Economic Dreams - Economic Nightmares

Soros: Financial Crisis Stems from Super Bubble

Like me, George Soros is no believer in "equilibrium economics". Rather he believes that sometimes we will see an equilibrium, but that it will be short-lived. Like Hyman Minsky, Soros argues that stability will itself sow the seeds of the next instability. Soros says we are in a unique place with our current crisis, experiencing both inflation and a recession at the same time. Hear/read more from Soros on today's NPR Morning Edition, Financial Crisis Stems from Super Bubble:

… Soros blames what he calls a "super-bubble" that started about 25 years ago. That's when a less-is-more philosophy became popular with economic regulators. That allowed Wall Street to invest increasing amounts of money in credit.

"The idea was that regulators always make mistakes, state interference in the markets just messes things up," Soros says. "And that was a false idea .... Regulators are human and bound to make mistakes, but markets are also human and they are also bound to make mistakes. Instead of markets always being right, they're actually always groping at trying to find out what the facts are. But they never get it right." …

Soros says there's a "super-bubble" in the economy that's bigger than just the recent housing crises, and he blames exotic financial instruments for helping cause it.

"The markets have introduced financial instruments with fancy names — CDOs and CLOs and all these strange instruments that are traded in very large volumes. And they were all constructed on the belief deviations are random.

Soros also has a new book out. Here is a snip from the introducion:

A New Paradigm for Financial Markets, Introduction, George Soros: We are in the midst of the worst financial crisis since the 1930s. In some ways it resembles other crises that have occurred in the last twenty-five years, but there is a profound difference: the current crisis marks the end of an era of credit expansion based on the dollar as the international reserve currency. The periodic crises were part of a larger boom-bust process; the current crisis is the culmination of a super-boom that has lasted for more than twenty-five years.

To understand what is going on we need a new paradigm. The currently prevailing paradigm, namely that financial markets tend towards equilibrium, is both false and misleading; our current troubles can be largely attributed to the fact that the international financial system has been developed on the basis of that paradigm.

The new paradigm I am proposing is not confined to the financial markets. It deals with the relationship between thinking and reality, and it claims that misconceptions and misinterpretations play a major role in shaping the course of history. …

Let me explain briefly how the theory of reflexivity applies to the [current] crisis. Contrary to classical economic theory, which assumes perfect knowledge, neither market participants nor the monetary and fiscal authorities can base their decisions purely on knowledge. Their misjudgments and misconceptions affect market prices, and, more importantly, market prices affect the so-called fundamentals that they are supposed to reflect. Market prices do not deviate from a theoretical equilibrium in a random manner, as the current paradigm holds. Participants' and regulators' views never correspond to the actual state of affairs; that is to say, markets never reach the equilibrium postulated by economic theory. There is a two-way reflexive connection between perception and reality which can give rise to initially self-reinforcing but eventually self-defeating boom-bust processes, or bubbles. Every bubble consists of a trend and a misconception that interact in a reflexive manner. There has been a bubble in the U.S. housing market, but the current crisis is not merely the bursting of the housing bubble. It is bigger than the periodic financial crises we have experienced in our lifetime. All those crises are part of what I call a super-bubble—a long-term reflexive process which has evolved over the last twenty-five years or so. It consists of a prevailing trend, credit expansion, and a prevailing misconception, market fundamentalism (aka laissez-faire in the nineteenth century), which holds that markets should be given free rein. The previous crises served as successful tests which reinforced the prevailing trend and the prevailing misconception. The current crisis constitutes the turning point when both the trend and the misconception have become unsustainable. …

Grizzly Times, Yet Some Hope on Horizon

Grizzly Bears roam the financial landscape: Doug Noland and Michael Shedlock here (or here) are ever-bearish, but so is Barry Ritholtz (Forbes video link). The "D" word is uttered ever-more-frequently. Yet I find myself thinking that just beyond this likely deep recession we are at the leading edge of a reformation: re-forming financial institutions—private and government—and bringing US and other banking "kicking and screaming" into the 21st Century.

In this I share hopes with Brad DeLong, Paul McCulley, Robert Shiller, and George Soros (or better still watch Soros: via the Financial Times in extended post). No one who is awake believes we will escape our current moment without at minimum a deep, prolonged recession. But some observers, like those just mentioned are less cynical than are they who believe that we are predestined to once-again repeat the tragedies of the recent past and earlier times—in particular to continue to reward speculative excess.

As per reform, Thursday's Senate Oversight hearings on the Bear Stearns mess (C-Span video link)) is almost 5 hrs. long, but worth watching to better understand where Ben Bernanke (Fed), Timothy Geithner ( NY Fed), Christopher Cox (SEC), and Robert Steel (Treasury) stand regarding hoped-for reregulation. (I recommend first panel: 3 hr. 40 min.)

It is by no means certain that we will indeed reregulate our system to once-again disallow the worst excesses of extended bouts of irrational exuberance and the irrational pessimism that must follow. But wu might. We must! I've hoped for reforms too often in the past and been disappointed, but signs of hope are on the horizon at a time when moderates are beginning to take the reins of power in the US Congress away from borrow-and-spend neoCons on the far right and traditional tax-and-spend Democrats on the far left.

Let's not be eager to blame the Federal Reserve, the Treasury, and the SEC for this mess. NeoCons and "free market fundamentalism" are better targets for blame. And let's not forget that there was good reason for bringing the Federal Reserve system into being long ago—to curb the excesses of "boom and bust" cycles. The system worked reasonably well after the late 20s, early 30s debacle to disallow Hyman Minsky’s PONZI FINANCE moments. That is, it worked well until the so-called "Republican Revolution" dismantled regulatory functions of government here in the US.

I’m not naïve enough to believe that we could have weathered the storms brought about by recent financial and technological innovations without some pain, but the real tragedy I see is that "we the people" of the USA haven't yet figured out that we need good government to accompany good markets—and that neither can work effectively in isolation or without continued vigilance and oversight from citizens and the press (now fortified with internet commentary).

Government agencies and institutions must begin to wake up to realities that W. Edwards Deming, Peter Drucker, and many newer management writers have helped the best of our private-sector entities understand—that innovation and quality reform must be institutionalized into the fabric of agencies and institutions, to be ongoing and ever-vigilant of changes in external environment that must be incorporated into internal corporate and government cultures. Let's hope wider government reform begins with the Fed, the SEC, and the Treasury.

Doug Noland: 'Breakdown of Wall Street Alchemy'

In his latest Credit Bubble Bulletin, Doug Noland concludes that "GSEs are poised as the next shoes to drop — the next Dominoes in an Escalating Contagion. … Simplifying highly complex circumstances, the various risk models that empowered the greatest leveraging of risk in the history of finance no longer function as expected — or as required to maintain highly leveraged exposures to a multitude of escalating risks. And it was all just only a matter of time. The overriding flaw was to ignore that a runaway Bubble in market-based finance ensured that various market and Credit risks all coalesced into One Massive, Unmanageable, Highly Correlated, Unhedgable, Undiversifiable Association of Interrelated Systemic Risks. "

Although Noland's assessments continue to be bleak, I find them to be more 'on the mark' week-on-week than any other source I go to. Maybe I'm just hearing what I confirms my preconceived biases. Or maybe not? More from Noland (emphasis added):

The Breakdown of Wall Street Alchemy, Doug Noland, Feb 15: This week provided further confirmation of ongoing momentous Credit market developments. … Like the asset-backed commercial paper market that was popular with structured investment vehicles until last summer, auction-rate securities, a form of rolling short-term funding for long-term municipal commitments, have become fashionable in recent years."

"Auction-rate securities" has joined the beleaguered ranks of "subprime," "asset-backed commercial paper," "SIVs," and the "monolines" — financial structures that flourished during the prolonged Credit Bubble but no longer pass market muster in today's Post-Bubble Risk Revulsion Backdrop. This week's "unwinding" of the "auction-rate" market and the blowing out of Credit spreads should be seen as an escalation of the ongoing unwind of "Contemporary finance" and its many avenues of Risk Intermediation.

On numerous fronts, the markets and economy confront a Highly Problematic Breakdown in "Wall Street Alchemy" — the disintegration of key processes that had for some time transformed ever-increasing quantities of risky loans into perceived safe and liquid debt instruments that enjoyed insatiable demand in the marketplace. In the case of the “auction-rate securities,” it was a clever restyling of long-term and generally illiquid municipal debt (as well as student loans and other borrowings) into perceived liquid securities that could be easily sold at regularly recurring auctions (every one to a few weeks). With scores of flush corporate treasury departments and wealthy clients (managing huge Credit Bubble-induced cash-flows) keen to earn extra (after-tax) yield on "cash equivalents," the Wall Street firms had been diligent in ensuring (making markets for clients, when necessary) a highly liquid and enticing marketplace. Now, with the onset of Risk Revulsion and Acute Financial Sector Balance Sheet Pressures, investors are running for cover and Wall Street firms are shunning the use of their own capital to support this and other markets. Market liquidity has evaporated, confidence has been shattered, and we are witnessing yet another "run" on a previously popular risk market/asset class. The music has stopped for another game of musical chairs.

