The water served at the latest Group of 20 (G-20) meeting of finance ministers and central bankers last weekend must have contained copious quantities of lead or have been shipped over from Stalinist Russia using a time machine. For nothing else apparently explains this newfound angst among the finance officers of this group – and in particular those from the developed countries – to cut off their noses to spite their political masters.
Cynical people wholly unlike myself may say that this august gathering somehow figured out the futility of their actions and instead of admitting defeat decided to engage in diversionary tactics such as egging on non-scandals. Be it what it may, all that chest-beating is of little consequence in terms of paving the way for a resolution of the key issues confronting the global financial markets.
As a recap for readers unaware of the brouhaha, the US media have been increasingly shrill in recent days about the “billions” of dollars in bonuses paid in firms rescued with taxpayers’ money. These range from AIG, which was rescued with US Treasury funds from the middle of September to the present all the way to Merrill Lynch, bought by Bank of America (which in turn received government funds in December to replenish the capital lost in the purchase).
Interestingly, the initial scandal was brought about by the Bank of America-Merrill Lynch merger, which had been hastily arranged by US authorities in mid-September as investment banks teetered on the edge; Lehman Brothers did go bankrupt in that period. Since then, a series of management challenges within the newly merged entity may have created substantially enough bad blood to cause the lid to be blown off the events leading to a Merrill Lynch decision to pay US$3.6 billion to its employees just a working day or two before the merger was officially consummated on January 1, 2009.
Realizing that the depth of problems not previously known about Merrill and confronting a 80% decline in their own share price, Bank of America officials had to move quickly to stem the damage; therefore deciding to fire the Merrill Lynch chief executive, who had remained in the merged entity as part of the new senior management team. Understanding this context is key: the bonus issue at Merrill Lynch surfaced and became a lightning rod for populist anger only because of the dynamics of declining share prices at Bank of America and the resultant internal management squabbles.
To a large extent, government officials had stood by the side in the whole charade, as their efforts to stabilize the financial system meant essentially looking away at all the private arrangements being made between the buyer and seller in terms of management positions, compensation and the like. Indeed, new evidence showed that Bank of America actually wanted out of the mooted merger with Merrill Lynch once it understood the scale of losses that had been hidden from view.
By arranging the merger without proper scrutiny or understanding of Merrill’s books, in effect it was the US Treasury and the Federal Reserve that helped to increase risks to their own financial system. Compounding the error, the Fed persisted with the Bank of America rescue of Merrill Lynch because of the scarring from the Lehman bankruptcy fiasco; however, it is clear that no safeguards had been put in place to ensure that the combined entity would be acceptable to the investing public.
Like Iraq, only worse
Closely mirroring the colossal incompetence shown by the two agencies (US Treasury and Federal Reserve) in the Merrill Lynch rescue was the issue of the government’s own rescue of AIG. Concerned that a collapse of AIG could unravel the vast market for credit default swaps and therefore imperil the entire global financial system, the US government sought to provide funding for the entity while it could cut the size of its overall exposures.
The problem with that arrangement was once again that the people put in charge of monitoring the unwind of AIG – from the US government naturally – had no real understanding of the credit derivative exposures at the heart of the company. In effect, what AIG had done was to write many times the value of its own shareholders’ capital in insurance contracts on the fast-collapsing market for credit globally in a futile bid to make some extra earnings.
In the dying days of the US administration of George W. Bush, the greatest mistake made in the aftermath of the Iraq War – firing all of Iraq’s soldiers – was repeated in the AIG rescue, when most of the senior management was fired and a number of key risk-takers were simply dismissed from service.
As with the Iraq War, the Bush administration made the mistake of thinking that it had the resources to start with a clean slate. And once again, that wasn’t to be because the very people who had run AIG into the ground were really the only people who understood the entirety of the risk on the books as well as the impact on the economics of the entity of a forced dismantling.
The new people put in place were usually on secondment from other departments within AIG, with marginal understanding of the risks on the books, not to mention only a passing familiarity with the technical aspects of trading in the derivatives markets. Sure enough, the result of this colossal misallocation of resources could have well been to accentuate rather than to ameliorate the losses previously booked.
This observation is based on the steady worsening of AIG’s liquidity position since the government takeover, which suggests that while the contracts on which the company owed money were being paid out, those on which it had to receive funds weren’t subject to aggressive collection. The paucity of experts clearly has hurt the process.
To hire experts needed to fix the mess at government-owned companies in the US as well as in the United Kingdom and other Group of Seven (G-7) members, it is highly likely that proper incentives would have to be given. A realistic look at the current AIG “scandal” shows that bonus payments were hardly material, at less than 0.1% of the $150 billion that had been squandered by the government as liquidity support for the company.
