Thursday 20 March 2008

Is the US economy heading for a collapse?

March 20, 2008
An open letter to Mr Ben Bernanke, chairman, US Federal Reserve:


Decades back, one of your predecessors splendidly captured the post-gold standard and the consequent free float of the US dollar scenario rather succinctly when he termed the US dollar as 'our currency, others' responsibility.'

It is this responsibility cast on outsiders like me that compels me to write this open letter to you.

As I write this, I am fully conscious of the fact that we are living in exceptionally troubled times. I am equally conscious of the fact that being the chairman of the US Federal Reserve, you are in effect the central banker to the entire world. Surely, it is an unenviable position.

Your actions, sir, not only impact the United States economy, it does have the potency to impact the global economy. That explains, partly, if not wholly, the 'why' to this letter.

Yes, I am indeed aware of the sub-prime crisis that has engulfed the entire global financial sector. I am sure you are fully aware as to how your predecessor, Mr Alan Greenspan -- one of the most influential economists of our times -- described the sub-prime crisis in his book -- The Age of Turbulence. According to him the American economy was 'facing not a bubble but a froth -- lots of small, local bubbles that never grew to a scale that could threaten the health of the overall economy.'

Yet, as events turns out, I suspect, Alan Greenspan is wrong. But the point is not merely the judgemental capacity of Alan Greenspan. Rather, it reflects poorly on the American regulatory mechanism.

After all, wasn't he the product of a system that was repeatedly touted as fail-proof; at least in surveillance, supervision and regulation? And my worry is that you too are a product of the very same system that has compelled him to be wrong.

Saving US economy from the US Fed!

In fact, the starting point of the present conundrum was the American assumption about globalisation. In hindsight, your assumption that the world was 'flat' seems to be incorrect. In fact, it was skewed, tilted, slanted -- anything but flat.

Based on such simplistic assumptions that you can prepare a global order for the world, you unleashed a war between interest rates and the index, between spenders and savers, between exporters and importers, and between producers and consumers. In this war, your countrymen -- or institutions that were controlled by Americans -- mostly wrote the rules.

More importantly, the US Fed sided with the index, consumers, spenders and importers -- all in the name of free market, capitalism and, of course, globalisation.

And you thought the world had no other options but to follow your model. It is in this connection I am reminded of the title of the famous book, Saving Capitalism from Capitalists by Raghuram Rajan, the noted economist.

I only hope and pray that your actions do not lead to a situation where we need to save the American economy, the US dollar and, by extension, the entire global financial system from complete collapse from your actions or inactions. Save the US economy from the US Fed!

Systemic failure?

Your actions over the past few months wherein you have reduced the benchmark interest rates from 5.25 per cent to 2.25 per cent now is akin to a village hakim (doctor) in India, prescribing his only concoction as medicine to patients suffering from sterility to those in advanced stages of pregnancy.

By merely prescribing rate cuts repeatedly since September 2007, to an outsider it would seem that the US Fed is keen to attack the symptoms rather than to address the systemic malaise.

In a scenario where the wave of bad news keeps coming regularly, with rumours of financial institutions going belly-up hitting markets continuously, and with markets alternating between crisis and calamity, one is not sure about the efficacy of the interest rate cuts effectuated by you. More importantly markets are not responding to your line of treatment.

Or is the diagnosis of the entire problem wrong?

All of us want to know -- in case the problems persist -- whether you will cut the benchmark interest rates to zero? Assuming that the pains in the markets are not mitigated even then, what is the monetary, or for that matter, policy instrument available to deal in such a scenario?

Crucially, even six-months after we first heard about this crisis, despite all the surveillance, systems and procedures, we are yet to figure out the aggregate value of the sub-prime losses. Despite all the tall claims about the efficacy of your regulators, why is that we are still kept in the dark? Is it that they are unable to fathom the problem?

Or is it a comprehensive failure of the entire system? I am scared as experiences from 9/11 demonstrate that American surveillance systems are indeed suspect -- both on fiscal and physical matters.

Is it a mere $100-200 billion, as it was reported originally and thereupon dismissed as inconsequential by some? Or is it $400-600 billion as reported by UBS or Goldman Sachs subsequently? Or is it $1 trillion as reported by economists like Roubini and others? Or is it something more that compels you to be silent?

Lack of trust compounded by silence

Whatever it be, an official statement from you clearly defining the extent of the problem, would be in order. At least that in my opinion, sir, would put an end to the uncertainty that is plaguing the financial markets all across the globe. And, sir, as you know, markets abhor uncertainty, for lack of trust is highly corrosive.

Nouriel Roubini captures this paradigm brilliantly when he states: 'The lack of trust in counterparties -- driven by the opacity and lack of transparency in financial markets, and uncertainty about the size of the losses and who is holding the toxic waste securities -- will add to the impotence of monetary policy and lead to massive hoarding of liquidity that will exacerbate the liquidity and credit crunch.'

Sir, the problem that is confronting the US economy does not only concern liquidity, profitability, capital adequacy or solvency. It concerns credibility of the system leading to lack of trust. And your studied silence is compounding the issue.

When rouges go berserk

But this is not a mere issue of even a trillion dollars as others opine. As the Fed chairman, I am sure you are aware of the magnitude of the problem. Let me elaborate.

Sir, you may recall that it often said that when normal men go berserk they are called rouges. When rouges go berserk, it is called the global financial system -- a system that is defined, dominated and denominated by the world of derivatives.

Sir, as you may be aware that derivatives are creatures of the world of 'virtual finance' that dominates the world of 'actual finance,' several times over.

With the best of financial minds engaged in devising complex and exotic derivative instruments, regulators across continents are oblivious to the net impact of these instruments (aggregate value estimated to be in excess of $500 trillion in 2007 when the world GDP is approximately $40 trillion only) on global economy.

In this world of virtual finance, currency, commodity, and stocks have been uniformly converted into financial assets. And as every market gyrate violently, risks would materialise, then crystallise and get actualised, the cascading effect of this highly leveraged game in the world of 'virtual finance' on the relatively tiny world of 'actual finance' is indeed mind-boggling.

Sir, no wonder you are silent on the extent of the potential damage -- both on actual and virtual finance. And this is eloquent testimony to the fact that the markets are beyond your control, your surveillance and your regulations.

Sir, I am sure you would know that even on the morning of November 9, 1989 (A different 9/11) one could never have predicted the fall of the Berlin wall that evening. That in turn signified the fall of Communism. Though analysts had predicted its fall for over two decades, the abruptness did catch everyone by surprise.

Sir, the world does not want to be caught once again by such nasty surprise. Already economists like Martin Wolff (in the US) and Gurumurthy (in India) have predicted large-scale intervention by the 'US public sector' to bail out private finance firms from collapse. The recent bail out of Bear Stearns was an indicator of what lay ahead.

But this solution seems to suggest the conversion of the US into a perfect socialist state -- socialism for the rich, mighty, privileged and those who were reckless with others' finances.

In the alternative, the US runs the risk of going the erstwhile USSR way with the only variation that abrupt collapse of the US, unlike USSR, could have profound impact on global economy.

Either way it would seem that you are following the Russian model. What a fall for a country that was held to be a model for free markets and capitalism! Surely Karl Marx would be chuckling at your predicament.

Sir, your silence on all these matters is funereal. And the list of those who doubt the very viability of the US economy is growing by the minute. Let me confess with a heavy heart, sir, today, I have joined that bandwagon.

With best regards,

M R Venkatesh

The author is a Chennai-based chartered accountant. He can be contacted at