This week saw heightened systemic stress stampede toward the epicenter of the U.S. Credit system. It certainly didn't help that insurance behemoth AIG Group reported an almost $5bn writedown of its Credit default swap portfolio or that international securities dealer behemoth UBS reported massive losses on its U.S. Credit positions. Confidence was further shaken by huge losses reported by mortgage insurers, as well the twists and turns of the "monoline" bust turned apparent bailout. In the markets, various indices of investment grade Credits widened sharply to record levels. The key "dollar swap" (interest-rate derivative hedging) market saw spreads widen sharply. Agency spreads also widened significantly. Benchmark Fannie Mae MBS spreads widened a remarkable 20 bps against 10-year Treasuries, while agency debt spreads widened a noteworthy 12.5 basis points to 69.5 bps (high since November). The Breakdown of Wall Street Alchemy is now pushing the Credit Market Dislocation uncomfortably close to the core of our monetary system.

I'll return to financial aspects of this crisis, but I definitely feel the economic ramifications of the unfolding Credit Crisis are receiving short shrift in the media. This week saw parts of the municipal debt market grind to a virtual halt and the corporate debt market take another significant blow. Investment grade debt issuance has now slowed markedly after beginning the year at near record pace. At this point, the junk, CDO, ABS, "private-label" MBS, muni, and even investment grade debt markets are all somewhere between impaired, dislocated and completely dysfunctional. There is no mystery behind the recent string of abysmal economic reports.

The preliminary reading on February University of Michigan Consumer Confidence dropped 8.8 points to the lowest level since the 1992 recession. The Economic Conditions index sank and the Economic Outlook index plunged, while one-year Inflation Expectations rose from 3.4% to 3.7%. The Economic Outlook has sunk a remarkable 22 points since July. Falling national home prices are clearly wearing on confidence. This week, Dataquick reported that home sales throughout much of California have collapsed to more than 20-year lows, while home price declines accelerate. This is a huge unfolding issue/debacle for the MBS, agency, mortgage insurance, CDO, and Credit derivatives markets, not to mention the U.S. banking system and real economy. Countrywide Financial reported delinquencies on its $1.5 TN mortgage servicing portfolio had jumped to 7.47%, up from the year ago 4.32%. The New York "Empire" Manufacturing index sank to the lowest levels since April 2003.

The economy is now faltering badly and there is every reason to expect the downturn to gather pace — negative real interest rates compliments of the Fed and stimulus package compliments of the federal government notwithstanding. While fourth quarter data is not yet available, one can look to the first nine months of 2007 to gain important perspective. Despite the dislocation in the subprime mortgage market, Non-Financial Debt Growth accelerated from Q2's 7.2% to Q3's 8.9% (from the Fed’s Z.1 report). And while Household Debt Growth had slowed to a 6.9% pace, Business Borrowings accelerated to a blistering 11.9% annualized rate in the third quarter. This was the strongest corporate debt growth since the tech/telecom boom in the late nineties. Importantly, total (financial and non-financial) Corporate Debt expanded at an 11.1% rate during the first three quarters of 2007, followed by 9.3% growth in State & Local government borrowings. And while residential mortgage debt was slowing meaningfully, Commercial Mortgage Debt was expanding at an almost 13% rate.

Total (financial and non-financial) Credit expanded a seasonally-adjusted and annualized record $5.0 TN during the third quarter — as nominal GDP expanded at a 6% pace. While many trumpeted the "resiliency" of the U.S. economy in the face of mortgage and housing woes — more adept analysis would have focused on the massive Credit creation that had come to be required to sustain the Bubble Economy. Importantly, the faltering subprime market initially instigated only greater excesses throughout commercial real estate, municipal finance, M&A finance, and corporate lending more generally. The Credit Bubble was sustained at the great cost of heightened instability and weakened structures — especially throughout leveraged lending, state & local finance, and investment-grade corporate borrowings. Keep in mind that through the third quarter CDO issuance was actually running ahead of 2006's record pace. Until the fourth quarter, record Credit growth continued to fuel the finance-driven economy. This is all now coming home to roost.

Today, with bursting bubbles in corporate and municipal finance joining the mortgage bust, the U.S. Bubble economy has quickly fallen desperately short of sufficient Credit and liquidity. And the greater the Credit market dislocation and broad-based tightness of Credit, the bleaker become economic prospects and the more intense the Revulsion to Wall Street's Credit instruments. The days of free-flowing cheap finance for home buyers, state and local governments, LBO firms, commercial real estate speculators, college students, risky auto buyers, and high-risk Credit card holders are over — and they will not be returning for some time to come.

When I have previously underestimated the "resiliency" of the U.S. Credit Bubble and economy, it was in each instance a failure to appreciate the capability of Wall Street finance to expand to ever greater degrees of Bubble excess. Today, with "contemporary finance" mired in a historic collapse, I am confident that the Credit system is today only in a position to surprise on the downside. It is this framework that shapes my view of a rapidly escalating Credit crisis feeding an arduous economic adjustment period.

And while it could undoubtedly prod a highly speculative stock market, there is no resolution to the "monoline" dilemma that would meaningfully influence the trajectory of the unfolding Credit and economic bust. As we've been saying for awhile now, confidence in Wall Street finance has been irreparably shattered. Trust has been broken in "AAA" ratings, "mark-to-model," CDO structures, myriad risk models, Credit insurance, counter-party risk, and various instruments and vehicles for intermediating risk in the markets. Moreover, old fashioned lending will not come close to sufficing the demands of a highly imbalanced Bubble economy, especially with bankers nervous and retrenching. Again, we're witnessing nothing less than the Breakdown of Wall Street Alchemy — one that took a turn for the worst this week.

In a disconcerting development, recent market developments seem to confirm that the leveraged speculating community and the GSEs are poised as the next shoes to drop — the next Dominoes in an Escalating Contagion. Along with the "monolines" and mortgage insurers, the "Credit default swap market" and GSE mortgage Risk Intermediation were at the epicenter of the most egregious Systemic Risk Distortions and Accumulations. They are now quickly moving to the forefront of Current Acute Fragilities. Simplifying highly complex circumstances, the various risk models that empowered the greatest leveraging of risk in the history of finance no longer function as expected — or as required to maintain highly leveraged exposures to a multitude of escalating risks. And it was all just only a matter of time. The overriding flaw was to ignore that a runaway Bubble in market-based finance ensured that various market and Credit risks all coalesced into One Massive, Unmanageable, Highly Correlated, Unhedgable, Undiversifiable Association of Interrelated Systemic Risks.

Bill Gross: Mr. Bernanke - we have a problem

Bill Gross's Feb 1 Investment Outlook is worth a look. Echoing Paul Krugman, Gross suggests that we now need some deep Keynesian stimulus, not the 'Stimulus Lite' fare being bandied about by the Bush Administration and the Congress. Implicitly, but without any real plan to make it happen, Gross also suggests we need to return to earlier fundamentals of honesty and thrift, abandoning the 'quick fix' mentality that has at once encouraged speculation and outright financial fraud and buried the American middle classes under mountains of debt. Soundbite: "[T]he U.S. economy and its somewhat coupled global companion will sleep walk for some time and a resumption of prosperity as we knew it will be dependent on reforms of monetary and fiscal policy resembling the 1930s more than our past decade." Here's more:

Bill Gross, Better Late than Never, Feb 1: … Paul Krugman, …, proposing revolutionary solutions for the Japanese recessionary malaise of the 1990s and writing a book in 1998 entitled The Return of Depression Economics … referred to the fact that the crucial task of future policy would be to bolster demand as was the case in the FDR-driven 1930s as opposed to encourage supply which has been the case since the Reagan revolution. Although Krugman doesn't comment, in my opinion, it's not that Reagan was wrong — he was in fact brilliantly correct and timely in his supply-side revolution.

Iverson aside: I can't go along with Gross here. I find the very idea that Reagan "was brilliantly correct" repulsive. I believe that Reagan helped to mislead the US, and helped jump-start a 30+ year-long "irrational exuberance" party that is now unwinding badly. Back to Gross:

That pendulum, however, appears to have swung too far in the direction of the private market. But Krugman (and yours truly) was a tad early in his forecast for reversal I think, because of the failure to recognize the potency and the inventiveness of modern finance.

Until recently, U.S. and therefore global demand has been driven by the ability to lower interest rates and extend credit to an increasing majority of Americans. Mortgages, auto finance, and credit cards were offered on increasingly liberal terms and continually lower yield and risk spreads because of Wall Street ingenuity and — importantly — the naïve endorsement of their black magic by rating services willing to sell AAAs for a fee. … Demand, as Krugman would likely retrospectively recognize, was bolstered and supported by innovative, securitized finance which in turn was nurtured by lax regulation and a belief that things could not go wrong — and if they did — that policy makers, both monetarily and fiscally oriented, would make things right. The repair, if needed, was labeled the "Keynesian compact" and it made for a deal with the American public: it would be OK to have free markets because policymakers know enough to prevent another Great Depression. Demand could always be stimulated with a combination of easy money/budget deficits. Prosperity in effect, was guaranteed.

