Economic Rebalancing

The global economy is horribly out of balance, with the United States going deeper into debt each year as a result of a huge trade gap. This blog describes the process of global economic rebalancing. If you have any comments or questions about the posts here, please don't hesitate to use the comments section.

Tuesday, November 10, 2009

It's Not Risk, It's Fraud

We hear everywhere about the "risks" bankers took and how their bad bets came back to haunt us all. It's gotten so that every time I see the term "risk," I cringe.

The problem is not that they made reasonable bets and just got unlucky, as the term "risk" implies. The problem is that they fudged their accounting to show inflated profits over a period of years. This was done primarily through absurd loss assumptions on loans and the use of complex and deliberately confusing derivatives. Eventually the fraudulent schemes had to collapse under their own weight. Many of us saw it coming and warned others about it repeatedly and fruitlessly (read my posts on this blog over the past three years for proof of that).

The problem is systemic. Corporate executives want accounting rules that allow them to commit fraud and they lobby Congress aggressively to prevent fair and accurate accounting. The net effect of years of systemic fraud is that we have created huge amounts of imaginary wealth that inevitably will collapse. This occurred with the deflation of the internet stock bubble. It is occurring now in unwinding of the housing bubble. It will occur on a much larger scale as the liability for around $20 trillion worth of Federal, state and municipal government debts get transferred to the people. It will hit retirees especially hard as pension plans come up far short of being able to meet their obligations.

Inflation will likely be the primary means of transferring the losses to the masses. The Federal Reserve will choose to print the money it needs to keep our government operating after our foreign creditors finally stop throwing good money after bad. Salaries and pensions may or may not fall in dollar terms, but as the dollar loses value and inflation mounts, the real value of our salaries and benefits will decline.

We can reduce the damage we'll have to absorb in two main ways:

1. Individually, we can invest wisely. Many try to hedge their inflation exposure with investments in precious metals, but this strategy is not income generating, and fundamentally it just seeks to limit losses. A more practical approach is to invest in foreign assets that generate positive returns in other currencies.

2. Collectively, we can recognize that the problem is one of fraud, work to correct the systemic flaws that encourage and facilitate this fraud, and make sure that the individuals and institutions responsible absorb the greatest share of the losses. That means creating accurate and conservative accounting rules, breaking up the big banking powers to limit their excessive power, and forcing insolvent enterprises through a quick, efficient, orderly and honest bankruptcy process so that they can continue to operate free of fraud.

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