Читать книгу The Committee to Destroy the World - Lewitt Michael E. - Страница 6

The 2008 financial crisis didn’t materialize out of thin air – and neither will the next one. The worst financial crisis since the Great Depression was caused by policy errors that encouraged economic actors to borrow too much and spend or invest the money unproductively – and the next one will follow the same script. Surveying the debris of their work after the crisis, politicians, central bankers and regulators swore they would never allow such a crisis to happen again. Predictably, their promises were broken virtually the moment they were uttered.

By the time the first edition of this book was published in early 2010 under the title The Death of Capital, financial markets had stabilized but economies were still struggling to recover. Almost six years later, they are still struggling – except the world is much more leveraged, the geopolitical landscape is much more fractured, American politics are more divided, and policymakers have run out of answers.

Post-crisis economic reforms followed two paths: heavy regulation and activist monetary policy. Both of them missed the mark because neither addressed the rising tide of debt that is steadily suffocating the global economy. In fact, all of the responses to the financial crisis involved the creation of more debt. On the surface, it appeared that conditions were improving but under the surface the imbalances that caused the crisis were intensifying.

The post-crisis recovery was based on a mirage: an epic accumulation of debt created by central banks lowering interest rates to zero and engaging in trillions of dollars of quantitative easing. In their wisdom, policymakers decided to solve a debt crisis by creating more debt out of thin air, guaranteeing an even more severe crisis in the future. And it wasn’t just the United States that saw its debt grow significantly. Debt also increased in Europe and Japan after the crisis. But in China, the country most responsible for driving the post-crisis global recovery, it exploded beyond reason. China’s growth was built on the biggest debt bubble in history.

China’s debt explosion was either ignored or cheered on by the financial press and Wall Street. These observers adopted the unfounded belief that China was exempt from normal economic forces. Some of us dissented from this view and warned that China’s debt-fueled growth was unsustainable, but our voices were drowned out by the bubbled masses. But when China’s economy began to slow sharply in 2014, it became apparent that China was playing a role in the post-crisis global economy analogous to that played by the U.S. housing market before the crisis. In the mid-2000s, the U.S. housing market created huge amounts of debt that not only inflated housing prices at home but ended up inflating asset prices around the world. In a similar fashion, China’s so-called “economic miracle” inflated the prices of commodities, real estate, and other financial assets around the world. In 2007, the world experienced a debt crisis that originated in the U.S. housing industry and radiated out into the global economy. In 2016, the world faces a debt crisis that originated in China and commodities and is spreading out into the global economy. The common ingredient is excess global liquidity created by central banks.

According to the McKinsey Global Institute, China’s total debt increased from $7 trillion in 2007 to $28 trillion by mid-2014.1 To place these figures in context, household debt in the United States increased by $7 trillion in the period leading up to the financial crisis in 2008. And America’s federal deficit increased by roughly $7.5 trillion between January 2009 and mid-2015.2 So China, an economy only 50 to 60 percent as large as the United States, saw its debt increase by three times as much as America’s household debt grew during the housing bubble or, alternatively, three times as much as America’s federal deficit grew during the first six-and-a-half years of Barack Obama’s presidency (a period that included four consecutive years of $1 trillion deficits). Moreover, much of China’s debt was directed into wasteful and unproductive real estate and commodity investments that will never produce a reasonable return or generate enough income to service or repay the capital that funded them. So much for China’s “economic miracle.”

In a globalized world, the effects of China’s epic debt explosion were not confined to that country’s borders; China’s unconstrained borrowing created unsustainable demand for commodities and massive overproduction in mining, mineral, chemical, and related industries throughout the world. It left in its wake massive overcapacity in commodity-related industries across the globe. Once this debt-fueled expansion began to run out of gas in mid-2014, China’s growth began crumbling, commodity prices began collapsing, credit markets began collapsing, and global growth began slowing from already depressed post-crisis levels.

Then central banks did what central banks do – they compounded their earlier policy errors by repeating their old ones. They doubled down on the failed policies they were employing to stimulate economic growth in an over-indebted post-crisis world. On October 31, 2014, Bank of Japan Governor Haruhiko Kuroda announced unprecedented new stimulus measures in another desperate attempt to break Japan’s decades-long economic spiral. In January 2015, European Central Bank (ECB) President Mario Draghi followed suit with Europe’s first-ever quantitative easing initiative. Only Janet Yellen’s Federal Reserve was moving in the opposite direction by ending its own quantitative easing program, but this was primarily through sins of omission that strengthened the dollar and exerted additional downward pressure on commodity prices, U.S. corporate profits, and the global economy.

By mid-2015, serious cracks began to appear in global markets. Greece defaulted and had to be bailed out again by the European Union while solidifying its status as a failed state and global security threat as an entry point for refugees from a shattered Middle East. Emerging markets were melting down with particular weakness in Brazil and Russia. China’s stock market was crashing and the country shocked global markets by beginning a concerted effort to devalue the yuan. Puerto Rico declared itself insolvent (something anyone with a functioning cerebellum already knew was the case). Leveraged oil and gas companies in the U.S. were filing for bankruptcy left and right. And then the U.S. stock market, which had struggled to rise all year, suffered sharp losses and extreme volatility in August and September, shaking the confidence of investors. The post-crisis debt party had run long past midnight – and nothing good ever happens after midnight.

With interest rates around the world stuck at zero, there was little prospect that the $200 trillion of debt suffocating the global economy could ever be repaid by conventional means. The world is incapable of generating enough income to pay the interest and principal on that much debt. Instead, it was obvious that this debt could only be repaid through a combination of currency debasement, inflation, and defaults. Stated plainly, this means that the value of fiat money is going to be obliterated. Of course, politicians, central bankers, and policymakers have been destroying the value of money for years. But now they are going to have to accelerate their efforts. Out-of-control debt is metastasizing, crippling global growth and sucking the lifeblood out of the global economy. Central bankers badly miscalculated when they decided to try to solve a debt crisis by printing trillions of dollars of additional debt.

A Regulatory Theocracy

The 2008 financial crisis and, before that, the 9-11 attacks drastically reshaped the world. Each of these seminal tragedies unleashed massive policy responses that radically altered American life for the worse. As a result of the 9-11 attacks, the United States invaded Iraq and Afghanistan and launched anti-terror operations in Pakistan, Yemen, and Somalia; passed the Patriot Act that expanded surveillance of its citizens; and established a massive new bureaucracy in the Department of Homeland Security to protect the nation. As a result of the expansion of the radical Islamic terrorism around the globe that triggered the 9-11 attacks, Americans can no longer travel freely or feel secure in public places due to the growing threat of random violence. American police forces are militarized and the freedoms enjoyed by our parents and grandparents are limited by our own fears and our government’s failure to effectively fight our enemies at home and abroad.

Financial regulation was supposed to improve after the financial crisis, but instead it deteriorated into an orgy of mindless rulemaking. In a perverse interpretation of his campaign promise of “Hope and Change,” Barack Obama left post-crisis financial regulation in the hands of the same cast of inept economic policymakers that led America into crisis in the first place.

He named Lawrence Summers as his chief economic adviser, a man whose inflated opinion of himself dwarfs his meager accomplishments such as rejecting CFTC Chair Brooksley Born’s pleas to regulate derivatives in the late 1990s despite himself knowing virtually nothing about derivatives. He named Timothy Geithner, who ran the Federal Reserve Bank of New York before the crisis while Wall Street leveraged itself into insolvency right under his nose, as his Treasury Secretary.

And, in perhaps his most disappointing move, the president brought in Mary Schapiro, an undistinguished career regulator who had mastered the art of failing upward, to run the already ineffective Securities and Exchange Commission (SEC). Among Ms. Schapiro’s notable failures was allowing Bernard Madoff to run the largest Ponzi scheme in history right under her nose as she served as a senior regulator and ultimately the Chair and CEO of the National Association of Securities Dealers in the mid-to-late 1990s, the height of Mr. Madoff’s fraud.

Rather than new blood and new thinking, Mr. Obama relied on the same people responsible for the policy errors that contributed to the crisis to fix those errors. Those who had warned of the problems before they happened were nowhere to be found.

