words are addressed only to the less well-off. The administration talks about the impact of 'moral hazard' on the poor 'speculator' who borrowed money and bought a house beyond his ability to pay. But moral hazard somehow isn't an issue when it comes to the high-stakes speculators in corporate boardrooms.

 

How Did We Get into This Mess?

 

A unique combination of ideology, special-interest pressure, populist politics, bad economics, and sheer incompetence has brought us to our present condition.

 

Ideology proclaimed that markets were always good and government always bad. While George W. Bush has done as much as he can to ensure that government lives up to that reputation-it is the one area where he has overperformed-the fact is that key problems facing our society cannot be addressed without an effective government, whether it's maintaining national security or protecting the environment. Our economy rests on public investments in technology, such as the Internet. While Bush's ideology led him to underestimate the importance of government, it also led him to underestimate the limitations of markets. We learned from the Depression that markets are not self- adjusting-at least, not in a time frame that matters to living people. Today everyone-even the president-accepts the need for macro-economic policy, for government to try to maintain the economy at near- full employment. But in a sleight of hand, free-market economists promoted the idea that, once the economy was restored to full employment, markets would always allocate resources efficiently. The best regulation, in their view, was no regulation at all, and if that didn't sell, then 'self-regulation' was almost as good.

 

The underlying idea was, on the face of it, absurd: that market failures come only in macro doses, in the form of the recessions and depressions that have periodically plagued capitalist economies for the past several hundred years. Isn't it more reasonable to assume that these failures are just the tip of the iceberg? That beneath the surface lie a myriad of smaller but harder-to-assess inefficiencies? Let me venture an analogy from biology: A patient arrives at a hospital in serious condition. Now, it may be that the patient has simply fallen victim to one of those debilitating ailments that go around from time to time and can be cured by a massive dose of antibiotics. In this case we have a macro problem with a macro solution. But it could instead be that the patient is suffering from a decade of serious abuse-smoking, drinking, overeating, lack of exercise, a fondness for crystal meth-and that it has not only taken a catastrophic toll but also left him open to opportunistic infections of every kind. In other words, a buildup of micro problems has led to a macro problem, and no cure is possible without addressing the underlying issues. The American economy today is a patient of the second kind.

 

We are in the midst of micro-economic failure on a grand scale. Financial markets receive generous compensation-in the form of more than 30 percent of all corporate profits-presumably for performing two critical tasks: allocating savings and managing risk. But the financial markets have failed laughably at both. Hundreds of billions of dollars were allocated to home loans beyond Americans' ability to pay. And rather than managing risk, the financial markets created more risk. The failure of our financial system to do what it is supposed to do matches in destructive grandeur the macro-economic failures of the Great Depression.

 

Economic theory-and historical experience-long ago proved the need for regulation of financial markets. But ever since the Reagan presidency, deregulation has been the prevailing religion. Never mind that the few times 'free banking' has been tried-most recently in Pinochet's Chile, under the influence of the doctrinaire free-market theorist Milton Friedman-the experiment has ended in disaster. Chile is still paying back the debts from its misadventure. With massive problems in 1987 (remember Black Friday, when stock markets plunged almost 25 percent), 1989 (the savings- and-loan debacle), 1997 (the East Asia financial crisis), 1998 (the bailout of Long Term Capital Management), and 2001-02 (the collapses of Enron and WorldCom), one might think there would be more skepticism about the wisdom of leaving markets to themselves.

 

The new populist rhetoric of the right-persuading taxpayers that ordinary people always know how to spend money better than the government does, and promising a new world without budget constraints, where every tax cut generates more revenue-hasn't helped matters. Special interests took advantage of this seductive mixture of populism and free-market ideology. They also bent the rules to suit themselves. Corporations and the wealthy argued that lowering their tax rates would lead to more savings; they got the tax breaks, but America's household savings rate not only didn't rise, it dropped to levels not seen in 75 years. The Bush administration extolled the power of the free market, but it was more than willing to provide generous subsidies to farmers and erect tariffs to protect steelmakers. Lately, as we have seen, it seems willing to write blank checks to bail out its friends on Wall Street. In each of these cases there are clear winners. And in each there are clear losers-including the country as a whole.

 

What Is to Be Done?

 

As America attempts to work its way out of the present crisis, the danger is that we will listen to the same people on Wall Street and in the economic establishment who got us into it. For them, our current predicament is another opportunity: if they can shape the government response appropriately, they stand to gain, or at least stand to lose less, and they may be willing to sacrifice the well-being of the economy for their own benefit-just as they did in the past.

