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Will America Become a Third-World Country?

Published 02/26/09 Paul Craig Roberts, former Secretary of the U.S. Treasury - Print Article
E-mail - editor@economyincisis.org

Editor's Note: While EconomyInCrisis.org believes that intervention was needed on behalf of American banks, the course of action our government pursued was not beneficial to the American economy.

The following article was contributed by Paul Craig Roberts and may not reflect the views or opinions of EconomyInCrisis.org. Feedback is welcome.

The demise of America's productive economy left the U.S. economy dependent on finance, in which the United States remained dominant because the dollar is the reserve currency. With the departure of factories, finance went in new directions. Mortgages, which were once held in the portfolios of the issuer, were securitized. Individual mortgage debts were combined into a "security." The next step was to strip out the interest payments to the mortgages and sell them as derivatives, thus creating a third debt instrument based on the original mortgages.

In pursuit of ever more profits, financial institutions began betting on the success and failure of various debt instruments and, by implication, on firms. They bought and sold collateral debt swaps. A buyer pays a premium to a seller for a swap to guarantee an asset's value. If an asset "insured" by a swap falls in value, the seller of the swap is supposed to make the owner of the swap whole. The purchaser of a swap is not required to own the asset in order to contract for a guarantee of its value. Therefore, as many people could purchase as many swaps as they wished on the same asset. Thus, the total value of the swaps greatly exceeds the value of the assets.

The next step is for holders of the swaps to short the asset in order to drive down its value and collect the guarantee. As the issuers of swaps were not required to reserve against them, and as there is no limit to the number of swaps, the payouts can easily exceed the net worth of the issuer.

This was the most shameful and most mindless form of speculation. Gamblers were betting hands that they could not cover. The U.S. regulators had abandoned their posts. The American financial institutions abandoned all integrity. As a consequence, American financial institutions and rating agencies are trusted nowhere on earth.

The U.S. government should never have used billions of taxpayers' dollars to pay off swap bets as it did when it bailed out the insurance company AIG. This was a stunning waste of a vast sum of money. The federal government should declare all swap agreements fraudulent contracts, except for a single swap held by the owner of the asset. Simply wiping out these fraudulent contracts would remove the bulk of the vast overhang of "troubled" assets that threaten financial markets.

The billions of taxpayers' dollars spent buying up subprime derivatives were also wasted. The government did not need to spend one dime. All government needed to do was to suspend the mark-to-market rule. This simple act would have removed the solvency threat to financial institutions by allowing them to keep the derivatives at book value until financial institutions could ascertain their true values and write them down over time.

Taxpayers, equity owners and the credit standing of the U.S government are being ruined by financial shysters who are manipulating to their own advantage the government's commitment to mark-to-market and to the "sanctity of contracts." Multi-trillion dollar "bailouts" and bank nationalization are the result of the government's inability to respond intelligently.

Two more simple acts would have completed the rescue without costing the taxpayers one dollar: an announcement from the Federal Reserve that it will be lender of last resort to all depository institutions including money market funds, and an announcement reinstating the uptick rule.

The uptick rule was suspended or repealed a couple of years ago in order to permit hedge funds and shyster speculators to rip off American equity owners. The rule prevented short-selling any stock that did not move up in price during the previous day. In other words, speculators could not make money at others' expense by ganging up on a stock and short-selling it day after day.

As a former Treasury official, I am amazed that the U.S. government, in the midst of the worst financial crises ever, is content for short-selling to drive down the asset prices that the government is trying to support. No bailout or stimulus plan has any hope until the uptick rule is reinstated.

The bald fact is that the combination of ignorance, negligence and ideology that permitted the crisis to happen is still present and is blocking any remedy. Either the people in power in Washington and the financial community are total dimwits or they are manipulating an opportunity to redistribute wealth from taxpayers, equity owners and pension funds to the financial sector.

The George Bush and Obama plans total 1.6 trillion dollars, every one of which will have to be borrowed, and no one knows from where. This huge sum will compromise the value of the U.S. dollar, its role as reserve currency, the ability of the U.S. government to service its debt and the price level. These massive costs are pointless and are to no avail, as not one step has been taken that would alleviate the crisis.

If we add to my simple menu of remedies a ban for short selling any national currency, the world can be rescued from the current crisis without years of suffering, violent upheavals and, perhaps, wars.

According to its hopeful but economically ignorant proponents, globalism was supposed to balance risks across national economies and offset downturns in one part of the world with upturns in other parts. A global portfolio was a protection against loss, claimed globalism's purveyors. In fact, globalism has concentrated the risks, resulting in Wall Street's greed endangering all the economies of the world. The greed of Wall Street and the negligence of the U.S. government have wrecked the prospects of many nations. Street riots are already occurring in parts of the world. On Sunday, Feb. 22, the right-wing TV station Fox "News" presented a program that predicted riots and disarray in the United States by 2014.

How long will Americans permit "their" government to rip them off for the sake of the financial interests that caused the problem? Obama's Cabinet and National Economic Council are filled with representatives of the interest groups that caused the problem. The Obama administration is not a government capable of preventing a catastrophe.

If truth be known, the "banking problem" is the least of our worries. Our economy faces two much more serious problems. One is that offshoring and H-1b visas have stopped the growth of family incomes, except, of course, for the super rich. To keep the economy going, consumers have gone deeper into debt, maxing out their credit cards and refinancing their homes and spending the equity. Consumers are now so indebted that they cannot increase their spending by taking on more debt. Thus, whether or not the banks resume lending is beside the point.

The other serious problem is the status of the U.S. dollar as reserve currency. This status has allowed the United States, now a country heavily dependent on imports just like a Third World or lesser-developed country, to pay its international bills in its own currency. We are able to import $800 billion annually more than we produce because the foreign countries from whom we import are willing to accept paper for their goods and services.

If the dollar loses its reserve currency role, foreigners will not accept dollars in exchange for real things. This event would be immensely disruptive to an economy dependent on imports for its energy, its clothes, its shoes, its manufactured products and its advanced technology products.

If incompetence in Washington, the type of incompetence that produced the current economic crisis, destroys the dollar as reserve currency, the "unipower" will overnight become a Third World country, unable to pay for its imports or sustain its standard of living.

How long can the U.S. government protect the dollar's value by leasing its gold to bullion dealers who sell it, thereby holding down the gold price? Given the incompetence in Washington and on Wall Street, our best hope is that the rest of the world is even less competent and even in deeper trouble. In this event, the U.S. dollar might survive as the least valueless of the world's fiat currencies.

Authors Bio: Dr. Roberts is a former university professor, a former associate editor of the Wall Street Journal, and a former Assistant Secretary of the US Treasury.

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