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the crash interview: edward luttwak
edward luttwak
He is a well known military strategist and consultant, and Senior Fellow at the Center for Strategic and International Studies in Washington DC. He is the author of Turbo Capitalism: Winners and Losers in the Global Economy. (Interview conducted in the spring of 1999.)
Describe the world economic situation in the aftermath of the rolling crisis that began in Asia in 1997.

Everything is much as before, except that before, this whole outflow of investment from the center to these strange, exotic, new countries was done very confidently. Now, whatever money remains there is very nervous and is just waiting to come out. A lot of people are watching the course to see when they can come out, when the loss level reaches a point, as things improve, that they can afford mentally to take a loss. So everything is the same, but everything is different. Before everything was propelled by optimism, and now everything is dragged down by pessimism, often unwarranted.

There's an argument that is ongoing about who's to blame for this crisis--crony capitalists, weak leaders like Yeltsin, investors who panicked and fled, Washington's policies. Where do you weigh in?

Well, the largest cause of what happened is impersonal; don't blame this man or that man or even a group of people. It's simply the fact that a whole capitalist system--which is counter-weighted in the United States by powerful, aggressive lawyers and legislation and by a whole Calvinist mentality--all this system gets shipped abroad where you do not have the Calvinist counter-weight, the legal system that keeps everybody on the watch. It gets transferred there and instead of being a balanced automobile with engines and brakes, it's all engines and no brakes.

By merely transferring the same system that works in the U.S. to a country like Indonesia, you guarantee yourself a crash, because you simply don't have the counterweights ... I call it 'turbo-capitalism,' meaning accelerated capitalism and often without the brakes. Therefore, by merely transferring the same system that works in the United States to a country like Indonesia, you guarantee yourself a crash, because you simply don't have the counterweights. In this case, let's say, you don't have independent bank regulators, very aggressive, very well-equipped, very well-financed ... making sure the banks don't overlend, don't give sweetheart loans to shareholders or creditors and such ... I call it "turbo-capitalism," meaning accelerated capitalism and often without the brakes and the counterweights to make the system balanced, in equilibrium ...

Our own U.S. government officials have been going around the world preaching privatization, deregulation, the opening of international markets, reducing tariff barriers, in all these different ways unleashing the market, releasing the market. They never went around saying to people, "Wait a minute, before you do any of the above you have to put into place a very strong legal system. You have to breed aggressive liability and tort lawyers."

... Were the U.S. government officials shortsighted, or was it, in fact, ideological, that we wanted no controls?

In reality, in the United States, even after deregulation ... Americans live in the web of laws and regulations. This is a society which proclaims its freedoms, but which has, in fact, very strong regulations in all [arenas]--environmental regulations, occupational safety regulations, anti-discrimination regulations, architectural regulations, building codes, and so on.

They are extraordinarily restrictive of life because they are obeyed. When the United States embarked on this crusade ... They were driven ideologically by this notion that it's a magical market, market worship, and so on. They just did not ever say anything about the other part, namely, the system of counterweights, legal and regulatory counterweights, which remain very strong in the United States, even though the industries have been deregulated.

Why were the lessons of the Mexico crash not learned? ...

... Why weren't the lessons of Mexico learned? How come we had [a] big crisis, financial crisis, in Asia in 1997, which is analogous to the one we had in Mexico in 1994? Only three years have passed. The lessons should have been learned. Investors should not have been flooding East Asia with money after their experience with Mexico.Now, the Mexican crisis had all the elements of the Asian crisis of '97 and the Russian crisis of '98--a government that borrows short to invest long. It always has to keep reborrowing the total amount of its debt ... which every month it has to go back and raise lots of funds just to keep going. Banks which make large and incautious loans, often to insiders or friends of friends, and a lot of the money being used for projects that cannot possibly work out, like the toll highway in Mexico to Oaxaca. Wonderful road, but nobody can afford the tolls. It's [in] a desert and enormously costly.

Why weren't the lessons of Mexico learned? It had to do with the way the rescue was done. The rescue was very quick, very rapid. There was massive intervention. Everything was propped up, the peso was devalued, but then the devaluation was controlled. The financial superstructure was, therefore, rescued long enough and to the degree sufficient to enable the bondholders to take the money out. So that, in fact, very few investors lost money in Mexico. The consequences were absorbed in Mexico itself. Once the financial superstructure collapsed, then, of course, sales went down, production, employment, and so on. A lot of Mexicans lost their jobs. Other Mexicans suffered cuts, drastic cuts, in their incomes and many businesses, small businesses, have disappeared.

