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. …

Short take on MuCulley at the Hyman Minsky Conference

I've been meaning to post up a cut-down version Paul McCulley's recent assessment of our current plight: "Reverse Minsky Moment" interview with Kathryn M. Welling, but haven't yet. So yesterday I was glad to see Floyd Norris do a spot on McCulley's talk at the Hyman Minsky Conference for the NY times, titled Ponzi Squared:

… Minsky argued there were three levels of investment as the cycle progresses. First comes hedging, in which investments are made to reduce risk. Then comes the speculative phase, and finally the Ponzi phase, in which the investment can be justified only by the assumption that prices will keep rising, not by the expected income.

Paul McCulley of Pimco, the big bond manager, gave an interesting speech in which he said the recent subprime mortgage fiasco proceeded to a fourth level — one that he called "Ponzi-squared" — before it collapsed.

At the end, he said, the marginal subprime loan was:

No money down
No documentation of income
Initial below-market teaser interest rate
Negative amortization

That is not a loan, he said. Instead, it amounted to giving the home buyer a call option to buy the house at the current market price, coupled with a put option to sell the house back at that price.

If house prices kept rising, the "buyer" could make the small interest payments to keep the option open, and eventually sell the house. That happened for a time, and led to the conclusion by rating agencies that such borrowers were good risks.

But when prices went down, the "buyer" would suffer no loss if he exercised the put and gave the house to the lender. That is just what happened.

As Paul Simon wrote in 1975, said Mr. McCulley, the strategy became:

Drop off the key, Lee,
And set yourself free.

Here is the written version of McCulley's April 17 talk at the Minsky Conference. Oddly, the "Drop off the Key" remarks are not included, although they are in the longer, Welling-McCulley rendition above. Some tidbits:

… [I]n what I call a "Reverse Minsky Journey" … Ponzi Units evaporate. Then many Speculative Units morph into Ponzi Units and are shot. Surviving Speculative Units are only those with explicit liquidity support from banks, who have explicit liquidity support from the Federal Reserve. Hedge Units, of course, remain standing tall, fundamentally sound, though cheaper in price, providing an excellent long-term buying opportunity.

This has been precisely the process in place since almost a year ago, and particularly since last August, when the shadow banking system — defined as any levered lender who does not have access to (1) deposit insurance and/or (2) the Fed’s discount window — experienced a modern-day run, with asset-backed commercial paper holders refusing to roll over their paper. It has not been fun. It has not been pretty. And it is not over.

Along the way, policy makers have slowly recognized the Minsky Moment followed by the unfolding Reverse Minsky Journey. But I want to emphasize "slowly," as policy makers, collectively, still suffer from more than a thermos full of denial. Part of the reason is human nature: to acknowledge a Reverse Minsky Journey, it is first necessary to acknowledge a preceding Forward Minsky Journey — a bubble in asset and debt prices — as the marginal unit of debt creation morphed from Hedge to Speculative to Ponzi.

That is difficult for policy makers to do, especially ones who claim an inability to recognize bubbles while they are forming and, therefore, don’t believe that prophylactic action against them is appropriate. Nobody likes to admit they were blind, dumb, or asleep at the switch. Or all three. …

That's not to say that Minsky had confidence that regulators could stay out in front of short-term profit-driven innovation in financial arrangements. Indeed, he believed precisely the opposite:

"In a world of businessmen and financial intermediaries who aggressively seek profit, innovators will always outpace regulators; the authorities cannot prevent changes in the structure of portfolios from occurring. What they can do is keep the asset-equity ratio of banks within bounds by setting equity-absorption ratios for various types of assets. If the authorities constrain banks and are aware of the activities of fringe banks and other financial institutions, they are in a better position to attenuate the disruptive expansionary tendencies of our economy."

Minsky wrote those words in 1986! Twenty-two years later, we can only bemoan that his sensible counsel was ignored. …

Minsky's insight that financial capitalism is inherently and endogenously given to bubbles and busts is not just right, but spectacularly right. And when the financial regulators are not only asleep but actively cheerleading financial innovation outside their direct purview, a disaster is in the making, as the last year has taught us. We have much to learn and relearn from the great man as we collectively restore prudential common sense to bank regulation — both for conventional banks and shadow banks.

