India and the US ... updates galore ...

India recently cut its key interest rate to offset a slowdown due to a global recession. The Reserve Bank of India (Indian Fed) announced that it didn't see any signs of a quick turnaround. This seems to make the over 20% rise in the BSE Sensex, from 9000 to 11000, over the last few weeks seem a little premature.

Meanwhile, while Krishna Byre Gowda seems like a case for a genuine Obama-like figure in India, Mayawati is also laying claim to the fame. I read recently that she says her status as a lower caste person rising to the top makes her the Obama of India. Here's the Times of India drawing a similar comparison. Clearly being like Obama is a badge that everyone is going to claim, but this seems a little far fetched.

Finally, I was in a discussion recently about the excessive nature of US debt. As of 2008, US public debt was ~US$ 10.7 trillion, i.e. 74.6% of GDP. India's public debt is 78% of its GDP. Japan's public debt is now 170.4% of its GDP.

What does this mean for the US?

On healthcare

How horrendously socialistic is Obama's Healthcare proposal? Well here is the current policy:

Make Health Insurance Work for People and Businesses -- Not Just Insurance and Drug Companies.

• Require insurance companies to cover pre-existing conditions so all Americans regardless of their health status or history can get comprehensive benefits at fair and stable premiums.
• Create a new Small Business Health Tax Credit to help small businesses provide affordable health insurance to their employees.
• Lower costs for businesses by covering a portion of the catastrophic health costs they pay in return for lower premiums for employees.
• Prevent insurers from overcharging doctors for their malpractice insurance and invest in proven strategies to reduce preventable medical errors.
• Make employer contributions more fair by requiring large employers that do not offer coverage or make a meaningful contribution to the cost of quality health coverage for their employees to contribute a percentage of payroll toward the costs of their employees' health care.
• Establish a National Health Insurance Exchange with a range of private insurance options as well as a new public plan based on benefits available to members of Congress that will allow individuals and small businesses to buy affordable health coverage.
• Ensure everyone who needs it will receive a tax credit for their premiums.

Reduce Costs and Save a Typical American Family up to $2,500 as reforms phase in:

• Lower drug costs by allowing the importation of safe medicines from other developed countries, increasing the use of generic drugs in public programs, and taking on drug companies that block cheaper generic medicines from the market.
• Require hospitals to collect and report health care cost and quality data.
• Reduce the costs of catastrophic illnesses for employers and their employees.
• Reform the insurance market to increase competition by taking on anticompetitive activity that drives up prices without improving quality of care.

Highlighted in red above are the policies that would essentially cost millions, but most of these are actually tax breaks. Highlighted in blue above are regulatory provisions, which, if mismanaged could prove draconian. Highlighted in green above is a provision that envisages using market forces and government subsidies to do for the healthcare sector what Fannie Mae etc. have done for the mortgage industry.

This is an old analysis of the healthcare plan comparing McCain's and Hillary's plans with Obama's. The reason I added this is that in many ways, his plan has changed.

Is Obama's plan nationalized healthcare? Not really. Most of the government spending comes from a bunch of tax credits and assistance that shifts part of the responsibility for healthcare onto tax payers.

Is it anti-business? Somewhat. There are several provisions that could be viewed as draconian. He requires all large employers to provide employees healthcare. So, companies that don't currently provide healthcare or short shrift employees, may find their costs rising. He wants insurance companies to cover pre-existing conditions - which could cause healthcare costs to go up, or the profitability of many plans to go down. He makes it easier to import drugs. So, companies that charge less for drugs overseas, and more in the US, may suddenly find their ability to differentially price may recede - which is bad for the companies that profit from this.

Interestingly, he does not introduce price controls. The basic plan is designed to introduce more competition and provide some government assistance to get poor people onto some sort of healthcare plan. This is not nationalized healthcare a.k.a. UK, but government subsidized health insurance.

Of course, the plan is only a set of principles, and the real issues will surface only when Congress gets too it. However, prima facie, the only socialist aspect about the plan is its intent - i.e. that government has a responsibility to ensure that everyone has access to affordable healthcare. Once you accept that, the plan is about as non socialist as you can get in meeting the twin objectives of ensuring everyone has access to affordable healthcare and ensuring government has a limited role in people's healthcare.

Critics galore ...