Well "probably" guaranteed — but the historic growth rate of that prosperity may now be threatened. Because demand in the form of consumption has been artificially and fictitiously stimulated in recent years by financial engineering run amuck, there is a legitimate question as to whether its black hole imploding destructiveness can be totally countered with another dose of lower yields and deficit spending packages. The $150 billion "return to sender" deficit plan advanced by Bush and the Congress, for instance, amounts to just 1% of GDP and is labeled temporary. It will be of marginal benefit to long-term prosperity. To understand why, consider that the productivity of our economy ultimately depends on its ability to 1) innovate, and 2) save and invest, and that there is little of either in this stimulus package. Some have even suggested — and with my somewhat grudging concession — that this package will help the Chinese economy more than ours. Americans will use the rebates to buy Chinese imports offered at Wal-Mart and the $150 billion will then wind its way inevitably back to Asian coffers. The U.S. needs a Krugman "demand-based" fiscal package alright, but a $300-$500 billion permanent one, in addition to the proposed temporary package, because as mentioned in last month's Outlook [Pyramids Crumbling], as the system of modern day levered shadow finance slows to a crawl or even contracts at the edges, its ability to systemically fertilize economic growth must be called into question. But government writing checks for American consumers which then flow to foreign central banks is not the permanent solution; it only makes sense in the short-term as a life preserver. To provide a stable recovery path, government spending needs to fill the gap — not consumption. Public works programs, badly needed infrastructure repairs, as well as spending on research and development projects should form the heart of our path to recovery. Assistance for homeowners? That too — figure out a fiscal/regulatory way to stop the slide in housing prices and foreclosures but please — no traffic jams at the Wal-Mart checkout counter in 2009 and beyond.

Approaches to monetary policy must change as well. 1% short rates were so effective 5 years ago that they not only bolstered demand but created a housing bubble of Frankensteinian proportions. Those days, however were influenced by the creation and implementation of adjustable-rate mortgages (ARMs) that were priced at the short end of the yield curve. Millions of ARMs were issued at 2% and 3% teaser rates, many with terms of up to 5 years before their inexorable adjustment upwards. Surfeits of houses were bought at artificial prices because of these generous terms and billions in home equity loans were taken out — both driving demand and the economy forward. But adjustable-rate mortgages are a dying relic. Originators will no longer offer them except on onerous terms. No more teasers or pleasers of that ilk; there are regulators to deal with, and lawyers on the prowl with class action lawsuits in their briefcases.

And so the monetary attempt to halt housing's — and therefore the economy's — downward slide rests on the shoulders of the 30-year mortgage. If so, then Mr. Bernanke — we have a problem. First of all these 6-7% 30-year mortgages now require a significantly higher down payment than in prior years. 20% down? Say what? Where does a 30-year-old couple get that kind of money? Secondly, however, and just as important, what motivates a future homeowner to pay 6%+ interest for an asset that is going down in price? It was an easy decision to pay subprime yields of that and then some when housing prices were accelerating at double-digit annual percentages; the benefit was obvious. Now however, with prices in negative territory, the risk/reward is tilted towards the renter.

My point is that Chairman Bernanke must recognize the reduced benefits and obvious dangers of a déjà vu trek to 1% short rates. Those yields produced 5% 30-year mortgage rates to the homeowner for a 2-3 month period in 2003 and they could do so again, but bubble creating, inflation inducing damage to the U.S. dollar would be the likely result now. Best to stop far short of 1% and at the same time encourage reforms in FHA government assisted programs that would permit subsidized mortgage rates with minimal down payments.

An artificially low, 1% short-term interest rate was an elixir during the days of a burgeoning shadow banking system. It cannot be the solution now.

In combination, a well constructed, more than temporary fiscal/monetary stimulus plan is what is required to rejuvenate a U.S. economy reeling from a low punch delivered by a private market economy gone too far. Its "Rosemary's Baby" took the form of a shadow banking system based on leverage and the fateful conclusion that a finance-based economy alone can deliver prosperity. It cannot. As Keynes theorized and then Krugman affirmed, when private demand falters, it becomes the responsibility of government to fill the breach. Because it likely will not do so effectively until after a new Administration is elected in late 2008, the U.S. economy and its somewhat coupled global companion will sleep walk for some time and a resumption of prosperity as we knew it will be dependent on reforms of monetary and fiscal policy resembling the 1930s more than our past decade. Better late than never.

Timely, Temporary, Targeted Depression

While we wait for world market jitters to calm (whenever that may be). And while we wait to see if the US Congress gets a 3-T stimulus package together (as if that might help. We can all take some minor comfort in knowing that all Recessions (even those called Depressions) are Timely, Temporary, and Targeted:

• Timely: Recessions happen timed to events that suggest that "unbridled enthusiasm" is finally at an end—and confidence is lost.
• Temporary: All things come to an end, even Depressions. Some episodes just take longer to unwind than others.
• Targeted: Aimed to hurt most those who have over-extended themselves in debt or speculative frenzy. Aimed too to finally allow for responsible discussion of effective regulation, although there may be less-than-responsible discussion during initial panic—that hopefully will not get set into irresponsible policy.

After the bell:

Wall Street joins global equity plunge, Kristina Cooke, Reuters, Jan 22: NEW YORK (Reuters) - Stocks slid sharply on Tuesday [at the opening bell], joining a global equity rout on fears of a U.S. recession and pushing the Nasdaq into bear market territoryInvestors dumped equities even after the Federal Reserve cut interest rates by 75 basis points in a surprise intermeeting decision. The move from the U.S. central bank follows two days of sharp losses in Asia and Europe on worries a deteriorating U.S. economy would drag other regions down with it. …

The move from the U.S. central bank follows two days of sharp losses in Asia and Europe on worries a deteriorating U.S. economy would drag other regions down with it.

Deconstructing 'Recession 2008?'

I spent an hour yesterday listening to three economists (Brad DeLong, Mike Mandel, and William Beach) discuss our current plight. I found their insights compelling. Areas of agreement, included:

• Don't look to the US Government for effective Fiscal Policy Help — particularly in an election year
• Don't look to the Fed to ease much pain since they are pretty much helpless in the face of a faltering US housing market (See Krugman too)
• Best we can do is to see both borrowers and lenders share the pain, with some pain (how much?) shared by the rest of us

The forum was hosted by Dave Iverson (a different, more erudite Dave Iverson) and aired on KQED, NPR, San Francisco. It's well worth an hour of your time, if only to get better acquainted with Brad DeLong's longer-than-a-post reflections (but skip the questions and answers). From Delong's Grasping Reality…

KQED | Forum: Recession 2008? [Jan. 11]

http://www.kqed.org/.stream/anon/radio/forum/2008/01/2008-01-11a-forum.mp3

Host: Dave Iverson

Guests:

• Brad DeLong, professor of economics at UC Berkeley
• Mike Mandel, chief economist for BusinessWeek
• William Beach, senior economist and director at the Center for Data Analysis at the Heritage Foundation

Thanksgiving Cheer: HERE'S ROUBINI!

With the stock markets increasingly jittery, and just in time for Thanksgiving, I can't resist leaving a little ray of sunshine BAG OF GLOOM at your doorstep: via FT Alphaville, Stand by for "generalized systemic financial meltdown", Helen Thomas, Nov 21 or straight to the source, HERE'S ROUBINI …

Nouriel Roubini, Nov 16: … I now see the risk of a severe and worsening liquidity and credit crunch leading to a generalized meltdown of the financial system of a severity and magnitude like we have never observed before. In this extreme scenario whose likelihood is increasing we could see a generalized run on some banks; and runs on a couple of weaker (non-bank) broker dealers that may go bankrupt with severe and systemic ripple effects on a mass of highly leveraged derivative instruments that will lead to a seizure of the derivatives markets (think of LTCM to the power of three); a collapse of the ABCP market and a disorderly collapse of the SIVs and conduits; massive losses on money market funds with a run on both those sponsored by banks and those not sponsored by banks (with the latter at even more severe risk as the recent effective bailout of the formers’ losses by theirs sponsoring banks is not available to those not being backed by banks); ever growing defaults and losses ($500 billion plus) in subprime, near prime and prime mortgages with severe known-on effect on the RMBS and CDOs market; massive losses in consumer credit (auto loans, credit cards); severe problems and losses in commercial real estate and related CMBS; the drying up of liquidity and credit in a variety of asset backed securities putting the entire model of securitization at risk; runs on hedge funds and other financial institutions that do not have access to the Fed's lender of last resort support; a sharp increase in corporate defaults and credit spreads; and a massive process of re-intermediation into the banking system of activities that were until now altogether securitized. …

As differentiated a wee bit by Yves Smith:

Naked Capitalism, Nov 17: … I agree with Roubini that there is the very real possibility of a financial horrorshow, However, I differ with him on some of the particulars. We are not going to see bank runs. We didn't have them in the late 1980s where S&Ls were actually failing and Citi nearly went under. However, we are already seeing institutional money getting very costly for Citi, and their tsuris have only begun. And we are seeing more examples of Citi-type behavior, where banks have what effectively were contingent liabilities (think, for example, of the guarantees and/or cash injections to keep affiliated money market funds from breaking the buck). These funding or liability demands are coming at precisely the time when bank equity is under strain, due to the need to increase loss reserves and writedowns. Look, for example, at asset backed commercial paper. The Financial Times reported today that banks have shown substantial balance sheet growth of late. But it isn't net new lending; it's credit commitments or actual drawdown related to ABCP.

I expect Citi to be in serious trouble in 6 to 12 months, and that specter will increase risk premia for many banks, and could push others towards the edge. So I anticipate a lot of near-failures, some gunshot marriages, and possibly even real bank collapses, but the mechanism will not be a run by retail depositors.

But I expect to see more serious damage among the "large complex financial institutions" of which Citi is one. There are 16 behemoths that have been deemed by the Bank of England as especially important to global credit intermediation. One is already in the process of taking a body blow. If we see damage to any others, it will lead to a contraction in the credit markets, both directly (shrinkage of their balance sheets) and indirectly (shrinkage of everyone else's balance sheets due to new found conservatism and sharply higher borrowing costs). The securitization market, absent government agency paper, is not functioning very well right now. It will really start laboring if conditions on Wall Street continue to deteriorate.