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.

'W' as Hoover?

A 'wild card' scenario, for sure. But what if the Bush Administration were to now retreat to its ideological roots — i.e. "markets rock, government sucks" — and pretend that market forces alone ought to bring us out of this credit crunch? Having contributed mightily to the stage-setting for the current crisis, the Administration might indeed catapult it into full-scale depression. Here is Gaius Marius' workup of this possibility:

the potential for real problems, gaius marius, Decline and Fall of Western Civilization, March 14: there's a canard in american political history that herbert hoover did nothing to alleviate the onset of the depression. such was the angle of attack from franklin roosevelt in 1932, and so successful was that campaign that its propaganda became embedded in american mythology.

it's not so, of course -- hoover was a very activist commerce secretary who took an active role in creating the credit excesses of the 1920s, and then an even greater activist stance in forestalling the bust. the new deal was his deal, by and large, carried out in grand scale by roosevelt as the depression wore on.

one can argue about the wisdom of government intervention in the aftermath of the bubble bursting, of course. but the original sin is in the creation of the bubble -- something that can only be done with government at minimum standing aside from its natural regulatory role, and indeed in this case was facilitated by manipulation of interest rates and the underwriting of massive credit backstops in the form of the GSEs.

many american conservatives are so totally divorced from reality on the issue so as to be dangerous. they generally have encouraged all manner of government facilitation of the credit bubble under the bush administration since 2000, but there remains underneath an ideological and utopian desire for non-interference. and now that long-building problems which arose with government complicity are surfacing, the animal desire to flee the problem (and all responsibility for creating it) is also surfacing -- in the form of belated laissez-faire.

moral hazard aside, an honest history of capitalism will reveal that every major crack-up since the tulip mania of the 1620s was addressed with government-taxpayer bailouts on some level. it is part of capitalism to do so -- the losses, once too great, are socialized, and this is the price paid for the long-term benefits of price-driven resource allocation. that this fact isn't part of the ideological mantra of capitalism as defined by the zealots and high priests is as meaningless as the fact that the doctors and philosophers of communism were disappointed by the impurity of the system in practice. and it is very important for in situ leadership to understand that ideological purity is a noose by which they will be hung if they insist.

what has happened in the united states is not good, but it is probably manageable IF government recapitalization of the banking system gets underway. however, the sort of public denial of deep-seated problems at the heart of the system that our executive leadership is apparently willing to forward -- beyond being yet another dimwitted escapade of a kind with that which led them to eschew the "reality-based community" over iraq -- can have massive ramifications if it results even in just a significant delay of action. once a deflationary credit unwind gets underway, it can be extremely difficult to stop. the key will be to support the banks well before that happens, and then to move into the credit markets with a measure of regulatory zeal longer-term to prevent the kind of credit underwriting lapses that characterized 2002-2007.

it seems almost comic that the tragic administration of george w. bush -- unsatisfied with trashing american soft power and cultural advantage, unsatisfied with plunging this nation into a fiscal and military morass in the middle east, unsatisfied with widening and hardening virtually every division in the american political landscape -- would take its infamous conflation of raging incompetence and ideological zeal to the final length of sealing the american economy in a tomb. and yet it might. if the administration draws a line against government recapitalization and tries to defend it, it will actually become what roosevelt once only painted the adminstration of herbert hoover as. and that would have the potential for real problems.

Lingering question: Did Herbert Hoover get a "bad rap" re: The Great Depression? That is, is Marius correct in this assertion: "hoover was a very activist commerce secretary who took an active role in creating the credit excesses of the 1920s, and then an even greater activist stance in forestalling the bust. the new deal was his deal, by and large"? See, by contrast, The Ordeal of Herbert Hoover.

