The Emperor's New Clothes

When I was a kid, I read this beautiful story by Hans Christian Anderson about a foolish emperor. The story (called “The Emperor’s New Clothes”) is about an emperor who cares for nothing but his appearance and attire and hires two tailors who promise him the finest suit of clothes that is not visible to anyone who is unfit for his position or stupid. The emperor himself cannot see the clothes but pretends that he can, lest he appear unfit for his position. Wearing the “suit”, he comes out in a public procession and everyone keeps up the pretense praising the emperor for the fine suit. However, a child in the crowd cries out that the emperor is wearing nothing at all. The emperor is embarrassed, realizing that the child is correct, but continues with his procession.

Alas this is just a story. In this real world, the child is severely punished by the emperor. What else can explain the sudden resignation of Deven Sharma, the president of rating agency S & P? His historic decision to downgrade the AAA rating  of USA evoked strong responses from everyone. While some praised him for having the courage and conviction to take on the might of the US government, many others, including US policymakers and economists like Paul Krugman, criticized him publicly. The US government alleged that S &P overestimated future government debt by $ 2 tn. S & P countered by saying that the US government had become "less stable, less effective and less predictable". Global markets have remained volatile ever since.

However, the US government seems to have the ‘shoot the messenger’ attitude rather than focusing on the real issue here. It’s not as if one fine day S & P woke up from a deep slumber and downgraded USA. This had been coming in for a while. The following is an extract from an article on S&P’s website dated April 18, 2011.

“ On April, 18, 2011, Standard & Poor's Ratings Services affirmed its 'AAA' ratings on the United States of America(AAA/Negative/A-1+) but revised its outlook on the rating to negative. Our opinion of the recent and expected further deterioration in the U.S. fiscal profile, and of the ability and willingness of the U.S. to soon reverse this trend, was the driving factor in our decision to revise the outlook to negative.

What Our AAA/Negative/A-1+ Sovereign Credit Rating On The U.S. Means

A Standard & Poor's sovereign credit rating represents our opinion on both the ability and willingness of aparticular sovereign government to pay its market debt in full, on time, and according to the terms of the obligation.

For the U.S., our sovereign rating applies to the $9.0 trillion in publicly held debt issued by the U.S. Treasury outstanding as of Feb. 28, 2011.

According to Standard & Poor's ratings definitions, an obligor rated 'AAA' is one that, in our opinion, has extremely strong capacity to meet its financial commitments. 'AAA' is the highest issuer credit rating we assign. By comparison, when we rate an obligor 'AA', we are expressing our view that the obligor has very strong capacity to meet its financial commitments. Under our ratings definitions, the creditworthiness of a 'AA' obligor differs from the highest-rated obligors only to a small degree. We may assign a plus-sign modifier ('AA+') to what we consider to be the strongest 'AA' obligors.

Our negative outlook on our rating on the U.S. sovereign signals that we believe there is a likelihood of at least one-in-three of a downward rating adjustment within two years. We currently expect that if we do lower the rating, it would be by no more than one notch to 'AA+', reflecting only a small degree of deterioration in our opinion of the U.S.'s creditworthiness.”

The real issue of discussion here is the massive US debt (expected to be close to 75% of GDP), the corresponding deficits and how difficult it would be to close it out. Debts, taken to stimulate the economy in the wake of the financial crisis, have almost doubled since 2007 (as a % of GDP). In the meanwhile, the government has neither been able to raise taxes nor been able to reduce expenditures; nor is there any ideological consensus between political parties on how to handle this situation.

Given this backdrop, S &P’s call, though questionable, cannot be drastically wrong. It could only be right or marginally wrong. The fact that US faces a severe financial challenge is  unquestionable.

Having borne the brunt of public anger and criticism in the sub prime crisis of 2008, the rating agency seems to have learnt its lessons. They do not want to be caught in the same situation as 2008 where they kept on giving high ratings to structured financial instruments only to see them crumble like a pack of cards later.

