Germany Invades Poland: World War II Begins

During the night of August 31, 1939 a Mozart symphony was being broadcast over the radio station in Gleiwitz, a German border village now part of Poland, when a group of German Gestapo dressed in Polish army uniforms broke in. They began firing pistols and shouting in Polish over the open microphones that they were invading Germany. They brought with them Franciszek Honiok from the Sachsenhausen-Oranienburg concentration camp, also dressed in a Polish uniform, whom they injected with lethal poison and then shot, leaving his body behind to appear to be one of the unfortunate saboteurs. The next morning, three German army groups stormed across the Polish border starting World War II 72 years ago this week.

With the invasion well underway, Hitler continued the charade. At 10 a.m. that morning he addressed the Reichstag and said:

“Recently in one night there were as many as twenty-one frontier incidents: last night there were fourteen, of which three were quite serious. I have, therefore, resolved to speak to Poland in the same language that Poland for months past has used toward us...

… for the first time Polish regular soldiers fired on our own territory. Since 5:45 a.m. we have been returning the fire ... I will continue this struggle, no matter against whom, until the safety of the Reich and its rights are secured.”

Of course, all of the 21 “frontier incidents” had been staged by Germany under the code name “Operation Himmler” whose creator, Heinrich Himmler, was the head of the Gestapo. A week before the incidents, Hitler had boasted to his generals:

"I will provide a propagandistic casus belli. Its credibility doesn't matter. The victor will not be asked whether he told the truth."

Leading up to the invasion of Poland, Hitler had correctly concluded that British Prime Minister Neville Chamberlain and French Prime Minister Edouard Daladier were both appeasers – paralyzed by their nightmarish memories of World War I – and would therefore be slow to confront his militaristic aggressions. After all, in violation of the Treaty of Versailles which concluded World War I, both leaders had allowed German rearmament in 1935. Both had done nothing when Hitler again violated Versailles with his reoccupation of the Rhineland in 1936 and his demand for Anschluss, or union, with Austria in March 1938.

A few months later at Munich, both caved again and allowed Hitler to transfer the “ethnically German” Sudetenland from Czechoslovakia to Germany. The following year in March 1939, betting that Chamberlain and Daladier would do nothing again, Hitler occupied all of Czechoslovakia, violating the Munich Pact that he had signed with Chamberlain just six months earlier. The feckless Prime Minister had flown back to England waving that document and assuring the crowd greeting his return at the airport that he had won for them “peace in our time.” That phrase has gone down in history as the tagline for gullibility when naïve world leaders appease an international bully expecting that conciliation preserves peace. Think Jimmy Carter.

As he continued to reassemble pre-World War I Germany, in March 1939 Hitler demanded that Lithuania return the province of Memel, which Germany lost to it after World War I. Then he demanded that Poland permit the construction of a road and railways across its territories to rejoin East Prussia – severed after World War I – and Germany. Poland refused but thought it wise to enter into an agreement with Britain and France that would bring them to its aid if invaded. Hitler was so unconcerned with this treaty that the next month he ordered his generals to begin planning the invasion of Poland and scheduled it to begin on September 1.

However, Hitler was genuinely concerned that his invasion of Poland might threaten the paranoid dictator Josef Stalin and start a war on Germany’s eastern front. As much as he despised Stalin and hated communists, Hitler proposed that both Germany and the Soviet Union should invade Poland to their mutual gain in reestablishing their pre-World War I borders. Hitler’s Foreign Minister, Joachim von Ribbentrop, succeeded in negotiating a secret treaty with Stalin which was signed on August 23, assuring that the Soviet would not interfere with Germany’s invasion plan.

Hitler could not believe his good fortune.

Without any warning, then, three German army groups consisting 1.5 million men and 2,700 panzer tanks swarmed across the Polish frontier in the pre-dawn of September 1. The German battleship Schleswig-Holstein, which had arrived days earlier in the harbor of Danzig (modern-day Gdansk) on a “courtesy visit,” opened fire on the small Polish garrison there.

German tactics employed panzers to punch holes in Polish defenses in a rapidly-moving advance that prevented a static defense line from forming, quickly allowing the tanks to get into rear areas where they could isolate and envelop defenders before they could regroup. The infantry followed an hour or so behind the tanks to mop up surrounded defenders in a strategy later called blitzkreig or “lightning war.” Overhead 1,300 airplanes provided support to ground troops and tanks. Among them was the Stuka dive bomber acting as airborne artillery. The Stukas destroyed targets ahead of the tanks, preventing reinforcements. They were equipped with sirens intended to terrify their victims as they swooped toward the ground.

Behind the infantry came the SS Einsatzgruppen (special units) – little more than Himmler’s trained killers – who began roaming from house to house, systematically murdering local officials, teachers, doctors, aristocrats, Jews, clergymen, anyone who might oppose German occupation.

On the diplomatic front Poland called for help from its British and French allies at 8 a.m. on the morning of the attack. Not until 10 a.m. did the British Foreign Secretary, Lord Halifax, summon the German chargé d'affaires to ask for an explanation of this "very serious situation." The German chargé said his country was defending itself against a Polish attack.

Hitler still hoped that he might seize Poland without starting a war with the west. To that end, Italy's Benito Mussolini, who was not yet a German ally, hinted to British and French diplomats that he might be able to engineer a resolution with Germany if they would agree to allow the free city of Danzig, then administered by the League of Nations, to return to Germany as it had been before World War I. Without even demanding Germany’s withdrawal from Poland as a condition, the French foreign minister said he was interested in discussing it. But the British refused to engage in any talks without a German withdrawal first. In the end both countries sent their Berlin ambassadors to meet with the German Foreign Minister Joachim von Ribbentrop, warning him that they would fulfill their obligation to Poland unless the invasion was broken off.

Hitler remained adamantly silent to their threat. On the second day of the invasion, Britain was ready to issue an ultimatum, but France stalled for more time saying its army was not prepared to take the field. That evening, Chamberlain addressed the British House of Commons about the crisis. But Commons was fuming over his dithering, giving him no choice but to tell the French that Britain would go it alone if necessary.