In recent days, people on the left and the right have been coming out of the woodwork with advice galore for the administration. Obama has found friends in strange places. First, we have David Brooks expressing hope in Obama's Afghanistan strategy and declaring it a winnable war. This view gets support from Rachel Maddow at the other end of the spectrum. In her recent TV spot, she talked it up so much, it seemed like she was trying to sell it to herself.

Then we have Krugman declaring emphatically that Summers and the Obama team aren't taking the true lesson of the current mess - i.e. a fundamental repudiation of the market mystique.

Meanwhile, we have Michael Gerson defending Obama's use of the teleprompter, pointing out that a leader's attempt to express himself with precision is not a sign of a lack of genuineness, and neither is a politician's attempt to wing it anything but shallowness.

Michael Gerson's article I wholeheartedly agree with. The idea that a leader who thinks through what he or she is about to see is somehow less of a leader for relying on a script is laughable. It would be different if the assumption was that Obama wasn't intellectually able, but even his critics have to acknowledge his intellectual prowess.

On the war, I am less sanguine than these more upbeat assessments. Afghanistan is definitely where the US should focus, but remember that this is the region that handed the British and the Soviets their defeats. A protracted engagement in Afghanistan could be worse than both Iraq and Vietnam. Furthermore, wars are and always been massively draining on the national coffers. So, I would be more cautious in singing Obama's praise. The question in my mind is whether he can stay focused on achievable goals, or whether he will get distracted by idealistic fervour. As long as he is pragmatic, it should be fine.

Finally, on Krugman and the economy. I know that Krugman is not happy about the market mystique dominating. True market's need regulation. However, you have to only look at highly regulated markets around the world to realise that enabling the heavy hand of government is a cure that may be worse than the disease it attempts to cure. So, am I unhappy about Obama's hesitance? No. In fact, I am more concerned that he may be tempted to allow many of the more radical ideas proposed by Congress to pass. The question is whether he will be able to stand up to a Congress dominated by his own party, while still building consensus for his agenda. My guess - doubtful!

Spitzer on the financial mess ...

OK ... so Elliot Spitzer proved to have questionable sexual morals and marital fidelity. But, in this interview, he makes some fascinating points. The basic point he is making is that there is no legislation that can compensate for regulatory incompetence or lack of will. If the executive does not enforce the laws, then the laws are moot. Ironic, but very true.

TARP version ... how many has it been again?

Timothy Geithner just announced his new TARP plan: $75BN to $100BN to back $500BN of funds to buy troubled assets. How is this different from the Paulson plan? It is a little more specific. It does leverage private capital. However, in essence, it is the same plan.

Here's how it would work:

• Let's say a Bank seeks to sell pool of mortgages worth $100;
• A private auction decides that asset is now worth $84;
• The private investor and government put up $6 each;
• They then borrow remaining $72 from government;
• That loan is guaranteed against any losses;
• If asset is later sold at higher price, government makes profit and private investor pays back loan and pockets profit;
• If asset is sold at lower price, government and private investors could lose initial investment.

Am I missing something, or is this really saying:

• The government and the private investor share equally in all the gains on the entire $100;
• The government and the private investor share equally in losses till 14% of the market value at the auction, and
• The government foots the bill for any loss in excess of 14% of the value.

If this is right, it seems like a pretty good deal for investors if the market valuations now are relatively fair.

Krugman, meanwhile, is railing against the plan. I didn't quite follow his logic. His main argument seems to be that the banks will still have lost the money they have, and no amount of taking stuff off the books will help. True. But wouldn't the lack of exposure to further downside risk reduce the inter bank solvency issue somewhat? If Krugman has a reason to believe it won't, he didn't explain it in the article.

Krugman has pointed out that history has shown that some amount of nationalization is necessary.

Couple of points.