In the aftermath of the financial crisis, Congress passed The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). Naturally, this bill turned into a regulatory and lobbying orgy that ended up sapping liquidity and vitality from the financial system while leaving derivatives inadequately regulated and the individuals who committed crimes that contributed to the financial crisis unpunished. Dodd-Frank was 14,000 pages in length and included 398 rule-making requirements, rendering it almost impossible to administer by the SEC and other agencies charged with administering it. Like the badly flawed Affordable Care Act, which House Majority Leader Nancy Pelosi famously (and disgracefully) said had to be passed into law in order for the members of Congress to know what it actually said, Dodd-Frank was another piece of absurdly complex legislation that was voted on by people who didn’t read it or understand its contents or its unintended consequences.

The gargantuan Dodd-Frank bill was the government’s main regulatory response to the financial crisis. The law required banks to reduce leverage and risk-taking activities using taxpayer money (reforms that I proposed in the first edition of this book). While some of these goals were accomplished, the forms in which they were implemented rendered the financial system less liquid, more rigid, and more susceptible to another financial crisis.

Legislators and regulators failed to recognize that inflexibly bolstering bank capital would severely reduce market liquidity, yet that is precisely what occurred. By 2014, liquidity in fixed income markets had dried up as banks restructured their businesses to meet the demands of the new law. Corporate bond inventories held by dealers dropped by 70 percent while Treasury market liquidity evaporated. This happened as debt markets increased dramatically in size; by 2015, the U.S. corporate debt market had doubled in size to $4.5 trillion since before the crisis, yet it had become much more difficult to trade bonds than a decade earlier. The evaporation of market liquidity will inevitably make the next crisis more severe than the last.

The government’s role in the economy and its intrusions into the daily lives of its citizens are immeasurably greater today than on September 10, 2001. The costs in terms of lost privacy and freedom are incalculable. We live in a world run by regulators who are operating in the dark while exercising increasingly untrammeled power. We are lorded over by a growing regulatory state to whom courts – particularly the Roberts Supreme Court – have granted enormous and undue deference. The Tyranny of the Alphabet – the FBI, IRS, SEC, FINRA, NLRB, EPA, OSHA – governs our lives. The rise of the regulatory state coupled with the epic increase in debt are smothering the economic vitality of the United States and dooming this country and the rest of the world to generations of sluggish growth.

The expansion of the regulatory state is appalling in breadth. Over the last decade, 768,920 pages of federal regulations have been added to the Federal Register, an average of almost 77,000 pages a year.3 A nearly incomprehensible 36,877 new regulations were added during that period.4 It is a miracle that the American economy can function at all under the weight of all of these rules, many of which can give rise to substantial criminal and civil penalties in the hands of overzealous and corrupt prosecutors (of which there are no shortage).

We have come a long way from February 1999 when Time Magazine celebrated “The Committee to Save the World” – Alan Greenspan, Robert Rubin, and Lawrence Summers (see Figure I.1). Time’s misguided anointment of these three men coincided with the birth of the European Union, which enslaved vast swathes of southern Europe in an economic straitjacket. Shortly before the three men were celebrated by Time, they had successfully thwarted efforts by U.S. Commodity Futures Trading Commission chair Brooksley Born to regulate over-the-counter derivatives, a decision that contributed less than a decade later to the worst economic crisis since the Great Depression. As we came to learn, with men like these in charge of saving the world, the world was going to find itself in deep trouble.

Figure I.1 Apocalypse Then

SOURCE: Time, February 1999.

A decade later, Mr. Greenspan admitted to Congress that his basic assumptions about economics and human behavior were wrong. Mr. Rubin was trying to justify his $100 million sinecure at Citigroup, Inc. while refusing to acknowledge any responsibility for the actions of his underlings that pushed that bank into insolvency and a federal bailout on his watch. And Mr. Summers kept failing upward, retaining his sneer of intellectual superiority while consistently demonstrating why academic economists like him are the last ones anyone should ask for economic policy advice.

Unfortunately, economic governance would get much worse and “The Committee to Save the World” was succeeded by “The Committee to Destroy the World” (see Figure I.2) after the 2008 financial crisis (although the mainstream press never identified them as such, leaving that to me in The Credit Strategist5). In 2015, the troika leading the world’s largest central banks was still pursuing crisis-era policies long after the crisis had passed. By that time, new strains were appearing in the global economy due to the failure of fiscal policymakers to adopt meaningful pro-growth policies and the perpetuation of crisis-era monetary policies long past their sell-by date.

Figure I.2 The Committee to Destroy the World

SOURCE: Haruhiko Kuroda photo by Michael Wuertenberg, https://commons.wikimedia.org/wiki/File: Accelerating_Infrastructure_Development_Haruhiko_Kuroda_(8410957075).jpg#filelinks; Mario Draghi photo by Remy Steinegger, https://commons.wikimedia.org/wiki/File: Mario_Draghi_World_Economic_Forum_2013.jpg; Janet Yellen photo by Day Donaldson, https://www.flickr.com/photos/thespeakernews/16165619661.

Governed by intellectual fallacies and cowed by markets, The Committee to Destroy the World adopted policies that were guaranteed to lead the world straight into the jaws of another financial crisis. Global interest rates were kept at, near, or below zero for years while central banks purchased trillions of dollars/yen/euros of government bonds based on the delusion that these policies would stimulate economic growth. Naturally, they did precisely the opposite.

Einstein supposedly said that the working definition of insanity is repeating the same mistake and expecting a different result. That remark should be applied to the working definition of stupidity and central bankers. By 2014 (if not earlier), there was abundant and irrefutable evidence that quantitative easing was failing to stimulate growth in the United States. In fact, it was sapping economic vitality and market liquidity and contributing to the most disappointing economic recovery in memory. In the 2011–2014 period, GDP growth in the United States averaged a measly 2.0 percent according to the Bureau of Economic Statistics. And during Barack Obama’s presidency, the high point for annual GDP growth was a tepid 2.5 percent in 2010.

Nonetheless, faced with mounting evidence that their policies were not working, central bankers, demonstrating that there is a difference between being educated and being smart, refused to change course; instead, they persisted with their failed policies. Their subsequent expectations for economic growth never came close to materializing. Table I.1 shows the “central tendency” projections of GDP growth by Federal Reserve governors and bank presidents compared to actual GDP in the 2011–2015 period.

Table I.1 “Central Tendency” Projections of GDP Growth Compared to Actual GDP in the 2011–2015 Period

SOURCE: Federal Reserve Board.

Looking at this record, one could reasonably conclude that it would be more useful to ask a group of English professors to forecast the economy.6 In the wake of their failures, the Fed left behind a grossly over-leveraged economy whose fragility was disguised by artificially inflated stock prices, artificially low interest rates, and artificially suppressed volatility. You have to hand it to Ben Bernanke and his progeny – they couldn’t have designed a more disastrous set of policies had they consulted Dr. Victor Frankenstein.7

Things didn’t have to be this way. A sounder and more creative intellectual approach and bolder political initiatives would have produced far better results. But there are no Paul Volckers running central banks today and no Winston Churchills leading the world. Mr. Volcker was willing to battle inflation while being demonized in the press and Churchill fought the Nazis from an underground London bunker while being bombarded by the Luftwaffe every night.

Today, we are left in the hands of people like Janet Yellen and Barack Obama. Mrs. Yellen was terrified to raise interest rates by a mere 25 basis points for years for fear of upsetting markets while Mr. Obama, who tellingly removed Churchill’s bust from the Oval Office, loaded the American economy with job-killing regulations and multi-trillion dollar entitlements while appeasing tyrants, betraying our allies, and apologizing for American power and principles. They say that societies get the leaders they deserve. I say we deserve better.

A Crisis Wasted

Shortly after President Obama took office in 2009, I received a telephone call from one of the Obama administration’s top economic advisers. I was asked whether I was willing to speak to the small group advising the president how to regulate derivatives after the financial crisis. The individual who called me said he was uncertain whether he could get me a hearing but felt it was important for them to hear my views (which were published, among other places, in the first edition of this book) since the president and Lawrence Summers, the president’s top economic adviser, believed it would be appropriate to leave regulation of derivatives in the hands of regulators. My view, which the caller had shared with the group, was that regulators do not understand derivatives and are not qualified to regulate them. After some back and forth, I was not invited to share my views with the group; there was little appetite to hear them, and derivatives regulation was left in the hands of people who do not understand them.