Don't Trust 'The Press'

Dean Baker tells us that we ought not trust the media. In this case it's because they seem to have bought into the 'economy is sound' story for too long, missing the housing and stock bubbles and instead cheering on the ongoing American-led consumption party. On that latter note, Robert Reich tells us that the party is over—the American consumer is tapped out. Worse, the power brokers (including the media) don't yet see it:

The US economy, Pravda style, Dean Baker, The Guardian, Jan 28: … Just as the Soviet press [in the bad old 'cold war' days] wanted the public to trust the wisdom of the party bosses, … pillars of the [American] elite media want the public to believe that the experts who are the insiders on the decision-making process in Washington are uniquely qualified to craft policy. …

Misunderstanding the economy's weakness earlier this month is trivial compared to the much more grandiose mistake of failing to recognize the $8 trillion housing bubble, or before that, a $10 trillion stock bubble. If performance mattered, then the experts who got things so hugely wrong would no longer be the ones shaping public policy. Instead, with the Washington Post style beautification process, experts can jump from policy disaster to policy disaster and never have their failures affect their standing.

If we are ever to have an open debate on economics, or any other area of public policy, we will need media that honestly discuss policy failures and that hold those in charge accountable. In the current situation, the economic disaster facing the economy was entirely preventable, but the Federal Reserve and the rest of the inside crew were either too incompetent to recognize the housing bubble or felt the short-term benefits outweighed the costs that the country would inevitably face when the bubble burst. … [Most] major news outlets chose to hide any serious debate on the problems posed by the bubble on the way up, and they would like to prevent any discussion of this massive policy failure even in retrospect.


The Real Recession Problem: Consumers Are at the End of Their Ropes, Robert Reich, Jan. 28: … [Business tax breaks exemplify] the illogic of what’s called supply-side economics. If you reduce the cost of investing, so the thinking goes, you’ll get more investment. What’s left out is the demand side of the equation. Without consumers who want to buy a product, there's no point in making it, regardless of how many tax breaks go into it.

Which gets us to the real problem. Most consumers are at the end of their ropes and can't buy more. Real incomes are no higher than they were in 2000, while food and energy and health care costs are all rising faster than inflation. And home values are dropping, which means an end to home equity loans and refinancing.

Most of what's being earned in America is going to the richest 5 percent, but the rich devote a smaller percent of their earnings to buying things than the rest of us because, after all, they’re rich — which means they already have most of what they want. Instead of buying, the rich invest most of their earnings wherever around the world they can get the highest return.

Add all this together and there's just not enough consumer demand out there to keep the American economy going. We're finally reaping the whirlwind of widening inequality and ever more concentrated wealth. Supply-siders who want to cut taxes on corporations and the rich just don’t get it. Neither does most of official Washington.

Jim Cramer's Rant: 'Fiction in Financials'

Normally I'm not one to recommend financial madman Jim Cramer's rants. But I'll make an exception today for: Cramer Rages on Banks: 'Where's the SEC?!'. The video feed (embedded in the CNBC post) is well-worth a few minutes of your time, even to endure a short ad at the beginning. The CNBC post begins, "Why isn't the Securities and Exchange Commission getting more involved in the whole banking sector writedown situation? Especially since the numbers are likely to get worse, not better? That's what Jim Cramer, CNBC's resident stock guru, wants to know." Then continues:

… "It's all fiction!" [Cramer] declared during a forceful exchange ….

"How can we have these levels of fiction in financials after Sarbanes-Oxley? How do people get away with this? How do they live with themselves?"

Cramer made his comments while reviewing results from Merrill. But his real consternation surrounded the insurers who cover banking investments. Some of those insurers haven't come clean about their liabilities, Cramer speculated. Eventually they will, and then the "fiction" will disappear, he said.

The banking sector and its related industries are all too chummy, Cramer accused. That led the numbers related to mortgage investments -- investments that are currently souring -- to break from reality.

"I think the financial guys all belong to the same club and they got to protect each other," he said.

Worse, those executives behind the current credit crunch are unlikely to get any punishment for their mistakes and disingenuousness about their numbers, Cramer opined.

"I'm fed up with it. The American people should be fed up with it. And the SEC should be fed up with it," Cramer said.

"This is what the SEC is supposed to protect us from," he added. …

P.S. Cramer takes aim too at so-called "mortgage insurers".

Hat Tip: Paul Kedrosky, Infectious Greed.

"Conservative" Economic Policy Dies a Timely Death

Obituary: Conservative Economic Policy, Jared Bernstein, TPM Café, Oct 19: Conservative economic policy is dead. It committed suicide.