The Mexicans are still suffering today, four or five years later, for the consequence of the crisis, but the bondholders were rescued in a matter of hours or days. The consequence was that the incautious and reckless investors who had gone into Mexico and sent the money down, which was then misused because of a lack of regulations and controls, therefore, did not learn the lesson that they have to be careful with their money in other remote and exotic locations. Of course, the money went into Southeast Asia, and you had the same cycle phenomenon. And then you went into Russia with the same results.

The Mexican rescue had two defects. Defect number one was that the investors were not hurt and didn't learn the lesson.The second defect is that because the investors were not hurt, all the consequences were absorbed in the economy itself as opposed to being absorbed in the financial superstructure ...

Have changes on Wall Street added to these problems?

Well, the changes in the market, the turbo-capitalist changes which transform remote villages in Mexico, obviously, are most powerful on Wall Street itself, right at the source. There, the transformation has been almost a social transformation.

The Wall Street houses, namely, these places where there were people ... who used to take the savings of the country and package them in ... bonds and shares and warrants, and then conveyed them one way or the other for investment in the United States or abroad, these finance houses used to be run by people who called themselves financiers or ... investment bankers, sometimes merchant bankers.Now, somewhere in these august establishments there used to be a nasty little place where there were people known as traders, because in order to acquire the savings and channel investment through various forms of securitization, which is creating bonds, you also have to be in a market because when you have made some securities you have to sell them. Occasionally, you have to want to liquidate so you have to buy them and so on.That trading function was an ancillary function to the main function, which was to gather savings and make investments. That trading function has become bigger and bigger, and these places are not run any more by people whose focus is on gathering savings and making investments. They have been completely taken over by the traders whose focus is on, of course, buying and selling day-to-day paper or by the hour or by the minute or sometimes by the second in order to make these very small arbitrage profits or to make larger cyclical or tumble up and down profits and so on.

The traders have taken over the investment bankers; therefore, there's been a whole change in sociology, in mentality and habits. I mean, it used to be that you didn't invite the traders to dinner because they might steal the silver, you know. They might take one of the spoons.

Now the traders run the bank, and the whole mentality is, of course, the transactional profit. The only thing that they don't like is stability. Any form of instability, whether the market's going up or the market is going down, is perfectly okay for them. Stability they don't like ...

Do the traders pay any attention to the consequences of their trades, their actions, in a country like Thailand, Russia or Indonesia?

You mean, the social consequences?

Yes.

Oh, no, no, no. That would be absurd. I mean, if you're a trader and you're facing a screen and you're trying to make some arbitrage--buying a little less and selling for a little more in a different market--the last thing on your mind is going to be consequences. The fact that you sell the Thai baht, somebody in Thailand may have to sell his daughter to a brothel in Bangkok, that's the last thing you're going to think about and, indeed, it would be very unfair to ask him to think of that ... The traders ... are simply attempting to make the difference between buying and selling; therefore, you've had a complete transformation in the heart of Wall Street in the balance of power within these places ...

How would you characterize the advice that the U.S. government has given Russia since the collapse of communism?

Well, the total advice flowing into Russia ... predominantly, it was American advice. They did not get Italian advice or French advice ... France and Italy were not models. They did not propose themselves as models. They were not accepted as models. Instead, the model was the American model, so the effect was to go from a completely state-owned economy where everything is run by the state except for very minor and illegal services and minor trading ... to the most extreme capitalist system ... The only model that was proposed to them was the model of maximum privatization. Don't privatize slowly or halfway, privatize everything, maximum deregulation, maximum liberalization, and so on ...

What was not proposed to them, once again, were the counterweights. Nobody told the Russians that, if you go from a state-owned economy to a free-market economy, you have to have the things that make the free market work, namely, the powerful legal system, powerful regulations.

And the creation of their short-term treasury bills, their GKOs?

Well, Russian public finance started really quite well. The basis of it was that Russia was exporting a lot of raw materials--oil, gas, timber, and gold. Prices were reasonably high. Therefore, even though ... they were running some negatives on some of the payments, the overall balance of payments was very positive. Every month, there were a couple of billion dollars of balance of payments surplus, a bigger trading surplus, and that was what you actually had in hand. The Russian treasury began every month with some new money produced by its large exports of raw materials.

Then, on this sound basis, the Russian treasury started taking advantage of the fact that it was much easier to raise short-term money than long-term money. The future of Russia was uncertain. Five-year bonds or 30-year bonds, if the Russians had issued 30-year bonds the way the U.S. Treasury does, nobody would have bought them. So they found that, on the other hand, that people were quite willing to buy short-term bills. [These are] the famous GKOs, as they are called in the West, initials which to Russians now sounds as sinister as KGB ... .