On the first page of his magnum opus, Stabilizing an Unstable Economy, the great economist Hyman Minsky wrote: “Economic theory is the product of creative imagination; its concepts and constructs are the result of human thought.”8 There is nothing foreordained about economics; it is merely a series of intellectual constructs about how the world works. It is a soft science. Accordingly, its forecasts are more often wrong than right. As a human intellectual construct, it is subject to the deficiencies of human thought – in the shorthand of the markets, greed and fear. These flaws lead economists to make less than optimal policy choices, and that is nowhere more apparent than in the responses to the 2008 financial crisis.

After the crisis, the government consistently sought advice, not from those who correctly predicted the housing bubble and resulting market collapse, but instead from those economists and strategists who missed the obvious warning signs and those investors who lost enormous sums of money. If your fund was down 80 percent, you were at the top of the list of the people the government called for advice. Of course, many of these people purchased their seats at the table with large campaign contributions; that is what happens in a system of crony capitalism. Nonetheless, it was a shame that we were calling on the same individuals who led us to the brink disaster to lead us out of it. We can see the results of that approach six years later: an over-leveraged and over-regulated financial system that is failing to fuel sufficient economic growth to pay our current and future obligations.

In the midst of the crisis, presidential aide Rahm Emanuel (who was not the individual who called me) famously said that it would be a shame to let a crisis go to waste. But that is exactly what happened. Despite heroic efforts to prevent a complete collapse of the financial system after the failure of Lehman Brothers and the near demise of insurance giant AIG, policymakers failed to address many of the underlying regulatory, fiscal, and monetary policy failures that led to the financial crisis while also creating new ones.

That is not to say that they did nothing: they took some important steps to reform the U.S. banking system and make it better capitalized. But they failed to address the two biggest elephants in the room: (1) the incessant growth of debt in the U.S. and around the world; and (2) the $650 trillion derivatives infrastructure that hangs over the entire edifice of global finance like a dark cloud waiting to burst. Excess debt and all that comes with it pose the greatest risk to global financial stability since the Great Depression and absolutely nothing has been done to tame this beast.

The Death of Fiscal Policy

Mr. Obama inherited an extremely difficult situation upon taking office, but he made it worse through a series of deliberate policy choices that further weakened the American economy. His proclivity for government rather than market solutions imposed enormous regulatory burdens on the economy that impeded private sector growth while loading the government with trillions of dollars of future obligations that it can’t afford to pay.

The first large piece of economic legislation that Mr. Obama promoted was the $800 billion American Recovery and Reinvestment Act. The president touted this so-called stimulus bill as a massive boost for the American economy when it was passed by a Democrat-controlled Congress in February 2009, but it proved to be a bust. Very little of the money was spent to increase the productive capacity of the American economy as proven by the economy’s sub-par growth in the years that followed. We may not have been building bridges to nowhere like Japan and China, but we weren’t building bridges to the future either.9

Then Mr. Obama decided to impose a new multi-trillion-dollar entitlement on one-sixth of a struggling American economy – The Patient Protection and Affordable Care Act (familiarly known as ObamaCare). Unable to get the highly unpopular law passed in Congress by conventional means, he worked with Senate Majority Leader Harry Reid and House Speaker Nancy Pelosi to force the bill through via the federal budget reconciliation process that only requires 51 votes rather than the normal three-fifths majority. This legislative device was inserted in the Congressional Budget and Impoundment Control Act of 1974 to end filibuster, close debate, and pass controversial budget bills. Of course, ObamaCare was much more than a mere budget bill, but this was only the first of many instances where the Obama administration trampled on the rule of law to pursue its ideologically driven policy goals. The Democratic leadership dressed up the healthcare bill as a phony civil rights measure, even parading former civil rights leader and House member Elijah Cummings up the steps of the Capital on the day of passage, to push the law through Congress over the opposition of the Republicans and much of the American public.

In order to gain business support, the administration bought off the health insurance, hospital, and healthcare industries that stood to gain millions of new patients whose bills would be paid by the government. The merger boom in these industries in the years following passage of the law (with no meaningful antitrust review) coupled with escalating drug costs (with no complaint from the administration) spoke to the devil’s bargain that paved the way to so-called “healthcare reform.”

While most people agree that all American citizens should have access to healthcare, the harried, procedurally irregular and politically dishonest way in which the law was passed imposed a deeply flawed and prohibitively expensive bill on American taxpayers. ObamaCare is another multi-trillion-dollar entitlement whose true costs were deliberately delayed until after Mr. Obama leaves office. By late 2015, the law was already struggling due to its high costs and flawed incentives. More than half of the regional coops set up under the law had failed, year-end 2016 enrollment was projected to come in at half the 20 million originally projected by the Congressional Budget Office, and the country’s largest healthcare insurer, United Healthcare, announced in November 2015 that it was considering withdrawing from ObamaCare exchanges due to massive losses. We are also learning that the true costs of the law’s expansion of Medicaid to the states is going to be in the tens of billions of dollars as federal subsidies roll off, placing enormous burdens on state budgets after Mr. Obama leaves office. The law asks nothing of its beneficiaries and provides no means to pay for itself. Its dubious economics are only rivaled by it questionable legality. The law survived two near-death challenges in the Supreme Court only because Chief Justice John Roberts flouted long-established standards of statutory interpretation to rewrite the statute, severely damaging his institution’s integrity and reputation in the process.10 In truth, Mr. Obama’s dream of universal healthcare is an economic and political nightmare.

Monetary Policy Follies

The Failures of the Fed

Since the financial crisis, the Federal Reserve and its foreign counterparts have engaged in policies that failed to stimulate sustainable economic growth and, once they saw them fail, refused to change course and instead intensified the same policies.11 While former Federal Reserve Chairman Ben Bernanke was rightfully praised for the steps he took during the financial crisis to prevent a total collapse of the financial system, his successor, Janet Yellen, kept emergency policies in place far too long after the crisis ended. The result was seven years of zero interest rates and trillions of dollars of quantitative easing that boosted financial markets but left the economy struggling to grow.

These policies also created inflation in the prices of many of the products and services used by consumers despite these higher prices not being reflected in official government inflation statistics. They also contributed to a dramatic increase in wealth inequality in the United States, which exacerbated social instability and political divisiveness during an administration that purported to be benefitting those most damaged by the policies designed to help them.

Monetary policy led to massive inflation in the prices of financial assets such as stocks and bonds as well as art and other collectibles, high-end real estate, and anything else denominated in increasingly debauched paper money. These assets experienced what the economist Irving Fisher termed a “money illusion” in which the inherent value of the assets themselves was not increasing; instead, the value of the fiat currencies used to purchase them was deteriorating.12

At the same time that consumers were being told by the government that the prices of the everyday goods they need in order to live were barely increasing, these prices were actually rising sharply. In a word, the government was lying to them. Figure I.3 shows the rise in inflation as measured by the government.

Figure I.3 Rise in Inflation as Measured by the Government

SOURCE: CLSA, U.S. Bureau of Economic Analysis.

These numbers are, of course, utter nonsense despite the fact that Wall Street and other establishment economists accept them at face value. For the real story, look at Table I.2, which shows the actual increase in the prices over the last 10 years of many of the products and services actually used by consumers.

Table I.2 Increase in Prices over the Last 15 Years

SOURCE: (1) Bloomberg, (2) National Center for Education Services, (3) St. Louis Fed, (4), Trulia, (5) St. Louis Fed.

Only a professional economist would really believe that the prices of goods and services are not increasing at a rate that threatens the ability of ordinary Americans to maintain a reasonable standard of living. “Official” government inflation statistics, which guide monetary policy, bear little relationship to what is happening in the real world. The fact that monetary policy is based on these numbers is not only an intellectual insult, it is a profound moral betrayal that violates the government’s social compact with its citizens. Monetary policy is guided by a deliberate falsehood perpetrated by a government robbing its citizens of their money and their freedom.