Its allegiance to market solutions, tax cuts and spending cuts, supply-side nonsense, manipulative and corrosive ties to industry and the rich, have left it wholly unable to cope with the challenges we face. Its terribly limited toolbox simply cannot address the economic insecurities and opportunities generated by today's global, interconnected, polluted, insecure, dynamic, bubble-prone economy.

What's more, progressives have developed an alternative policy set with the flexibility to combine market forces with the necessary regulation and redistribution to address these challenges. Whether that agenda will ever see the light of day is another question.

… The fundamental flaw with conservative economic policy is its reliance on markets for problems that markets can’t solve. It is widely recognized, for example, that consumer-driven health care … does not begin to address the challenge of health care reform. Similarly, while we can all agree that globalization has many positive attributes, simply calling for more "free trade" doesn't address either pervasive income losses to many Americans or the unfulfilled promise of trade to the poor in developing countries.

A related flaw is the inability of the empty conservative toolbox to deal with the critical economic questions of the day. How much regulation is necessary to both foster growth and innovation while avoiding the rampant speculation that has infected key sectors, such and housing and financial markets? The conservative answer is "none," and that's obviously wrong. The last two economic recoveries have been crippled by bursting speculative bubbles. But the trick, of course, is correctly calibrating the regulatory agenda.

On inequality, … [There is] nothing in [conservative ideology's] toolbox to address inequality. To the contrary, their tax policies exacerbate it.

And while education provides a critical leg up, it cannot be the sole policy solution for inequality …. When the benefits of (accelerated) productivity growth are flowing almost exclusively to a narrow sliver at the very top of the wealth scale, something else besides "enhanced returns to skills" is going on.

… Too much power rests in the hands of too few right now, and they have used their political and financial power to pursue violent, shortsighted foreign policy, steer the lion's share of growth their way, and avoid dealing with the challenges of global warming, health care, and inequality.

So we are left with a riddle: how can conservative, economic elites be both powerful and dead at the same time?

It's because they are zombies: their ideas that are dead but their political and economic clout remains prodigious and threatening. They can still win elections. But they cannot govern—they're proving that with every new failure of the government they demonize but still dominate. … Yet zombies are always dangerous, and while the tide appears to be turning against them, their defeat is by no means a sure thing. …

In my decades of life as a progressive economist, I've never seen such an outpouring of good ideas. … But good policy solutions by themselves won’t win the day. I remain deeply nervous that progressives will fail to tap this uniquely clear moment of the failure of conservative policy. And the stakes are very high. If we squander this opportunity—if we fail to get the majority of the electorate behind the progressive ideas touted above, or we fail to push wavering centrist democrats toward these ideas—we may not be able to repair the damage. I don't mean to be alarmist, but we must stop the zombies before it's too late.

October, The Month of the Crash: Bill Moyers

Just when I was beginning to think we might get out of our financial mess without a hard landing, last night on his PBS Journal Bill Moyers resuscitated my case of the jitters relative to complex derivatives and hedge funds. Moyers interviewed Robert Kuttner and William Donaldson, former Chairman of the SEC. Note too that Moyers Journal has a blog too.

Both Donaldson and Kuttner advocate re-regulating our financial markets so that "middlemen" could no longer take the lion's share of the gains from latest financial innovations and globalization. It's worth a look. And there are a bunch of good links to learn more from Kuttner, Donaldson, John Bogle and others. Here is a snip from the interview:

WILLIAM DONALDSON: … [People]read every day about the fantastic profits being made by hedge fund managers and so forth. And yet they're out there, two-family, two-- Mom and Dad both working. They say there's no inflation, but they're paying more for gasoline and paying more for the everyday necessities of life, and so forth. So in effect, the great middle class in this country has not-- it's tough. They have not really shared in what's going on now.

BILL MOYERS: Are you saying that this insecurity that you sense in the market has something to do with inequality in America? That is--

ROBERT KUTTNER: Directly. I called my book The Squandering of America because I think the promise of the economy as an economy of shared prosperity is being squandered because the middlemen in the financial markets--

BILL MOYERS: And the middleman is?

ROBERT KUTTNER: Well, it can be a banker, it can be a trader, it can be a broker, it can be someone who's-- running a hedge fund.

BILL MOYERS: So he or she is doing what that you don't like?