And if securitization looks less attractive because investors are far more stringent (and maybe no longer believe ratings) and Wall Street looks to have lost a couple of cylinders, then the banks need to step into the breech. Ah, but will they? Banks for the most part are no longer in the habit of keeping a lot of their own loans on their balance sheet. …

Fear Makes a Comeback

An old adage says markets are driven and balanced over time by greed and fear. This seems particularly true when markets get into their manic phases. Martin Wolf reminds us that the tide has now shifted from greed to fear, and brings Hyman Minsky to the forefront of our thoughts:

Fear makes a welcome return
by Martin Wolf
Commentary
Financial Times

"At particular times a great deal of stupid people have a great deal of stupid money. . . At intervals. . . the money of these people — the blind capital, as we call it, of the country — is particularly large and craving; it seeks for someone to devour it, and there is a 'plethora'; it finds someone, and there is 'speculation'; it is devoured, and there is 'panic'." Walter
Bagehot.*

Panic follows mania as night follows day. … Ours has been a world of … confidence, cleverness and too much cheap credit. This is not new. It is as old as financial capitalism itself. The late Hyman Minsky, who taught at the University of California, Berkeley, laid down the canonical model. The process starts with "displacement", some event that changes people's perceptions of the future. Then come rising prices in the affected sector. The third stage is easy credit and its handmaiden, financial innovation.

The fourth stage is over-trading, when markets depend on a fresh supply of "greater fools". The fifth stage is euphoria, when the ignorant hope to enjoy the wealth gained by those who came before them. The warnings of those who cry "bubble" are ridiculed, because these Cassandras have been wrong for so long. In the sixth stage comes insider profit-taking. Finally, comes revulsion.

In the latest cycle, displacement began with the huge cuts in interest rates in the early 2000s, which drove up prices in housing. The easy credit was stimulated by innovations that allowed those making the loans to regard their service as somebody else's problem. Then people started to buy dwellings to resell them, not live in them. Subprime lending was a symptom of euphoria. So, in a different way, was the rush of bankers into hedge funds and of the wealthy and big institutions into financing them. Then came profit-taking, falling prices and, last week, true revulsion.

This was what George Magnus of UBS bank calls a "Minsky moment". It was the moment when credit dried up even to sound borrowers. Panic had arrived.

The correct policy response is also well known. … The central bank must save not specific institutions, but the market itself. It must advance money freely, at a penal rate, on good security.

In providing money to the markets last week and this, the … central banks have been doing their jobs. Whether the terms on which they have done this were sufficiently penal is another matter.

Financial markets, and particularly the big players within them, need fear. Without it, they go crazy. Moreover, it is impossible for outsiders to regulate a global financial system riddled with conflicts of interest and dominated by huge derivatives markets, massive trading by highly leveraged hedge funds and reliance on abstruse mathematics and questionable statistical models. These markets must regulate themselves. The only thing likely to persuade them to do so is the certainty that the players will be allowed to go bust. …

The world has witnessed four great bubbles over the past two decades – in Japanese stocks in the late 1980s, in east Asia’s stocks and property in the mid-1990s, in the US (and European) stock markets in the late 1990s and, finally, in the housing markets of much of the advanced world in the 2000s. There has been too much imprudent finance worldwide, with central bankers and ministries of finance providing rescue at virtually every stage.

Unfortunately, there is every chance of repeating mistakes. A bail-out has already occurred in Germany. … More are likely. US legislators want Fannie Mae and Freddie Mac to bail out the mortgage markets.

The pressure on the Federal Reserve to cut interest rates will also grow. … The consequences [of this implosion] cannot be "ring-fenced", as those of LTCM were. Trust in counterparties and financial instruments has fled. The likelihood is a period of recognising losses, tightening credit conditions and deleveraging.

Such a period, desirable in itself, will lead to strong pressure for swift declines in interest rates, at least in the US, and so for another partial bail-out of a crisis-prone system. This pressure should be resisted as long as possible. …

*Cited in Manias, Panics and Crashes: a History of Financial Crises, fifth
edition. Charles P. Kindleberger and Robert Z. Aliber (Basingstoke: Palgrave
Macmillan, 2005)

[Note: This condensed version of Wolf largely borrowed from Mark Thoma, here.]

Andy Xie's perspective is similar. And Xie punctuates his own warning to the Fed, titled "It's time for central bankers to stop bailing out markets", Financial Times, Aug 14 [$] , with:

… If central banks try to bail out Wall Street, it would lead to high inflation for years. The inflationary effect of loose monetary policy of the past was offset by the deflationary effect of globalisation. Now China and other developing countries are experiencing high and rising inflation. Loose money will go straight into inflation. The vicious cycle of the wage-price spiral of the 1970s has not occurred as both labour and capital still believe in the inflation-fighting credibility of the central banks. If they loosen up again to bail out Wall Street, this credibility may be squandered. The ensuing wage-price spiral could ruin the global economy for years to come.

What is occurring is an opportunity for central banks to restore their credibility. Markets have been taking more risk than they should because they believe that central banks will come to their aid during times of crisis, like now. The penchant of Alan Greenspan, former US Federal Reserve chairman, to flood the market with liquidity during financial instability is the genesis of this "central bank put". As long as this expectation remains, financial bubbles will occur again and again. Now is the time to act. Let the crooks go bankrupt. Central banks should bury the Greenspan "put" for good.

So what's it going to be? Will Bernanke heed Xie's warning and attempt to restore faith in 'The Fed'? Or will he unleash the helicopters? Has he already?

I"m still willing to give Bernanke some rope. So far, I believe the Fed and other central bankers have done what they must in the wake of the recent crisis, although I wish they had done some things in advance, say mid-1990s.

If Bernanke moves to lower interest rates anytime soon, and if that indeed fuels fires of speculative frency once-again, then I'll join the ranks of the hounds, biting at the heels of the Fed. But not until/unless.

Financial Armageddon: New Book

Michael Panzner's Financial Armageddon: Protecting Your Future from Four Impending Catastrophes doesn't pull any punches. The book is a hard-hitting exposé of what may be our future, as events that have been wound up by more than a decade of irrational exuberance wind down in reverse. Against this frightening backdrop — made all the more frightening by this week's market jitters — Panzner concludes with book with some pointers to help average people navigate the treacherous waters of what may well be an inevitably dark near-term future. And to prepare them to better set a stage for brighter days on the other side of darkness for themselves and for their children.

Panzner's graphic depiction of future events is more detailed than I have seen before. In this it reminds me a lot of John Kenneth Galbraith's The Great Crash: 1929, which leaves Panzner in a great position to do a historical follow-up after the fact much like Galbraith did. For the rest of us, the book paints a picture to hold in front of us, and to test against as the future unfolds.

Clearly the future will not exactly follow the book. But that is not the point. Rather, Panzner wants us to better understand the complexities, the leverage-built-upon leverage, the gleefulness and gullibility of the actors, and more of what constitutes America's house-of-cards financial community that too many celebrate as America's highly-resilient economy.

On the run-up side we are led through the saga of America's decades-long party that has depleted the personal savings of many of our citizens. We are exposed to corporate shenanigans and government complicity in over-promising retirement and health care entitlements. We witness the mess that the government and "we the people" have made of our ever-more-bubbly housing sector, and how the Greenspan Fed misled average people into Adjustable Rate Mortgages in an era when interest rates could not fall, or at least would not fall further.

Among other misdeeds, Americans have forgotten that they need savings for security and they have used their houses (via refinancing) as giant ATM machines to buy new cars and other consumer goods. The party, as egged on by corporations and the government, seems never-ending. But, of course, the party must end. And it must end badly, in part due to too much greed, too much leverage, too little attention to prudent risk, and too much related "innovation" in the financial services sector that mislead many and their bankers, brokers, and commentators to believe that a new era had arrived, when all that was happening was a repeat of an age old penchant for mania, albeit with modern twists.

Add to this the never-ending consolidation in the financial services industry that helped keep stock prices pumped ever-higher and, when coupled with the perception that the true giants were now Too-Big-To-Fail, the stage was set for dominos to fall when one or more of the TBTFs actually begins to falter. Add in the recent Congressional and Administrative undoing of the many financial checks and balances put in place after the Great Crash and we see a stage set for disaster. Panzner elaborates:

There are too many links in the chain and too many points of vulnerability in the financial system, especially for commercial banks, which have been some of the most aggressive contributors to the recent credit bubble expansion. Ironically, a 2006 report that the FDIC was disbanding many bank closure teams because of a lack of failures may well have been one of the most ironic moments in the long and sorry saga of moral hazard and unintended consequences. Like dominos, when one begins to fall, the others won't soon be far behind.

If readers aren't shaken enough by the moral failures of the traditional banking community and supposed government overseers, Panzner devotes an entire chapter to derivatives, hedge funds, leverage, and risk concentration — and the seeming calm-before-the-storm that collectively they have wrought on the markets. His devotion is that of an "insider," with more than 25 years experience in stock, bonds, and security markets working with some of the biggest players including HSBC, Soros Fund, ABN Amro, Dresdner Bank, and JPMorgan Chase. Here is how Panzner sums up the problem:

… [D]espite recent efforts to address at least some of the concerns, past and present structural deficiencies have laid the groundwork for a chaotic and possibly nightmarish scenario. Thos who believed they were covered might be left scrambling to hedge their sudden and unexpected exposure, desperate to make up the shortfall under conditions of duress.