At 9 a.m. on the morning of the 3rd, the British ambassador in Berlin, Sir Neville Henderson, was told to deliver a final ultimatum. Ribbentrop refused to receive him. Henderson was told to give his ultimatum to his German interpreter, which he did, reading a prepared text to the interpreter.

In 1945 Ribbentrop’s interpreter, Paul Schmidt, recalled the encounter. “I regret that on the instructions of my Government I have to hand you an ultimatum for the German Government,” Henderson said with deep emotion, and then he read it out loud:

More than twenty-four hours have elapsed since an immediate reply was requested to the warning of September 1st, and since then the attacks on Poland have been intensified. If His Majesty's Government has not received satisfactory assurances of the cessation of all aggressive action against Poland, and the withdrawal of German troops from that country, by 11 o'clock British Summer Time, from that time a state of war will exist between Great Britain and Germany.

The two men expressed regret over the circumstances that would end their personal and diplomatic relationship, and then Schmidt took the document to Hitler’s Chancellery. Ribbentrop, he recalled, was standing by a window and Hitler was seated behind his desk. Most of the members of Hitler’s Cabinet and key men of the Nazi party had gathered anxiously in the anteroom next to Hitler's office.

Schmidt translated the ultimatum aloud to Ribbentrop and Hitler and then stood in silence.

After what seemed like an eternity, Schmidt said, Hitler turned to Ribbentrop, who had remained standing by the window. “What now?” asked Hitler with a savage look, as though implying that the Foreign Minister had misled him about England's probable reaction. Ribbentrop answered quietly: “I assume that the French will hand in a similar ultimatum within the hour.”

Schmidt left Hitler’s office and passing through the anteroom he said to those gathered: “The English have just handed us an ultimatum. In two hours a state of war will exist between England and Germany.” Again the news was followed by complete silence.

Air Marshall Goering looked at him and said: “If we lose this war, then God have mercy on us!” Propaganda Minister Goebbels stood in a corner, downcast and self-absorbed. Everywhere in the room Schmidt saw looks of grave concern, even among the lesser members of the Nazi party.

Hitler had gambled and lost.

At noon on September 3, Chamberlain spoke in the Commons saying that his years of appeasing Hitler had come to naught.

This is a sad day for all of us, and to none is it sadder than to me. Everything that I have worked for, everything that I have believed in during my public life has crashed into ruins. There is only one thing left for me to do: that is to devote what strength and powers I have to forwarding the victory of the cause for which we have to sacrifice so much.

In months, the Chamberlain government would collapse, and the king would invite Winston Churchill to become his Prime Minister.

The night of Chamberlain’s Commons speech, the British liner Athenia on its way to Canada was torpedoed and sunk 200 miles west of Scotland by a German U-boat. Of its 1,400 passengers, 112 were lost, among them 28 Americans. They were the first to die in the war.

Also that night, Adolf Hitler left Berlin for Poland to see what his armies had wrought. He was met by General Heinz Guderian, his tank commander who had cut a swath through northern Poland connecting East Prussia and the Baltic with Germany once again. Together they toured in Hitler’s car. When Guderian showed Hitler all that remained of a Polish artillery regiment, Hitler asked, “Our dive bombers did that?” Guderian proudly answered, “No, our panzers.” This was the killing power of blitzkrieg.

By September 6 two of the three German army groups had linked up at Lodz in the center of Poland. This cut the country in two and trapped a large part of the Polish army between the attackers and the German border. In two days all that would remain of the Polish fighting strength would be encircled in five isolated pockets.

By September 8 German panzers were in the outskirts of Warsaw. The blitzkrieg had covered 140 miles in only eight days. The battle was essentially over. Two days after that all remaining Polish forces were ordered to regroup in eastern Poland against the Romanian border bridge and hope for relief from the British and French. That help would not come.

On September 17 the Red Army crossed the Polish border in the east, ending any hope for Poland to survive as an independent country.

The Polish navy had fled to England with the outbreak of hostilities. Many survivors of the ground fighting got across the Romanian border and eventually worked their way to the west to fight as Free Polish Forces with the western allies. These included many Polish pilots who made it to England and joined the RAF. They would later fight in the Battle of Britain.

The defenders of Warsaw held out under unrelenting German bombing until September 27 before surrendering.

When the fighting ended, about 65,000 Polish troops had been killed. The Germans seized 420,000 soldiers as prisoners and the Soviets seized 240,000. Most of the prisoners would come to a bad end. About 120,000 Polish soldiers escaped through the Romanian Bridgehead when it was evident that they would get no help from England or France.

Germany sustained relatively heavy losses in vehicles and planes – approximately the equipment of an entire armored division and 25% of its air strength. Their personnel losses were about 16,000 killed, a small percentage of the troops that entered the battle but a substantial enough number to prove this had not been a German cakewalk.

Five weeks after the invasion, Poland was completely occupied and would remain occupied by German forces for another 5 ½ years. Over five million Poles would be killed during World War II, three million of them Polish Jews.

It’s Nixon’s Fault

Last Monday was the 40th anniversary of President Nixon’s unilateral decision to end the 1944 Bretton Woods system of international exchange which tied the US dollar to gold at a rate of $35 per ounce. We’ve been paying for it ever since and that the current international financial turmoil is evidence. Gold closed for the first time above $1,800 per ounce this week, meaning the dollar since Nixon’s time has depreciated to about 18 cents.

What hath Nixon wrought?

The economies of the post-World War II world had to be rebuilt and one way to do that quickly was through international trade. Free trade relied on a predictable conversion of international currencies since there was no “world currency” or world government that could issue currency and manage it. Therefore the architects of the Bretton Woods system set up a system of fixed exchange rates that allowed governments to buy or sell their gold at the price equivalent to $35 per ounce.

If a country was overstocked with dollars because of positive trade balance with the US, its central bank could present a pile of dollars to the central bank of the US (i.e. the Federal Reserve) and get it redeemed for gold at $35 per ounce instead of holding dollars. Why would central banks do this? Because they might believe the US was printing too many dollars – like Nixon did to pay for the Viet Nam war. There was obviously a limit, however, to how long the US Fed could exchange gold for dollars before it had none and therefore had no backing to its currency.

