http://www.harpers.org/archive/2008/10/hbc-90003696
Six Questions for Eric Janszen on the Economic Collapse
By Rafil Kroll-Zaidi
Angel investor and iTulip.com founder Eric Janszen contributed to this
month’s Forum, “How to Save Capitalism: Fundamental fixes for a
collapsing system,” and wrote “The Next Bubble: Priming the markets for
tomorrow’s big crash” in the February 2008 Harper’s. Rafil Kroll-Zaidi
interviewed Janszen via email; answers have been edited for length and
clarity.
1. Is the Dow still inflated?
Answer: It is. My Dow target since 2006 has been around 5,000. Here’s
why: The impact on the stock market of the 2003–2007 monetary and fiscal
reflation was similar to that of the 1933–1937 reflation–except that
this most recent reflation was enhanced by real estate asset-price
inflation. Sure, by 1937, the stock market had nominally recovered 80
percent of what it lost between 1929 to 1933. But in real,
inflation-adjusted terms, it recovered only 50 percent of what it lost.
Today, all of the pricing power that was temporarily injected into the
economy with the credit expansion is running in reverse, with
across-the-board debt deflation. Soon the dollar will resume its decline
relative to commodities (although not currencies) increasing food and
energy inflation pressures in the United States, even as unemployment
rises and wages deflate.
2. What can we expect from federal intervention?
Answer: The government has been trying to manage the debt deflation for
over a year, to no avail. The markets are “pricing in” the structural
problems of the banking system and financial markets–problems, as I
said, that cannot be addressed with ad-hoc and marginal national
policies. The entire global financial and monetary system has to be
overhauled. This will require immediate and unprecedented cooperation
among governments and institutions. But America lacks the global
political leadership needed to drive the process.
Time is short. The financial-markets crisis is now spilling over into
the real economy. Soon unemployment and other hardships will limit the
ability of governments to sell a global bailout package. This is how the
first great era of globalism degenerated into political chaos in the 1930s.
The nationalization of the U.S. banking system is a bold step. The
markets are pleased, as has been the pattern for government
interventions in years past: when interventions are promised, the
markets crash up; when the interventions are not delivered, the markets
crash down. When the interventions vastly exceed expectations, as with
the agreement among governments in the U.S., the U.K., and Europe to
purchase shares in leading banks–nationalization in all but name–the
stock markets react with manic enthusiasm.
Certainly short-term risks to investors have declined. The markets
correctly understand that a functioning credit system is a prerequisite
for a modern economy. But getting the credit system working again is
like restarting a heart-attack victim’s heart. The underlying cause
still has to be addressed, and that takes years, and other organs may
fail while the patient is out.
3. It seems like the whole finance economy was Long-Term Capital
Management writ large: basically no one, not even regulators,
appreciated just how precarious it all was. How do we create a stable
regulatory structure?
Answer: The decline in regulation is a symptom of FIRE economy interests
(Finance, Insurance, and Real Estate) taking control of the political
machinery to increase profitability. But the profitability of the credit
industry was a side effect of interest rates falling (after the Volcker
Fed raised them to 20 percent). The incursion of the credit industry
into every aspect of American life–college tuition, health care–was the
result. But it’s worse than that. Manufacturing was financialized. Take
the auto industry–a finance manager at one of the Big Three automakers
told me, “We used to be a car company that sold financing on the side.
Now we are a bank that makes cars.” Look at GM stock in recent days.
It’s gotten hammered worse than during the Great Depression, not only
because of a coming loss in production profitability but also because of
the loss in profits from credit operations that had become such a large
part of their operating profits. The regulators have to start over.
4. There have been warnings about how precarious it is for the $63
trillion credit-derivatives market to be bigger than the “world
economy.” What are people talking about when they bring up this figure?
Answer: Credit-default swaps (CDSs) have been described as insurance
policies taken out between two parties. One party agrees to insure
against the default of a bond; the other party agrees either to pay out
the insured amount if the default happens during the term of the
contract or to keep the premium if it doesn’t. But CDSs are not exactly
like insurance policies–you do not have to own the asset in order to
take out insurance against it. So the CDS market is like thousands of
gamblers taking out hundreds of fire-insurance policies of various
terms–say, averaging five years–against hundreds of houses. The total
value of the insurance premiums of all of the contacts may be $4
trillion (known as the gross market-replacement value) while the total
liability of all of the counterparties may be $63 trillion (notional
value) if all of the houses were to burn down. The gigantic notional
value of CDS market is often covered by financial journalists with
alarm. But the chances that all of the houses are going to burn down in
five years is close to zero. The actual liability is somewhere between
the gross replacement value of $4 trillion and the notional value of $63
trillion.
If the “statistically correct” thing happens and only one of the several
hundred houses burns down in five years, then the total amount that all
the counterparties owe together is manageable. But if many of the CDS
contract writers are using the same or similar risk models and they
happen to be substantially off, then the total cost of the insurance
payouts may exceed the insurers’ ability to pay. The insurers will be
forced to default on the default insurance.
The risks are: 1) that a few such defaults will lead to others, causing
a panic; 2) that in a panic that the CDS market cannot be bailed out by
the Fed because the market is based on of thousands of handwritten
contacts enforced by novation, the weakest form of contact
settlement–which means there is no central clearinghouse where parties
can be brought together to work out problems; and 3) that there is a
considerable concentration of CDS liabilities among a small number of
financial firms. That is why Bear Stearns, for example, was bailed out,
and why Lehman should have been bailed out, from the perspective of
financial system stability.
5. How much worse will it get, and has anyone been able to beat this market?
Answer: It happens like this:
* the dollar, declining;
* import prices, rising;
* goods prices, flat to rising;
* wages, falling;
* asset prices (stocks, bonds, real estate), falling;
* long-term interest rates, low but rising;
* short-term interest rates, low but flat to falling.
The probable outcome will be an inflationary recession or an
inflationary depression–a toxic and complex mix of asset-price
deflation, wage deflation, and energy-price inflation that will have an
impact on food prices.
I don’t think most Americans understand just how much trouble the
country is in. We are backing ourselves into a corner. Our debt-laden
economy is highly sensitive to increases in long-term interest rates,
and those since 2003 have become largely determined by foreign capital
inflows from central banks, sovereign wealth funds, and other official
(as opposed to private) sources. If a significant geopolitical shift
away from financial support of the U.S. takes place–due to, say,
military conflict between U.S. creditors, or perhaps due to rising
economic and financial crisis at home–the source of those inflows may
quickly dry up. One reasonable estimate I read forecasts a 2 percent
increase in the ten-year Treasury bond per year that inflows stop and
holdings merely remain constant. That will tend to increase mortgage
rates and slow the U.S. housing market and economy further.
As the economy contracts, the inexorable logic of the American political
economy is to increase protectionist and unilateral measures, as if the
United States were still a net creditor as in the late 1970s. If such
policies are pursued (which caused the world trade negotiations to
collapse earlier this year) the results will be disastrous for America:
the current orderly diversification from the dollar may become disorderly.
As to beating the market–members of iTulip.com moved from stocks to cash
starting at the end of 2007 and have continued to buy gold since 2001.
Some of our members have purchased negative index funds such as SRS and
have done well.
6. Who should go to jail?
Answer: Many will go to jail, but I’ll wait for the hearings before I
offer a judgment.
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