But the systemic risks do not only stem from a particular instrument or market. They exist also because of the concentration of exposure at certain large commercial banking groups, including JPMorgan Chase, Bank of America, Citibank, Wachovia, and HSBC. According to data collected by the U.S. Comptroller of the Currency, as of the fourth quarter of 2005, these five institutions accounted fo 96 percent of the more than $100 trillion of derivatives contracts outstanding among 836 U.S. Banks. Remember too, the exposure of Fannie Mae and Freddie Mac, who have $1.5 trillion of derivatives between them to hedge against risks in their massive portfolios.

Panzner follows with thorough looks into possible depression and hyperinflation, investigating the economic, financial, social and geopolitical aspects of these possible nightmares.

In the last part of the book, Panzner help us better understand necessary planning for these depressing contingencies. His philosophy parallels mine: Better that we heed an old maxim: "Assume the worst, hope for the best, and be prepared for whatever happens." Panzner gives us insights (and hope) in terms of investments, relationships, and lifestyles.

Having just finished both Peter Bernstein's Against the Gods and Charles Kindleberger and Robert Aliber's Manias, Panics, and Crashes I didn't expect to be impressed with Financial Armageddon. But I was impressed! Don't take my word for the worth of Panzner's book. Wander over to his blog and take a look at the advance praise from the back cover. Then explore the rest of his website, including Panzner as Featured Guest on Jim Puplava's Financial Sense Newshour, 3/3/2007.

Will Sub-Prime Loan Defaults Create Another Amaranth?

Will Sub-Prime Loan Defaults Create Another Amaranth?, 2/14/2007: When HSBC Holdings (NYSE:HBC) announced an earnings restatement last week, setting aside 20 percent more for loss provisions on sub-prime mortgage loans, the equity market for HBC and other sub-prime lenders such as New Century Financial Corp (NYSE:NEW) sold off sharply. But the prospect of rising loan defaults on bank balance sheets, in relative terms, is the good news.

Rising loan defaults are a normal feature of any credit cycle. What makes the past few years different is the degree to which derivatives and aggressive loan securitizations have spread the risk around, beyond the financial institutions which historically have specialized in creating and managing such illiquid risks. According to the FDIC, in 2005 almost 68 percent of home mortgage originations were securitized. …

Over the rest of 2007, we fully expect to see most of the major money centers announce higher loan losses and provisions for retail mortgage portfolios, and some banks may even be forced to restate previous periods. But the real threat to all of the major US banks involved in significant asset securitization lies in the probability that many of the collateralized loan structures employed to shift risk off bank balance sheets will unwind.

As Jody Shenn of Bloomberg wrote this week: "Subprime loan buyers typically can force lenders to buy back the mortgages they sell if borrowers miss their first few payments, any type of fraud is discovered, or the loans otherwise fail to meet the guidelines laid out in a sales contract." This is true even if the loans were packaged into a collateralized debt structure or CDO, anointed with a credit derivative enhancement from a hedge fund, and blessed with an explicit credit opinion from a rating agency, before being sold to yet another hedge fund.

Jamie Dimon, chief executive of JPMorgan Chase (NYSE:JPM), disclosed last week that JPM held only $5bn of higher-risk sub-prime loans, just two per cent of its total retail portfolio. He then bragged that the bank had sold much of its mortgage exposure — but to whom? Fact is that JPM, the largest derivative dealer on earth, likely sold much of its loan exposure to its hedge fund clients, highly leveraged entities that have significant clearing and credit exposure to JPM.

As the wheels start to come off of the mortgage collateral wagon in 2007, a number of money center banks and broker dealers, particularly the ones with large prime brokerage operations, may be forced to repurchase CDOs from hedge funds, mutual funds, banks and other clients who discover to their dismay that there is no bid for this paper, credit agency rating or no. This situation will be particularly poignant for JPM, which seemingly was the proximate cause of the Amaranth hedge fund failure and even profited from the fund's demise, as we wrote in a previous issue of The IRA. …

(via Institutional Risk Analyst):

See also, Hedge Fund Problems Start With the Fed, 2/5/2007

The Asset Shufflers meet the Pessimists (Realists?)

Earlier this week Tim Iacano commented on last weekend's Barrons ($) roundtable discussion, headlining a group he referred to as "a large group of asset shufflers who plan to make as much hay as they can while the sun still shines, and a smaller coterie of realists who fear that something will eventually go terribly wrong."

Included in the latter category is Cassandra-like Mark Faber, who I look to for insight more than a little. Here's a snip:

The Asset Shufflers, Tim Iacono: A consumption based economy driven by rising asset prices where most of the asset owners do not yet know how much "wealth" they've lost in the last year due to falling home prices. What could possibly go wrong?

Moderator: You've been quiet, Marc. What's wrong?

Marc Faber: I agree with Art [Samberg] that we are in the midst of the greatest synchronized economic expansion in the world. In the first 150 years of capitalism, the colonial system prevailed. It was never the objective of the industrialized countries to boost growth rates in the colonies. They were used for exploitation. Once the colonial system broke down, roughly three billion people fell under communism and socialism. After 1980 commodity prices collapsed and Latin America went into a depression. Then the Soviet Union collapsed. While Latin America began to recover in the 1990s, Japan, at that time the second-largest economy in the world, had stopped growing. The Asian crisis hit in '97, the Russian crisis in '98. So there was no synchronized growth.

The recovery began in November 2001 in the U.S. Strong consumption growth in the U.S. boosted industrial production, notably in China. Incremental industrial growth, combined with strong personal-income gains and capital spending, then led China to import resources, in particular oil. That led to rising commodities prices, which greased the economies of the Middle East and the former Soviet Union. Demand from China for copper and iron ore greased Latin America and Australia, and those countries grew rapidly. They demanded more imported goods, capital goods and luxury goods from Europe and Japan, and bingo! You suddenly had the whole world expanding rapidly. However...

Moderator: We knew that was coming.

Faber: Global imbalances have increased. The emerging world has grown much more rapidly than the United States. In the U.S., ultra-expansionary monetary policy got under way ahead of Y2K in 1999. It continued after 2001, when the Fed slashed interest rates to 1% from 6.5%. Though the Fed has raised rates since 2004, to 5.25%, we still have expansionary monetary policies worldwide. If you define economic growth by consumption, the U.S. has grown rapidly and will probably continue to grow. If you print money you give people the opportunity to spend. But along with the spending came a growing trade and current-account deficit, which was offset by surpluses in Asia. Every region of the world has a current-account surplus with the U.S. For the first time in capitalism, the poor countries, notably China, are financing consumption in the U.S. This will not last forever.

In 2006 -- hurrah, hurrah -- the Dow Jones Industrial Average was up 16% and the S&P 500 14%. But in euro terms the S&P was up less than 5%. In gold terms it was down. Against most commodities, the Dow was down. The U.S. also has a split economy. The typical household is not doing well. But one economy is doing exceedingly well: the asset shufflers in this room. [Nervous laughter] This economy is in the greatest bubble ever. There's a bubble in the art market; art prices were up 27% last year. There's a bubble in equities, especially in emerging markets, and in real estate in Anglo-Saxon countries. The big threat is not that liquidity will vanish because of Federal Reserve action. The Fed will print money, I guarantee you. But when asset markets go up, they create liquidity by allowing people to borrow more money against appreciating assets. When asset values go down, liquidity contracts immediately because people repay loans. The moment the asset bubble begins to deflate, liquidity will contract.

Some would call Dr. Faber a wet blanket, others would call him a realist. …

Samberg: Where is the bubble? I'm confused. Marc appropriately gave us a history lesson about how the world has changed to one in which economic growth and personal freedom and better lifestyles are adopted across the globe. The most mature financial markets are here in the U.S., and we're the clearinghouse for the world, which can lead to long-term problems. But why turn a positive into a negative? The world is awash with growth. It is awash with liquidity, and our markets can clear liquidity better than any others.

Moderator: It is also awash in consumption, extravagance and debt.

Faber: America's current-account deficit has greased the whole world. Latin American markets are in the midst of a huge boom. The Argentine stock market is up 10 times from the lows. Latin American debt on a total-return basis has doubled in the past five years. In Asia we have bubbles in real estate. In the U.S. there's a debt bubble. Debt is now 330% of GDP. That will prevent the Fed from ever pursuing tight monetary policies, even if it becomes necessary.

Hickey: Asset bubbles are always fun while you are going through it. The tulip bubble was fun. The Mississippi bubble was fun. But they always end in tears and disaster.

Gabelli: I'll float a bubble. Abby, the Democrats won the midterm elections in a landslide. Marc, should we worry about a politically motivated constraint on global trade?

Faber: I'm less worried about that than this: The five brokerage firms in New York -- Merrill Lynch, Morgan Stanley, Lehman Brothers, Bear Stearns and Goldman Sachs -- paid out $36 billion in 2006 bonuses. Compensation and bonuses together roughly are equal to Vietnam's GDP. I see a bipolar world in which there's the typical household in the U.S. or Western Europe, and then this huge wealth concentration. It will lead to a political backlash one day. Moderator: Starting in Connecticut.

Yeah, that's going to be the tricky part. One day they'll storm the castle and drive the asset shufflers out into the streets and then things might get ugly.

But it ain't going to happen this year.

Can Minsky Respond to Krugman's criticism of 'The Hangover Theory'?