Faced with that fact, Nixon announced on August 15, 1971 that the US would no longer honor the Bretton Woods arrangement, thus breaking the links between the major world currencies and a real commodity like gold. The gold standard has not been used in any major economy since that time.

The dollar thereafter became “fiat currency,” backed by nothing but the “full faith and credit” of the federal government – a euphemism for its ability to tax its citizens. In effect the dollar was worth what people thought it was worth. This became known as the Nixon Shock in which the US dollar replaced gold as the sole backing of currencies and became the reserve currency for other sovereign states.

One advantage – some say the only advantage – of tying a currency to a gold standard is that it prevents a country from printing too much money. If the money supply rises too fast, then people will exchange the money being cheapened by its abundance for gold whose supply is fixed in the short term. Over-printing money will therefore cause the country’s treasury to eventually run out of gold – an incentive to turn off the printing presses. In the case of the US, the Fed would be restricted from enacting policies that significantly alter the growth of the money supply, which in turn limits the inflation rate of the country.

The gold standard also impacts foreign exchange markets. If Canada is on the gold standard and has set the price of gold at $100 Canadian an ounce and Mexico is also on the gold standard and set the price of gold at 5,000 pesos an ounce, then one Canadian Dollar must be worth 50 pesos. The widespread use among countries of gold standards therefore establishes a system of fixed exchange rates. If all countries are on a gold standard, there is then only one real currency, gold, from which all others derive their value. The stability that the gold standard imposes on the foreign exchange market is often cited as another of its benefits.

While the stability caused by the gold standard is among its greatest strengths, it is also one of its greatest weaknesses. If exchange rates between currencies are fixed, notwithstanding the changes in the economies of those countries, a profligate country is insulated from suffering the monetary consequences of trashing its economy. Moreover, a gold standard severely limits the stabilization policies the Federal Reserve can use to combat bona fide requirements to print money – like calming the stock market sell-off panic of 1987. These attributes cause countries with gold standards to have severe economic cycles.

So it might seem that the only benefit of the gold standard is that it prevents long-term inflation in a country by blocking the over-printing of money. However, some gold standard critics point out that even this benefit is questionable. If you don’t trust a central bank to keep inflation low, why should you trust it to remain on the gold standard for generations? Or to stick with the exchange to which the currency is tied?

But absent a gold-based currency, all sorts of currency skullduggery becomes available to a government. The US, for example, can inflate its way out of debt. Greece can’t do that; because it traded the drachma for the euro in 2001, and Greece can’t print euros. Many say the US ought to take advantage of this unique opportunity. Inflation, they argue, is good for debtors and bad for creditors, and we should not forget that the US is the world’s biggest debtor nation. Judicious money printing – what Fed Chairman Bernanke calls “quantitative easing” – supposedly lets the Fed control inflation somewhat. While inflation like taxes acts as a drag on economic growth, and while it hits the poor harder than any group in society, politicians can shrug their shoulders on election day and claim innocence in causing inflation which they can’t do when they raise taxes.

But investors around the world aren’t taken in by currency manipulations. They know the incompetence of the US in managing its financial affairs can explode into a fiscal crisis at any time. And they know demagogues like Obama penalize success by taxing it away and whining about corporate jets – all the while creating an economic climate that is hostile to business and causes it to park $1.5 trillion on the sidelines instead of creating jobs. The recent stock market roller coaster is symptomatic of what these policies cause: the flight to gold – the historic haven from inflation and government-caused bubbles.

Were it not for Nixon, it is quite likely that we would not have suffered the financial crisis of the past four years; or the multiple crises that have rocked world economies. We likely would have avoided the recent stock market roller coaster and S&P downgrade, both of which came after the feeble debt ceiling settlement.

How?

When a bank creates credit for a private loan to a business or individual, it expands the money supply. If nothing else changed there would then be more money chasing the same quantity of goods – the prescription for inflation. The thing that prevents inflation in this case, however, is that the bank expects something in return for its loan – a return of its principal with interest. This means the borrower has to do something to get richer in the future in order to repay the loan with interest and do so fairly quickly – not decades down the road. The economic return created and the relative speed with which it’s created assures that the monetary system only increases the money supply in parallel with an increase in output – more goods – which is not inflationary. Should the borrower fail to get rich enough to repay the loan and defaults, the bank loses some of its capital and must restrict its future lending.

This is not the case when the government borrows money. Unlike business or individual borrowing, which may default because of incompetence or circumstances that can’t be controlled, the government is presumably always a good risk to the extent that it taxes its citizens to repay its loans. (People often forget that the government is a pauper supported by its productive class. Moreover, the US government has an outstanding record in its ability to collect taxes relative to that of other countries whose citizens make tax evasion an art form.)

A loan to the government increases the money supply just as a private sector loan. But that is where the similarity ends. Government borrowing is not compelled to create wealth to repay its obligations since taxpayers are its default protection – its collateral, if you will. And government borrowing is almost always wasted because its expenditures create no offsetting value for the economy. Defense spending, while judicious in a dangerous world, is waste. Welfare spending, while humanitarian, is waste. America’s nomenklatura may beat its collective breast and boast about the jobs government creates, but government creates “jobs” by hiring one person to dig a hole and another to fill it up. Then how about the millions on the government payroll who comprise its bureaucracy? Government pays people to administer its programs, most of which are waste – the equivalent of digging a hole and refilling it repeatedly. But government can’t create the equivalent to a private sector good or service or the value-creating jobs that produce those products and services.

Absent the linkage between money supply and the added value needed to get richer, which exists in private sector borrowing and spending, government borrowing and spending is always inflationary, doubly so because taxing also removes money from the private sector that would otherwise be productively deployed.

None other than Alan Greenspan recognized these defects and spoke in favor of a gold-based currency. In his essay “Gold and Economic Freedom” he wrote that the opposition to the gold standard by big government welfare state advocates was prompted by their recognition that the gold standard is incompatible with the chronic deficit spending needed to support the welfare state. The welfare state, he further notes, is nothing more than a mechanism by which governments confiscate the wealth of the productive members of a society to support its welfare schemes and that this confiscation is accomplished through taxation and inflation.

