Later this week, I’m going to argue that the Fed’s recent rate cut is at best an exercise in futility and at worst a mistake.  [another editorial note:  turns out I was wrong, at least on the second part.  exercise in futility perhaps, mistake, no.  see my next post.] First, it’s time to lay the groundwork:

The Creation of Free Debt¹

In the early days of the bail-out debate (way back in the first week of October), Robert Reich gave a talk at the Commonwealth Club in which he, rightly, laid part of the blame for the origins of the current economic crisis at the feet of the Clinton Administration (of which he was a part from 1993 through 1997, as Clinton’s first Secretary of Labor). Regardless of where your politics lie, it’s pretty clear that the roughly 1998-vintage annulment of venerable Glass-Steagall (which among other things created a separation between investment banking and commercial banking activities in the US) was the first in a series of major errors which eventually resulted in today’s crisis.

Add to this something Reich didn’t touch on: the Clinton administration perpetrated the second error later in its watch, when it agreed with numerous Wall Street giants that credit default swaps (the “big bad” CDSs we keep hearing about these days) ought not to be regulated. Why CDOs should have been (and must now be) regulated will be the subject of still another post, but for now let’s stipulate that CDSs are opaque derivative instruments (i.e., not only not transparent but also based on inscrutable “if…then…else” risk structures which, for lack of inspection, can mask huge exposure to global externalities) and that the practice of “netting”²  (in which an investor hedges by purchasing two CDSs with opposite and mutually-exclusive pay-off circumstances, thus “netting to zero” his exposure regardless of which of the two outcomes takes place) has exposed the entire economy to systemic risk of counterparty default. Why? Because netting (offsetting hedges) don’t work if one of the two contracts in the hedge blows up because one of the insurers—think AIG—is suddenly unable to pay. And if everyone is a counterparty to everyone else, well, you get the picture….  (My friend Paul Sheehan, who at one time was in charge of derivatives oversight at money center banks as an examiner for the NY Fed and now runs an Asian event-driven hedge fund, points out that AIG wasn’t actually defaulting;  it was merely subjected to an avalanche of “collateral calls” by counterparties who insisted that AIG set first $20 billion, then $40 billion and then $60 billion aside as collateral against their CDS obligations.)

Enter into this brewing perfect storm the High Priest of Economic Growth, Alan Greenspan, who, along with the Bush Administration, feared that the 2000/2001 bubble bursting and the tragedies of 9/11 might conspire to create a Depression. Greenspan’s Fed—amid much aplomb from the neo-supply-siders of the Bush administration—cut the Fed Funds rate so precipitously and so aggressively (down to 1.00% in early 2003) that, as Reich points out, real interest rates were negative for perhaps a year or two. I took a look at the data and produced the chart at the top of this post, and to be specific, real interest rates were negative for nearly 11 quarters (2.75 years) between 2003 and 2005.  (see figure above)  And, as others have pointed out, the problem wasn’t just negative real interest rates per se, but the fact that such low Treasury rates drove the world of investors who were looking for “safe” fixed income securities to look elsewhere—to CDOs.³

Is it any wonder that everyone and his brother who could support even a moderate credit rating borrowed like there was no tomorrow?(Don’t even get me started about the Ponzi scheme perpetrated by the rating agencies, the bond issuers and their syndicators.)Of course not. If you were a public company CFO from 2003 to 2005, you were crazy not to borrow: it was free! And what did you do with all that money?  You couldn’t invest it into real operations because you couldn’t scale that fast, and neither your business nor the economy wouldn’t support it anyway.  (That was one of many hints:  if your business can’t consume more debt without doing something off the reservation, perhaps you have no business drawing down that debt in the first place!)  And so you gamble with it.  You create demand for new and interesting securities with which to sate your demand for returns on debt you have no business generating in the first place.  So you overheat demand for CDOs, and you create an irresistible temptation for the bankers to create more and more of them.  Commercial banks did it. Investment banks did it.  Even insurance companies did it.

Thus Clinton Administration policies and Bush Administration policies created the perfect storm:

If you have been thinking about the ramifications of what the Fed did earlier this week, you can see where this is going. But that will have to wait for the next post(s)….

1. Inflation data from http://inflationdata.com/inflation/Inflation_Rate/HistoricalInflation.aspx, Fed Funds data from http://www.the-privateer.com/rates.html.  Graph by the author.
2. The best explanation of both the system risk from netting and CDSs in general I’ve come across comes from the absolutely super This American Life/NPR News collaboration “Another Frightening Show About the Economy”, itself a follow-up to an earlier and equally excellent collaboration cleverly titled “The Giant Pool of Money”
3. credit to “The Giant Pool of Money” for explaining this so clearly.