The Fed’s post-crisis policy was driven by a deliberate attempt to ignite inflation despite the fact that prices are rising just fine on their own in the real world. This policy confiscated the savings of ordinary Americans while triggering serious geopolitical consequences such as the Arab Spring, which was unleashed by higher food prices in the Mideast, and a race by China and Russia for valuable energy resources around the world. There was an enormous disconnect between an activist monetary policy that sought to inflate already inflating prices and a fiscal policy that was shut down during the first six years of the Obama presidency by Senate Majority Leader Harry Reid.

To some extent, the incredible vitality and innovation of the U.S. technology sector helped counteract some of the effects of these disastrous policies. But despite the revival of Apple, Inc. and the Apple ecosystem of products as well as the advent of new companies such as Facebook, Inc. and Tesla Motors, Inc. and the growth of Amazon.com, Inc. and Google, Inc. and new products pouring out of the biotechnology industry, the United States still saw a disappointing recovery coupled with the largest debt increase in history while the world around it grew dangerously indebted and unstable. In the end, iPhones, “friending,” and producing 50,000 or 100,000 electric cars a year are not going to save us.

The European Monetary Experiment

As problematic as U.S. monetary policy was since the crisis, it was even more misguided in Europe. While low rates effectively deprived American savers of enormous amounts of income over the past six years, Europeans experienced a much more dangerous phenomenon beginning in early 2015 when more than €2 trillion of European debt started trading at negative yields in response to a long-awaited and ill-fated quantitative easing program announced by ECB President Mario Draghi in January 2015.

Like the U.S., European governments failed to implement the types of fiscal policies necessary to grow their economies. This left Mario Draghi with little choice (in his own mind at least) but to mimic the failed policies of other central banks. By February 5, 2015, as Table I.3 illustrates, 10-year bond yields in Europe had dropped to historically low levels.13

Table I.3 10-Year Yields at February 5, 2015

DATA SOURCE: Financial Times.

These yields deprived individual savers as well as institutions such as insurance companies and pension funds of the ability to earn any meaningful return on their capital. A few months later in April 2015, German 10-year bund yields sank to a mere 5 basis points before markets came to their senses and sold off viciously, moving the yield back up to the high double digits (still absurdly low but better than near-zero). By way of comparison, U.S. 10-year Treasury yields were 1.81 percent on February 5, 2015. When the bond yields of functionally insolvent countries like Spain and Italy are lower than those of the United States, markets are seriously distorted. Even Greece’s 9.53 percent yields were delusionally low; by June they would be 20 percent higher as the country teetered (once again) on the brink of financial collapse.

The ECB’s QE program was not only doomed to fail for the reasons that all QE programs unaccompanied by meaningful fiscal reforms are doomed to fail but also because European bond markets were ill-suited to such a regime. European bond markets were already illiquid prior to the launch of QE and quickly became dangerously more so afterwards; front-running of the ECB’s bond purchases by hedge funds and other investors depressed yields to absurdly low levels. Many of these investors suffered losses when the market reversed in May 2015 (as I warned in The Credit Strategist) because there were a limited number of buyers for bonds that were little more than certificates of confiscation. The ECB was limited in the bonds it could buy under the terms of its QE program, and private sector buyers started coming to their senses, putting an end to another momentum trade. In broader policy terms, however, QE is what happens when fiscal policymakers lack the courage and wherewithal to enact pro-growth economic reforms and leave it to monetary policymakers to fill the gap.

The ECB was forced into QE because European politicians were unwilling to stop spending other peoples’ money to prop up over-indebted welfare states like Greece, Spain, Italy, and Portugal. Greece is the most blatant example of a failing state dependent on borrowing money from its neighbors that it can never hope to pay back. But it is not the only example: Spain, Italy, and Portugal (and likely France) are not far behind. Mario Draghi is prepared to tax all Europeans with future inflation (both directly and through currency debasement) to keep these countries afloat and the flawed European Union intact, but that is a promise bound to be broken in the future because it sunders the social contract between governments and their citizens. Sooner or later these countries will not be able to finance their deficits and will move towards default.

Under the current form of the Maastricht Treaty, the ECB is legally barred from directly financing member states by printing money, but QE is the first step down that road. Markets rely on the ECB to support European sovereign debt, which is why European bond yields dropped to such low levels during the first half of 2015 (and returned to those levels again late in the year). At some point, however, the ECB’s existing tools will prove insufficient and either the Maastricht Treaty will have to be amended (a tall order) or abrogated or European sovereign debt will no longer enjoy the confidence of markets (the latter being the more likely outcome for investors).

Even more disturbing than the sight of negative yields was the market’s complacency in the face of a phenomenon that violated the very tenets of capitalist economics. If this was the nineteenth century, there literally would be blood in the streets, but modern man has been fooled into worshipping central bankers. The problem with this brand of religion is that investors may think they are worshipping God but are really worshipping the Devil because central banks have made it very clear that they intend to confiscate their citizens’ money through inflation and currency devaluation.

The Bank of Japan has been doing that for years only to be followed by its Western counterparts. When members of The Committee to Destroy the World complain that inflation is too low in a world in which goods and services grow more expensive every day, they are admitting that they intend to destroy the value of fiat money. In January 2015, the ECB, like other central banks, attempted to solve a solvency problem linked to excessive debt accumulation with policies designed for a liquidity problem. That is like trying to treat cancer with an aspirin regimen.

The confiscation of capital through artificially negative interest rates in Europe was just a more drastic version of what was happening in the U.S. since it lowered interest rates to zero during the financial crisis. While deflation posed a greater threat in Europe, in the U.S. it was a mirage despite deluded claims by members of the Federal Reserve that inflation is too low. Real world prices of goods and services increased dramatically over the past decade; only economists claim otherwise, which is another reason why the last person you should ask about the economy is an economist.

Low yields in the U.S. have confiscated enormous amounts of money from American consumers. As Christopher Whelan of Kroll Bond Rating Agency writes: “ZIRP [zero interest rate policy] has reduced the cost of funds for the $15 trillion asset U.S. banking system from roughly half a trillion dollars annually to less than $50 billion in 2014. This decrease in the interest expense for banks comes directly out of the pockets of savers and financial institutions.”14 In other words, banks are paying out hundreds of billions of dollars less in interest as a result of the Fed’s repressive policies. In fairness, this is not a one-way bet; consumers also pay lower mortgage rates. But ZIRP and QE have clearly benefited borrowers while punishing savers.

While economists believed that interest rate repression would stimulate economic growth and reduce inflation, it did nothing of the sort. Instead, it suppressed economic growth and unleashed epic financial asset inflation while doing little to reduce inflation in goods and services. The latter only looks tepid because the government measures it in ways that have little to do with the real world. Fed apologists can use all the excuses in the world, but there is only one of two ways to explain this: rank incompetence or a willful desire to distort the facts.

Negative interest rates in Europe are a symptom of policy failure and a violation of the laws of capitalism. The same is true of persistent near-zero rates in the United States and Japan. Invisible rates render it impossible for fiduciaries to generate positive returns for their clients, insurance companies to issue policies, and savers to entrust their money to banks.15 They are a symptom of failed economic policies, not some clever device to defeat deflation (which for the most part doesn’t yet exist or pose a serious threat) and stimulate economic growth. These policies are mathematically doomed to fail regardless of what economists, who are merely failed monetary philosophers practicing a soft science, purport to tell us. The fact that European and American central banks followed the path of Japan with virtually no objection represents one of the most profound intellectual failures in the history of modern economic policy.

While the global economy is facing a solvency problem linked to excessive debt accumulation, the world’s central banks are pursuing policies designed for a liquidity problem. As noted above and discussed further below, the only solutions in this known universe for a solvency problem are inflation, currency devaluation or default (the other possibility, extremely high rates of growth, is unrealistic). Since none of these real-world solutions is politically palatable – no leader on today’s world stage has the courage to propose them and would be voted out of office by selfish and short-sighted constituents if he/she did – central banks are left creating huge doses of debt since equity can’t be conjured out of thin air. But all of this debt is just exacerbating the solvency problem and failing to solve the liquidity problem, pushing global markets closer to crisis.