 

There are a number of economic tools at the country's disposal. As noted, they can yield contradictory results. The sad truth is that we have reached the limits of monetary policy. Lowering interest rates will not stimulate the economy much-banks are not going to be willing to lend to strapped consumers, and consumers are not going to be willing to borrow as they see housing prices continue to fall. And raising interest rates, to combat inflation, won't have the desired impact either, because the prices that are the main sources of our inflation-for food and energy-are determined in international markets; the chief consequence will be distress for ordinary people. The quandaries that we face mean that careful balancing is required. There is no quick and easy fix. But if we take decisive action today, we can shorten the length of the downturn and reduce its magnitude. If at the same time we think about what would be good for the economy in the long run, we can build a durable foundation for economic health.

 

To go back to that patient in the emergency room: we need to address the underlying causes. Most of the treatment options entail painful choices, but there are a few easy ones. On energy: conservation and research into new technologies will make us less dependent on foreign oil, reduce our trade imbalance, and help the environment. Expanding drilling into environmentally fragile areas, as some propose, would have a negligible effect on the price we pay for oil. Moreover, a policy of 'drain America first' will make us more dependent on foreigners in the future. It is shortsighted in every dimension.

 

Our ethanol policy is also bad for the taxpayer, bad for the environment, bad for the world and our relations with other countries, and bad in terms of inflation. It is good only for the ethanol producers and American corn farmers. It should be scrapped. We currently subsidize corn-based ethanol by almost $1 a gallon, while imposing a 54-cent-a-gallon tariff on Brazilian sugar-based ethanol. It would be hard to invent a worse policy. The ethanol industry tries to sell itself as an infant, needing help to get on its feet, but it has been an infant for more than two decades, refusing to grow up. Our misguided biofuel policy is taking land used for food production and diverting it to energy production for cars; it is the single most important factor contributing to higher grain prices.

 

Our tax policies need to be changed. There is something deeply peculiar about having rich individuals who make their money speculating on real estate or stocks paying lower taxes than middle-class Americans, whose income is derived from wages and salaries; something peculiar and indeed offensive about having those whose income is derived from inherited stocks paying lower taxes than those who put in a 50-hour workweek. Skewing the tax rates in the other direction would provide better incentives where they count and would more effectively stimulate the economy, with more revenues and lower deficits.

 

We can have a financial system that is more stable-and even more dynamic-with stronger regulation. Self- regulation is an oxymoron. Financial markets produced loans and other products that were so complex and insidious that even their creators did not fully understand them; these products were so irresponsible that analysts called them 'toxic.' Yet financial markets failed to create products that would enable ordinary households to face the risks they confront and stay in their homes. We need a financial-products safety commission and a financial-systems stability commission. And they can't be run by Wall Street. The Federal Reserve Board shares too much of the mind-set of those it is supposed to regulate. It could and should have known that something was wrong. It had instruments at its disposal to let the air out of the bubble-or at least ensure that the bubble didn't over- expand. But it chose to do nothing.

 

Throwing the poor out of their homes because they can't pay their mortgages is not only tragic-it is pointless. All that happens is that the property deteriorates and the evicted people move somewhere else. The most coldhearted banker ought to understand the basic economics: banks lose money when they foreclose-the vacant homes typically sell for far less than they would if they were lived in and cared for. If banks won't renegotiate, we should have an expedited special bankruptcy procedure, akin to what we do for corporations in Chapter 11, allowing people to keep their homes and re-structure their finances.

 

If this sounds too much like coddling the irresponsible, remember that there are two sides to every mortgage-the lender and the borrower. Both enter freely into the deal. One might say that both are, accordingly, equally responsible. But one side-the lender-is supposed to be financially sophisticated. In contrast, the borrowers in the subprime market consist mainly of people who are financially unsophisticated. For many, their home is their only asset, and when they lose it, they lose their life savings. Remember, too, that we already give big homeowner subsidies, through the tax system, to affluent families. With tax deductions, the government is paying in some states almost half of all mortgage interest and real-estate taxes. But many lower-income people, whose deductions are meaningless because their tax bill is too small, get no help. It makes much more sense to convert these tax deductions into cashable tax credits, so that the fraction of housing costs borne by the government for the poor and the rich is the same.