There's nothing wrong with that. Everybody does that. Things started going wrong when, instead of having most of the debt, let's say, in medium-term four- or five-year notes or bills or bonds, which means that your debts you can cycle it over the years, more and more of the funds were raised by issuing these one-month GKOs. Suddenly, even though the total indebtedness of Russia remained rather low considering the size of the economy and the size of their exports, much of it was in the short-term notes that they add to these bills, which they had to keep turning over.

So, let's say we have two guys and one guy has debts of a million dollars, but they are long-term debts; it's a 100-year mortgage. Well, he can manage that. Another fellow only has debts of $100,000, but he raises the money on monthly bills, so every month he has to find $100,000, every month he has to find a new $100,000 to repay the bill and keep it running.

Now, the man who owes a million dollars actually has a much easier life than the one who owes $100,000. That is the difference between long and short. What happened in the Russian case was that with the vigorous participation of Western banks and trading hands which got involved in the game, they started issuing these GKOs. And the moment there was any instability or nervousness the interest rates shot up.Suddenly, we saw a Russian treasury, which started rather soundly, becoming a treasury dependent on the short-term notes. The interest rates would shoot up. Suddenly, there were 40% interest rates. You could make 30% interest. Instead of getting 5%, 6% from the U.S. Treasury or 4% from the Germans or 2% from the Japanese, you can make 30% in Moscow, 40% by buying GKOs.

Naturally, there was an enormous flow of money into it, reckless short-term money, brave short-term money ... watchful short-term money, and also money that should never have gone there, money from pension funds, of all things, someone in the Midwest [who] ends up buying short-term things.

... The bills reached those high levels, and the system became unraveled when the thing that was supporting it, namely, the healthy Russian balance of trade, the result of big Russian exports of oil and gas and timber and gold, the Russian balance of trade started deteriorating, declining because of the worldwide crash in commodity prices. That's the most sinister aspect of the economy, as we speak, is that commodity prices everywhere are very low, extremely low, whether it is hog pork bellies in Chicago, soya in Brazil, oil for the Russians ...

Once the Russian balance of trade started going down because the price of oil and timber and gas collapsed, then for the Russian treasury you no longer had this healthy balance of payment surplus that was coming in every month, which was underpinning the foreign confidence in the whole Russian public finance and concretely providing money to repay the investors.

Once this expressed itself through the sharp rises in the interest rates with the GKOs, then the warning signs should have come in. People out there in the investment community should have known that if somebody pays you 40% or 50%, that is not sustainable ...These things don't last, cannot last, and they should have been pulling back. That would [have], of course, [caused] a short-term bill crisis in Russia, but then it would have given warning and time for more serious remedies. Instead, they remained incautiously, the lessons of the Mexican crisis being completely forgotten because, indeed, the Mexico rescue was so fast and so painless, really.

... Things came to a head in August 1998--August 13th--Black Thursday when everything collapsed. But the underlying phenomenon that mainly happened was the fall in commodity prices, which reduced the basic ability of the Russians to pay back anybody.

Who should have understood what was going on? Shouldn't the U.S. Treasury and the IMF, who are still deeply involved in the Russian government's decisions on its economy, have known what was going on?

What happened was that officials at the U.S. Treasury, people like Undersecretary [Lawrence Summers], Secretary Rubin, they were watching this, but they have statutory responsibilities for the domestic economy. They are responsible for aspects of the American economy. They have no power or responsibility in regard to the Russian economy. Did they issue warnings? They didn't. They could have issued warnings; they didn't. That's the limit of the responsibility, if any.

The most serious responsibility is American private institutions. Goldman Sachs, as far as I know, went into the situation very late in 1998 and manufactured bonds, earned very large figures to make Russia's state bonds, which it then proposed and sold to American mutual funds so that the savings of Americans--could be small personal savings or large mutual funds--were then invested in Goldman Sachs paper, which was Russian state debt paper, which naturally lost much of its value when the crash happened.

Note that these were not in rubles. So they were not affected by the ruble devaluation. The interest rates were not as phenomenal ... because they were not short-term at 40% or 50% or 100%, but rather longer term at 10%, 11%, modest percents. But, of course, basic confidence in Russia collapsed. Therefore, these were drastically discounted. The mutual fund managers did not want to hold them because this is another consequence of disembodied, remote, indirect capitalism, which is that people in the middle are not really the owners.