Out-of-Control Global Debt

The global economy cannot generate enough income to service and/or repay the debts it has already incurred or, for that matter, the incalculable trillions of dollars of future promises politicians have made. In this respect, the United States is just a microcosm of the rest of the world. As Figure I.4 illustrates, debt has grown much faster than the economy in the United States since the early 1980s. Furthermore, the gap between the growth rate of debt and the growth rate of the economy has accelerated over the past two decades, which guarantees that the economy can never hope to catch up and generate enough income to pay the interest or the principal on the debt.

Figure I.4 Debt Has Grown Much Faster Than the Economy in the U.S. Economy

SOURCE: BofA Merrill Lynch Global Investment Strategy, Federal Reserve Bank, DataStream.

In September 2014, the Geneva-based International Centre for Monetary and Banking Studies published a study entitled “Deleveraging? What Deleveraging?” where it reported that, “[c]ontrary to widely held beliefs, the world has not yet begun to delever and the global debt-to-GDP is still growing, breaking new highs.”16 The report was written by the highly respected economists Vincent Reinhart of Morgan Stanley, Lucrezia Reichlin of the London School of Business, Luigi Buttiglione of Brevan Howard Capital Management LP, and Philip Lane of Trinity College in Dublin. Going further, the report’s distinguished authors warned that, “in a poisonous combination, world growth and inflation are also lower than previously expected, also – though not only – as a legacy of the past crisis.”17

The authors showed that, excluding the leverage of financial companies worldwide, debt was equivalent to 212 percent of global GDP, up 38 percent since 2008. Debt was equivalent to roughly 264 percent of GDP in the U.S., 257 percent in Europe, and 411 percent in Japan. While debt was rising, global growth was falling. The six-year moving average of the world’s potential growth rate fell to below 3 percent post-crisis from about 4.5 percent before the crisis, no doubt largely due to the much higher level of debt weighing on economies. When increasing amounts of financial and intellectual capital are devoted to servicing debt, growth is bound to suffer (see Figure I.5). Further, the authors point out: “Deleveraging and slower nominal growth are in many cases interacting in a vicious loop, with the latter making the deleveraging process harder and the former exacerbating the economic slowdown. Moreover, the global capacity to take on debt has been reduced through the combination of slower expansion in real output and lower inflation.”18

Figure I.5 Global Debt Has Increased by $57 Trillion since 2007, Outpacing World GDP Growth

SOURCE: Haver Analytics, national sources, World Economic Outlook, IMF; BIS; McKinsey Global Institute analysis.

This disturbing picture was confirmed several months later by The McKinsey Global Institute. In a report entitled “Debt and (Not Much) Deleveraging,” McKinsey reported that between 2007 and 2014, global debt had grown by $57 trillion to $199 trillion, raising the ratio of global debt-to-GDP by 17 percentage points. Developing countries have accounted for half of this growth; government debt has soared (by $25 trillion) and private sector deleveraging has been limited. Households in the U.S., UK, Spain, and Ireland had deleveraged somewhat, but elsewhere they had not. In particular, as noted earlier, China’s total debt quadrupled from $7 trillion in 2007 to $28 trillion by mid-2014, fueled by real estate and shadow banking, and China’s total debt as a percentage of GDP exceeded that of the United States (but honestly, who knows how bad China’s opaque debt figures really are?). McKinsey summed up the last five years of the global economy: “[i]t is clear that deleveraging is rare and that the solutions are in short supply.”19 Actually, it is not solutions that are in short supply but rather the political and moral courage to implement them.

Both the McKinsey and the Geneva reports illustrate beyond a shadow of a doubt the unsustainable and dangerous path on which the global economy is set. Even worse, the policy mechanisms that brought the world to this point largely destroyed the market’s ability to send meaningful pricing signals to market participants. Since the crisis, central banks have been the largest buyers of government bonds, distorting the market’s normal supply/demand dynamics and “snapping the antenna” off the bond market in the words of economist Dr. Philippa Malmgren.20 Governments have distorted the price of benchmark bonds as well as the price of money and made it virtually impossible to determine the natural rate of interest or inflation.

Untamed Derivatives

One of the primary forms that global debt has assumed in the modern economy is the derivatives contract. AIG blew up because it wrote too many derivatives contracts on collateralized bond obligations that held billions of dollars of subprime mortgages. But the derivatives threat in the market in 2008 was much broader and deeper than that – there were roughly $60 trillion of credit default swaps that were written on a wide variety of underlying obligations that brought the financial system to its knees.

Seven years later, despite efforts to tame the derivatives beast, these instruments of financial mass destruction still pose an existential threat to the global finance sector. One of the stated aims of Dodd-Frank was to address the “too big to fail” problem in the financial industry. Unfortunately, the legislation left in its wake a much more highly concentrated financial industry with fewer firms that are no longer “too big to fail” but actually “too big to save.” One of the primary ways in which they are “too big to save” is by holding hundreds of trillions of dollars of derivatives on their balance sheets whose true risks their managements don’t understand (because if they did understand these risks, they wouldn’t allow their institutions to hold them).

The Bank for International Settlements reported that the notional amount of outstanding over-the-counter derivatives stood at $630.1 trillion at December 30, 2014.21 The “gross market value” of outstanding derivatives contracts, which measures the cost of replacing them at prevailing market prices and the maximum loss that market participants would suffer if all counterparties failed to perform, increased over the second half of 2014 from $17 trillion in June to $21 trillion at the end of December 2014.22 A third measure of derivatives exposure, “gross credit exposure,” which adjusts gross market values for legally enforceable bilateral netting agreements but does not take account of collateral posted with respect to the contracts, rose to $3.4 trillion at the end of December 2014 from $2.8 trillion in June 2014.23 In a moment, we will see why the “gross market value” and “gross credit exposure” figures, which are large enough to shatter the financial system in the next crisis, are important but still don’t tell the whole story.

The Office of the Comptroller of the Currency tracks the exposure of U.S. banks to derivatives and reported that just four large U.S. banks (JPMorgan, Bank of America, Citigroup, and Goldman Sachs) carried a combined $220.4 trillion of derivatives on their books at the end of December 2014. This figure dwarfed their combined $769.2 billion in equity capital by multiples ranging from 151 at Bank of America to an astounding 565 at Goldman Sachs (see Table I.4).

Table I.4 Exposure of U.S. Banks to Derivatives ($ in billions)

SOURCE: 2014 Annual Reports; Office of the Comptroller of the Currency Quarterly Report on Bank Trading and Derivatives Activities Fourth Quarter 2014.

Since then, these banks have reduced their derivatives books by several trillion dollars each, but their derivatives exposures still remain dangerously large. Excluded from this list is the world’s largest known purveyor of derivatives, Deutsche Bank AG, which as of late 2015 held $60 trillion of derivatives contracts on its books. Deutsche Bank may well pose the single biggest systemic risk of any financial institution in the world.24 This is because it suffers from severe management, operational, and regulatory deficiencies that have gone unremedied for more than a decade. These problems finally burst into the open in July 2014 when The Wall Street Journal disclosed that the Federal Reserve Bank of New York’s concerns about the bank had been growing for years.

On December 11, 2013, Daniel Mucca, a New York Fed senior vice president responsible for supervising Deutsche Bank, wrote the following to the bank’s senior management: “Since 2002, the FRBNY has highlighted significant weaknesses in the firm’s regulatory reporting framework that has remained outstanding for a decade. Most concerning is the fact that although the root causes of these errors were not eliminated, prior supervisory issues were considered remediated and closed by senior management.” He added that financial reports produced by the bank “are of low quality, inaccurate and unreliable. The size and breadth of the errors strongly suggest that the firm’s U.S. regulatory reporting structure requires wide-ranging remedial action.” The New York Fed had voiced concerns about the quality of the data reported in 2002, 2007, and 2012. The letter said that the bank had made “no progress” at fixing previously identified problems and examiners found “material errors and poor data integrity” in its U.S. public filings, which are used by regulators to evaluate its operations. Mr. Mucca added that the shortcomings amounted to a “systemic breakdown” and “expose the firm to significant operational risk and misstated regulatory reports.” The bank’s external auditor, KPMG LLP, also identified “deficiencies” in the way the bank’s U.S. entities were reporting financial data in 2013 according to an internal email reviewed by The Wall Street Journal.

