The best-seller The Perfect Storm tells a true story of a ship caught in a vortex created by a continental low-pressure system, a tropical hurricane, and an arctic cold front off the shores of Newfoundland.  This complex disaster comes to mind when trying to describe the nature of the crisis that nearly closed down the routine clearance and credit functions of the U.S. financial sector, precipitating an avalanche of stock and commodity prices.

Three overbearing global financial forces have collided to produce this ongoing global financial crisis.  The first force was the great credit binge, which has grown exponentially since World War II.  The current total of outstanding U.S. credit is 350 percent of GDP (Gross Domestic Product, the nation’s output).  Between 2000 and 2008, dollar-denominated credit has grown relentlessly at nine percent per year, well in excess of GDP.  This growth of credit is not sustainable as a substitute for saving for investment.

The second force is the devaluation of the dollar—that is, the decline of the foreign exchange value of the U.S. dollar.  Since 2000, the United States has hemorrhaged more than five trillion dollars abroad in manufacturing trade deficits.  This accumulation of trade debt far exceeds the $2 trillion of federal debt accumulated over this period; even if we add to the federal debt the $2.25 trillion stimulus and bailout plans, the trade debt is still larger.  Even though the price bubble of imported energy and other commodities has burst, our trade deficit is still increasing U.S. debts at a rate of three quarters of a trillion dollars per year.  As measured by the Federal Reserve’s major currency index, from 2000 to mid-2008, the dollar was devalued by 30 percent, though it has since bounced back 10 percent.  The devaluation is likely to return to unprecedented lows as soon as the current market instability is soothed and emergency foreign reserves in dollars is not considered necessary.  A sound national currency is second in importance only to military capability to secure our nation’s homes and borders.

Third is the current worldwide recession, which, in all likelihood, will be steeper and longer than those of recent memory—possibly even ending in the second economic depression of the last hundred years.  The United States has made globalism her priority at the expense of national interests, and we have promoted consumption to the neglect of saving for investment.  In the short term, fair trade abroad and more frugal domestic policies will be hard to secure.  But these are essential for our economy both in the short run (to recuperate from recession), and in the long run (for national and global security).

What made this collision inevitable was the 1999 deregulation of banking by Congress, which repealed the Glass-Steagall Act.  (This measure was adopted in the Great Depression to separate commercial from investment banking, and later from insurance companies.)  The effects of the mergers that followed this deregulation were compounded by the Federal Reserve’s lax regulation of lending, which has allowed derivative securities—credit swaps and tranches (portions) of CMOs, CDOs, and SIVs—to replace equity in backing up loans, enabling an explosive growth of credit.  Clever offset positions used these securities tools, which were “assured” by rating agencies to be low risk, to sell derivative tranches of the issuers’ collateral in order to gain rich commissions, retaining only a fraction of the tranches.  The whopping $120 trillion in complex securities derived from $50 trillion of credit issues has bewildered both investors and regulators, who bought the bubble on faith.  Both the Clinton and Bush II administrations used the Community Reinvestment Act (CRA) to “encourage” mortgage bankers to issue “subprime mortgages” based on zero equity, dubious incomes, and little justification for lending in order to make home ownership possible for the poor.  Conservative banks were transformed into financial casinos.  And the derivatives allowed credit to expand in virtually unlimited proportions.

Derivatives of pools of CRA mortgages formed the basis of highly rated tranches of the pools; the remaining high-risk tranches were offered as high-yield junk securities.  Soon, pools of used-car loans, credit-card debt, and commercial loans of questionable rating were miraculously converted into safe-rated derivative securities as well.  The derivatives that had stimulated the growth of Fannie Mae, Freddie Mac, the FHA, and other federal agencies or “affiliates” that inflated the mortgage market for real estate were joined by the private financial institutions and affiliate hedge funds.  The front-end fees of the financial institutions were astounding, and the profits of the U.S. financial sector rose to more than one third of all corporate U.S. profits.  The unbridled growth of the residential real-estate market and of mortgages offered for speculative investments in rental houses and unaffordable homes led to the collapse of easy credit when the interest on adjustable-rate mortgages adjusted upward and delinquent mortgage payments soared.  Subprime mortgage and other garbage pools quickly lost their luster.  Credit-swaps gained rapidly as substitutes for equity as collateral, and varied derivatives rose to enormous levels.

The collapse of credit markets, particularly those for mortgages, led great investment and commercial banks, and the giant federal “affiliates” Fannie Mae and Freddie Mac, to insolvency, forcing them to plead for bailout money from the federal government.  Potentially solvent institutions were merged, while the insolvent but operationally functional were taken over by federal regulators to repackage them for disposal to private investors.  Fannie Mae and Freddie Mac were nationalized as federal agencies.  The doors of commercial banks were mostly kept open, but the United States found herself sinking into a serious recession.  The same thing happened to other countries who are dependent on the U.S. market and those devalued dollars they have accumulated, thanks to U.S. trade deficits.  Their crises mirror ours, since the liquidity and value of dollarized and domestic credit instruments have deteriorated.

Reversing the conditions that caused the perfect storm will not be enough if we want to return to sound economic policies.  U.S. producers must be provided a level playing field through border-adjusted consumption taxation, which would balance tax rebates on exports with imposts on imports.  Washington also needs to enforce our trade agreements and protect our intellectual property rights.  This will help close the trade deficits, as well as the federal and private saving deficits—deficits that prevent the investment necessary to create jobs and maintain prosperity.

The perfect storm shows us that complex derivatives are no substitutes for equity.  Both the Wall Street cabals and the federal officials who turned a blind eye to their illegal practices must be relentlessly exposed, if not prosecuted.  The insistent demands by libertarians, neoconservatives, and supply-siders for unregulated free markets reflect their naiveté about human nature.  Civilization requires laws and their enforcement, and police departments do not serve only “police states.”  Wall Street is an unbridled market personified by powerful, arrogant management that flaunts its incomparable greed.  It requires stronger regulation by agencies that are tougher than the current Federal Reserve, OCC, FDIC, and SEC.

At this moment, a new administration is feverishly making plans for pulling the economic ship from the storm.  These plans do not address the real problems we are facing nor provide remedies for reform.  They could make the storm much worse.  Time will tell.