ROBERT KUTTNER: They are taking risks that put the whole economy at risk, and they are cutting themselves too big a slice of the pie at the expense of little people. The biggest hedge fund operators make over $1 billion a year. A normal CEO pay packet now is $40 million or $50 million a year. And the median worker in this country despite the fact that GDP is up 18 or 19 percent since 19-- since 2000, hasn't had a raise. Just barely keeping even. So, what I want people to appreciate is that the risks in the financial economy, and the increase in security in the rest of the society, are two sides of the same coin. We've given up on a form of managed capitalism that produced board prosperity. And we need to get it back.

WILLIAM DONALDSON: I'm not quite as pessimistic as Bob is on this. I think when you step back the economy is-- is working pretty well.

ROBERT KUTTNER: For most people.

WILLIAM DONALDSON: For a lot of people. But--

ROBERT KUTTNER: Yeah, I agree.

WILLIAM DONALDSON: --as I said before, I think it's disparate sharing of the wealth. I think we need to pay more attention to the ne-- as you said, the negative aspects of this. I think we need to understand-- what's going on globally in terms of our markets. I'll put in a plug for the people at the SEC. It was and is one of the finest agencies in the country, known for its independence. Known for being nonpolitical. I think that's changed a little bit in recent years, just as everything's become more political. I don't think there's any room for political thought on the SEC commissioners. I think they have one charge and that is to protect investors and to make sure that the rules work. And I think that we've gotta give the SEC the horsepower to do its job. Again, as we were talking earlier, some of these instruments-- they're extremely difficult to understand. Some of the Ph.D.'s that devise them, I'm not sure they really understand them. And you've got people at the SEC who are trying to keep up with that. Trying to understand it. It's a big job.

ROBERT KUTTNER: But the SEC-- does have a wonderful tradition as an independent regulatory agency. However, the commissioners are appointed by the President, they're confirmed by Congress. And the budget is legislated by Congress. Whenever Arthur Levitt, who was the distinguished predecessor of Bill Donaldson, tried to be an aggressive regulator, Congress threatened to cut off his budge. So the forces against regulation in the public interest, as good as the SEC is, are stronger than they had ever been. I don't know if that makes me an optimist or a pessimist.

BILL MOYERS: Are we courting a repeat of '29?

WILLIAM DONALDSON: Well, I think that's a little strong. Again, I think that the Federal Reserve, the Central Bank, has an ability to reverse a downturn, but at great cost. I mean, we haven't mentioned the where the dollar is overseas. We haven't mentioned--

BILL MOYERS: We can't see it.

WILLIAM DONALDSON: Well it's disappearing. BILL MOYERS Through the floor.

WILLIAM DONALDSON: So I think that the central banks have a greater technique and ability to meet this problem. But insofar as they do-- we run into a moral hazard, i.e. we bail out the people who made bad or devious, or whatever you wanna call 'em, investment decisions. So you sort of are saying, "Go ahead and do whatever you want, and you can count on the good old Fed--"

ROBERT KUTTNER: Right, and the risk--

WILLIAM DONALDSON: --"to bail you out.

ROBERT KUTTNER: The risk is that every time we repeat this cycle, we get bigger and riskier bubbles. And with the dollar being in the tank-- it's not a costless kind of bailout. One would have thought that if the dollar were down to 140 Euros there'd be a run on the dollar. We're gonna see inflationary pressures as a result of the cheap dollar. So it's not as if the Fed can simply print more money to bail out these excesses, and there be no cost to everybody else.

BILL MOYERS: Do you agree with Bob Kuttner's thesis that our politics is undermining our prosperity by squandering America?

WILLIAM DONALDSON: Well I think that we are seemingly paralyzed on a number of issues that face the country. Not just in the financial markets, but the resolution of Social Security system, the resolution of the health care system, the rebuilding of our infrastructure, the attention to the environment. All of these things seem to be taking a second seat to issues that have nothing to do with making sure that this great economy we have continues for the benefit of everybody.

See also Mark Thoma's Rising Inequality, Oct. 12.