... Now, Goldman Sachs is not being penalized for this because it operates in this manner internationally between the Russian treasury and the world financial market assets. Of course, in the United States itself, Goldman Sachs has sold things to mutual funds, which may or may not retain the memory of what Goldman Sachs sold to them. But the American authorities, which would regulate such conduct domestically, not to the point of eliminating risk, but there are responsibilities about conveying information, for example, failure to warn, have no responsibilities internationally, and that is the big non sequitur. This is the big contradiction, which is that enormously tight regulations domestically or at least tight observation, tight monitoring, close monitoring and nothing abroad.

Can you talk some more about the worldwide commodity crisis?

As we speak, there's a presumption of prosperity. Indeed, there are many sounds of prosperity, a lot of employment, and so on. But, in fact, in the global economy, a very sinister development is taking place, which is a global crash in commodity prices.

It sounds very technical--pork bellies, copper bars--but in reality, primary producers, whether it's Americans who raise hogs, Zambians who mine copper, oil producers, whether it's Russia, Norway, Saudi Arabia, or any of the other, Indonesia, Venezuela, are all suffering enormously because the prices are so low that the income has collapsed.

... Now, please note the very time, [at] the very top of the world economy in Wall Street, at the peak of the superstructure, you have a fantastic boom, a bubble of explosion in share values at the base of the world economy, you have a drastic loss of income.

Now, that's not the old inequality tale--some are very rich and some are very poor. That has to do with stability. In fact, the last time we had Wall Street in the stars and the commodity prices really low was in 1929. That was the beginning of the Great Crash, as you would expect because Wall Street, after all, it sells the shares of companies which produce and sell things.

Somebody, somewhere has to buy something in the end from one of these companies to make that share worth for them what it's supposed to be worth, or at least a fraction of that. And that buyer, in turn, is somebody who's sustained by his own employment, which depends on these other sales. All of it, then, flows back to the base, the raw material base, whether it is the pork bellies or the beef ranching, and all of those incomes have crashed.

That is the most sinister aspect of the present world situation, not surprising because if you look at the sources of the demand, the basic source of demand, the banking crisis in Japan strangles demand. The banks are not there to lend money.

In Europe, very deliberately, they are running what is called, technically, a tight fiscal policy for the sake of the Euros, and they have basically raised taxes and cut government spending. In addition, the interest rates are relatively high ...

In the United States, in the Clinton administration proudly announces and privately talks of its surplus, "We're not running deficits any more," or "We have a surplus." That might be very virtuous, but it does mean that the U.S. government is taking in more money from taxes than it's putting out. Therefore, along with Europe and Japan they are strangling the amount which is impacting on the base of the world economy.

The huge contradiction, of course, is that we are in a global economy, and yet, when President Clinton plays his politics to run a surplus because he wants to be tougher than the Republicans, and when in Europe they pursue more maniacally the Kamikaze act, and in Japan they have the bank problem, they do not put one, two, and three together to realize what it does conjointly to the world economy, namely no demand, lack of demand ... And this is an endangering poverty ...

Do you think the possibility of a global recession, if not depression, is a very real one right now?

As we speak, the possibility of a global recession is a very real one. On the one hand, you have the base of the world economy. You have the impoverishment that comes from very low commodity prices stretching from Wisconsin to Chile, Wisconsin pork bellies, Chile copper, everything in between, the oil in Venezuela, and so on. It affects entire countries ... Somebody should be out there pumping demand into the system. Instead of pumping demand, we have the United States running a surplus because of the politics of it.

... Now, what was avoided would be the coherent, united, harmonious, and smart intervention by the authorities. Given what happened last October when the crash took place, there were some waves and panic, and people were suddenly afraid that they wouldn't have a pension, their mutual funds would disappear. People asked themselves how much money they still had invested in the old-fashioned way, you know, just by putting it in bonds and banks.

At that moment, there was no harmonious response. It was all done by the American Federal Reserve. Alan Greenspan and the Federal Reserve acted. Everybody else talked or did nothing ... I don't think [the Federal Reserve is] going to be sufficient to prevent the [next] crash, which will come sooner or later ...... It's like having a great ball there on the top of an incline of a slope and when accelerated down, the only thing supporting it is just the Federal Reserve, the American regulatory financial and control system, because no global mechanism has been set up; no coordination has really been set up between the American and the Europe and the Japanese economic controlling entities.

At most, there is a liaison between the central banks, but they only control monetary policy, so we have a contradiction here. We have a global, a financial and an economy with no global financial control mechanism, therefore, a crash is only a question of time.

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