Over 40 years ago, Greenspan said welfare (which we call entitlements today) statists are quick to recognize that if they wish to retain political power, the amount of taxation had to be limited, and they had to resort to borrowing to support welfare and other programs. Borrowing became the drug for deficit spending, and the governments of industrialized economies are addicted to it.

A gold standard currency restricts the amount of deficit spending because every extension of credit must be offset by a claim on tangible assets. But absent a gold standard, the government issues bonds that are not backed by tangible assets. They are backed government's promise to repay debt out of future tax revenues – in effect mortgaging future generations who become the government’s collateral. As more and more is borrowed, then more and more bonds are printed and sold to creditors but only by increasing the interest rate. Year after year deficits pile up forming a fiscal coral reef that we call the national debt – now $14 trillion in the US.

By abandoning the gold standard, Nixon allowed future government statists like Obama to throw away the national debit card and opened the way for them to convert the banking system to an unlimited credit card. Treasury bonds replaced tangible assets and became treated as if they were what a deposit of gold formerly was.

Until recently, the US government recognized the danger in allowing its citizens to own gold and prevented it. Since growing the money supply increases inflation and inflation causes society’s earnings and savings to lose value, inflation is confiscation in disguise. Without the gold standard, there is no way to prevent this confiscation. Roosevelt realized that if everyone converted their bank deposits into gold (or silver, or another valuable commodity) and refused to accept paper money or checks as payment for obligations, the government could not create its massive borrowing potential by issuing Treasury bonds. Therefore, he issued his illegal and unconstitutional 1933 Executive Order 6102 forbidding private holdings of gold. President Ford sensibly repealed it in 1974.

In the first 19 months of the Obama administration, the federal debt held by the public increased by $2.53 trillion, which is more than the cumulative total of the national debt amassed by all US presidents from George Washington through Ronald Reagan. Most Americans understand that their currency is losing value and that their tangible assets – homes, stocks, personal property – are being undermined by government spending. That is why there is a flight to gold pushing its price over $1,800 per ounce with expectations that it could go above $2,000 if not more by year end.

It may not be possible to get our government back on a gold standard. But many of us are already there.

What in the World Is Happening?

Or maybe the way the question should be asked is, “What is happening in the world?”

The Republicans and Democrats had their shoot-out at the Not So OK Corral last week and then went home to rest from their labors, confident that they had given the markets assurance that a $900 billion spending reduction – spread over ten years (that’s $90 billion annually for those of you from Palm Beach County, FL) – could somehow equate to increasing federal spending by $7 trillion over 10 years. Since the Congressional fat cats had planned to increase, yes increase, spending by $8 trillion, they thought the reduction to $7 trillion should count as a cut. Why not then plan to increase spending by $10 trillion, cut it to $7 trillion, and then Congress could have gone home to the voters claiming they had saved us tax-paying troglodytes $3 trillion? In fact you could pick any set of numbers and have all kinds of savings. Wow! This Washington math is great!

“Honey, I bought this $750 thingamajig that I really didn’t need and couldn’t afford, but it was on sale and marked down from $1,000 … I saved us $250!”

This kind of fiscal silliness caused the US stock market to respond by shedding 2,000 points (16%) over the last two weeks.

Then, alas, Standard & Poor’s downgraded its credit rating on long term US government debt for the first time in history. Yep, from AAA to AA+ saying the deal reached by lawmakers to cut the federal deficit by an estimated $2.1 trillion over a decade didn’t go far enough, and “America’s governance and policymaking [is] becoming less stable, less effective, and less predictable than what we previously believed.” Ouch!

His High and Mightiness felt compelled to provide his own risk analysis: “No matter what some agency may say, we’ve always been and always will be a triple-A country.” Yeah, well tell that to American investors who are afraid (rightfully so) that we are headed into the second dip of a double-dip recession. They know the Federal Reserve, with interest rates essentially at zero, has limited ability to pull another rabbit out of the hat. Two rounds of quantitative easing (called money-printing for you monetary tyros) pumped $2.3 trillion into the financial markets but failed to get the economy so it could stand on its own.

Then last week, trying to cajole a swooning stock market to stop swooning, Fed Chairman Bernanke, over the objections of three other Fed members, promised to keep interest rates where they are for two years. Assuming he means to keep this promise, it was stupid to make it, since Bernanke can’t see the future and doesn’t know what will happen that may compel interest rates to rise.

Rather than pander to the stock market as an election approaches, I hope Bernanke is paying attention to the Vesuvian eruption that may be building in the European Union. Americans don’t pay much attention to what is going on across the big pond, but if the European Union or the euro collapse, our economy can be dragged into their financial cesspool.

Quick background …

The European Union (EU) was created in the early 1990s to challenge the efficiency of the US domestic market and to challenge the US standing as a superpower. It is an economic and political integration of 27 member (primarily European) states with a combined population and GDP that approximately equals that of the US. The major EU countries ranked in terms of their population are Germany, France, UK, Italy, and Spain, which represent a substantial majority of the EU population.

The EU has a European Central Bank (ECB) that functions like a poor imitation of the US Federal Reserve, and there are other governmental institutions that try to operate independently of member countries but can’t because members have not given up their sovereign identities.

The eurozone is a monetary union of 15 countries which have traded their sovereign currencies for the euro. This eliminated the shifting exchange rates that hampered trade between these 15 countries. The UK, Sweden, and Denmark have remained in their sovereign currencies but are members of the EU. A common currency allows (in theory) the euro to compete with the dollar as a world reserve currency.

Both US and Europe are currently in economic turmoil. Why? Because the underlying structural problems in the US and global economies that caused the financial and economic crisis in 2008 have not been fixed.