However, given what we have seen in Greece and Ireland in the recent past, there is no denying that there is a serious threat on the ability of nations to repay their sovereign debt; and the US should be no exception. So Uncle Sam, instead of shooting the messenger, you should focus on getting your house in order and figure a way out to get out of this financial mess.

Lords of Finance

I have been reading the Lords of Finance for some time now and have completed approximately half of the 500 page book. I must admit that it is an extremely well written book on The Great Crash and Depression. It is a lively and fascinating "event by event" look at the slow motion lead up to The Great Crash, and the four men that could have prevented the Depression.  Liaquat Ahamed describes the four men as follows: ‘Four men in particular dominate this story: At the Bank of England was the neurotic and enigmatic Montagu Norman; at the Banque de France, Emile Moreau, xenophobic and suspicious; at the Reichsbank, the rigid and arrogant but also brilliant and cunning Hjalmar Schacht; and finally, at the Federal Reserve Bank of New York, Benjamin Strong, whose veneer of energy and drive masked a deeply wounded and overburdened man.’

One of the important point the book makes is how factors other than purely economic issues play a role in making economic decisions and how the consequences of those economic decisions then bounce back onto the wider political arena.

Ahamed's central thesis is that the critical decisions made by these four bankers not only caused the Great Depression but also created the conditions for World War II.

The book beautifully explains the complexities and the workings of the financial system at the macro level and throws light on some extremely interesting facts. Some of these are as below:

Gold Standard

The book intricately explains how the gold system used to work till the late twentieth century and the issues with it. The most fateful event of all the events during the early twentieth century was the decision to adhere to the gold standard. In retrospect, tying the amount of currency a country has in circulation to the amount of gold it has in its vaults appears arbitrary and nonsensical. However, it seemed like a good idea at the time, it provided a universal standard against which countries could stablize their currencies. It was a ruinous decision. As Liaquat Ahamed notes, all the gold mined in history up to 1914 "was barely enough to fill a modest two-story town house." There simply was not enough of it to fund a global conflict or to allow economic recovery afterward. 

Federal Reserve

The US was without a central bank until Woodrow Wilson signed the Federal Reserve Act on December 23,1913. The reason for not having a central bank, it was argued, was that it put too much power in the hands of one institution and was therefore undemocratic and un-American. However, in October 1907, the US was rocked by a severe financial crisis caused by the failure of unscrupulous characters to corner the market in the stock of a copper company, resulting in a severe run on the banks. Through some decisive action by JP Morgan, the panic was finally contained. It was only after this incident that an effort was made to create a central bank.

Bank of England

The Bank of England in the nineteenth and early twentieth century was run like a club. Its membership was drawn from closed inner circle of city bankers and merchants. Those who became governors were required to take temporary leave of absence from their own businesses. To be the governor of Bank of England, was therefore not a mark of particular merit, but merely sign of the right pedigree, patience, longevity, and the luxury of having a sufficiently profitable business with partners willing to let one take four years’ leave. The director of the bank did not pretend to know very much about economics, central banking or monetary policy. An economist of the 1920s described them as resembling ship captains who not only refused to learn the principles of navigation but believed that these were unnecessary.

Germany Hyperinflation

In 1923, Germany experience the single greatest destruction of monetary value in the human history. It was experiencing an economic depression after the first world war.  Prices rose 40 fold in 1922 and the mark correspondingly fell from 190 to 7600 to the dollar. By August 1923, a dollar was worth 620,000 marks and by early November 1923, 630 billion. Basic necessities were priced in billions – a kilo of butter cost 250 billion. It was not only the extraordinary numbers but the dizzying speed at which prices were soaring. In the last 3 weeks of October 1923, prices rose 10,000 fold. In the time it took to drink a cup of coffee in one of Berlin’s cafes, the prices might have doubled !

The book has taught me more about financial markets than all my academic studies in B school. It is utterly surprising that most B schools do not have a compulsory course on the history of financial markets. They would rather concentrate on teaching bogus models that never ever work in the real world. My advise to all B school students and participants of financial markets – the book is a must read!

Rather than splendid personalities and events, the book's real advantage is timeliness. 

More on this later when I finish reading the book.