PS.. Moyers dealt with another topic near and dear to my heart: Difference, Dissent and Tyranny. In Moyers' interview with Anouar Majid, the two punctuated a point that is the reason why I blog, particularly about government functions. Moyers sums up Majid's main point: "Stifling disagreement and smothering debate … can have dangerous effects on a civilization." Here in the US, we have become a nation steeped in silence in a historical moment when we ought to be "in the streets protesting" and "screaming from the rooftops". Instead we spend way too much of our time watching "reality-based TV" or playing video games."

A Long, Hot Summer of Volatility and Discontent. Or Not?

Prudent Bear's Doug Noland looks for a summer of Volatility and Discontent … setting the stage for major disappointment and disillusionment. An October surprise? Earlier? Later? At all? Who knows? But the last week has proven interesting indeed. On a more conservative note, Tuy Duy at Economist's View admonishes us to "beware of bears who focus on the downside of every piece of data; [without demonstrating] a willingness [and the wisdom] to look through the soft spots in the data."

Doug Noland, Q1 2007 Flow of Funds, 6/8/2007: …[It's] surprising bonds ignored rampant global liquidity excess for so long. The abrupt nature of the yield spike is surely problematic for those highly leveraged players (and curve speculators) caught on the wrong side of the market. Clearly, scores of players had positioned for the imminent start of a Fed easing cycle. It’s never a smooth process when the crowd rushes to the exit an unsuccessful "crowded trade." But to what extent this unwind impacts liquidity (reduces gross excess) is difficult to assess at this point. The near-term market assumption will likely be that the jump in market yields is sufficient to keep the economy and inflationary pressures in check – holding the Fed at bay.

And while it was a painful week for fixed income, for the system as a whole it was anything but the worst case scenario (rates spiking, stocks collapsing, dollar sinking and spreads blowing out). The yen only rallied slightly, encouraging players that yen carry trade dynamics are still quite favorable. The dollar rallied and most spreads were only moderately wider for the week. Emerging market equities were ok. On a global basis, I doubt recent yield increases will have much influence on overheated Credit systems.

But the week can be viewed as another body blow to a vulnerable marketplace weakened by subprime and heightened volatility. This yield spike certainly comes at an especially poor time for fragile housing markets and mortgages. Yet for global equities, securities finance and M&A – today's prevailing booms and sources of new liquidity – the near-term outlook is anything but clear. I would be somewhat surprised if the current cost of funds meaningfully restrains the overheated M&A Bubble. I would also expect the equities bulls to play hardball, keen to keep the bears on their heels. But it should be increasingly obvious that this massive and unwieldy pool of global speculative finance is a serious problem.

As master of the obvious, I'll predict we're in store for A Long, Hot Summer of Volatility and Discontent. The bond market was content for some time to ignore unfolding fundamentals. The stock market has been gleefully disregarding reality. From Iraq to the entire Middle East to Russia – the disturbing geopolitical backdrop has curiously remained a non-issue. The enormous ongoing cost of national security and the global "war on terror" are brushed off as if they are inconsequential. But, then again, inflating financial markets create their own rationalizations, spin and reality. The latest round of bullish propaganda has really pushed the envelope, setting the stage for major disappointment and disillusionment. If history is any guide, expect a period of wild volatility leading to a financial accident.

Tim Duy, Coming to Terms with the Fed, 6/11/2007: For several months I have watched the disconnect between market participants and the Fed. Such disconnects by definition end only one of two ways; either the Fed moves to the market, or the market moves to the Fed. The market has clearly moved to the Fed over the past two weeks, and analyst after analyst seems to be having a sudden realization that the Fed actually intends to keep rates on hold for the foreseeable future. Moreover, they actually believe that the dominant threat is really higher inflation. No, really.

To be sure, the drumbeat of bearish sentiment was grinding me down as well. I considered the possibility that the Fed would maintain an inflation bias if only to keep market expectations from veering even more toward an imminent rate cut And I had to rethink my whole outlook when John Berry at Bloomberg made his sudden, albeit temporary, foray into the "rate cut is possible" camp.

So what changed so quickly? Was it reduced Chinese purchases of Treasuries? Or problems in the subprime leaking into the broader markets? Or Bill Gross’ sudden change of heart (not so coincidently after bringing former Fed Chairman Alan Greenspan on board?)