• Firstly, Krugman is right. Some form of nationalization is probably the most effective answer. Government guarantees / nationalization gives people confidence about the solvency of their counterparties. Geithner's plan does that too. However, the degree of confidence inspired by the former is far more and so, I would argue, it is a much quicker fix. Obama, however, needs to weigh the political expediency of nationalization and what it might do to his ability to get other policies passed. So, the fact that we haven't gone there may be just as much a political calculation as an economic one.
• Secondly, at one point in the article, Krugman writes: "And now Mr. Obama has apparently settled on a financial plan that, in essence, assumes that banks are fundamentally sound and that bankers know what they’re doing." [emphasis added] In so saying, Krugman betrays his political biases and, dare I say it, his naivete. Firstly, how can pouring $500 BN to $1 trillion into the banks in addition to billions already spent suggest that anyone in government think there is anything, fundamentally or otherwise, sound with the banks? But, maybe Krugman is reflecting on the competence of bankers, particularly senior management. In this context, I too have concerns, but is Krugman's idea any better? If we nationalize, who can we replace everyone in these organizations with? Would the bank actually operate better? Yes, they made bad bets, as did everyone else. Does that mean the government will do better? The same government who regulated these industries so 'brilliantly'?

I too am concerned that those who caused the mess are not paying a high enough cost. Having said that, there seems to be a tendency on the left to assume that just because one option is bad, the others are necessarily better. That's a logical fallacy. Krugman and others need to explain why they believe so. Also, nationalization may indeed solve the immediate crisis faster. However, would it really be the long term interest of the nation? Are nationalized banks really better banks?

My guess is that before this is over, a number of these banks and financial institutions are going to be nationalized. AIG and Citi effectively are already. Political expediency aside, more probably would have been already. However, I am not as convinced as Krugman that Obama's reticence to nationalize is necessarily a bad thing.

Ben speaks ...

It's almost unheard of for a sitting Fed Chairman to give an interview of any kind. This 60 Minutes interview with Ben Bernanke is an exception. Nothing startling, but still very interesting.

Worse than the Great Depression?

How bad are things? Well, in some ways its not quite as bad as the Great Depression. Unemployment now is officially around 7%, although including hidden unemployment its probably more like 14%. In the Great Depression, unemployment had touched 25%.

However, in other ways, economists are beginning to point out that it's much worse. Why? Well, for one things are moving faster than anyone imagined possible. Volcker points out that the global fall in industrial production is unprecedented and breaks even the worst doomsday predictions. George Soros points out that there is no end in sight to the financial crisis. The market capitalization of the banking sector now hovers at about what the government has pumped in.

The trouble is that admit that they don't really know what will work. At this point, everyone is trying their best and hoping a lot.

The stimulus package is too small

OK, I've said it before, and I'll say it again - the stimulus package passed by Congress is too small. President Obama should consider a second stimulus, and consider it fast. Don't believe me, here is the assessment buried in the minutes of Federal Reserve's most recent meeting of its open market committee:

“All participants anticipated that unemployment would remain substantially above its longer-run sustainable rate at the end of 2011, even absent further economic shocks; a few indicated that more than five to six years would be needed for the economy to converge to a longer-run path characterized by sustainable rates of output growth and unemployment and by an appropriate rate of inflation.” [emphasis added]

Paul Krugman, who admittedly is not a fan of the scaled down plan, points out that with the package in place, the closest parallel is the Panic of 1873 which was a 5 year recession. That would mean we could be in a slump till 2012.

Even otherwise, this makes it seem as if what the administration is shooting for is not recovery but stabilization. Not very inspiring!

Mortgage relief plan

Here is the executive summary of the plan announced by Obama today for mortgage holders. The plan could save a lot og homeowners a lot of money. Here is some very useful Q&A that explains how.

The stimulus bill

Whew, so we have a stimulus bill, and Obama has discovered why so few have governed from the center. He has managed to dissatisfy everyone - the lefties are upset about the giveaways to the wealthy, the righties are upset about the huge spending. Anyway, here's what they are proposing:

Aggregate spending proposal totaling $311 BN, to be allocated as follows:

• Investments in Infrastructure and Science - $120 billion
• Investments in Health - $14.2 billion
• Investments in Education and Training - $105.9 billion
• Investments in Energy, including over $30 billion in infrastructure - $37.5 billion
• Helping Americans Hit Hardest by the Economic Crisis - $24.3 billion
• Law Enforcement, Oversight, Other Programs - $7.8 billion

Let's put this in perspective. According the Federal budget estimates, the aggregate outlay by the US government projected for 2009 was $3.107 BN. This spending represents about a 10% increase in the US budget, or roughly 2% of the US GDP. This is through spending alone. While the exact numbers are hard to come by, new agencies are reporting on TV that almost 80% of this amount is likely to be spent in the next 18 months.