 

About these matters there should be no debate-but there will be. Already, those on Wall Street are arguing that we have to be careful not to 'over-react.' Over- reaction, we are told, might stifle 'innovation.' Well, some innovations ought to be stifled. Those toxic mortgages were certainly innovative. Other innovations were simply devices to circumvent regulations-regulations intended to prevent the kinds of problems from which our economy now suffers. Some of the innovations were designed to tart up the bottom line, moving liabilities off the balance sheet-charades designed to blur the information available to investors and regulators. They succeeded: the full extent of the exposure was not clear, and still isn't. But there is a reason we need reliable accounting. Without good information it is hard to make good economic decisions. In short, some innovations come with very high price tags. Some can actually cause instability.

 

The free-market fundamentalists-who believe in the miracles of markets-have not been averse to accepting government bailouts. Indeed, they have demanded them, warning that unless they get what they want the whole system may crash. What politician wants to be blamed for the next Great Depression, simply because he stood on principle? I have been critical of weak anti-trust policies that allowed certain institutions to become so dominant that they are 'too big to fail.' The harsh reality is that, given how far we've come, we will see more bailouts in the days ahead. Now that Fannie Mae and Freddie Mac are in federal receivership, we must insist: not a dime of taxpayer money should be put at risk while shareholders and creditors, who failed to oversee management, are permitted to walk away with anything they please. To do otherwise would invite a recurrence. Moreover, while these institutions may be too big to fail, they're not too big to be reorganized. And we need to remember why we're bailing them out: in order to maintain a flow of money into mortgage markets. It's outrageous that these institutions are responding to their near-monopoly position by raising fees and increasing the costs of mortgages, which will only worsen the housing crisis. They, and the financial markets, have shown little interest in measures that could help millions of existing and potential homeowners out of the bind they're in.

 

The hardest puzzles will be in monetary policy (balancing the risks of inflation and the risk of a deeper downturn) and fiscal policy (balancing the risk of a deeper downturn and the risk of an exploding deficit). The standard analysis coming from financial markets these days is that inflation is the greatest threat, and therefore we need to raise interest rates and cut deficits, which will restore confidence and thereby restore the economy. This is the same bad economics that didn't work in East Asia in 1997 and didn't work in Russia and Brazil in 1998. Indeed, it is the same recipe prescribed by Herbert Hoover in 1929.

 

It is a recipe, moreover, that would be particularly hard on working people and the poor. Higher interest rates dampen inflation by cutting back so sharply on aggregate demand that the unemployment rate grows and wages fall. Eventually, prices fall, too. As noted, the cause of our inflation today is largely imported-it comes from global food and energy prices, which are hard to control. To curb inflation therefore means that the price of everything else needs to fall drastically to compensate, which means that unemployment would also have to rise drastically.

 

In addition, this is not the time to turn to the old- time fiscal religion. Confidence in the economy won't be restored as long as growth is low, and growth will be low if investment is anemic, consumption weak, and public spending on the wane. Under these circumstances, to mindlessly cut taxes or reduce government expenditures would be folly.

 

But there are ways of thoughtfully shaping policy that can walk a fine line and help us get out of our current predicament. Spending money on needed investments-infrastructure, education, technology-will yield double dividends. It will increase incomes today while laying the foundations for future employment and economic growth. Investments in energy efficiency will pay triple dividends-yielding environmental benefits in addition to the short- and long-run economic benefits.

 

The federal government needs to give a hand to states and localities-their tax revenues are plummeting, and without help they will face costly cutbacks in investment and in basic human services. The poor will suffer today, and growth will suffer tomorrow. The big advantage of a program to make up for the shortfall in the revenues of states and localities is that it would provide money in the amounts needed: if the economy recovers quickly, the shortfall will be small; if the downturn is long, as I fear will be the case, the shortfall will be large.

 

These measures are the opposite of what the administration-along with the Republican presidential nominee, John McCain-has been urging. It has always believed that tax cuts, especially for the rich, are the solution to the economy's ills. In fact, the tax cuts in 2001 and 2003 set the stage for the current crisis. They did virtually nothing to stimulate the economy, and they left the burden of keeping the economy on life support to monetary policy alone. America's problem today is not that households consume too little; on the contrary, with a savings rate barely above zero, it is clear we consume too much. But the administration hopes to encourage our spendthrift ways.

 

What has happened to the American economy was avoidable. It was not just that those who were entrusted to maintain the economy's safety and soundness failed to do their job. There were also many who benefited handsomely by ensuring that what needed to be done did not get done. Now we face a choice: whether to let our response to the nation's woes be shaped by those who got us here, or to seize the opportunity for fundamental reforms, striking a new balance between the market and government.

 

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