I prefer a much more straightforward explanation. It is not simply that Fed policymakers struck forcefully and frequently with what I call “the look through the slowdown” story (for recent examples see Chicago Fed President Michael Moscow, Kansas City Fed President Thomas Hoenig, and Richmond Fed President Jeffrey Lacker, not to mention Fed Chairman Ben Bernanke). Talk can only carry you so far; more important is the apparent confirmation of the Fed’s story via the steady flow of data that argues for a reacceleration of economic activity.

In the last two weeks, we have seen solid readings on both the manufacturing and services ISM surveys, a second consecutive gain on core (nondefense, nonair) capital goods orders, a fall in the inventory to sales ratio as firms work off their excess stockpiles, the trade deficit improve, and the a rebound in NFP after April’s soft read (note that the continued stability of initial unemployment claims at the 300k mark suggests that the labor market remains reasonably solid). All in all, incoming data is forcing analysts to raise their Q2 forecast as high as 4'.

It is worth noting the steepening of the yield curve particular in the 2 to 10 year range, suggests the threat of recession drops considerably a year out, consistent with the Fed’s outlook. And a rebound in Q2 would leave the Fed fully discounting away any stories of a “hard landing” in Q1. But still lurking in the forecast is the housing/consumer story. Early Q2 data (April personal consumption, reads on retail sales) on the consumer is not disastrous, but clearly points to a slowdown from the Q1 pace. Moreover, estimates of mortgage equity withdrawal continue to trend downward as the housing slowdown drags on and on. Still, continued job growth will provide support and my expectation is that consumer spending pulls back to the 2 percent range; slow enough to pull the economy to a pace somewhat below trend, fast enough to forestall a recession – or rate cuts.

Note that I have been consistently surprised by consumer resilience.

Bottom Line: For the moment, the Fed is looking more right than wrong, forcing the more bearish elements of the investing community into a reevaluation of their policy outlook. Has the pendulum swung too far, or not enough? I doubt that question will be answered until the housing market fully washes out. And beware of bears who focus on the downside of every piece of data; the Fed, since Hurricane Katrina, has consistently shown a willingness to look through the soft spots in the data.

Oligarchic Capitalism: New Trend?

Dani Rodrik recently commented on emerging oligarchy in Russia. It is interesting to think of it as an emergent phenomenon, in Russia, China, India, … and ask "whether oligarchic capitalism represents a transition stage that will eventually lead to a true market economy and political democracy, or whether it is a blind alley that can only lead to another inefficient socioeconomic system". I side with those who are "not otimistic".

Oligarchic Capitalism in one country, Dani Rodrik's weblog, 4/30/07: Something funny [i.e. odd] happened to Russia on its way from socialism to capitalism. A bunch of politically-connected "oligarchs" managed to subvert the process while making themselves hyper-rich. In a fascinating paper [pdf], Serguey Braguinsky asks " whether oligarchic capitalism represents a transition stage that will eventually lead to a true market economy and political democracy, or whether it is a blind alley that can only lead to another inefficient socioeconomic system." He is not optimistic. A major contribution of the paper is its database of almost 300 oligarchs covering a period of ten years. Among its conclusions: the newer generation of oligarchs, who had little connections to the old nomenklatura system and who could have produced a true entrepreneurial class, ended up engaging in rent-seeking and asset-stripping instead, becoming virtually indistinguishable from the old kind. …

China's Shenzhen Index: Shades of Nasdaq Bubble

(via Michael Panzner's Financial Armageddon)

Since December, China's Shenzhen Composite Index has soared more than 57% amid frenzied buying by investors blithely ignoring government attempts to rein in liquidity and clamp down on wild speculation.

Yet if you compare the graph of the Chinese market over the past year to that of the Nasdaq Composite Index prior to its March 2000 peak, it paints a decidedly less sanguine picture: that of lemmings poised to scurry madly over the edge of a cliff.

Panzner has more.