Both Mark Thoma and Brad DeLong have recently been playing with Paul Krugman's dissing of the Austrians: The Hangover Theory. I have no such intent here. I have dabbled with Austrian thinking/writing enough to have a healthy respect for complexity, human psychology, market cycles, etc. I have learned economics from various schools of thought and especially, perhaps, from Robert Heilbroner, who was able to probe the minds of the "worldly philosophers". Looking across various schools of thought helped to round out my non-traditional views.

Instead of dissing the "Austrians" or any other school of thought, I just want to attempt to solve a puzzle left by Krugman. Here is a frame:

The Hangover Theory, 12/1998, Paul Krugman: …A recession happens when, for whatever reason, a large part of the private sector tries to increase its cash reserves at the same time. Yet, for all its simplicity, the insight that a slump is about an excess demand for money makes nonsense of the whole hangover theory. For if the problem is that collectively people want to hold more money than there is in circulation, why not simply increase the supply of money?

Questions that Krugman ignores are: How exactly is the supply of money to be increased? How are those who are to lend to be induced to lend? How are those who are to borrow to be induced to dare to borrow? Remember that in the scene Krugman is exploring, 'bankers' (many) have just been burned because they were encouraging ever-more-speculative loans on the way up the credit-bubble mountain, some of which have now failed, leaving the bankers to shoulder some of the loss. What is to make the bankers think they are now encouraging prudent investments? Similarly what is to make businesses think that the environment is now safe to borrow into?

Krugman's puzzle: "The hangover theory, then, turns out to be intellectually incoherent; nobody has managed to explain why bad investments in the past require the unemployment of good workers in the present."

Maybe the Austrians cannot explain it, but Hyman Minsky, following Keynes ideas on market cycles and inherent problems, has managed such an explanation. At least I think so. In Minsky's explanation (expansion) of Keynes financial economics we move from the narrowness of Keynes historical perspective, looking "at a depressed economy, tending to chronic underinvestment and thus to high and long lasting unemployment"; to Minsky's later historical perspective, looking "at a vibrant economy with upward instability, naturally inclined to overinvestment and overindebtedness." (Elisabetti De Antoni, 2005, "The (too?) Optimistic 'financial Keynesianism' of Hyman Minsky" [PDF] p. 25). Dominating both scenes "are expectations and the degree of confidence placed in them" (De Antoni p. 9).

Central to Minsky's theory is "the relationship between debt commitments and profits." (De Antoni p. 5 ). This is where it gets interesting, psychologically and economically, in helping to address the questions, "Who is to lend what to whom?" "Why Would they dare?" What many writers are unwilling to entertain is the lag time necessary to induce either bankers to loan money or credible businesses to borrow money after bubbles burst.

A time lag is needed in order to allow the psychological cloud of pessimism to move far enough into the backdrop to once again begin the cycle of guarded optimism and trust that a better day is possible, then optimism, exuberance, irrational exuberance and boom, then bust, irrational pessimism, pessimism, guarded pessimism, and finally around again to guarded optimism and trust.

This story sounds a bit Austrian. The Minsky twist is that he advocates that central bankers (Minsky uses the term "big government") interrupt the cycle during "irrational" phases on both the upside and the downside in attempts to minimize the run-up and the run-down. Minsky also acknowledges that government action may do more harm than good if timing is not good, or if the form of government action is not appropriate.

This brings us to the "basic criticism made by Minsky against the Neoclassical Synthesis … that it neglected financial relationships, precisely those in which instability lurks" (De Antoni p. 2). The instability derives from time-lags in contracts between borrowers juxtaposed against changes in Fed policy or action, and expectations of such.

De Antoni lays out the story line of the boom/bust cycle:

The relationship between debt commitments and profits is central to Minsky's theory. … Given the limits of collective and individual rationality, in Minsky's world the recent experience is the main guide to the future. The ease with which payment commitments have been met in the recent past determines the confidence in the future fulfillment of debt commitments. This triggers an important deviation amplifying mechanism: "A history of success will tend to diminish the margins of safety that business and bankers require and will thus tend to be associated with increased investment; a history of failure will do the opposite." (Minsky, 1986 [Stabilizing an Unstable Economy] p.187). Expansion thus turns into a euphoric boom. Sooner or later, however, euphoria ends by clashing with reality: "As a previous financial crisis recedes in time, it is quite natural for central bankers, government officials, bankers, and even economists to believe that a new era has arrived. Cassandra-like warnings that nothing basic has changed, that there is a financial breaking point that will lead to deep depression, are naturally ignored in these circumstances" (Minsky, 1986, p. 213). Financing is often based upon the assumption that "the existing state of affairs will continue indefinitely" (Keynes 1936 [The General Theory of Interest, Employment, and Money] p. 152 ). On the contrary, "each state nurtures the forces that lead to its own destruction" (Minsky 1975 [John Maynard Keynes] p. 128). (De Antoni p. 5).

Did Minsky solve the puzzle? I think that he began the solution, and his followers are now continuing the inquiry/discovery, most recently through the work of Eric Tymoigne and others at The Levy Economics Institute, Bard College..". Am I wrong? At minimum I hope more economists will at least explore the work of Minsky and other Post Keynesians.

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See also:
Banking and Financial Crises, Gary A. Dymski, January 2005
Minsky's thesis: Keynesian or Marxian?, Steve Keen, 2001
Krugman and The Liquidity Trap: Why Inflation Won't Bring Recovery in Japan, Jan A. Kregel, March 2000
The Nonlinear Dynamics of Debt Deflation, Steve Keen, 1998

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{Note: I edited this slightly on 1/19, 1/23: Among other things, I put quotes around the word "irrational," i.e. :"'irrational' phases" of market cycles above. As Eric Tymoigne, correctly notes (In an email) " I would be careful to call all those behaviors "irrational" for two reasons. First I think they are rational given the uncertain world we leave in and the institutional framework of capitalism. Acting according to the rational expectation model is irrational. Second, even if large optimism are indeed a reality, they are not necessary, in Minsky's theory, to explain the weakening of the economy."}

A Minsky-like Restatement of Keynes Market Irrationality Warning

Among famous statements attributed to John Maynard Keynes, this one is my favorite: "Markets can stay irrational longer than you can stay solvent." As I learn more about Hyman Minsky, I wonder how he might have restated Keynes' warning. Here is an attempt: "The market is irrational, is not prone toward equilibrium, but instead is subject to cycles of irrational exuberance and irrational pessimism."

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{Update Jan. 5}
A second attempt: "The market is a complex, adaptive social system, is therefore not prone toward equilibrium, but instead subject to phase shifts, cycles, and transfomation. Groups of people who play in the market are prone to cycles of irrational exuberance and irrational pessimsim."

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As to 'equilibrium' Elisabetta De Antoni says, ( "The (too?) optimistic 'financial Keynesianism' of Hyman Minsky," [PDF] p. 6 )

...Minsky totally rejects the 'crutch' represented by the concept of equilibrium. Instad of speaking of equilibrium or disequilibrium, Minsky ... 1986 p. 176— just like Joan Robinson — prefers to refer to states of tranquility hiding within themselves disruptive forces destined to gain strength with the passing of time. In his view: "instability is determined by mechanisms within the system, not outside it; our economy is not unstable because it is shocked by oil, wars or monetary surprises, but because of its nature" (Minsky 1986 [Stabilizing an Unstable Economy] p. 172)...

On 'irrational markets' De Antoni says, (p. 24)

...From a cyclical perspective, rescessions can be traced back to the preceding boom. Quoting Minsky "In some important sense, wha was lost from the insights of the 1920s and 1930s is more significant than what has been retained ... The spectacular panics, debt deflations, and deep depressions that historically followed a speculative boom as well the recovery from depressions are of lesser importance in the analysis of instability than the developments over a period characterized by sustained growth that lead to the mergence of fragile and unstable financial structures." (Minsky, 1986 p. 173).

Minsky advocates for 'big government' to act as a stabilizer to the excessive exuberance of 'free market capitalism,' But Minsky was also aware that 'big government,' if imprudent might destabilize rather than stabilize.

On 'big government stabilization,' De Antoni says (pp.18-19):

Given the tendency of capitalist economies to financial crises, followed by debt deflations and deep depressions, the issue of the efficacy of economic policies acquires a crucial role. From this point of view, Minsky does not place much faith in monetary policy. Given that a great part of the money supply is endogenously created by banks and given the innovative capacity of the financial system, the central bank has only a limited control over the supply of money. In any case money influences the demand for assets, rather than or goods. Thus, the central bank intervention may turn out to be harmful as well as ineffective. Quoting Minsky, (1986), "Monetary policy to constrain undue expansion and inflation operates by way of disruptiong financial markets and asset values. Monetary policy to induce expansion operates by interest rates and the availability of credit, which do not yield increased investment if current and anticipated profits are low" (p. 303-4). Instead of aiming to control the money supply or the behaviour of the economy, the central bank should focus on its function as lender of last resort. By enabling the financing of financial institutions and by sustaining asset prices, the central bank might prevent financial crisis, so removing the threat of debt deflations and deep depressions.

In fact, Minsky assigns to fiscal policy the task of promoting full employment and stabilizing the economy. As he puts it, "fiscal policies are more powerful economic control weapons tha monetary manipulations" (1986 p. 304). ...