One needn’t spend much time browsing in The Bazaar before you realize: the proverbial cat is out of the bag. He is not the first to report that the knowledge of how to construct a nuclear weapon is no longer particularly hard to come by. (You may not quite be able to download the plans off the Internet, but the basic “gun” model used in the Little Boy (Hiroshima) bomb is fairly easy to construct from the right amount of Uranium 235.) Thus for a long time, the world has relied for its nonproliferative intentions on the difficulty of obtaining sufficient quantities of weapons-grade U235 (loosely defined as uranium whose 235 isotope is present at >90% by mass). Building centrifuges requires far more engineering and machining expertise than does building the actual bomb, and Western nonproliferation efforts (and the IAEA‘s efforts) have thus focused on nipping the process in the materials production bud.

Blame it on the leaky Russians (Langewiesche convinces us that they had little, if anything to do with nuclear proliferation) or the incredibly trusting Dutch, who initially hired A. Q. Kahn and later let him waltz out of the country with the plans for what are still considered state-of-the-art uranium centrifuges (state-of-the-non-classified-art, I should say), or the Pakistan government, which first propped up Kahn and which later bowed to US pressure to arrest him—and then promptly locked him away under house arrest so that no Western intelligence services could ask any further awkward questions relating to the involvement of the Pakistani government itself—but no matter how you slice it, not only has nuclear knowledge proliferated, but therefore so has nuclear technology. The North Koreans, the Iranians and the Libyans now also have the know-how (if not the machines, in the case of newly-reformed Libya) to produce significant quantities of weapons-grade uranium, and of course so do the Pakistanis, the Indians, the Israelis (not officially , the Germans, the French, the British, the Chinese, the Russians and the US. That’s roughly half the world’s population (50.6%, to be precise) whose governments are known have access to nuclear weapons technology. A majority.

Thus I conclude that the nonproliferation agenda is bankrupt. So far as we know, we have kept these weapons out of the hands of non-state actors. But such was not the aim of the Nuclear Nonproliferation Treaty! In order to create effective controls which might curb the transfer of nuclear technologies to non-state actors, we’ll have to start by identifying what didn’t work in the NPT—for starters, the overt inequity between the nations permitted to maintain such weapons (namely the permanent members of the UN Security Council) and those not permitted to do so. The NPT created second-class citizens of half the world. Any surprise the world didn’t abide by the treaty? It’s Versaille all over again: a Phyrric victory of an asymmetric treaty over geopolitical reality.

So much for sleeping tonight.

Earlier this month, I participated in a seminar led by Clark Kent Ervin, the former Inspector General of the Department of Homeland Security, author of the frightening and eye-opening Open Target: Where America Is Vulnerable to Attack. The seminar focused on the current nature of the terrorist threat against our country. We were an eclectic bunch: a US Army Major military intelligence specialist in counterterrorism, two State Department employees, a venture capitalist or two, and a few of us who otherwise have some association our nation’s security infrastructure.

Despite our various backgrounds, a palpable sense developed in the room that something remains deeply wrong with America’s counterterrorist strategy. My friend and colleague, Major General (Retired) Steve Siegfried, who was the Inspector General of the US Army as well as the first Director of Homeland Security for South Carolina, puts it this way: of all of the steps terrorists take before and during a terrorist attack, most of them take place before the attack: they plan, they reconnoiter, they fund, they rehearse, they stage, and only then do they execute. So that means that most, if not all, of terrorist prevention can (and probably should) take place before execution. But look closely at the structure of DHS: not a single intelligence agency exists within DHS. How can the Department prevent terrorism by staunching it in its early stages, if it doesn’t have a mandate or an internal structure to generate the intelligence necessary on which to react? Think about it differently: you can either prevent or you can react. If you can’t gather intelligence, how can you prevent? DHS is fundamentally structured to be eternally reactive!

We are not the only ones who think there’s a problem. Foreign Policy and The Center for American Progress published a fascinating–and frightening–study, called “The Terrorism Index.” They asked 100 of the country’s top foreign policy experts some basic questions. The results are shocking:

• 81% of these experts believe the world is more dangerous for America and its interests than it was immediately after 9/11.
• 43% of the American public think we are safer, while only 19% of experts agree.

• 75% believe the US is losing the war on terror. (That’s 93% of liberals, 81% of moderates, and 50% of conservatives.)
• 46% of the American public think we’re winning.

• 62% believed that US policy towards North Korea is having a negative impact on US national security, despite the fact that 73% of respondents believed that North Korea ought to be Priority Number 1.

For an excellent overview, watch this video:

So at least this blogger thinks the situation is worse than we think. And as a “business guy,” I know very well that you can’t fix what you can’t measure. So the first step is to get a measurement of the problem–start realistically measuring the threat level (no more yellow/orange/red business, please!)–and then executing to fix the greatest threat. That would be North Korea’s nuclear ambitions.