Friday, March 17, 2006

3/17 Three Headline Stories this Week as Manifestations of the Dominance of Speculative Finance

This post repackages a few previous ones. We’ll comment on several news items from this week as manifestations of the dominant impact of global speculative finance. They are Goldman Sachs record profits and the record U.S. current account deficit, sharply mounting scientific evidence of much more rapid than expected climate change, and the Enron trial.

On Tuesday, March 14, Goldman Sachs reported better-than-expected first-quarter of $2.5 billion, up 62%. According to Reuters, “ record trading revenue, accompanied by one of the busiest periods for mergers and acquisitions ever, resulted in record revenue and earnings.” A portolio manager was quoted as saying, "There were a lot of good things in currencies, in commodities and many credit products. Goldman also has the greatest presence in non-U.S. markets and those markets are growing exceptionally fast."

On the same day, Bloomberg reported that “the U.S. current account deficit widened more than forecast to a record $224.9 billion in the fourth quarter, driven by a ballooning trade gap that is poised to worsen this year....For all of 2005, the deficit reached $804.9 billion, the biggest ever…[it] equaled 7 percent of the nation's gross domestic product in the fourth quarter and 6.5 percent of GDP for all 2005, both all-time highs. The deficit set a record in seven of the last eight years.”

The juxtaposition of Goldman Sachs reporting record-breaking profits on the same day that the U.S. Commerce Dept. reported record-breaking current account deficits is a good indication of who benefits most from the current global speculative finance system. And note well that Goldman's profit is after paying out huge compensation for its employees far, far in excess of what the average American can imagine.

This is the end-result of a critical choice made by the financial markets in the 1980s. At that time, the issue was how to compete against manufacturing trade competition from Japan, Germany, etc. (See my 2/10 "Bush’s American Competitiveness and Advanced Energy Initiatives: “Deja Vu All Over Again” Twenty-five Years Too Late?" link)

Eventually, corporate America, strongly influenced, via the CEO stock option linkage, by the short-term preferences of its speculative capital markets, chose to outsource, and U.S. economic policy emphasized seeking free global capital markets for its financial giants being spoon-fed liquidity steroids by Greenspan's Fed and later also the Bank of Japan.

The corporate and policy shifts away from manufacturing competitiveness to an emphasis on unfettered globalized speculative finance enabled the U.S., with its highly vaunted advantages in flexibility, especially its ability to implement wholesale layoffs without corporate consequences, to "wrong-foot" the manufacturing-oriented, more socially consensual Japanese and German economies, which also were hurt by the bursting of a huge bubble in the former and the enormous costs of the re-unification with East Germany in the latter.

The relatively dismal performace of its main competitors combined with technology innovations in the U.S. gave a large comparative advantage to U.S. "free market" speculative finance, which then resulted in two huge booms/bubbles, in tech in the late 1990s and currently in real estate, in the process sucking in the "global savings glut" (Bernanke's term, which is actually a reflection of poor financial intermediation, corporate governance and social safety nets in many countries, not excess savings per se), initially attracted by high U.S. returns and later continued by policy decisions by central banks

After the collapse of the TMT equity bubble in 2000-02, the long-term stagnation of real wages and mediocre employment growth in the early phases of the recovery may have started to become more politically difficult. But Greenspan managed to keep the economy reflated barely skipping a beat with his negative real interest rate policy supporting a global real estate/consumer spending boom (aided by the Bank of Japan's zero interest rate "quantitative easing"), while public attention was re-focused from corporate "bad apples" to foreign enemies in a permanent war setting.

The problem with this "solution" is that it has just put the U.S. deeper in much greater debt (see my 2/14 "Mommy, Where Do McMansions Come From?" link), while seriously lowering its standing abroad, and, importantly, greatly distracting it from focusing on the real solutions to its real problems.

The end-result was reported Tuesday, Goldman Sachs and key financial players making huge profits at the same that the U.S. sinks further into debt to foreigners, while the de-industrialization of America has led to worker average real earnings that have been stagnant the past five years and are down 17% since 1972 (Table B-47, pg 338, "2006 Economic Report of the President, link).

This situation continues to increase political pressure on China to redress the effects of fateful U.S. mis-allocation of its resources away from advanced high-tech manufacting into speculative finance, enormously benefitting the very few in the financial elite, with Wal-Mart temp jobs with no benefits for the rest.

Another manifestation of the dominance of the global speculative finance is increasing evidence that global climate change is occurring more rapidly than previously modeled. Here are some of the headlines from the mainstream press reporting new scientific studies in just the past month:

March 14, "Climate change 'irreversible' as Arctic sea ice fails to re-form;” March 14, “"Global warming gases at highest levels ever: UN;" March 3, “"Antarctic ice sheet decline startles scientists: Losses contradict earlier climate forecast;” March 3, “"Antarctica Cannot Replace Ice Loss: Study finds continent is shrinking faster than it can grow. Experts say changes to the global water cycle could hasten the pace of sea-level rise;" Feb 17, "Ice Dumped by Greenland's Glaciers Triples in 10 Years: Scientists say 'wake-up call' study indicates that sea level could climb even more quickly than current projections;" March 10, "Bering Sea Climate Is Shifting: Scientists say sea life is fighting to survive as the water warms up and ice melts sooner. The changes are profound and may be irreversible;" March 6, “Global warming evidence grows -U.N. expert."