No doubt Minsky didn't get everything right, as none of the great economists have. They are human, after all. They lived in times different our own. The complexity and novelty that arise spontaneously from the workings of the complex systems (physical, biological and social) that enfold us guarantee that each of us perceives the world a bit differently, depending on when we live. Still, Minsky got enough right, building particularly from Keynes (who built from foundations laid down earlier) to seriously challenge status-quo financial economics and central bank practices.

For further explorations/extensions of Minsky's financial economics, see particularly the works of Eric Tymoigne and L Randall Wray, The Levy Economics Institute, Bard College.."

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{Update Jan 5, edited Jan. 23}
In Extending Minsky's Classifications of Fragility to Government and the Open Economy, L. Randall Wray argues that "the U.S. is in an increasingly precarious position" ... "[I]t is likely that many individual units have moved from hedge to speculative positions, and even to Ponzi positions…."

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Tech Bubble Only a Warm-up

Doug Noland is sounding alarms again: "Derivative players have no fear of illiquidity or market dislocation. … [M]ajor increases in sector Credit Availability and marketplace liquidity have done wonders to the ballooning Credit Derivatives market (that doubled in size the past year!). Writing corporate Credit protection these days is akin to writing flood insurance during a long drought – the only limit to profits is the amount of insurance that can be written. It’s become a full-fledged mania in desperate search of more tulip bulbs. …"

Doug Noland's Credit Bubble Bulletin (10/27/06), Current Account "Recycling" Distortions: ... Central banks are now realizing they must take global levels of liquidity seriously, the ECB’s former chief economist, Otmar Issing, said Friday. 'I am concerned about excessive liquidity in the world,' Issing told a conference for economic students here. This concern is shared by the current members of the ECB’s Governing Council, who have taken the lead in alerting other central banks to the risks at hand, Issing noted. 'There is now increasing support of the view that excessive liquidity world-wide is fueling asset prices and is something which has to be taken seriously by central banks…This is a real concern.'" [10/27/06] from Market News International. [emphasis from Noland]

… I would not be surprised if we learn that total Business borrowings (from the Z.1) expanded at a 10% rate. This would be up from the robust 8.6% growth during the first-half and place 2006 easily on pace for the biggest corporate borrowing binge since 2000. This is despite corporate America having for the past few years been on the receiving end of massive Credit Bubble-induced profits and cash-flows.

At this point lacking all the pertinent data, I will nonetheless postulate that the immense gap between ongoing U.S. system Credit expansion and the actual financing requirements of the real economy extended further during the quarter. This would help explain the loosening of Financial Conditions we’ve witnessed over the past few months, as well as the "excessive liquidity in the world" that worries Dr. Issing and the ECB. U.S. and international equities markets have been posting big gains, global bond prices have rallied nicely, already narrow corporate Credit spreads have become only narrower, and emerging markets have inflated spectacularly. And with recent GDP deceleration largely explained by the abrupt slowing in residential construction combined with a jump in imports, there is ample support for the view the economy isn’t being buffeted by any tightening of Financial Conditions.

I will continue to disappoint some readers, as I have no intention this evening of dwelling on either the economic slowdown or September’s decline in home prices. My focus will remain on the Financial Sphere -- examining the factors and dynamics behind booming global asset markets, as well as the ramifications for seemingly endless liquidity. I believe very strongly that current global securities market and asset inflations are associated with some underlying disarray in the Credit mechanism – with destabilizing finance – with Monetary Disorder. What is it? Where is it? And why is it?

I remember how the GSEs’ almost 30% expansion during 1998 (to total assets of $1.4 TN) became a prevailing source for a marketplace liquidity Bubble that culminated in the technology/telecom mania in 1999/early-2000. The massive second-half 1998 GSE expansion certainly played a defining role in the post-LTCM "reliquefication." They provided an invaluable backstop to the leveraged speculators, arresting potentially destabilizing de-leveraging, while fostering general liquidity over-abundance. If not for this powerful Monetary Process (in conjunction with Fed rate cuts, of course), I seriously doubt the system would have enjoyed the wherewithal to embark on 1999/2000’s historic telecom and corporate debt lending binge. Major Bubbles are dictated by powerful evolving processes, and clearly market perceptions of both abundant liquidity and the backstop for speculative activities cultivated a self-fulfilling boom in Credit and speculative excess.

And while gross excesses were conspicuous in the stock market, the technology/telecom Bubble was very much a creature of (nurtured and financed by) extraordinarily loose underlying Financial Conditions and resulting extreme Credit growth. This was especially the case in regard to key Monetary Processes that evolved from the GSE liquidity creation mechanism and then expanded to the massive "leveraged lending"/telecom/junk/ corporate debt lending Bubble. Throughout the boom, the stock market remained the popular analytical focus, while paramount developments were unfolding insidiously in the Credit system. A potent influx of Monetary Disorder from the GSEs energized underlying lending excesses and speculative impulse, creating a backdrop conducive to momentous financial and economic Bubbles.

Returning to today's Monetary Disorder, the environment beckons for a steadfast focus on the bowels of the Credit system, especially with regard to unusual Monetary Processes with the proclivity for nurturing Credit and speculative excess. As such, where are the key sources, intermediation, and uses of system Credit/liquidity/purchasing power? What dynamics, on the margin, are influencing the biases and endeavors of the expansive pool of speculative finance? Well, I don’t believe the ramifications of our massive Current Account Deficits receive the attention they deserve.

Unprecedented in size – soon to surpass $225 billion quarterly – and duration, U.S. Current Account Deficits create one of history’s most commanding – and, I would contend, destabilizing - Flows of Finance. Think in terms of a highly integrated Credit system comprised of bank, Wall Street, finance company, securitization, and securities (leveraging) finance. This Credit apparatus freely creates financial claims/purchasing power, and a large portion of these dollar balances flow to the accounts of manufacturers, energy producers, and other exporters from around the world. This massive Flow of Finance, much of it then acquired by and intermediated through foreign central banks, is directed back to a limited supply of perceived top-quality and liquid U.S. securities. No serious analyst would dismiss the view that a dynamic involving such massive financial flows on a protracted basis would impart severe marketplace distortions.

Not dissimilar to the impact of GSE operations back in 1998, the massive expansion of foreign central bank dollar holdings has gone a long way in underpinning market confidence. The overwhelming consensus view has evolved to the point of believing the bond market is safe from yield spikes and the currency markets are protected from abrupt dollar declines and crises. Clearly, Treasury market participants have for some time operated with the perception that liquidity would remain abundant and prices supported. And, more generally, bond and dollar speculators must today take comfort that irrepressible foreign buying will continue to provide an invaluable market "backstop." Derivative players have no fear of illiquidity or market dislocation.

Beyond underpinning market confidence and liquidity generally, how has this massive ongoing foreign dollar balances "recycling" operation (Monetary Process) distorted the nature of underlying speculative flows (as the GSE did post-1998)? Well, this is where the analysis gets more interesting. I've convinced myself that foreign buying has distorted pricing in "top-tier" U.S. securities to the point of significantly reducing prospective returns - for speculators and investors alike. And the inverted yield curve – that was seemingly destined to be a temporary anomaly in an age of (borrow short/lend long) speculative securities leveraging – now has more the appearance of an enduring effect of unrelenting Credit excess, resulting Current Account Deficits, and foreign dollar balances "recycling."

The confluence of a massive cumulating pool of global speculative finance and eviscerated speculative profits in "top-tier" (notably Treasury and agency) securities has surely fomented some serious recalibration of speculative trading strategies. For one, it has doubtlessly encouraged greater borrowing in yen, Swiss francs and other low-yielding currencies, with resulting flows providing important dollar support. Probably more important to the underlying structure of the U.S. and global economy, the speculator community has been pressed into "lower-tier" Credit instruments to achieve acceptable returns. This helps to explain the insatiable demand for securities in some notable sectors, including emerging market debt and "private-label" mortgages.

It is my view, however, that the greatest unfolding Credit system distortion is a resurgent corporate debt Bubble. Importantly, the Current Account "Recycling" Distortion- induced flight into "lower-tier" Credits coincides with a significant decline in mortgage originations. The banking system is now aggressively pushing commercial lending in an ill-advised endeavor to sustain (Mortgage Bubble-induced) inflated lending profit growth. At the same time, there are huge "capital markets" profits available for the major "banks" by matching the global speculator community with the higher-yielding securities and structures today so in demand, as well as by speculating in Credit themselves.

The wall of finance flowing into the corporate debt market has had a profound effect on the availability of Credit. Spreads have narrowed and even the most vulnerable corporate borrowers have enjoyed the capacity to recapitalize. Meanwhile, those hedge funds and proprietary trading groups investing in "Credit" are today sitting near the coveted top of the global performance leader board. And, no doubt about it, major increases in sector Credit Availability and marketplace liquidity have done wonders to the ballooning Credit Derivatives market (that doubled in size the past year!). Writing corporate Credit protection these days is akin to writing flood insurance during a long drought – the only limit to profits is the amount of insurance that can be written. It's become a full-fledged mania in desperate search of more tulip bulbs.

And this is where it gets dangerous. Over-heated demand for underlying corporate loans has instigated a self-reinforcing lending boom, especially for M&A, LBOs, and stock buybacks (lending to finance real investment is simply not large enough to satisfy the enormous demand for loans). In true Bubble fashion, the greater the (non-productive) lending excess and resulting asset inflation, the more compelling it is for the next borrower to pursue an only larger loan to acquire a stock or company at a recently inflated price. And the larger the borrowings the greater the available liquidity searching for a home; the less likely it is for companies to hit the wall and default; the greater the profits on writing Credit default swaps, investing in collateralized debt obligations, and speculating in Credit generally; and the greater the gold rush mentality to envelope corporate Credit markets.