As heartening as it is to hear that the Fed is on the case, the real question is how six years after the financial crisis an institution holding enough derivatives to blow up the global financial system could be permitted to operate with financial controls that would force a corner drug store out of business. People have asked how Bernie Madoff was able to escape the attention of regulators for so many years, but in that case regulators never flagged the fraud that was occurring under their noses. In the case of Deutsche Bank that – to repeat – holds enough derivatives on its books to blow up the world, regulators repeatedly flagged problems but failed to either require them to be fixed or to rein in the bank’s operations in order to protect investors and the system. This is simply inexcusable.

Not only has the issue of concentration risk in the financial system been inadequately addressed, but it was exacerbated by the extinction of several large firms during the financial crisis and a new regulatory regime that blindly favors size over flexibility while allowing derivatives risk to fester right under regulators’ noses. This is one more example why that White House official wanted me to explain to the people advising President Obama that relying on regulators to police derivatives is going to end in tears.

Those who like to downplay the risks of derivatives, all of whom are grossly conflicted because they have an economic interest in the instruments’ continued growth, argue that focusing on notional derivative contracts exaggerates the risks they pose. They argue that systemic risk should be measured in terms of the lower “gross credit exposures,” which, as noted above, stood at $21 trillion at December 31, 2014. Even this number, however, should make the hair stand up on the back of the neck of anyone who understands how these instruments work. But focusing on anything other than the larger notional amounts of outstanding derivatives demonstrates a basic failure to understand how modern markets operate.

James Rickards, who among his many accomplishments was brought in to help restructure the insolvent Long Term Capital Management hedge fund after it blew up after using too much leverage and too many derivatives in 1998, explains why the much larger notional figures are the relevant ones to focus on in terms of evaluating risk:

In complex systems, shorts are not subtracted from longs – they are added together. Every dollar of notional value represents some linkage between agents in the system. Every dollar of notional value creates some interdependence. If a counterparty fails, what started out as a net position for a particular bank instantaneously becomes a gross position, because the “hedge” has disappeared. Fundamentally, the risk is in the gross position, not the net.25

In other words, lower “total gross credit exposure” or “gross market value” are relevant when it doesn’t matter, i.e., when markets are functioning normally. In a crisis, as Mr. Rickards explains, counterparties either will be unable and/or unwilling to perform and the volume of broken contracts will overwhelm these institutions and render them instantly insolvent.

Financial markets are complex systems. They exhibit exponential rather than linear change because their constituents are interlinked and interdependent; any change in one component affects all of the other components in the system. Since financial markets involve human actors, they involve an additional, unquantifiable factor: the issue of trust. A market is ultimately built not on a foundation of money but on a bedrock of trust, which Francis Fukuyama defined as “the expectation that arises within a community of regular, honest, and cooperative behavior, based on commonly shared norms, on the part of other members of the community.”26

Debt instruments are contracts in which two parties agree to undertake certain obligations to each other. If they fail to fulfill those obligations, each of them can pursue legal remedies against the other in a court of law. The problem with such a regime is that the pursuit of such remedies takes years while the failure to meet one’s obligations can inflict immediate damage from which a party can never truly recover. Furthermore, in the event of a systemic crisis, the financial wherewithal to make the other party whole may not exist.

In 2008, the world caught a glimpse of what happens when financial counterparties lose trust in each other as well as confidence in the system. Many of them refused to meet their obligations under all types of financial contracts including derivatives contracts. This led the entire system to the brink of collapse. The financial system has placed itself in an extremely vulnerable position by allowing more than $600 trillion of derivatives contracts, including at least $16 trillion of credit default swaps as of December 31, 2014, to proliferate in the hands of a small group of firms.

Efforts have been made to tame credit derivatives, but these efforts largely miss the mark. The primary focus has been to move derivatives trades onto clearing houses that can provide regulators with greater transparency27 as well as to establish collateral requirements and similar rules. The problem with this approach, as I noted in the first edition to this book, is that clearing houses can inadvertently become new “too big to fail” institutions if they run into financial trouble during a crisis and are themselves deemed to pose systemic risk. If a clearing house were to experience financial trouble and become unable to meet its obligations, there would be an enormous temptation to bail it out in the name of financial stability; this would merely replace one “too big to fail” institution (the banks) with a new one (the clearing house). Furthermore, as discussed in Chapter 7, significant volumes of derivatives trades are still being conducted beyond the scope of regulatory scrutiny.

Credit default contracts on subprime mortgages rendered AIG insolvent and forced the U.S. government to bail out the insurer. The volume of outstanding credit default swaps is much lower today than on the cusp of the financial crisis. The notional volume of single-name credit default swaps declined from $25.1 trillion in 2007 to $10.8 trillion in mid-2014.28 The notional volume of multi-name credit default swaps has also decreased significantly from $20.1 trillion in 2007 to $8.6 trillion in mid-2014 (most of these are swaps on index products such as high yield bond or loan indices). Nonetheless, these volumes still dwarf the capital of dealers and the $2.3 trillion of total capital in the high yield bond and bank loan markets in 2014.29 If counterparties were to become unwilling or unable to perform again, all bets would be off. The system remains overleveraged and unprepared for another crisis for which the only response would appear to be a blanket government guarantee of the obligations of the institutions carrying these trillions of dollars of derivatives on their books.

These risks are far from theoretical. In 2013 – a mere five years after the collapse of Lehman Brothers and near-collapse of AIG, the latter of which would have constituted an extinction-level-event for the global financial system – JPMorgan lost more than $6 billion on trades involving credit default swap bets on high yield bond indices in the incident infamously known as the “London Whale.” This multi-billion loss happened right under the nose of the bank’s CEO Jamie Dimon, widely believed to be the best risk manager in the business. This illustrates that even those considered to be the smartest guys in the room don’t understand derivatives, which are highly complex and specialized instruments.

Furthermore, this unfortunate episode demonstrated once again that credit derivatives markets are thinly traded and highly illiquid and volatile; when market conditions deteriorate, counterparties become unable or unwilling to perform and create systemic dislocations that sink the values of the securities underlying derivatives contracts. In point of fact, despite their large notional volumes, credit default swap markets have always been (and will remain) extremely illiquid as investors learned during the 2008–2009 crisis when relatively low trading volumes led to huge moves in the credit spreads of troubled firms such as Bear Stearns and Lehman Brothers as described in Chapter 7.

Rather than reducing systemic instability, credit derivatives significantly increase systemic fragility and render illiquid underlying cash markets far more prone to large price swings not only in a crisis but in normal market conditions. This volatility and potential for loss (particularly in leveraged portfolios) has been disguised since 2009 by central bank-distorted markets. When the next market dislocation arrives, as it inevitably will, these derivatives will again earn their reputation as the “weapons of mass financial destruction” that Warren Buffett bestowed on them (although that has not prevented the Oracle of Omaha from investing in them extensively himself!).

Market Corruption

While the financial system is now populated by fewer “too big to save” institutions, it also appears that these firms are “too big to jail.” But the real story is that our government lacks the wherewithal to enforce its own laws.30 The highly concentrated nature of risk in the financial system is more problematic in view of the inability of regulators to rein in institutions’ bad behavior. Some of the world’s largest banks have engaged in serial violations of the law and paid large fines while being given multiple waivers shielding them from the loss of their banking licenses while virtually none of the corporate executives who committed the deeds in question have been punished criminally. Deutsche Bank’s ability to keep regulators at bay is just one example of the corruption of markets.

After the savings-and-loan crisis of the early 1990s, over 1,000 executives were prosecuted and more than 800 convicted. While some of these prosecutions, such as Michael Milken’s, were politically motivated and unjust, the lion’s share were appropriate. After the 2008 financial crisis, which unlike the savings-and-loan mess posed a true systemic threat, virtually none of the individuals who participated in the decisions that caused systemic harm has been prosecuted.

Speaking as a highly experienced attorney and market practitioner as well as a citizen, this breeds disrespect for the law and the government that is obligated to enforce the rules of fair play. As The Economist writes: “If banks have been involved in acts serious enough to qualify for billions of dollars in penalties, then a few more executives must surely have committed a crime.”31 Surely the crimes did not commit themselves, nor did they materialize out of thin air; they were the result of deliberate actions on the part of highly educated and presumably intelligent individuals who deserve to be punished. The fact that they were not punished is a profound regulatory and moral failure that weakens the financial system.

