Talk:Political interpretations of The Wonderful Wizard of Oz/JulianDelasantellisArticle

When the big guns fail Julian Delasantellis Asia Times Online Aug 21, 2007

In the 1939 movie adaptation of L Frank Baum's 1900 novel The Wonderful Wizard of Oz, all the characters were in awe of the tremendous magisterial power of the Wizard. Dorothy, the friends she met on her journey (the Tin Man, the Cowardly Lion, the Scarecrow), and all the other various citizens of Munchkinland, they all believed that it was the Wizard, in his castle in the Emerald City, who possessed the powers to make all their problems right, to make all their lives sweet. Then Dorothy's little dog Toto pulled away the curtains that concealed the Wizard's supposed magic machine, and found only smoke and mirrors; as for the Wizard himself, he was just a rather ordinary little man.

Last week, chance and circumstance pulled down the curtains covering the smoke and mirrors of the operations of the US Federal Reserve. Behind them, instead of a magical wizard able to contain the raging crisis now spreading across the world's financial markets, we find the chairman of the United States Federal Reserve, Ben Bernanke.

And his magic is proving to be as ineffective in curing the ills of the world's financial markets as was the Wizard's in getting Dorothy back to Kansas. What a difference 10 days make in the new hyper-charged world of turbo finance.

As I noted in my August 14 Asia Times Online article "Central banks' easy money, easy virtue", it was on August 7 that the Federal Reserve concluded a policy meeting decrying the possibility that the gathering storm in the financial markets necessitated a near-term reduction in Federal Reserve interest rates. Soon after, President George W Bush said there was sufficient liquidity in the system to withstand anything wicked coming out of the financial markets.

In what must have been one of the last plays presidential adviser Karl Rove called from the sidelines and which was sent into the huddle of his reliable right-wing spin machine, the editorial page of the Wall Street Journal, Fox News, along with commentators Larry Kudlow and Jerry Bowyer, all said that Bush and his laissez-faire economic philosophy had delivered to the world an economy sufficiently robust to withstand any challenges from the chaos spreading out of the markets for subprime mortgages.

But in the expanse of time from those long-ago blissfully halcyon economic days of a week and a half ago, much of the laissez-faire economic community has treaded a path reminiscent of Caledon Hockley (Billy Zane) in the 1997 movie Titanic, from first denying that there was any problem with the unsinkable ship, to now pushing aside women and children to get a place in the lifeboats. As the great ship World Liquidity raises its mighty stern into the air to commence its slide into the sea, these previously pleased pundits started screaming out for help from the Federal Reserve.

And they got it, as the Fed cut a key benchmark interest rate by 50 basis points. But as their rescue is proving Bernanke to be, like the Wizard, more Kansas carnival barker than omnipotent seer, it may be creating more problems than it solves.

There are three main cannons in the arsenal of any US Federal Reserve field marshal. One is called open market operations, another is the operation of what is called the discount window, the third is targeting a specific level of the Federal Funds rate. In the past 10 days, the US Federal Reserve has shot off two of its three cannons. The first was an abject failure; the second has had an infinitesimally small effect. Maybe the citizens of Munchkinland will stand for the exposure of their avatar as a fraud, but the citizens of Moneymarketsland will certainly not.

The open market operations were the almost US$400 billion of reserves injected into the world's money markets by the US Fed and other central banks since August 8; I described the mechanics of these procedures in my August 14 article cited above. The results of these procedures can probably be best described as very expensive failures. With billions of dollars of liquidity evaporating daily in the markets, interest rates had been rising in the specific money markets that the Fed and the other central banks had influence over; in the US, the Federal Funds rate, targeted at 5.25%, topped 6%. The interventions settled things down - a bit - the Federal Funds rate returned to its target range, but other indicators of the health of the private short-term money markets remain in very tenuous shape.