Especially after suffering through this year's stock market volatility and painful corrections in the energy and global "reflation trade," the relative stability of returns available from the various methods of writing (flood) Credit insurance has of late looked awfully appealing. And to what extent the Bubble in corporate Credits has been fostering speculative flows into U.S. corporate securities – and in the process supporting the dollar today but creating dangerous systemic vulnerability in the process – is something to ponder.

It's not only the resurgent corporate debt Bubble that has me recalling 1999/2000. It was no coincidence that NASDAQ went parabolic about the time deterioration in underlying fundamentals was gathering pace. A spectacular short squeeze, flight into perceived safer corporate bonds, and liquidity creating securities/derivatives leveraging were prominent aspects of that period's Monetary Disorder. Today, an extraordinary confluence of factors including the housing downturn, economic vulnerability, destabilizing Credit excesses being "recycled" back to U.S. securities markets, and a major shift of speculation into riskier Credits is fueling a corporate debt Bubble with a present scope and future consequences that greatly exceed anything from 1999. The tech Bubble was only a warm-up…

Dr. Issing is absolutely correct: "… Excessive liquidity world-wide is fueling asset prices and is something which has to be taken seriously by central banks." Tonight I’ve focused on U.S. Credit system dynamics. But our massive Current Account Deficits have as well spurred lending, liquidity and speculative excess around the world. Our degraded currency has certainly unleashed systemic global Credit inflation, with profligate domestic Credit systems no longer disciplined by the (dollar-anchored) global marketplace. It’s more aptly described as “Global Wildcat Finance,” with Credit and asset inflation readily condoned by a speculating community that has come to wield incredible power and influence.

There have been scores of Current Account apologists, from Wall Street to leading academics to the very top of the Federal Reserve System. When will there finally be recognition that ongoing loose Financial Conditions, unparalleled Credit excess, and these massive Current Account Deficits pose a clear and present danger to U.S. and global stability?

"JucoJames" Joins the Bloggers Bear's Lair

I just added Jucojames to my econ blog list. The James' blog began June 1 with this,

… I am a financial professional in an industry that I believe is leading most of its clients down a path that will likely lead to widespread problems when the Baby Boomers approach retirement age. The US stock market is in a long term bear market which likely began in 2000. Its duration is likely to last at least another 10 years plus, and it is crucial for people in the US to realize the monumental challenges we face as citizens and investors over the next decade plus. …

The latest post are Bear Market in Full Force and Jim Cramer - soon to be a Pariah. With an beginning like that, what's there not to love for those of us who tend to think that irrational-enthusiam must at some point lead to irrational-pessimism both in short-run and longer-run cycles.

May You Live in Google Times!

An old Chinese curse/blessing states simply, "May you live in interesting times!" Google –as an indicator of the global communication age – has recently made times interesting indeed for many of us. First came Google's domination of the search-engine domain. Then came Google Blog Search. Now comes Google Finance.

The "interesting times" will no doubt continue as Yahoo, Microsoft, and others work counter-offensives relative to what they no doubt perceive as the newly framed Google threat.

Alvin Toffler noted some time back that this coming era The Third Wave would transform everything we know about civilization, and that, as noted in War and Anti-War (co-authored with Heidi Toffler) we would see "interesting" geopolitics along the path. I probably ought to re-read both books. So many books (both on the shelf and yet to be read) so little time! But Tofflers' notion that the old-wave separation between producer and consumer is coming to an end is nowhere more true than in the service sector: financial and accounting services, real estate, insurance....

Fnally, legendary financier Warren Buffett once quipped, ""If class warfare is being waged in America, my class is clearly winning." So it is for now. If you are not a capitalist, perhaps even a giddy speculator you are nothing.

But I remember reading about how the Great Gatsby era came tumbling down, and how it was a long time before such showy displays of wealth and dominance were allowed in the US. See, e.g. Thomas Frank's What's The Matter with Kansas?

And I remember well reading and re-reading John Kenneth Galbraith's The Great Crash: 1929 and won't soon forget the parallels between the 20s and what we are experiencing today.

Money for Nothin' and ...

Whether you are a business mogul, a politician, or a rocker… Whether you play the guitar, the lottery, or the speculative markets of high finance the American cultural "winners' game" is pretty much the same, caputured well by lyrics from Dire Straights:

Now look at them yo-yo's that's the way you do it
You play the guitar on the MTV
That ain't workin' that's the way you do it
Money for nothin' and chicks for free

Some of us are pretty tired of it. The whole game of "money for nothin'" and "work avoidance" as a cultural "good" are foreign to principles on which effective culture must be based. A few weeks before he was assassinated, Gandhi had a conversation with his grandson Arun wherein he outlined "Seven Blunders," out of which, said Gandhi, grows the violence that plagues the world. To his grandfather's list of seven blunders Arun later added an eighth, "rights without responsibilities" that is far too pervasive today. The blunders are:

• Wealth without work
  
• Pleasure without conscience
• Knowledge without character
• Commerce without morality
• Science without humanity
• Worship without sacrifice
• Politics without principles
• Rights without responsibilities

Gandhi called these disbalances "passive violence," which fuels the active violence of crime, rebellion, and war. He said, "We could work till doomsday to achieve peace and would get nowhere as long as we ignore passive violence in our world."

Note that wealth without work is number one on the list. Doug Noland has made a career or warning us about the addiction of speculative finance. In his latest, Flow of Funds, Noland gives us graphic evidence of our addiction, as well as a warning, once-again as to where we are headed:

Noland's conclusions:

...We are witnessing – both in the Fed’s "flow of funds" and with real world flows of finance - the consequences of many years of unrestrained asset and speculative-based Credit growth.

Through a Glass Darkly, or Not?

There seems to be much truth to the idea that we construct our realities around our perceptions of what is, what has been, and what might be. Nowhere does this seem more true than among social scientists, and perhaps nowhere more true than among economists. The New School's History of Economic Thought website identifies 67 different subdisciplines aggregated into eight main categories: "Pre-Classical" and Classical Schools of Political Economy, Anglo-American and Continental Neoclassical Schools, Heterodox and Keynesian Alternative Schools, and Themes and Other Thematic Schools.

Masters and disciples from the various schools don't agree on all that much, yet the popular press pays scant attention to the theological ("ideological" is the more politically correct term) and methodological underpinnings of it all. Instead they pit one individual economist against another in terms or cheerleading or nay saying whatever is the so-called "economic news" of the day, and leave it at that. If any here want to better understand the interrelationship between and among the "schools" in a anecdotal, historical word picture I recommend Goncalo L. Fonseca's The Walrasaid which concludes:

So your tired storyteller must end this saga with a word of caution. Perhaps at this point we should lay down our aspirations for a grand system and allow each of the battalions to roam independently for a while, proceeding on their own, examining each other in passing, learning from each other, each taking what is useful to their particular research program and leaving behind what is not. In time, if the gods are kind, there might be some convergence on some principles and possibly even a few conclusions, so that thereupon the discipline may be a bit more honest and maybe even helpful to humanity at large. But if there is not such a convergence, let us not take arms and violently charge each other in the name of ideological purity - for then we might slaughter and bury much of what is insightful and useful. Let us then listen, reflect critically, and proceed with caution.

Nonetheless, we need not rashly dismiss the dream outright. It is not unthinkable that a new conceptual revolution with the ferocity and thoroughness of the 1871 one could yet happen...and perhaps even sooner than we might expect.

To the initiated it should come as no surprise that a heterodox economist like me – at once a student of John Kenneth Galbraith, the Austrians, and the Game Theorists, of Hyman Minsky and John Keynes, and also of those labeled Post-Keynesians, as well as the small group who call themselves Ecological Economists – might mentally construct a picture of the world as dark as the one seen on the pages of this blog.

It proves easy, following the works of these masters to see that long cycles of good times lead to selfishness, political and business corruption, attendant deregulation, and fantasies that unfettered market mechanisms will bring about the financial and other salvation of the world. It proves easy to see the good times followed in long-wave cycles by times the both "try men's souls" and bleed the pocketbooks of middle and lower class people. It proves easy to see these times followed by gradual build up of confidence that itself gradually builds into over-confidence, then over-expansion of credit to set the stage for the next big problem.

What I'm wondering is how others see the world through much more rose-colored glasses. How it is that they see nothing but clear sailing ahead for as far as one can imagine? Most recently I ran across Stephen Skirchner's Institutional Economics blog.

Skirchner seems well-educated, a good writer, and glowingly optimistic. Yet within the span of a few posts, beginning with his January 24th "The Doomsday Cult Comes to Reno," Skirchner says "Warren Buffet is sounding more and more ridiculous," "Stephen Roach is having trouble getting his colleagues and clients to take him seriously," "PIMCO’s Bill Gross [is] keeping the doomsday cult alive," and "The Economist has a tired and predictable piece on Greenspan’s legacy." All of this, and likely more on his blog pretty much contradicts all of what I post here.

So what gives? How is it that Skirchner can be so optimistic and me so pessimistic? Does he see more than I? Less? Do we both see pretty much the same stuff, yet draw radically different conclusions as to what is and what might come? I dont' know.

Maybe Skirchner and others can help me to see the world differently, or at least to better understand how those I call "Cornucopians" can be so glowingly optimistic.