Meanwhile, there is a lot of discussion about the remaining part of the stimulus, reportedly $477 BN, a large part of which is in tax cuts. Haven't found the details on the web yet. Will post it when I do.

Is this package big enough? Probably not. At last not big enough to be sure it will work. But, if enough people start feeling good enough, it would stall the downward slide, and that might be a good start.

The conundrum of spending

The stimulus package being discussed is probably too small too work say some. This assessment is probably right, or at least, as Galbraith says, faced with the hurricane that is the current economic woes, it would be better to err on the side of excess than moderation. However, the alarming thing is that as people have tried to rack their brains to find ways to spend the extra money required, and they've mostly failed. The fact is, the marginal programs in the spending bill are mostly pork and mostly things that will occur over years, not months. It is unclear whether the President could in fact find an effective way to make the additional spending happen quickly, even if he wanted to. It is almost reminiscent of Brewster's Millions. I suspect Obama will need a separate social program to fill the gap, if he wanted to.

Senate version of the economic rescue plan

OK, here's the full text of the Senate's compromise bill. It is several hundred pages long, so it'll take me some time to condense it.

Meanwhile, here's an interesting provision:

"SEC. 1610. HIRING AMERICAN WORKERS IN COMPANIES RECEIVING TARP FUNDING.
(a) SHORT TITLE.—This section may be cited as the ‘‘Employ American Workers Act’’.
(b) PROHIBITION.—
(1) IN GENERAL.—Notwithstanding any other provision of law, it shall be unlawful for any recipient of funding under title I of the Emergency Economic Stabilization Act of 2008 (Public Law 110–343) or section 13 of the Federal Reserve Act (12 U.S.C. 342 et seq.) to hire any nonimmigrant described in section 101(a)(15)(h)(i)(b) of the Immigration and Nationality Act (8 U.S.C. 1101(a)(15)(h)(i)(b)) unless the recipient is in compliance with the requirements for an H–1B dependent employer (as defined in section 212(n)(3) of such Act (8 U.S.C. 1182(n)(3))), except that the second sentence of section 212(n)(1)(E)(ii) of such Act shall not apply.
(2) DEFINED TERM.—In this subsection, the term ‘‘hire’’ means to permit a new employee to commence a period of employment.
(c) SUNSET PROVISION.—This section shall be effective during the 2-year period beginning on the date of the enactment of this Act."

If I am reading this correctly, this implies that companies that are taking TARP funds are not permitted to hire new employees on H-1B visas, unless they are entirely in compliance with all the provisions of the Immigration and Nationality Act. Not sure if this has any material impact on anything, or am I missing something?

UPDATE: This is a much more thorough analysis of the H-1B clause.

Crash course

If you would like a quick and interesting view of the economy, particularly how extraordinary today is in the historical context, then this might make interesting viewing.

Essentially, what Chris Martenson is showing is that our current economy is based on growth, and due to the large base, it requires larger and larger absolute increments to sustain. In fact, though, our use of resources is now reaching proportions that are entirely unsustainable. Something has got to give.

It makes interesting viewing. The historical context is absolutely fascinating.

Putting things in perspective

This article puts some of the issues into perspective. This chart compares the job loss trend in this recession with the trend in the last two US recessions. Horrific!

US economy bad. Others worse.

While currently the economic woes in the US seem to be worse than in the EU, the IMF predicts that among developed nations, UK will be the worst hit with a contraction of 2.8% in 2009. The EU overall will shrink by 2%. The US will shrink by a "mere" 1.6% - that's roughly $220 BN reduction in the US GDP. Moreover, the IMF has warned that the UK is so structurally unsound that it will remain in debt for 20 years.

Of course, all this pales in comparison to Iceland. Iceland has become the first Western nation to get IMF help since 1976. With 17.1% inflation and outstanding bank debt that is six times its GDP, Iceland is expected to see 9.6% contraction in its GDP in 2009 and at best no growth in 2010. Their Prime Minister has now been forced to resign. Here's a summary of the timeline of key events in Iceland.

Meanwhile, while many developing economies have been ravaged by a combination of the drop in demand from Western economies and the drop in oil prices (a mixed blessing, depending on where you are), they are expected to continue to grow, although their growth will slow substantially.