Specifically, the US and other industrialized economies were and continue to live and spend beyond their means – consuming more than they produce. Moreover, the Asian (largely Chinese) economic boom has been fueled by intentionally undervalued currencies that imported a massive dollar reserve and caused the credit bubble in the US that burst three years ago. Finally, the eurozone system may have a single currency and a single monetary policy, but it doesn’t have a single economy running along side of it. A single economy, while essential, can’t be created simply by converting to a single currency.

In the post-crash years after 2008, the economic wizards in the industrialized economies resorted to what all good little Keynesians do – they flooded their economies with taxpayer-funded stimulus gimmicks in the form of deficit spending and money printing, which may have prevented a few people from leaping off of tall buildings, but it did nothing to create the virtuous cycle that only the private sector can create: i.e. growing sales and profits and employment that reinforce each as a self-sustaining growth engine. “Shovel ready” is what you expect to find in a pile of horse or cow manure and a politician, not in a sputtering economy. How’s the “hope and change” workin’ for ya’?

Since few politicians have ever held a real job, they fail to understand that only markets can right-size companies and industries, find the market-clearing price for houses and shopping centers, or bring wages in line with global competitive realities. Only markets can wring the speculative premium out of the price of stocks and commodities. And only markets can move workers from where they live to where they are needed, and create a match between the skills workers offer and the skills that companies require. These market corrections have to be allowed to happen not only in the US, but also Europe, China, Japan, and most of the rest of the world in order to bring an end to the current world economic mess. Right now, the EU is the ticking time bomb.

To put in perspective its importance to the US, the EU represents about 20% of the world economy and buys about 25% of American exports.

In 2010, Greek, Irish and Portuguese government debt totaled about $910 billion, a relatively small fraction of the debt of all members of the European Union – less than 7%. But even then it was well over the debt and deficits allowed for eurozone members. Deficits aren't supposed to rise above 3% of GDP for eurozone members, and debt should be no more than 60%. But these guys didn’t play by the rules. With a little book-cooking help from Goldman Sachs, which showed Greece how Enron accounting works, Greece had a deficit of 15% of GDP, Ireland 14%, and Portugal 12%.

In the short space that I have, let me just pick on the profligacy of Greece.

The wage bill of the Greek public sector has doubled in the last decade in real terms – and that number doesn’t take into account the bribes collected by public officials. (We call them campaign contributions in this country.) The average government job pays almost three times the average private-sector job. Sound familiar?

The national railroad has annual revenues of 100 million euros against an annual wage bill of 400 million, plus 300 million euros in other expenses. The average state railroad employee earns 65,000 euros a year ($92,600).

The Greek public-school system is a study in breathtaking inefficiency: one of the lowest-ranked systems in Europe, it nonetheless employs four times as many teachers per pupil as the highest-ranked school system: Finland’s. Greeks who send their children to public schools simply assume that they will need to hire private tutors to make sure they actually learn something.

There are three government-owned defense companies: together they have billions of euros in debts, and mounting losses.

The retirement age for Greek jobs classified as “arduous” is as early as 55 for men and 50 for women. As this is also the moment when the state begins to shovel out generous pensions, more than 600 Greek professions somehow managed to get themselves classified as arduous: hairdressers, radio announcers, waiters, musicians, and on and on and on.

The Greek public healthcare system spends far more on supplies than the European average, and it is not uncommon to see nurses and doctors leaving the job with their arms filled with paper towels and diapers and whatever else they can plunder from the supply closets.

You get the picture.

Greece, like the US, borrows a good deal of its current spending. Unlike the US, Greece is a terrible credit risk so its bond interest rates were going through the roof. Facing default, the International Monetary Fund and EU remonetized the Greek debt at lower interest, but even that interest has proved too high for Greece to carry. An independent nation could print more money and inflate its debt away, but because Greece is an EU member only the ECB can print money.

Therefore, the Greek government tried to impose austerity – good sense reductions in social spending, reductions in entitlements … the things the US ought to be doing. Austerity, however, is a relative term. When you and I have to bring our spending in line with our incomes, we don’t call it austerity, it’s just a fact of life. But when people have become so dependent on government largess, in fact addicted to it, asking them to retire at 55 instead of 50 is like sentencing them to five years at hard labor. The Greeks therefore took to the streets and rioted and burned and stamped their feet and held their breath like children until they turned blue. (Welfare-related riots are going on in London, and short of extreme violence, we saw similar civil unrest in the recent Wisconsin thuggery protesting Scott Walker’s attempt to bring budget sanity to a union-owned state. Expect to see more of this bed-wetting if the US Congress tries to cap entitlement spending.)

The Greek fiscal virus has now spread to Portugal, Italy and Spain, which along with Greece, are unflatteringly referred to by the acronym PIGS. These countries are realizing – as the US must also realize – that the much vaunted "European model" of generous welfare benefits is unsustainable and must renege on its promises. Predictably, this is highly unpopular among its entitlement addicts, and strains are beginning to show between the PIGS and non-PIGS in a real-world demonstration of Orwell’s Animal Farm dystopia.

Thus, while the EU financial crisis dominates the headlines, the real news is the potential of the political crisis to disintegrate it. The EU street is suffering the economic consequences of integration and the non-elite are grumbling about lost nationalism. Political pressure could build in some member states to the point that they pull out, walk away from their debts and the euro, and start over as independent states. Let’s hope that saving the EU is as important to its leaders as saving the euro.

Here is a chart that shows how incestuous the PIGS and non-PIGS lending is. (It’s called PIIGS in the chart because Ireland is included.) Obviously, if even one of the PIGS fails, it will pull down the pigsty, the barn, maybe the surrounding farm and fields. It won’t be pretty.

And the US won’t escape the implosion.

US banks and investment funds will be severely stressed. While they have relatively little risk exposure in Greece, their direct exposure in Italy and Spain is close to $85 billion and their indirect exposure through derivatives and financial contracts are about $365 billion. Money market funds have $1.2 trillion invested in European banks.

What would we do if the EU crisis defaults its obligations to the US? Another US bank bailout? Where’s the money going to come from?