In his classic study of financial bubbles, Manias, Panics and Crashes: A History of Financial Crises, Charles Kindleberger pointed to a common characteristic of speculative booms: “Commercial and financial crises are intimately bound up with transactions that overstep the confines of the law and morality, shadowy though these confines be. The propensities to swindle and be swindled run parallel to the propensity to speculate during a boom.”32 In May 2015, the government entered into another in a long line of settlements with a group of large financial institutions: a $5.6 billion settlement for the manipulation of exchange rates in the foreign currency exchange spot market. This was just the latest in a series of instances in which individuals working at the heart of the financial system violated the law but nobody went to jail. This settlement followed a similar one involving the manipulation of LIBOR by some of the same institutions.

As part of the settlement, the SEC decided to give another waiver to these institutions that would allow them to conduct business as usual despite the fact that they were repeat offenders. This did not sit well with one SEC Commissioner, Kara M. Stein, who is a frequent target of The Wall Street Journal’s editorial page for being too tough a regulator. In this case, however, Ms. Stein should be applauded for speaking out; she should remind us of Brooksley Born, the former chair of the CFTC whose warnings about the risks of lax derivatives regulation were dismissed by The Committee to Save the World in 1999.

Ms. Stein dissented from the grant of the waivers to UBS, Barclays, Citigroup, JPMorgan Chase, and the Royal Bank of Scotland, pointing out that this was Barclays’ third waiver since 2007, UBS’s seventh waiver since 2008, JPMorgan’s sixth waiver since 2008, Citigroup’s fourth waiver since 2006, and Royal Bank of Scotland’s third waiver since 2013. She wrote that, “[a]llowing these institutions to continue business as usual, after multiple and serious regulatory and criminal violations, poses risks to investors and the American public that are being ignored. It is not sufficient to look at each waiver request in a vacuum.”

She pointed out that UBS’s waiver in the earlier LIBOR case was expressly conditioned on no further violations. That condition was violated by its conduct in the foreign exchange case, yet another waiver was granted. She continued: “It is troubling enough to consistently grant waivers for criminal misconduct. It is an order of magnitude more troubling to refuse to enforce our own explicit requirements for such waivers. This type of recidivism and repeated criminal misconduct should lead to revocations of prior waivers, not the granting of a whole new set of waivers. We have the tools, and with the tools the responsibility, to empower those at the top of these institutions to create meaningful cultural shifts, yet we refuse to use them.” In conclusion, she wrote, “I am troubled by repeated instances of noncompliance at these global financial institutions, which may be indicative of a continuing culture that does not adequately support legal and ethical behavior. Further, I am concerned that the latest series of actions has effectively rendered criminal convictions of financial institutions largely symbolic. Firms and institutions increasingly rely on the Commission’s repeated issuance of waivers to remove the consequences of a criminal conviction, consequences that may actually positively contribute to a firm’s compliance and conduct going forward.”

Large institutions that repeatedly break the law have come to see multibillion dollar fines as another cost of doing business. They may complain about them publicly, but until their senior executives are made to pay the ultimate price – the loss of their jobs or their freedom – little is going to change. This may sound harsh, but the systemic harm resulting from the manipulation of markets as important as LIBOR and foreign exchange is profound.

Years ago, the senior executives of Salomon Brothers lost their jobs after it was discovered that Treasury auctions were manipulated on their watch; and we don’t need to be reminded what happened to Drexel Burnham Lambert, Inc. and its visionary leader Michael Milken after he was alleged to have violated laws much less serious than the manipulation of major markets like interest rates and currencies. Today the consequences of law-breaking have been gutted due to regulators’ fears of destabilizing large institutions during an epic credit bubble, something that Charles Kindleberger warned about. We should heed that warning and stiffen our spines against the fraud in our midst before it drags down the system with it. Manipulating markets is not business as usual and should not be tolerated; it should be punished severely before it inflicts harm from which the system can’t recover.

The Geopolitics of Appeasement

In 2008 the world was facing an economic crisis, but at least the geopolitical situation was relatively stable. That is no longer the case in 2016. Inexcusable foreign policy failures by the Obama administration have left the world a shambles.

The only thing worse than being led by a president lacking the knowledge, experience, and character to lead a great nation is to surround that leader with advisors with similar limitations. But rather than a team of rivals, Barack Obama assembled a confederacy of dunces in Joe Biden, Hillary Clinton, Susan Rice, and John Kerry, a group that supported his worst foreign policy instincts and choices. Principled and competent members of the foreign policy team like Leon Panetta, Robert Gates, General Stanley McChrystal, and General David Petraeus left the administration early. As a result of chronic mismanagement of foreign affairs by the Obama team, the global hegemony of the United States has been profoundly weakened since the financial crisis. It will take decades for America and its allies to recover.

As Charles Krauthammer writes: “For all the sublimity of art, physics, music, mathematics and other manifestations of human genius, everything depends on the mundane, frustrating, often debased vocation known as politics (and its most exacting subspecialty – statecraft). Because if we don’t get politics right, everything else risks extinction.”33 The Obama administration has gotten virtually nothing right when it comes to foreign policy. In the hands of President Barack Obama and his foreign policy staff, statecraft has been a series of abdications of American power and appeasements of America’s enemies throughout the world. It is virtually impossible to name a single place on the globe that is more stable at the end of Mr. Obama’s two terms in office than when he entered in January 2009.

The geopolitical stage deteriorated to such a dangerous extent under Mr. Obama that the United States is facing existential risks that didn’t exist during the financial crisis. Many of the forces creating these risks were simmering under the surface in 2008, but they were so badly mismanaged by the Obama administration that one could reasonably ask whether the errors were intentional. After all, even incompetence is supposed to have its limits. But with this administration, that was not the case. Sunni-Shia conflict and radical Islamic terrorism are hardly new phenomena. Nor are Russian aggression in Eastern Europe or Chinese incursions in the South China Sea. Yet the responses to these destabilizing threats on the part of Mr. Obama, Mrs. Clinton, and the rest of this foreign policy team were so incompetent as to beggar reason.

In November 2008, Americans elected an untested one-term Senator with no foreign policy experience and a desire to set a different course from his predecessor, George W. Bush. Unfortunately, that course was based on an ill-advised retreat from America’s leadership role in a world where anti-American and anti-Western threats were intensifying. There were certainly lessons to be learned from the foreign policy mistakes of Mr. Bush. Tragically, Mr. Obama and his team learned the wrong ones. Much of the country was rightly dissatisfied with the state of the country as George W. Bush ended his tenure and Mr. Obama offered the promise of “hope and change.” But as President Obama approached the end of his second term, “hope and change” had dissolved into the ugly remnants of a sluggish and overindebted economy; record levels of inner city black-on-black violence and minority unemployment; a profoundly weakened American presence abroad; and direct threats to America and its allies from radical Islamic terrorists As disturbing as were the domestic policy failures of the Obama years, the foreign policy failures were potentially catastrophic.

The world grew far more dangerous in the years after the financial crisis than at any time since the end of the Cold War. This situation was exacerbated by a lack of resolute American leadership to counter rising threats from Iran, ISIS, Russia, and China. By late 2015, Iran was closer to achieving nuclear capability than ever before while solidifying its control over much of the Middle East after signing a one-sided (in its favor) nuclear deal with the Obama administration that was opposed by a majority of Congress and the American people. Russia occupied Ukraine and was threatening all of Eastern Europe while establishing a military presence in the Middle East for the first time to bolster Iran and Syria. China was asserting itself aggressively across the South China Sea. And ISIS was breeding home-grown terrorism throughout the West while carving a swathe of antediluvian horror across the Mideast. Make no mistake – these are not only geopolitical risks but economic and market risks.

Even those who were unhappy with the aggressive foreign policy of George W. Bush must conclude that things went from bad to worse under Mr. Obama. To some of us, Mr. Obama’s belief that mullahs in Iran, jihadists in the Mideast, and Russian and Chinese leaders would succumb to his charms was dangerously naïve and completely delusional. But in our wildest dreams, even Mr. Obama’s sharpest critic could not have imagined that this president would inflict as much damage on American interests as he has done during his time in the White House.