The market in what is called commercial paper, very short-term (frequently no more than a day or two) corporate borrowing of money needed to fund a company's temporary funds shortage (or lending of funds from companies with a funds surplus) has closed for companies thought to have even the remotest connection with the subprime-mortgage debt in peril; no amount of open market operations will reach these borrowers.

If they can't find lending to fund a short-term liquidity need, they will begin to be pulled inexorably toward bankruptcy. Other indicators of the health of the short-term money markets, such as the London Interbank Offered Rate (LIBOR), the core indicator of what has come to be known as the Eurodollar market, are also indicating that these Fed monetary firehouse operations have yet to rain down on them with any needed liquidity. After being ensconced around 5.30% all year, this rate climbed to almost 5.90% in the midst of the Fed interventions; that means that wherever the money the Fed was attempting to put in the markets was going, it wasn't getting to the US.

So where were the billions of dollars in Fed intervention going? The market for US government-guaranteed three-month Treasury bills is one short-term money market where the Fed probably has not wanted to have the effect that it has. Rates in this market saw an astounding fall last week, dropping almost 130 points, to reach just under 3.6% at their lows in the middle of the week.

Looking at this market, you can just smell the fear permeating world money markets; investors in the US are now willingly sacrificing almost 200 basis points, 2% of yield, to be able to go to bed and know that their money will still be there next morning. This is not the case with lending in today's commercial-paper or LIBOR markets, where traders just can't be sure if the counterparty they just lent $100 million to is going to get detoured to the bankruptcy court before the loans can get repaid.

With the money market operations proving as ineffective as they did, the US Fed had to proceed to the next step, lowering the discount rate. In and of itself, the current construct of a free economy's central bank is a relatively recent phenomenon. Before the early 20th century, if one bank's impending insolvency threatened the insolvency of the entire financial system, it would either have to get an emergency loan from a wealthy private citizen (such as J P Morgan in the US, or the Rothschild family in Britain), or it would go under.

This was the cause of the grossly amplified economic booms and busts of the world's capitalist economies leading up to the crash of 1929. With the 20th century came the realization that this function, ensuring the stability of the financial system as a whole, best resided with the government, since its proper operation benefited the nation as a whole.

The aftermath of the "Great Panic" of 1907, wherein the US economy was only saved from the deep depression it would face 22 years later by the intervention of J P Morgan, led Congress to pass the Federal Reserve Act in 1913. The Bank of England was created in 1694, but it was only under the governorship of Sir Montagu Norman, beginning in 1920, that its function changed from a commercial bank, charged with making a profit, to that of a central bank, charged with maintaining the viability of the system as a whole.

Much like Pig Pen in the Charles Schulz comic strip Peanuts, sometimes a situation arises where there is one bank that the other banks just don't want to play with anymore. Nobody wanted to play with Pig Pen because they were afraid that the cloud of dust that encased him might rub off on them; likewise, nobody wants to lend to an alleged weak bank, because they fear that the cloud of possible insolvency that surrounds it may affect them, in that their loans to that bank would not get paid back.

Before modern central banking, these banks would close. That would then threaten with insolvency the banks to which the closed bank owed money; if those banks closed, then their creditors would be in jeopardy, and so on and so on, until the whole banking system was in jeopardy. In economic jargon, this type of crisis is called a "contagion", and it's a very apt metaphor: like someone sneezing in a hot, crowded elevator, one institution's sickness can make a lot of others very sick very fast.

Here, the central bank moves in, acting as the "lender of last resort". It, when no one else will, can lend to the first threatened bank. The interest rate it charges to these banks is called the discount rate, and it was that rate that the US Fed lowered on Friday morning.

The rate was cut 50 basis points, a half of a percentage point, from 6.25% to 5.75%. This is still 50 basis points above the standard interbank lending rate, the Federal Funds target rate, which has stood at 5.25% since June 2006. This is deliberate - the discount rate is supposed to be what is called a "penalty rate", like a teen asking Dad for money and getting a lecture along with the cash, the Fed wants to be available, but not an easy touch.

