AMERICA'S REAL ECONOMIC CHAOS

The American, indeed the world, economy has had much trouble of late. Financial and equity markets, not to mention an entire list of sectors led by real estate, have been badly battered. Virtually all economic indicators have been and continue to be in decline. Bad news comes out what seems like every hour of every day. Fear dominates markets around the globe. People across the country struggle to get a handle on what is happening in their lives.

Naturally, we turn to our political leaders and our government for answers and solutions. The expectation is that those in charge of the levers of power have the expertise and the capability to provide the answers we need and the direction that will resolve such large, overarching challenges like a troubled economy. In the process, we empower them to use their knowledge and insight, as the best and brightest available in such matters, to solve the problem.

So, what do we get? The kind of chaos to be seen when you cut the head off of a live chicken (use your imagination if you have never had that experience noting all the while that a chicken can still fly immediately after decapitation). Our "leaders" in government have been throwing everything their creativity will allow to make this economic nightmare go away.

Which leaves us with this important question: can you identify one single solitary supposed solution that has worked? Please, name it. Need more time to think it over?

Truth be told, you can have all day long to pick that winner and you will not find it. The nightmare persists and new answers continue to be brought forward as the solution we have all been waiting for. Not.

Along the way, we encounter the smoldering wreckage of each and every solution put forward to date. Many, as described in the article that follows, were not only not the answer but have in fact put the government, also known as the taxpayers (or, put another way, you and me), in a very vulnerable position as we move forward.

The real economic chaos in America is our chaos of leadership. We have people in Congress and people in government who are basically running in circles, having no idea what to do or if what they might try will actually work. The appearance is this: throw money (borrowed, since it is not cash on hand) at the problem in ever increasing amounts (we have moved this very day from hundreds of billions to trillions) in a desperate hope that something, ANYTHING, will work.

What we are witnessing is the contemporary reprise of the Keystone Cops; Moe, Larry & Curly; the Marx Brothers; and, most appropriately, the little Dutch boy sticking his fingers in the leaky holes in the dyke.

In the process there seems to be little, if any, concern for the size of the national debt or our national budget deficit. It would appear that now is not the time to worry about how this will all be paid for as the bill becomes due. Should several future generations, some yet unborn, be locked into a burden of massive debt they had no responsibility for: oh well, so be it.

If you are a hyper-partisan who cannot wait to blame it on the political party opposite yours, it is time for you to get a life. Both major party's are fully and completely responsible for: a) the whole mess in the first place, and; b) the ongoing mess being made in the effort to clean up the original mess. This is a fully bipartisan failure. If you are stuck on fixing the blame rather than fixing the problem, you are nothing more then part and parcel of the problem.

What does our immediate economic future hold? The honest answer is that no one has any idea. The little bit of light at the end of that tunnel is this: in the long term, which will be months and years, the American economy will return to full health.

Economic cycles of boom and bust have occurred throughout history and they will continue for as long as there are free market, capitalist economy's that provide people with the opportunities to improve their lives.


Cheque mate
From The Economist print edition
How AIG got Uncle Sam over a barrel

JUST how concerned should American taxpayers be about American International Group (AIG), the insurance company brought to its knees by its escapades in the credit-derivatives market? On November 10th a revised rescue package was announced, comprising $153 billion of capital injections and loans. That is the largest bail-out for any firm, anywhere, during the crisis. Is the government being, as AIG’s new chairman says, “very, very smart”, or has it been taken for one of the most expensive rides in corporate history?

Even on September 16th, when the state first intervened, AIG was a controversial candidate for assistance. Its insurance businesses are ring-fenced by local regulators and individually capitalised, precisely so they can survive a collapse of the holding company. A bankruptcy was avoided only because of the size of the holding company’s book of toxic credit derivatives, which senior executives barely understood. These left AIG so intertwined with other financial firms that its failure was judged by the Federal Reserve and Treasury to endanger the financial system.

Whether that judgment was right remains unknowable. But it is now clear that the original plan was flawed. That may be understandable: panic was in the air, AIG faced crippling collateral calls and Lehman Brothers had just folded. And the authorities lacked the wide powers granted by the Troubled Asset Relief Programme (TARP) approved by Congress in October. Unorthodox options, such as splitting the systemically threatening credit derivatives from AIG, were not under discussion.

As a result, the original plan looked a lot like the traditional remedy for a liquidity crisis at a solvent bank. The Fed offered a two-year, $85 billion loan. AIG would pay a penal interest rate and cede to the state an equity stake of just under 80%. But as collateral calls mounted on the credit derivatives, and AIG admitted to new problems, it became plain that the loan was too small. It was also too expensive: in the first year it would have cost almost as much as AIG’s profits in 2006, its best year ever.

Meanwhile the chances of AIG being able to repay the loan also shrank. In the second quarter, it had only $59 billion of core equity capital (defined here as book equity less goodwill, tax assets and stock ceded to the state). By the third quarter, more losses had cut this to a meagre $23 billion. Worse, much if not all of AIG’s capital sits “stranded” in the ring-fenced insurance units. That makes it hard to funnel it up to a holding company that is otherwise almost certainly insolvent.

The original solution was to sell the insurance operations to raise cash, but with AIG’s competitors also reeling, this looked less and less realistic. The alternative, of AIG tapping credit markets to repay the state, became ridiculous by early November. AIG’s own credit spreads implied that the company was headed for default (see chart). Prospects of even rolling over the $64 billion of non-government borrowing due to mature by 2011 became increasingly bleak.
That forced the hand of the authorities. In one sense the new package does what, with the benefit of hindsight, should have happened all along. The Fed will provide $53 billion of funding for two vehicles which will, in effect, assume AIG’s most toxic credit derivatives and mortgage-backed securities. These positions have been marked to fairly conservative levels.

In an alternative universe the government could then walk away, confident that it had dealt with the worst of the systemically important credit derivatives and that the insurance operations remained safely ring-fenced. But in the real world the state is now the biggest lender to AIG, which has drawn down the bulk of the original $85 billion facility. AIG has Uncle Sam in a bind. As a result, the Treasury, through the TARP, has been forced to recapitalise the insurer by purchasing $40 billion of preference shares. Despite this its economic stake in the firm will remain just below 80%. The Fed will also maintain a loan facility, on more generous terms, of $60 billion. And if AIG struggles to refinance its debts, it is quite possible that the state will provide a formal guarantee.

The Treasury has secured crowd-pleasing concessions; for example limits on executives’ bonus payments. But the real question is whether the preference shares are safe. AIG has a trillion-dollar balance-sheet. There is now a thin buffer of core equity between the taxpayer’s preference shares and any further losses. The hope is still that as markets recover, AIG can sell the crown jewels of its insurance business at a premium to book value. That may well take years. Plenty of time to reflect on how an offer of a temporary loan, to a company that barely made the list of systemically vital firms, spiralled into one of the biggest corporate bail-outs ever.

Copyright © 2008 The Economist Newspaper and The Economist Group. All rights reserved.

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