As his administration advanced, Mr. Obama managed foreign policy based on the assumption that what he regards as his superior intellect, knowledge, and judgment (for which, by the way, there is not a scintilla of objective evidence) superseded irrefutable and mounting evidence that his policies were producing results at odds with his own statements and the best interests of the American people. The worse the evidence became, the more he pursued the same damaging policies (an approach he shared with the nation’s central bankers). We need only look at the facts on the ground to see the ruins of Mr. Obama’s arrogant misconceptions.

Iran

In what will likely serve as his gravest foreign policy failure (unfortunately it is difficult to choose among so many disasters), the Obama administration entered a deal that will provide Iran with the opportunity to gain fast-track nuclear capability while freeing the country from crippling economic sanctions. The National Military Strategy of the United States is a report issued by the Chairman of the Joint Chiefs of Staff to the Secretary of Defense every year outlining the strategic aims of the armed services. The 2015 report, which was delivered in June 2015, described Iran as follows: “[Iran] is pursuing nuclear and missile delivery technologies despite repeated United Nations Security Council resolutions demanding that it cease such efforts. It is a state-sponsor of terrorism that has undermined stability in many nations, including Israel, Lebanon, Iraq, Syria, and Yemen. Iran’s actions have destabilized the region and brought misery to countless people while denying the Iranian people the prospect of a prosperous future.”34 Despite this warning from its highest ranking military official, the Obama administration agreed to a nuclear deal that gives the country a largely free path to nuclear capability after 15 years without limiting its support of terrorism or threats against Israel and the U.S.

The administration’s desperation for a deal despite Iran’s continued support for global terrorism and aggression in the Middle East would lead one to believe that the United States rather than Iran was in the weaker negotiating position. Yet as Karim Sadjadpour, an Iran expert at the Carnegie Endowment, wrote during the negotiations: “Iran is the one hemorrhaging hundreds of billions of dollars due to sanctions, tens of billions because of fallen oil prices and billions sustaining the Assad regime in Syria…And it’s Ali Khamenei [Iran’s Supreme Leader], not [U.S. Secretary of State] John Kerry, who presides over a population desperate to see sanctions relief.”35 With the Iranian currency plunging, inflation skyrocketing and the economy shrinking under the pressure of international sanctions, and with a bipartisan Congress pushing to further tighten the sanctions to increase the pressure on Iran in early 2015, Mr. Obama loosened the sanctions and injected billions of dollars into the Iranian economy while conceding in advance Iran’s right to enrich uranium.

Then, as the June 30, 2015, deadline approached (and passed), Mr. Obama and Mr. Kerry dismissed as “rhetoric” repeated incendiary statements by Mr. Khamenei and a vote by the Iranian Parliament rejecting demands that any agreement provide for inspections of Iran’s military facilities and immediate sanctions relief. In other words, while Iran was publicly stating that it had no intention of complying with any agreement (interspersed with calls of “Death to America” and for the destruction of Israel), Mr. Obama and Mr. Kerry continued to negotiate in good faith. Two weeks later, when a final agreement was reached, it allowed Iran to produce as much nuclear fuel as it wishes after 15 years, to limit inspections of its military facilities, to retain a significant number of its centrifuges, and to inspect its own Parchin nuclear site through a secret side deal with the International Atomic Energy Agency that was not disclosed to Congress (in violation of the law).

The agreement did not prevent Iran from entering new weapons deals with Russia, which it did before the ink was even dry on the agreement, or stop supporting terrorism. Iran was granted roughly $150 billion of sanctions relief that even the Obama administration admitted would be used in part to support Iran’s proxies Hamas and Hezbollah in their attacks against Israel. Reports indicated that Hezbollah had 120,000 rockets and missiles trained on Israel at the time the Iran deal was going to be signed by Mr. Obama, but that was apparently an insufficient threat to dissuade the president from moving forward from funding a group sworn to wipe America’s ally and the only democracy in the Middle East off the face of the earth.

The Iran deal was opposed by large majorities of both the Senate and the House of Representatives. While the Obama administration blocked any formal vote in the Senate (an act of epic moral and political cowardice), only 42 of 100 senators supported the deal. On September 11, 2015, the House of Representatives held a formal vote to approve the deal that was defeated by an overwhelming 269–162 majority. Numerous public opinion polls showed that an overwhelming majority of the American people objected to the deal. Nonetheless, Mr. Obama decided he knew better and moved ahead. It is impossible to recall another time in American history when a president so openly flouted the opinions of a majority of Congress, the country’s citizens, and its closest allies to appease a sworn enemy.

As Congress was registering its disapproval of the deal, Iran’s Supreme Leader was telling the world that Israel would not exist in 25 years, another in a series of inflammatory speeches repudiating any claims by the Obama administration that the nuclear deal would create a rapprochement between Iran and the West. Mr. Obama, of course, claimed that he was too sophisticated to believe such threats. The world also learned the same week that Congress rejected the deal that Russia had been secretly mounting a major military build-up in Syria to back the Iranian puppet regime of Bashar al-Assad, leaving the Obama administration scrambling to explain away another foreign policy debacle of its own making. And when the International Atomic Energy Agency (IAEA) issued its final report on Iran’s nuclear program as part of the deal in late 2015, it reported that Iran had not cooperated and had withheld key information required by the agreement. It is clear that Mr. Obama signed an agreement that only one party intends to honor, and that party is not Iran.

In entering the Iran nuclear deal, the Obama administration violated two clauses of the Constitution. It did so because it knew it could not enter the agreement by lawful means. First, it breached the Treaty Clause, which requires the president to submit major foreign policy agreements that constitute treaties to the Senate for two-thirds approval. Article II, Section 2 of the Constitution states that the president “shall have Power, by and with the Advice and Consent of the Senate, to make Treaties, provided two-thirds of the Senators present concur.” Knowing it lacked the requisite 67 votes to approve this agreement, Mr. Obama deemed the agreement to be an “executive agreement” that would only bind Mr. Obama and not subsequent presidents. In fact, only 42 members of the Senate supported the deal, 25 votes short of what would be necessary for a treaty. Of course, even if a subsequent president repudiates this unlawful agreement, the sanctions relief cannot be reversed.

The Obama administration also violated the Take Care Clause of the Constitution. Article II, Section III holds that the president must “take Care that the Laws be faithfully executed.” In May 2015, both houses of Congress passed by overwhelming majorities, and the president signed into law, H.R. 1191, the Iran Nuclear Agreement Review Act of 2015 (the “Review Act” also known as the “Corker-Cardin Bill”) that provided for congressional oversight of the nuclear deal. The Review Act required the president to submit to Congress the text of the deal as well as all “annexes, appendices, codicils, side agreements, implementing materials, documents and guidance, technical or other understandings, and any related agreements, whether entered into or implemented prior to the agreement or to be entered into or implemented in the future.” The administration violated this language by failing to provide to Congress the side agreements between Iran and the IAEA that provided, among other things, that Iran would be permitted to inspect its own Parchin nuclear site (the agreement Iran breached in late 2015). So in addition to violating the Constitution, Mr. Obama broke his word to Congress by failing to provide these side agreements.

In a further end-run around Congress and the American people, the Obama administration allowed the deal to be brought to the United Nations Security Council for approval before even bringing it to Congress, giving Vladimir Putin and Xi Jinping the first word on the agreement.

President Obama’s deal with Iran ignored the legitimate concerns of Israel, Egypt and Saudi Arabia and led these traditional American allies to seek new alliances and, in the case of the latter two, their own nuclear weapons capability. While the Israeli Prime Minister tried to explain to Mr. Obama that “the enemy of my enemy is my enemy,” the Middle East will now be governed by the adage “the enemy of my enemy is my friend.” Such arrangements are fragile and unstable. Obama’s dismissive treatment during his administration of Israel, the only democracy in the Middle East and a steadfast ally, has been a national and moral disgrace as well as a profound strategic blunder that weakens the influence and interests of the U.S. not only in the Middle East but throughout the world. This treatment most likely emboldened several Jewish members of Congress to vote in favor of the Iran nuclear deal, shamefully selling out their constituents and their principles. When you openly mistreat one of your most important allies, your other allies question your reliability and your character.