This crisis seems tailor-made for discount-rate lending and borrowing, at what is metaphorically called the discount window. (There is no actual teller wearing a green eye-shade behind something with the words "Discount Window" at the Fed headquarters on Constitution Avenue in Washington. All these transactions are effected through electronic funds transfer - EFT.)

Those commentators who say this entire crisis is overblown, that the world is still awash with liquidity, are correct, up to a point. There continues to be huge supplies of liquidity in the world's markets. The problem is that a lot of financial institutions now need some immediate contact with some of that liquidity, and are not getting it. One of those might be Countrywide Financial, the largest US mortgage lender. Countrywide's stock has declined 60% in a month, and it burned through its entire $11 billion emergency line of credit in a few hours on Thursday. Thus the Fed discount-rate move on Friday.

Soon we'll get data from the Federal Reserve that show how liberally the threatened banks used the now more reasonably priced discount window but, as for Friday, the market's reaction to the rescue move was, "Is that all?"

There is no evidence that the freeze-up in the commercial-paper market has thawed as a result of the discount-rate cut. Three-month Treasury bill rates did bump up, and LIBOR rates did bump down, but only nominally. They are still at levels that would have been associated with a serious system crisis only a month ago. The Vix volatility index, the global markets' fear thermometer, at 30, is remaining at historically high levels.

On its open, the US stock market behaved oddly. The Dow Jones Industrial Average rallied more than 400 points, but that was the high for the day. Midday, the market lost almost all of its gains before rallying again into the close, to end up with a gain of 233 points. US television news anchors reported these developments as if they were auditioning for the role of John the Baptist in their church's passion play, proclaiming the "Good News" of an imminent salvation.

But in reality, this rally was far from impressive, particularly considering recent bouts of high volatility in US and world equities. The 20-day mean of the Dow Jones index price change stands at 155, with a standard deviation of 105. If I've just transported you back to the yawning void of existential horror that was your secondary-school statistics class, the point here is that 233 points just isn't that much of a rally these days.

What does the Fed next do if the crisis, and the equity-market selling, resumes this week? Early-20th-century Harvard professor and philosopher George Santayana once defined a fanatic as someone who redoubles his efforts as he loses sight of his goals. In that light, Bernanke could throw in another 50-point discount-rate cut. That, however, would put the discount rate even with the Federal Funds rate, at 5.25%; that would eliminate the penalty aspect of borrowings at the discount window.

That opens up the possibility of a cut in the Federal Funds rate, perhaps at the Fed's next board meeting on September 18, maybe sooner, perhaps after an emergency Fed teleconference, as happened with the discount-rate cut on Friday. A Federal Funds rate cut delivers liquidity to the markets with more of a scattershot approach; as yet, that doesn't seem to be what the economy needs. It's not that the system is short of liquidity right now; the steep fall in the three-month Treasury bill rate proves that. Discount-rate borrowing, targeted like a sniper's rifle to borrowers who really need it, is the preferred mechanism to deal with the credit quality, not quantity, issues the markets are dealing with now.

That's why it's such a problem that the Fed's Friday discount-rate cut had so little effect. If what comes out of the barrel on firing your most powerful weapon is only a little stick with a flag that says "Bang" on it, your enemies, in this case the markets, will see that there's nothing you can do to deter them, to frighten them, to change their course of action. Panic will set in, perhaps worse than before; past the curtains, the smoke and mirrors, the Wizard is seen as impotent.

Who will then be charged with saving the financial system? Will it be the political system, Congress and the executive branch? That's a frightening prospect: the political system would require that any possible solution travel the same route that all US political policy issues now must do; it would have to pass muster from focus groups in the US heartland. That might result in a congressional debate on whether old farmer Johnson's patented moonshine-fueled flush toilet will solve all the nation's ills.