As surely as the Berlin Wall collapsed and along with it the Marxist economic experiment, the European welfare regime is crumbling. Yet during the US debt ceiling debate, the America Left was outraged that any rejiggering of entitlements would be a consideration in the reform calculus. Entitlements consume over 60% of federal spending and will consume all of the tax revenue in 2049 if they aren’t reformed. That doesn’t include the newest entitlement in the American welfare pantheon: ObamaCare.

On the heels of the debt ceiling compromise, which kicked the can down the road to a super committee whose members won’t be able to agree on bathroom breaks, the S&P downgrade decision assured that the debt crisis will not disappear from the American political consciousness until after the 2012 election as Obama had hoped. Far from it. The debt crises in Europe and the US are too interconnected. They will be fodder for front page punditry well into the 2012 election cycle. The evening TV news images of the EU crisis playing out in its streets will make the albatross of American entitlement spending impossible to ignore.

It’s the Left’s worst nightmare.

Fanniegate Part Deux

Continuing from last week, I am reviewing Morgenson and Rosner’s eye-opening new book about near meltdown of the American economy in 2008 – Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon. You may want to reread last week’s blog before this one.

What role did the rating agencies, regulators, and the revolving door between Washington and Wall Street have in protecting Fannie and Freddie instead of protecting investors and taxpayers?

Were the rating agencies culpable? Not wantonly. However the best and the brightest don’t go to work for a low-paying rating agency; they go to work with the high-paying big brokerage firms creating these exotic CDO and credit default swap “investments.” So the ratings agencies are chronically behind the power curve from the get-go as new products emerge from the brains on Wall Street, and since the Street can innovate so fast, Fitch, Moody's, and S&P analysts can’t keep up. If anything, the rating analysts want to accommodate their clients in hopes that they can jump ship to where the big bucks are. Moreover, CDO risk was hard to comprehend in the early days because of their limited history, and their rapid diffusion into the investor community spread the cancer before it could be detected.

How about the regulators? Were they asleep at the switch? In a sense agency regulators were outmaneuvered and policy regulators were lulled into complacency. Fannie CEO James Johnson and the Fannie/Freddie tag team were always able to quash any regulatory agency’s aggressiveness by complaining to Congress that closer scrutiny would impede their mission to get more low income people into home ownership. And with conniving campaign contributions, Johnson was also able to persuade Congress that their committees and subcommittees could provide better oversight than a regulatory agency. Those relative few in Congress who paid attention to Fannie’s shenanigans and objected to its manipulations were silenced or ignored.

Policy regulation also eased. Some of the easing was the relaxing of historic requirements that prevented unqualified people from being home buyers. Some easing was legislative. For example, in 1999, led by Republican Sen. Phil Gramm, Congress repealed Glass-Steagall – a law dating back to the New Deal when in 1933 it had been enacted to prevent certain types of financial institutions from merging or otherwise getting into conflicting businesses. Sanford (Sandy) Weill, CEO of Travelers Group, found his way blocked by Glass-Steagall when he thought it would be sorta’ nice if his company and John Reed’s Citibank could merge to form Citigroup. It didn’t hurt that Weill the Dealmaker had friends in high places, like Robert Rubin, Secretary of the Treasury, who would pull the congressional strings needed to clear the way for Weill to work his will. Rubin would subsequently leave Treasury and return to corporate American where the real bucks were. In fact his first job after leaving Treasury was Vice Chairman of Citigroup. Payback time! Over the next decade, Rubin would move up to Chairman and make more than $100 million, even as Citigroup sank deeper in the financial tar pit – requiring it to be rescued twice by taxpayers and forcing him to leave and join the unemployed. Poor baby.

There was a good reason for keeping commercial and investment banks separate – it protected depositors from losing their money if a commercial bank incurred losses trading for its own account. But with Glass-Steagall gone the door was open for banks to take greater risk. This should have been cause for the Federal Reserve to keep activities under tight scrutiny. Instead, the Fed was convinced that bankers would do the right thing. Why would bankers blow up their own company, the Fed reasoned? In fact, Alan Greenspan promoted this casual view. But in 2009, with the financial world flapping like a torn flag in a stiff breeze, Greenspan acknowledged his naiveté. His Ozship was no Wizard after all.

A tight web of personal relationships connected Fannie, Goldman Sachs, Citigroup, the New York Fed, the Federal Reserve, and the Treasury. In 1996, Fannie added Stephen Friedman, the former chairman of Goldman Sachs, to its board. In 1999, Fannie’s CEO Johnson joined Goldman’s board. Rubin’s protégé, Timothy F. Geithner, became President of the New York Federal Reserve Bank in 2003 and reduced its oversight of Wall Street. At that point, the banks knew they held all the cards, authors Morgenson and Rosner contend in their book.

Henry “Hank” M. Paulson Jr. became the head of Goldman in 1999 after CEO John Corzine, having made $500 million during his tenure, left to become first the Senator and then the Governor of New Jersey. Paulson’s tenure created many of Goldman’s most disastrous securities – while Geithner’s New York Fed looked the other way. While Big Hank headed Goldman, his net worth grew to $700 million. As the Treasury Secretary under George W. Bush, Paulson would oversee the taxpayer bailout of Fannie Mae, Freddie Mac, Goldman, Citigroup, other banks, and the giant insurer American International Group (AIG), on which Goldman had relied. As head of the New York Fed, and then as the Obama’s Treasury Secretary, Geithner would also oversee the bailout. Geithner was another of Sandy Weill’s protégés, and Weill even invited him to come over and run Citigroup before Geithner accepted Obama’s invitation to be Treasury Secretary.

The revolving door between Washington’s regulators and Wall Street was openly incestuous.

Without Wall Street’s willingness to supply billions of dollars to reckless lenders, the millions of Johnson’s bad loans couldn’t have been made. But enticed by the fees that Wall Street made to underwrite Fannie and Freddie’s securities, further enticed by the money to be made supplying credit lines to lenders like Countrywide to expand into risky mortgages, and even further enticed by the commissions made selling the MBSs and CDOs to investors around the world, the greed machine kicked into high gear.