Think of it as an insurance payment on your investment, and suddenly bonuses don’t seem like a bad idea at all.
The second bogeyman at the G-20 meetings was tax and, in particular, actions on tax havens. In a concerted move since the beginning of the year, governments of the G-7 leading industrialized nations have embarked on a collision course with various tax havens around the world, ranging from the US offshore (Cayman Islands, Bermuda, British Virgin Islands), European (Ireland, Switzerland, Austria, Luxembourg, Liechtenstein) as well as Asian destinations (Singapore).
While it is understandable that the G-7 would try to close their finance loopholes to ensure greater tax collections over the near term, given the vast increase in government spending that has been unleashed, it is also pertinent to note that the initiative is pointless for the following reasons:
1. Most rich individuals keeping funds offshore are no longer all that rich, having suffered vast losses on their investments within G7. This means much of the offshore funds will be used to repay banks for loans and so on; the available pot of wealth would diminish drastically under the circumstances.
2. Cuts in the income of the richest groups of people would mean that their ability to actually shift funds abroad remains questionable. Your average hedge-fund trader or property mogul is simply in the wrong business now; there is no potential turnaround in the situation over the near term.
3. Uncertainty with respect to tax treatment of inward investment flows comes at a particularly bad time for G-7 economies, given their need to grab pretty much whatever they can get over the next few months to pay for new investments in infrastructure and other initiatives.
Anger towards tax havens also misses the larger point, namely the failure of many countries to reward their entrepreneurs in the first place. High tax rates, and in particular the idiotic socialist idea of “progressive” tax rates wherein higher earners pay higher tax rates mean that the very people who are in the best position to reinvest in falling markets are often the very ones frozen out.
Think of it like this: if a businessman had 75% of his income, it is highly likely that he would invest a larger portion of disposable income back in the economy to enhance returns. Instead, if he were to be taxed so as to leave a paltry 50% in his hands with the government getting the extra 25%, it is likely that the government funds would be spent badly, leaving the economy overexposed to a downturn.
That is precisely where large parts of G-7 economies – the United Kingdom and the US are both good examples – find themselves. Both countries ran deficits through the past eight years or so; and instead of government borrowings going towards longer-term competitive advantages (investments) they were instead misallocated to near-term populism (spending).
This isn’t a political argument per se, given that the Republicans ran the US for the period while left-leaning Labour ran Britain; what it basically means is that governments are generally poor allocators of resources and worse spenders of taxpayer money.
Throw them a bonus …
As with the disastrous conduct of the Iraq war, it is possible to re-imagine scenarios for the bailout of both AIG and Merrill Lynch as follows:
1. Both AIG and Merrill Lynch are put in a federal protection program that guarantees their access to liquidity.
2. The government sends in qualified people – that is, folks who know a CDO from a DVD – to look into the books of the companies.
3. The bits of the companies without these funky exposures, for example the Merrill brokerage network, the AIG international business and so on, would be sold to buyers who have no reason to believe that any danger lurks below the surface. In this case, it is highly possible that the parts of the business could have fetched well more than what they actually have.
4. The bad bits are quarantined and examined closely by people with deep understanding of the businesses (for example, the foremost market experts on credit), as well as those with a history of actually making money on these things. Such individuals, rather than the moth-eared superannuated Muppets found by the US government, would have demanded a high wage or a bonus for their services (depending on whether they currently worked for these companies or not).
5. Incentivizing those people would have helped to reduce the potential fallout of losses from the AIG-Merrill situation, allowing the rest of the financial system to continue performing a whole lot better. Yes, that word again: pay the people who actually can help a bonus in order to ensure they do so.
Meanwhile in the real economy:
1. The US government announces a program of budgetary spending aimed at improving the quality of its infrastructure and to reduce overall energy consumption.
2. In parallel, it cuts the maximum tax rates in the country for the next five years to under 25%, allowing for reinvestment of profits into business growth. Longer-term growth prospects suddenly improve wholesale, allowing for a steeper government yield curve. This means more profits for the financial sector as well, and a more normal investing environment for everyone else, including insurance companies and pension funds.
3. The improvement in its fiscal positions from these steps allows the government to keep the US dollar stable in global markets, thereby removing any excuse for lazy Asian bankers to maintain their currency pegs.
4. With floating currencies, Asian consumers find their voices, and this leads to first gradual and then wholesale changes in trade accounts globally with the US deficit falling as Asia saves less.
Snap. There ends the dream. Instead of the above, what we have is ham-handed meddling in the private sector, barrels of pork being unrolled onto the unsuspecting public, significant future tax increases in store across G-7, wholesale currency devaluations around the world … and all the other topics that are familiar to the average reader of Asia Times Online.