AIG anger

AIG anger a roadblock to ending the credit crunch | The Australian

KEVIN Rudd is having his problems with the Senate, but they are trivial compared with the potential consequences of deteriorating relations between the Obama administration and the US Congress.

In fact, if Rudd is forced to significantly modify his proposed rollback of labour market flexibility, it will be a plus for the Australian economy and jobs. The same is certainly not true in the US.

If the latest flare-up over bonus payments to executives of insurance giant American International Group delays measures to fix the US banking system, then US and global recovery will be further set back.

Already the International Monetary Fund has again cut its dismal forecasts for global growth. Its first deputy managing director John Lipsky told a conference in Vienna this week that the IMF expects it will be the middle of next year before there are clear signs of a global upturn.

He added that even after recovery takes hold, global growth will be sluggish for some time and much weaker than levels seen earlier this decade. But there also is a consensus among the world's policy advisers, including the IMF, that there will no recovery until the US (and global) banking system is repaired.

This is reflected in last weekend's G20 communique from finance ministers and central bank governors meeting in London, which says their key priority is to restore lending by tackling head on problems in the banking system, by liquidity support, bank recapitalisation and dealing with impaired (toxic) assets.

And they all know this means particularly in the US.

According to reports, the meeting saw increased pressure on Barack Obama's Treasury Secretary Tim Geithner to speed up action to deal with US banks. Significantly, Geithner is emerging as the lightning rod for congressional fury over the AIG bonus issue, highlighting the risk of Congress rejecting expected administration requests for billions of dollars in additional funds to rebuild bank balance sheets.

The top Republican on the US Senate's banking committee, Richard Shelby, has warned that the Obama administration's handling of AIG is compounding the negative sentiment on more rescue money.

This is the second time in six months that AIG has threatened serious disruption of the international financial system. In September last year it was part of a series of tumultuous financial events that spilled over into a rapid collapse of economic growth in leading world economies.

On September 6 the Bush administration took over mortgage lending giants Fannie Mae and Freddie Mac. Later in the month, venerable Wall Street brokerage firm Merrill Lynch agreed to a takeover at a fire-sale price by Bank of America, but on the same day the Federal Reserve and the Treasury refused to bail out another Wall Street legend, Lehman Brothers, triggering global panic.

A couple of days later the Treasury and Fed decided, reluctantly, that they would rescue AIG with public money to avoid a looming meltdown in the international financial system.

AIG was on the verge of bankruptcy not because of its traditional insurance business but because of the activities of its financial products unit. This unit became a global leader in the financial derivatives market through what are known as credit default swaps: a form of insurance against default on corporate bonds and other securities, notably mortgage-backed securities, many backed by sub-prime housing loans.

In the boom times it seemed like money for jam, but when the boom went bust losses in the unit began to mount rapidly, pushing the whole business towards insolvency.

The US government, fearing a global financial catastrophe, gave AIG a two-year loan of $US85 billion and acquired an 80per cent stake in the company. Since then further government bailout funds have had to be injected, now totalling more than $US170 billion ($251billion).

It is executives of the financial products unit who have been paid the $US165million in bonuses that ignited the political firestorm engulfing Obama and Geithner this week.

Various steps are being taken to recoup these bonuses, but the damage has been done. Neither Congress nor the US public, which has deluged politicians with emails, letters and phone calls, will be eager to hand over billions more of taxpayers' money to bail out insolvent banks. Just how much more money may be needed won't be clear until the stress testing of leading US banks is completed, but the actual or de facto nationalisation of at least some large US banks is likely to be needed.

The longer this is delayed by congressional hostility to bailouts and nationalisation, the longer the US recession will run, as will the spillover into Europe, Asia, Latin America, Africa, India and other countries, including Australia. At the moment US politicians and their constituents are buzzing around like infuriated wasps and don't seem likely to be easily or quickly placated, just when urgent action on US banks is needed.

In his speech to Congress last month, Obama explained why urgent action is needed: "While the cost of action will be great, I can assure you the cost of inaction will be far greater, for it could result in an economy that sputters along for not months or years but perhaps a decade."

No wonder US Federal Reserve chairman Ben Bernanke, in an extraordinary appearance on US television network CBS's 60 Minutes, declared that of all the events and all the things he had done in the past 18 months, the one that made him angriest, that gave him the most angst, was the intervention in AIG.

So what happens while this is sorted out? We got the answer with the Fed's announcement it would pump another $US1.1trillion into financial markets, including this time buying $US300billion of US government bonds.

The Fed and other central banks will have to continue to play the role of banker to the financial system and economy, increasingly by printing money, something the Fed and the Bank of England have openly acknowledged doing. Their objective is to pump up nominal gross domestic product growth in a world where official interest rates are effectively zero, real GDP is falling and inflation risks are negligible.

In a world undertaking substantial private sector deleveraging, the alternative to reflating the economy is risk of a deflationary spiral. And with independent central banks, the historical danger of hyperinflation from governments printing money should not be a concern.

As Bernanke has pointed out, the money tap can be turned off relatively quickly as economies recover.