As it did, Fannie’s privatization detractors began to take notice of its warm and fuzzy claim of helping the underprivileged homebuyer, particularly the claim that its federal perks allowed Fannie to pass through its lower borrowing cost to its customers. The distinctly unfuzzy CBO was one of those detractors. In 1995 CBO deputy director, Marvin Phaup, calculated that Fannie and Freddie realized about $7 billion in benefits from their government links and they kept $2.1 billion for themselves and their shareholders. Phaup had discovered how Fannie was able to pay exorbitant executive bonuses and fund its self-preservation schemes.

Phaup’s report noted that the top five executives at Fannie held $44 million of its stock at the end of 1995. Since the management team at Fannie controlled taxpayer subsidies to a considerable extent, compensation levels like this could be in conflict with the interests of taxpayers and the government, Phaup therefore reported. “Congress may want to revisit the special relationship that exists between the government and Fannie Mae and Freddie Mac.” Oops!

CBO head June O'Neill was asked to quash the publication of the report but she refused. Then she received a visit from Franklin “the Enforcer” Raines, chief goon of Fannie’s CEO Johnson, who would later succeed Johnson as CEO. In her own words, O’Neill said, “Frank Raines and Bob Zoellick came and met with me and the people from CBO. All of us had the same feeling – that we were being visited by the Mafia.” O’Neill later testified before Congress corroborating the report’s findings but Congress wasn’t interested.

Although David Maxwell, James Johnson’s predecessor, had walked away with $20 million at his retirement, executive compensation at Fannie and Freddie had been relatively conservative. But when Johnson took over, compensation became tied to earnings growth and earnings growth became a strategic goal. During Johnson’s tenure, which ended in 1999, the annual executive incentive pay ballooned from 0.46% of after-tax profits to 0.79% – an increase from $8.5 to $35.2 million annually. Over his nine years while running Fannie, Johnson would personally take home roughly $100 million. His successor, Frank Raines, would do as well. The executives at Fannie and Freddie paid themselves private sector salaries without taking private sector risks.

The following year a long-delayed report required by law from Treasury was scheduled for release. It detailed the risks that Fannie and Freddie represented to the taxpayers and argued for their privatization. The CEOs of both Fannie and Freddie got copies. As usual, Johnson employed his brass knuckle approach in dealing with this threat. A meeting was demanded with Treasury Secretary Robert Rubin. Since Rubin was a personal friend of Johnson, he delegated the matter to Larry Summers, the Deputy Secretary who would later succeed Rubin as Secretary. The meeting dragged on over two days during which Fannie’s EVP, Robert Zoellick, and its CFO, Tim Howard, argued strenuously against the report’s conclusions. The conclusions were unacceptable, one observer recalled them saying. After the meeting ended, Summers demanded that staffers rewrite the report. One of the staffers said, “Nobody has bullied me in my adult life the way that Larry did on this one.” Summers and Zoellick met again after the meeting to discuss the position Treasury would take on privatization, after which Zoellick was seen “floating with euphoria” in the halls of Treasury, say the authors.

Incidents like these gave Fannie’s executives free rein to underwrite far more loans, further enriching themselves and their shareholders, but at increasing risk to taxpayers as lending standards declined.

A Johns Hopkins researcher studied those declines in underwriting standards and he too concluded it was time to cut the umbilical cord to Fannie and Freddie. In his 1995 report entitled “Government-Sponsored Enterprises and Changing Markets: The Need for an Exit Strategy,” Thomas Stanton wrote, “Pressure for the status quo, often backed by powerful political constituencies, can deter the government from acting until it is very late.” Johnson turned on Fannie’s PAC machine and began making generous contributions to the political campaigns of lawmakers. Stanton’s warning went nowhere in Congress.

Democrat Rep. Barney Frank considerably enjoyed Fannie’s largesse, which included not only campaign contributions (called bribes in most countries) but also the employment of Herb Moses, his “lover,” as Frank usually introduced him, in a cushy job at Fannie in 1991. In 2010 Frank was asked if Fannie’s hiring of Moses put him in a conflicted position for working on legislation favorable to the organization and Frank said, “I don’t think it influenced me at all.”

Other Congressional recipients of Fannie’s appreciation were Democrat Rep. Maxine Waters, Democrat Rep. Henry Gonzalez, Republican Sen. Chris Bond, Republican Rep. Robert Ney (later convicted of felony in the Abramoff bribery scandal that also snared Tom Delay), and Republican Sen. Bob Bennett.

Fannie’s payment of protection money would prove to be well spent. After a 2005 speech, Barney Frank was asked if the Fannie/Freddie subsidies would lure people into housing they couldn’t afford, he brushed it off with a curt, “We’ll deal with that problem if it happens.” When asked if it was becoming clear that Fannie and Freddie’s business practices were incautiously risky, Frank came back with “I think we see entities that are fundamentally sound financially.” During congressional hearings about Fannie and Freddie in 2003, Frank concluded that “there has been more alarm raised about potential unsafety (sic) and unsoundness than, in fact, exists.” Frank became Fannie’s most tireless defender and he was their baby.

Rep. Maxine Waters, water-carrier for Fannie, (sorry: couldn’t resist that one,) refused to support Republican Rep. Richard Baker’s 2003 plan to transfer oversight of Fannie and Freddie to a regulator in Treasury. Fannie liked being overseen by the feckless Office of Federal Enterprise Oversight (OFHEO) because it was weak and malleable. Republican Rep. Robert Ney, who received $10,250 from Fannie’s campaign gift machine and Republican Rep. Ed Royce, who received $5,850, sided with Waters. “I’ve sat through nearly a dozen hearings where, frankly, we were trying to fix something that wasn’t broke,” Waters said. “Housing is the economic engine of our economy and in no community does this engine need to work more than in mine.” Earlier that year Waters had introduced an initiative to eliminate down payments for low income homebuyers.

Fannie and Freddie had other powerful Republican defenders in the fight against increased oversight including Newt Gingrich and Robert Zoellick. Zoellick used his sharp elbows in Congress to assure that Fannie didn’t face tougher oversight, while Gingrich once stated that “Fannie Mae is an excellent example of a ‘former’ [my quotes] government institution fulfilling its mandate while functioning in the market economy.”