Global warming is not just about science and politics, as the mainstream media usually reports. The heart of the problem is actually economic.

The globalized speculative finance system avoids paying the true economic costs of global production and development, relegating these to unaccounted for “externalities.” These unpaid costs manifest themselves in climate change, environmental degradation, underinvestment in sustainable energy, stagnant real wages, attacks on benefits and pensions, substandard education, shortage of clean water, widespread malnutrition, inadequate health care, famines, exposure to natural disasters, etc., etc., etc.

The real costs of infrastructure and technology development, etc. are just being passed off onto future generations right now in a manic chase after the quick buck. This is not economically sustainable in the long run, and it is also morally wrong.

This is how I put it in my 2/11/06 "The Global Speculative Financial System as “Enabler” of America’s Addiction to Oil": link

"A fundamental problem of the global speculative financial system is that it is extremely heavily skewed in favor of seeking ultra-high short-term “paper” capital gains, usually through quick gimmicks and essentially using private "insider" knowledge, ultimately at the public's expense…."

“I.e., the hedge funds [now up to $1.5 trillion in assets] and proprietary trading desks [of Goldman, Citigroup, etc.] can make huge profits from overly leveraged trades in the explosively growing, very opaque private credit and derivatives markets (the latter now $300-400 trillion in notional value) because they have an implicit public guarantee of insurance via liquidity provision from the central banks should their trading models ever prove wrong.

”And the private equity firms, who also use leverage, and venture capitalists essentially arbitrage off their private knowledge as insiders to take advantage of the mispriced valuations in the heavily regulated public securities markets.”

"Little of the most highly speculative, unrelenting chase after the very big quick buck is ultimately fair and honest, nor is it economically productive and viable, relatively short-term appearances to the contrary."

"Rather, it greatly distorts the global market allocation of resources, since it results in the massive under-funding of basic, long-term projects that are the foundation for generating real wealth, but which can’t compete for capital allocation against short-term speculative capital gains offering much higher returns. Speculative finance capital, aka hot money from all sorts of unregulated private funds, is replacing sound productive long-term investments."

Finally, there is the ongoing Enron trial.

The real problem running through all the corporate scandals of 2001-02, which the mass media never got right despite the huge coverage, was, and still is, that corporate America, through the direct link via CEO stock options to actions to maximize short-term shareholder value, for many years now has been explicitly governed to slavishly respond to the grossly distorted market price signals and profit incentives created by global speculative financial markets.

This very close corporate governance-global capital markets link might be fine if the latter were operating properly. But they are not, they are clearly very overly speculative, hence they are misallocating real activity and real resources in the real economy via the distorted financial signals that the corporate CEOs are responding to.

The TMT equity bubble of the late 1990s essentially caused the corporate governance scandals, not the other way around. If the banks, venture capitalists and Greenspan had taken away the bubble, which they were not incentivized to do (the financial system has no real anchor), then that would have had the effect of also removing the distorted market incentives that led to the corporate scandals.

In Enron's case, it was no surprise, in fact it was almost inevitable, that bubble's perverted market incentives (which culminated in and was best exemplified by the merger of "new, new thing" AOL and real thing Time Warner) is what people like Skilling, Fastow, Lay, et al would respond to, in the way that they did.

So did all the investment bankers and venture capitalists complicit in issuing hundreds of essentially fraudulent, if legal, IPOs, during that period, which also was almost inevitable under the circumstances. NASDAQ lost 78% and the equity markets $8 trillion in market cap, March 2000 top to October 2002 bottom, one of the two largest crashes in history, and most IPO's lost far more than the market averages.

(I apologize to those, especially fair, honest people in the financial industry, who may take exception with such a strong characterization, I fully realize that most probably believe the "irrational exuberance" explanation of that bubble. This is not the time nor place to rehash that discussion.)

The wrong solution to corporate governance problems such as those exposed at Enron is to saddle productive corporate America with all sorts of very burdensome busywork bureaucratic rules and regulations, a la Sarbox. That is extremely counter-productive, especially for innovative and/or small companies which help drive the U.S. economy.

Sarbox is also very unfair and not in the American tradition of presumed innocence and fair dealing. Corporate America, which all but an infinitesimally small part of (on which the mass media focused) is honest, productive and well-meaning, was put in the perpetual Sarbox penalty box.

It is simply not fair and honest to punish very hard-working entrepreneurs, executives and managers with this onerous regulatory burden when they have never done anything wrong, and never will.

Sarbox has just been the Wrong Solution to the Wrong Problem all along. It was simply a knee-jerk political response--just what you would expect. Unfortunately, nothing has really changed to address the Real Problem.

A real solution to the real problem that caused the corporate scandals must address the core issue of the increasingly pressing need to start to rein in the worst excesses of the global speculative financial system. In this credit cycle, these excesses may be even more out of control than during the TMT equity bubble.

But up until now, they remain far more hidden from the media and public view in the credit and derivative markets (hence the credit excesses may have a chance to build up to dangerous levels before recognized by investors in public markets that may be affected, similar to an undetected gas leak that results in an unexpected explosion).