Where is all that money going?

I have been hearing about the profligate spending that is the Reinvestment and Reconstruction proposal more popularly called the "economic stimulus plan". So, I decided to investigate what they are proposing.

Here's the marked up summary of the proposal from the House Appropriations Committee, and of the tax portion from the house Ways and Means Committee. Obviously, this will change by the time of its passing.

The bad news, for people earning over $75K ($150K for married couples filing jointly), there is very little relief. Let's see if Obama lives up to his campaign promise of lowering taxes for everyone with income under $250K. It all depends on how they phase the relief out.

Here are some highlights of what they are proposing (I have highlighted in blue, those provisions that individuals earning more than $75K per capita would benefit from):

Taxation (these dollar amounts represent the cost over 10 years):

• $145 BN on a tax credit of 6.2% of earned income phasing out for people earning over $75K ($150K for married couples filing jointly);
• $4.60 BN on increase in earned income tax credits for very poor families;
• $18 BN on increasing child credit;
• $13 BN for college education assistance;
• $2.56 BN for assistance to first time home buyers;
• $27 BN for small businesses and acquiring companies;
• $50 BN for local and state government assistance;
• $16 BN on renewable energy investments;
• $4.27 BN on upto 30% tax credit capped to $1500 per annum on energy efficient improvements to existing homes, e.g. heaters, air conditioners, etc.

Spending proposals (not clear how these are expected to be phased):

• $54 BN on cleaner and more efficient energy (there is a small amount set aside to subsidize energy star appliances);
• $16 BN on science, technology and Internet access;
• $90 BN on improving roads, bridges and waterways;
• $141.6 BN on improving educational facilities and educational programs for poor and under privileged;
• $24.1 BN on improving healthcare services - particularly their computer systems;
• $102 BN in unemployment and hunger prevention benefits;
• $91 BN in preventing lay-offs in the public sector - state and local governments;

A few things to note:

First, the $800 BN number being thrown around is misleading. The cost of the tax proposals is over 10 years. The summary released by the Appropriation Committee on the spending proposals don't explicitly state how these costs will be phased. MSNBC suggested on Hardball that a substantial portion of it will not get spent till Obama's second term.

If we assume that the tax benefits would more or less be uniform over the 10 years or even skewed a little to later years, assuming economic growth and that 80% of the spending would be over the next one or three years, this would mean that the actual impact over the next two years of the stimulus is probably more like: $450 BN - $550 BN. Worse, over $100 BN is actually just preventing cut backs in government spending. So, it isn't incremental spend. The incremental spend is more like, $350 BN - $450 BN. Worse, this is spread over two to three years, which means that the immediate impact is likely $150 BN to $200 BN, which is just about 1.5% of GDP. Given the expected contraction in GDP is 1.6%, this seems low to spur growth. It'll just about cover the gap.

In terms of who gets the benefit, if you ignore timing differences, here's the allocation:

Tax cuts for individuals: 20%
Education: 19%
State and local governments: 18%
Underprivileged: 13%
Basic infrastructure: 11%
Renewable energy: 9%
Small businesses: 3%
Healthcare: 3%
Science and technology: 2%

Unfortunately, most individuals won't see most of these benefits for a while yet, whereas the spending increases will take near immediate effect.

On the economic recovery plan etc.

For those who are struggling with history of recession solutions ranging from Supply Side economics to Keynesian economics, this is an excellent brief map of the history of recession management in the US since the 1960s. Kennedy was actually the first President to consciously try a Keynesian solution to a recession. The other President to use it extensively was Reagan (in effect, although not in intent).

I don't know about you, but I am increasingly exasperated by the certitude with which talking heads on TV make assertions reiterating partisan rhetoric on the "economic rescue plan". Why do experts of all hues insist on peddling opinions as fact, despite the complete lack of evidence? Why not reproduce the facts in an intelligible way and leave it for viewers to decide? The truth is they don't know the answers, despite their protestations to the contrary.

Here's Warren Buffet on the topic of the economy. I've reproduced one part of the interview for you below:

Q: "... But there is debate about whether there should be fiscal stimulus, whether tax cuts work or not. There is all of this academic debate among economists. What do you think? Is that the right way to go with stimulus and tax cuts?"