Or maybe the crisis will be solved in the same manner in which the United States has solved all its economic problems this decade - through reliance on China. Michael Pettis, a Peking University professor of finance, has suggested China's government-run investment agency, its Sovereign Wealth Fund (SWF). I discussed SWF in my June 22 ATol article Careful what you wish for, China may grant it). SWF may swoop in and buy, at the bargain prices generated by the crisis, the discounted mortgage securities at the core of the crisis. Then, since they're also now selling at fire-sale prices, they may buy up some of the finance companies themselves - a rumor circulated around Wall Street last week that agents acting on behalf of China's still-nascent SWF were making inquiries related to picking up Countrywide Financial on the cheap. As Pettis puts it, "The large-scale shift of global reserves into what are being called sovereign wealth funds may provide the party with at least one more bowl of industrial-strength punch."

This solution makes perfect sense. The singular aspect of US economic life this decade has been that it has proved itself to be a society hell-bent on living beyond its means - the 7% of US gross domestic product represented by America's current account deficit means that the country sees nothing very much out of the ordinary or improper at consuming 7% more than it produces.

Much of that excess consumption was provided for by China. In the same manner, the current subprime crisis started with homeowners wanting to live in more houses than they could afford, mortgage brokers lending out more mortgage than the borrowers could repay, and fund managers buying up subprime-mortgage collateralized debt obligations, hoping to earn higher investment-portfolio returns than their intellect and trading skills could generate.

If the US does allow China to bail it out of a mess solely of its own creation, the US will prove itself less of a world superpower and more of a poor, hapless junkie walking into a pawnshop, desperate to sell another bit of its hard-earned family heritage built up over 200-plus years for just one more fix of plasma TVs, MP3 players, Barbie dolls and all the rest of the catalogue of cheap Chinese manufacture on which Americans are now hooked.

In recent years, an entire literary-theoretic subculture has arisen devoted to the belief that Baum's Wonderful Wizard of Oz was not meant to be just the pleasant, deracinated children's fable it is today, but a pointed allegorical tale related to the raging economic and finance controversies of its time.

This was the era when the debate was between those who wanted the United States to stay on the restrictive gold standard, the bankers and already-rich interests of the US east (as in the Wicked Witch of the East) and those, such as western farmers and populists, who wanted the US to adopt a looser, more accommodating silver standard - just like what Dorothy's magic slippers were made of (they were changed to ruby in the 1939 movie).

This is seen as Baum, a noted populist, advocating the silver standard as the solution to the nation's, particularly the rural and agricultural west's, economic travails. Dorothy's perilous journey down the yellow brick road is here seen as an allegorical warning about over-reliance on the gold standard. The Wizard, the potentate of the Emerald City, provided advice that was worthless, just as emerald-green US paper money unbacked by physical assets was seen to be.

If future literary theorists find an edition of The Wonderful Wizard of Oz that they think was first published in 2007, how will they decipher its symbolic code?

Poor, hapless Dorothy would be seen as representing an unfortunate subprime-mortgage borrower, her dreams of first-time home ownership, with its implied access to the American dream, spinning away and lost in the gale. The Good Witch Glinda, who tries to help Dorothy find her way in this new maze of financial uncertainty, would, of course, be seen as representing none other than the US CNBC cable network's curvaceous "money honey", financial journalist Maria Bartiromo.

The Tin Man with no heart would be the bankers foreclosing on Dorothy's mortgage; the Lion with no courage would be seen as a symbol of America's ruling neo-conservatives, the men who sent today's youth off to die in their wars to hide the fact that they did everything in their power to avoid doing the same in Vietnam. As for the Scarecrow with straw for brains, future literary theorists would pore through current media and conclude that he was an obvious reference to Bush.

But the story would need a new hero. Instead of the hapless Wizard - Ben Bernanke - it would be none other than the kindly, avuncular, bespectacled Zhou Xiaochuan, governor of the Bank of China, whose deployment of foreign-exchange reserves was seen to have saved both Dorothy's home and the US financial system ...

Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.