Ruminations, March 28, 2010

Can a country be too big to fail?

When a failing company fallsinto the category of “too big to fail,” at least in this country, thegovernment provides it with cash, financial guarantees and protection fromcreditors while it restructures. The rationale is that the failure of a largecompany will cause a failure of other companies and perhaps the entire economicinfrastructure of the country. Therefore, those to whom we have entrusted theresponsibility deemed that General Motors, Citibank and American InsuranceGroup were among a group of companies whose failure could wreak havocthroughout the entire country.

We don’t often considercountries as failures. After all, the land of a failed country always exists,the citizens continue to live and work, the language(s) is still spoken and anew political environment inevitably evolves. Nevertheless, countries do failand, when they do, there are few who have the resources or the will to savethem.

The monarchy of 18^thcentury Francewas fortunate to have among its citizens the classical economist Anne-RobertJacques Turgot. Turgot was a contemporary of Adam Smith and a more advancedeconomic theorist. He developed the theory of interest, rationalized thebenefits of free trade, advocated a tax system in which all citizens paidtaxes, opposed state interference in markets, opposed the privileges extendedto guilds (i.e., 18^th century unions) and supported aid and jobs tothe masses during economic downturns. Turgot rose to be finance minister andbegan to produce France’sfirst budget. He also began to take steps to implement his basic principles oflow taxes and no borrowing. However, by the time Turgot took office (1774)French finances were in dreadful conditions and Turgot’s proposals, which mayhave saved France,were aggressively opposed by the powerful in the king’s court. Turgot wasdismissed in 1776.

After Turgot left thegovernment, Francereturned to its profligate ways. It abandoned the budget, so there was no realway to tell what the financial picture was. Inflation increased dramatically(as high as 1,000 percent annually) and tax revenues fell. Unemployment in someFrench cities hit 50 percent. Franceadded to its economic woes by embarking on a seven-year war with Englandand by loaning money it did not have to the UnitedStates to support the American Revolution. Wheredid Franceget the money to support these endeavors? They secured large internationalloans that they could not, under the fiscal polices in place, repay. In 1789, Francecollapsed during the French Revolution. Was the real cause of the collapseeconomic? Probably.

Francewas one of the major countries in the world. Economically, it was one of thewealthiest. By the standard of the day, it was too big to fail but fail it did.

Another country “too big tofail” was the Soviet Union. During the firsthalf century of communism, the Soviet Uniongrew from a backward agrarian state to a backward industrial state. Part of theproblem was that because of the standard state secrecy and propaganda, precisefigures were not available and no one really knew how bad the economy was untilit became impossible to hide.

When U.S. President RonaldReagan took office, he initiated a defense spending program that the Sovietstried to match. By the time Reagan left office, UnitedStates military spending had topped $426 billionand 5.8 percent of the Gross Domestic Product (GDP). At the same time, Sovietmilitary spending is estimated to have been over $330 billion and 20.7 percentof its GDP.

With shortages in the Soviet Union due to pricecontrols, a surge in the money supply leading to high inflation (officially,there was no inflation, only government-controlled price adjustments and theblack market) and enormous budget deficits ($81 billion, 9 percent of GDP), by1989 General Secretary Mikhail Gorbachev had to try something. What Gorbachevtried was to save communism while implementing enough capitalism to solve hisproblems through greater market freedoms but without the concomitantinfrastructure. What he ended up with was what his successor Boris Yeltsinreferred to as trying “to mate a hedgehog with a grass snake.” This exacerbatedthe problem, and by 1991 “no monetary or fiscal control worthy of the nameremained” (Richard F. Kaufman and John P. Hardt in their book The Former Soviet Union in Transition).The Soviet Union failed.

In 2010, Greeceand Portugalare in severe economic crisis. Are they “too big to fail?” No; and that is whythey will not fail. Their economies, while perhaps large compared with 18^thcentury France,are small when compared with current world economies. Furthermore, statisticalreporting gives us a better read as to where their problems lie and, mostimportant, there are steps being taken in the European Union and theInternational Monetary Fund to strengthen them.

Are there, then, any countries that are ineconomic crisis that are “too big to fail?” Yes: the UnitedStates. Current gross debt (private andgovernment held) is over 86 percent of the GDP and increased by $2 trillionlast year to $7.8 trillion; it is expected to top $18 trillion by 2014 – almost150 percent of GDP. And, there is another $5 trillion in obligations owed byFannie Mae and Freddie Mac, two government-sponsored enterprises. Our tradedeficit for 2008 and 2009 was over $1 trillion. The majority of the public,economists and foreign governments are skeptical of the purported deficitsavings of the recently passed health care law, and perception influencesbehavior.

But there are differences between the 21^stcentury United States and 18^thcentury France, and betweenthe 21^st century United Statesand 20^th century Soviet Union. The U.S.rates of growth (either because of or in spite of, the Obama Administration,depending on your point of view) are realistic and though low, they showpositive gains; inflation continues to be low. Military spending although high(4.7 percent of GDP), continues to be within acceptable limits. And, perhapsmost important, the U.S. dollar continues to be the world’s reserve currencyand the primary vehicle for international trade. Foreign entities own almost $4trillion of U.S. debt and ifthe United Statesfails, they stand to lose it all. As General Motors, Citibank and AmericanInsurance Group were to the United States, the U.S. is to the rest of theworld: Too big to fail.

But don’t let it go to your head. Just becausethe economic failure of the U.S.is a scenario that everyone wants to avoid and will work to avoid, doesn’t meanthat the United Statescan’t fail. Although there is no immediate action anticipated, there has beentalk of replacing the dollar as the world’s reserve currency. Late last year, Chinasold some 5 percent of its U.S.debt holdings. At some point, in order to pay down the debt, a big tax increasemay be employed; tax increases reduce economic growth and the tax base on whichtaxes are collected.

We may be too big to fail, but that doesn’tnecessarily mean we can’t fail.

The people speak

Polls say that a majority ofthe public is opposed to the recently passed health care plan. Is the majorityright? Conservative politicians would say yes and liberal politicians would sayno.

Remember that PresidentObama received a majority of the vote in 2008. Was the majority right?Conservative politicians would say no and the liberal politicians would sayyes.

Remember that President Bushreceived a majority of the vote in 2004. Was the majority right? Conservativepoliticians would say yes and the liberal politicians would say no.

The point is that neitherliberal nor conservative politicians decide who is right. When a politiciansays “The American people want…” that’s just posturing and usually reflectswhat the politician wants.

When the people speak, theirdecision depends on the time and their mood and is usually through the ballotbox. 

Quote without comment

Paul Volcker, Chairman of the President’sEconomic Recovery Advisory Board and former Chairman of the Federal Reserve,1979-1987, speaking at the AsiaUSA Forum in SanFrancisco on March 10: “Thedollar will continue to hold the status as the world's reserve currency becauseno other has the power to replace it.”

Rob Kulak
http://www.examiner.com/x-15968-Hartford-Independent-Examiner