Warren Buffet: "The answer is nobody knows. The economists don’t know. All you know is you throw everything at it and whether it’s more effective if you’re fighting a fire to be concentrating the water flow on this part or that part. You’re going to use every weapon you have in fighting it. And people, they do not know exactly what the effects are. Economists like to talk about it, but in the end they’ve been very, very wrong and most of them in recent years on this. We don’t know the perfect answers on it. What we do know is to stand by and do nothing is a terrible mistake or to follow Hoover-like policies would be a mistake and we don’t know how effective in the short run we don’t know how effective this will be and how quickly things will right themselves. We do know over time the American machine works wonderfully and it will work wonderfully again."

Couldn't agree with him more.

On a different note, the complexity of the economic woes has been excellently summarized by Samuelson in his Op-ed piece. As Samuelson astutely points out, the US is facing three separate economic crises:

• A decline in consumer spending. Consumer spending is 70% of the US economy. With the wiping off of over $7 trillion in personal wealth, people just aren't spending any more.


• A breakdown of the financial system. Financial institutions just aren't lending, and without credit, there is little chance of growth. Part of this has to do with ravaged balance sheets due to mounting losses - the target of the TARP. Part of this has to do with the loss in confidence in several market making derivative and other financial instruments. And, a major part has to do with the uncertainties around people and companies' income potential and the consequential difficulty in developing appropriate lending criteria.


• Slowdown in the rest of the world: This is no longer just a US crisis. The rest of the world is slowing down. While a much smaller part of the US economy, the slowdown in the rest of the world could thwart attempts to kick start growth in the US.

Finally, let's clear up the confusion between the New Deal and Keynesian economics.

Although, Maynard Keynes did advise FDR he was neither the primary advisor to FDR nor the architect of the New Deal. Keynes inter alia advocated massive deficit spending and government intervention to ensure full employment as a means of reversing the depression. As this brief history of the New Deal in Wikipedia suggests, FDR didn't exactly do that. In fact, the US was very conservative in its approach and even tried to return to balanced budgets in the mid-1930s, with disastrous consequences. It is true that many of the structures that regulate today's economy were set up or restructured during the New Deal. However, as an example of Keynesian economics, the New Deal provides at best mixed data that can be sampled to buttress claims by both sides of the argument. The equivalence of the New Deal with Keynesian economics therefore is somewhat misguided.

More motgage trouble

In this article, the author discusses the Alt-A mortgage resets, which are expected to peak in 2009-2010. Essentially the author argues another risk uptick is in the offing which will throw a bunch of currently healthy people in a mess, particularly in a worsening economy. Not sure how credible the data is.

If this is true, can this averted? Well, maybe. One difference between the Alt-A resets and the subprime mortgage resets is the ability of the borrowers to refinance. If the US government is able to get Fannie Mae and Freddie Mac to lower refinance rates and create sufficient liquidity, some of the impact of the reset may be offset. If, if, if ...

Fear of cliffs

If you expected an article about the white cliffs of Dover, you will be sorely disappointed. I am referring here to cliff events in the context of the economy.

In recent days there have been frantic efforts by many in the government egged on by many reputed economists including advocates of free markets to intervene in the market and prop up failing institutions. They have intervened, but seemingly to little effect. What's going on? Why is there such a panic?

Underlying the theory of free markets is an assumption that free markets, even when not perfectly efficient, are mean reverting. This is why advocates of non-intervention speak of "market correction". The idea is that while there can be a distortion in value for a time, ultimately everything will automatically revert to a true value. Of course, this view assumes the existence of such am invariant 'true value'.

There is, however, a more interesting set of theories that have been evolving that postulate that natural systems, including financial markets are chaotic. This means, that while they may occasionally appear to be mean reverting, there is no reason that they should revert to a mean. Instead, even small changes can have extremely magnified effects resulting in a different level in the long run. In such systems, small changes can have huge, often catastrophic effects. Examples of such chaotic changes are literally the straw that breaks the camel's back or the butterfly effect. In this view, there are times when a financial system like the economy can stand at a brink, where on one side, it seems unwell but curable, and on the other it faces complete ruin.

Let me illustrate with an example.