Fannie even bought off academia, commissioning well-compensated reports from leading lights. Of note, the frequently obtuse economists Joseph Stiglitz (whose text I used in graduate school) and Peter Orszag (later Obama’s OMB Director) authored a study that chided critics who argued that “both Fannie and Freddie posed significant risks for the taxpayer.” According to these wise ones, the possibility of a blowup was “substantially less than one in 500,000 – and may be smaller than one in three million.” In 2003, the vastly overrated Republican Bush advisor, R. Glenn Hubbard, wrote a paper defending Fannie Mae’s risk management.

As George Bush began his campaign for a second term, an accounting audit found some significant book cooking at Fannie. By then Johnson had left as CEO and Frank Raines had taken over in 1999. The Office of Federal Housing Enterprise Oversight (OFHEO) found that, during Johnson's tenure as CEO, Fannie Mae had improperly deferred $200 million in expenses, enabling Johnson and his successor, Raines, to receive substantial bonuses in 1998, the last year of Johnson’s reign. A 2006 OFHEO report would later find that Fannie Mae had also thoughtfully underreported Johnson's compensation. No, it wasn’t the reported $7 million, it was more like $21 million.

The SEC isn’t amused when it learns that accounting has been irregular, and its laxatives are harsh. A meeting was called in December to convene SEC officials, the executives of Fannie and their lawyers, OFHEO and their counsel, and the SEC senior accounting staff. With everyone sitting around the meeting table, the SEC Chief Accountant, Donald Nicolaisen began. Holding up a sheet of paper, Nicolaisen said the vagaries of accounting might allow one acceptable accounting interpretation to be on one corner of this sheet and another equally appropriate interpretation could be on the opposite corner. Fannie’s accounting? Not even on the sheet of paper. Not even in the same area code. Maybe not even on same the planet. That’s how far out Fannie’s accounting was.

Raines sat stupefied, knocked him out cold by the SEC Chief Accountant. The wicked witch was dead. On December 21, 2004 Raines “accepted” what he called "early retirement" as Fannie’s CEO. Fannie would have to restate billions in earnings.

In 2006, the OFHEO sued Raines to recover $90 million in payments he received based on the overstated earnings, initially reported to be $9 billion but restated as $6.3 billion. Civil charges were filed against him and two other former executives by the OFHEO seeking $110 million in penalties and $115 million in returned bonuses from the three accused. On April 18, 2008, the government announced a “settlement” with Raines together with Tim Howard, Fannie's former CFO, and Leanne G. Spencer, Fannie's former controller. The three executives agreed “to pay” fines totaling about $3 million, which were actually paid by Fannie's insurance policies. Raines also agreed to donate the proceeds from the sale of $1.8 million of his Fannie stock and to give up stock options. The stock options were worthless. Raines also gave up an estimated $5.3 million of "other benefits" related to his pension and forgone bonuses. Compared to Raines, Willie Sutton was a chump.

Between 2000 and 2004 housing prices skyrocketed 31%. At mid-decade, 40% of the mortgages were for second homes – a clear warning sign of speculation. Refinancings reached $2.8 trillion in 2003. Thinking that housing prices had permanently enriched them, millions refinanced the equity out of their houses – historically the best forced-saving plan they had ever had – and used it to improve their lifestyles, albeit only temporarily. The nation was getting older and the traditional nest eggs or ways to transfer wealth to the younger generation was, in the words of Margret Mitchell, gone with the wind.

Many of the mortgages taken out by subprime borrowers were hybrid adjustable rate mortgages (ARMs). ARMs kept payments low for a set number of years, but when they reset, payments could easily double – exceeding what the homeowner could afford. When homeowners began to stop making mortgage payments, MBSs started performing poorly, and their derivatives, CDOs, lost about half of their value between 2006 and 2008. The riskiest tranches in the CDOs became worthless as subprimes defaulted.

About mid-decade, the Fed raised interest rates. The housing bubble burst in 2007 when the housing price index maxed out and began to decline. Supply and prices had outstripped housing demand and the tipping point had been reached. Many of those who had refinanced and cashed out their equity now found themselves owing more than their houses were worth.

What began happening was much like a network blackout – a fuse blows, overloading other circuits, and when their breakers blow, more overloads begin racing throughout the network until the network collapses. This happened to the American economy in 2008.

ARM defaults forced too many homes on the market just at the time the housing market was collapsing and couldn’t absorb them. No sales meant an acceleration of foreclosures, which began increasing in 2006. New home construction had already outpaced demand, and when large numbers of sales and foreclosures became available at deeply discounted prices, builders found that they couldn't sell the inventory of homes they'd built. Their construction loans were then foreclosed.

Clinton's calamitous National Partners in Homeownership program lay in tatters, a victim of incompetence, greed, Pollyanna intentions, corruption, government perfidy, unethical politicians and bankers and business executives, emasculated regulators, and the hubris of the Fed.

Taxpayers shelled out $153 billion to bail out just Fannie and Freddie, now wards of the state. For what? Both companies today still back more than half of all new mortgages – $5 trillion. Their executives are still pocketing fortunes while taxpayers underwrite the risks they take. Wall Street’s biggest banks are 20% larger than they were when they got into trouble, and the pay packages of their bright boys are as generous as ever. Government’s elected leaders and senior officials appear to have learned remarkably little from the country’s near death experience with economic collapse.

Could the 2008 credit crisis happen again? Yes, because Congress has done nothing to fix Fannie and Freddie, among other things. The laughably incompetent Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 – ironically authored by two of the cronies who most benefitted from the Fannie/Freddie excesses – was Congress’ response to the crisis. It should be repealed immediately and Glass-Steagall reinstated as law. Dodd-Frank spanned 2,300 pages. Glass-Steagall, the law that protected consumers for 76 years, consisted of only 34 pages.

In the end, we Americans will have paid dearly for this crisis with a decade of lethargic depreciated assets. We will have paid dearly with a decade of legitimate opportunities that would have arisen in a normal growing economy but are now forever lost. Yet we are and will remain more recklessly endangered than ever.