In the early part of this decade, as Enron devolved into a financial debacle, disclosures made to ratings agencies put the ratings agencies in a quandary. On the one hand, if they continued to maintain the same credit rating, then it was possible that in the interim time the company could find a way to pull itself out of the mess. On the other hand, if they reduced the rating, then it would automatically trigger a series of obligations that would hinder Enron's ability to borrow. The resulting mess would lead to further downgrades, and so on, quickly reducing Enron to junk bond status.

This was an example of a credit cliff. It's a situation where a small change in the conditions, i.e. Enron's credit rating, could push it over a cliff.

Two things to note.

• Firstly, the cliff was characterized by the value was driven belief that was ultimately self referential - i.e. it had value because people believed it had value. It was solvent as long as people believed that it was and would continue to be solvent.

• Secondly, the fiction was ultimately unsustainable.

How does this relate to the US economy? Well, you see, all those panicking economists are actually worried that the US economy is at such a cliff. The value of US companies, US markets, US debt and ultimately the US economy is ultimately dependent entirely on everyone's belief in the US economy and its ability to survive this crisis.

The problem is that the US economy as a whole is over-leveraged and over valued. The US need a HUGE amount of money to dig itself out. The only way for the US to get that money is that everyone continues to believe in the US.

With huge foreign holdings of US debt and US investments, if people suddenly started to doubt the US and started to disinvest, then the US economy could, in theory, collapse. The problem is that unlike the mean reverting view, in this view, the new equilibrium would leave the faith in the US economy so damaged that it would permanently destroy the US economy's value, and the US would never completely recover.

The Fed's experiment with Lehman caused a crash that has everyone spooked. They won't try it again. No other large US brand name can be allowed to fail. What the US government, Fed and all those illustrious economists are hoping is that if they can just hold on long enough, things will get better. They are banking on the assumption that it's in no one's interest to let the US fail. The alternative is a complete collapse of the US economy.

Are we really at such a cliff? Who knows? But you don't really want to find out by stepping off the ledge, do you?

However, note that all these interventions maintain a fiction. They keep you on the right side of the ledge. They don;t get you further away from the ledge. In fact, in some ways, they lift you up a bit, making the fall, if it comes, all the worse. So long as there is no catastrophic collapse of the economy, you could say these measures are working. But you are still at the edge.

To fix things, we still need to fix the underlying problem - asset price inflation. There are only two solutions. Either let the asset prices deflate. Or, let them stagnate until the value increases to the price. Neither is attractive. Both take time, maybe years. And, remember the second lesson from Enron is that ultimately the fiction can only maintained for so long. Let's hope the creditors of the US economy are more patient.

The $50BN fraud

This is the latest scandal to hit Wall Street. The facts are simple. Bernard Madoff, a hedge fund manager, has for years apparently run one of the biggest scams on wall street. He essentially took money from new investors and paid off older investors with it. The entire house of cards has collapsed with the fall in the world markets. The aggregate losses to investors, which includes some big names across the world, is estimated to be $50BN. He has been arrested, and is out on bail.

The puzzling part is that for years, investors, bankers, lawyers, IRS agents and auditors all scrutinized his books and concluded he was completely above board. The fact that this could continue for years (some estimate 10+ years) without alerting any regulators has investors shaken. The BBC is reporting that this has shaken foreign investors' confidence in the US regulatory system to an extent that could potentially have serious consequences for the US.

By the way, this is a classic Ponzi scheme. A Ponzi scheme is one where you delude people into thinking you are making them money by paying them off with money from incoming investors. You can keep this going so long as everyone trusts you.

The term "Ponzi scheme" refers to Charles Ponzi. Charles Ponzi was by no means the first to conceive of this. However, he did do it more extravagantly than most. In 1920, he was involved in a scheme to make money off arbitrage on postage stamps that promised to "double your money in 90 days". He realized soon enough though that he didn't actually need to buy the postage stamps and exchange them as he promised. He could do it on his books and everyone would go along with him. So, he kept paying off people with the money he collected from incoming investors. Ultimately, his scheme collapsed leading to his ruin, arrest and jail. He died in poverty in Brazil. Before he died, he is reputed to have told a reporter, "Even if they never got anything for it, it was cheap at that price. Without malice aforethought I had given them the best show that was ever staged in their territory since the landing of the Pilgrims! It was easily worth fifteen million bucks to watch me put the thing over."