Deconstructing the 'Financial Revolution'

Building in part from Kenneth Arrow's work, Woody Brock says we need many more derivatives to allow agents to hedge all risks…at least in a perfect theoretical world. But our world is not a perfect world and never will be, Brock argues, adding that "systems meltdowns can and do occur. Worse, leverage can amplify such meltdowns." I find Brock's ideas to be on target — both that we can expect more derivaties and that we need better disclosure and regulatory requirements in our financial systems. But I'm already sold on the notion that too few pay enough (or any) attention to "endogenous risk" in financial systems. Brock:

… The World of Reality: In reality, we live in a messy world in which securities markets are woefully incomplete—and always will be no matter how many more hedging instruments are developed. [This is a theorem.] And we live in a non-stationary environment marked by ongoing structural changes. In such environments, agents cannot know the true probability of all future events, and thus are regularly wrong. By virtue of both being wrong and being incompletely hedged, they can and do go bankrupt. As a result, systems meltdowns can and do occur. Worse, leverage can amplify such meltdowns.

The prospect of a meltdown is spookier today than it used to be. This is because of the fact that counter-party risks are no longer concentrated in large investment banks that can be readily identified and bailed out by the monetary authority during a crisis. Rather, they are diffused through myriad lesser counterparties whose identities and financial health are unknown to the authorities. Moreover, whereas large and visible players have balance sheet liquidity requirements imposed upon them, these lesser counterparties often do not. Thus we run the very real possibility of a cascade of debt defaults by households.

A mathematical description of all these problems that arise in a non-stationary world with incomplete securities markets has been set forth within the new theory of "Rational Beliefs" developed at Stanford University during the past decade…. In the language of this new theory, all these problems that arise in the real world if not in classical textbooks are captured by the crucially important new concept of "endogenous risk."

The Leverage Issue: As regards this last point about leverage, critics of today's status quo write as if the proliferation of derivatives itself implies greater leverage. This is not the case. It is true, however, that the use of derivatives has made it both more possible and more profitable to utilize leverage than ever before. Moreover, the use of derivatives can help disguise the extent of leverage should traders wish to mask over problems in their books. Thus, critics have a point when they claim that today's proliferation of derivatives could in principle help precipitate a meltdown. But it is often overlooked how leverage has helped to contribute to famous meltdowns throughout history in which derivative securities played no role at all.

All in all, there is at present no known way in which to net out the social cost of these negatives from the gains made possible by the proliferation of new instruments for managing risk. It would seem, however, that there is a huge net gain. Our own concerns center on the failure of government policy to curb excessive leverage …. [From John Mauldin's Outside the Box Newsletter, 3/20/2007]

The situation is worse still, perhaps, as the US government seems generally to not even recognize the problems of leverage, the problems of risk concentration, and so on. What next? Who knows? But Paul Kasriel recently added his name to the list of those signaling 'recession ahead!' [PDF], "barring upward revisions in the LEI [Leading Economic Indicators] and KRWI [Kasriel Recession-Warning Indicator] and sharp increases in the immediate months ahead, both indicators will be signaling that a recession is on the horizon."

Subrprime: A Disaster in the making?

From naked capitalism 3/19/07: [Last week] Jim Rogers stepped into the U.S. subprime fray on Wednesday, predicting a real estate crash that would trigger defaults and spread contagion to emerging markets.

"You can't believe how bad it's going to get before it gets any better," the prominent U.S. fund manager told Reuters by telephone from New York.

"It's going to be a disaster for many people who don't have a clue about what happens when a real estate bubble pops. …

The fund manager, who co-founded the Quantum Fund with billionaire investor George Soros in the 1970s and has focused on commodities since 1998, said the crisis would spread to emerging markets which he said now faced a prolonged bear run.

"When you have a financial crisis, it reverberates in other financial markets, especially in those with speculative excess," he said. …

"This is the end of the liquidity party," said Rogers. "Some emerging markets will go down 80 percent, some will go down 50 percent. Some will most probably collapse."
[Top investor sees U.S. property crash, Elif Kaban, Reuters, 3/14/07]

We agree with a lot of what Rogers says. Liquidity is at historically high levels, which has led to cheap credit (cheap from the borrower's standpoint, overprice from the lender's). There is asset price inflation in almost every market (although thanks to subprimes, the air has come out of the riskier parts of the mortgage market and commodities prices have fallen a bit too). We've pointed out that the Economist estimated that the US housing market was overvalued by 20% in 2005, and a recent chart indicates Americans are paying even more of their incomes than then (meaning the overvaluation has gotten worse). And housing bubbles, when they collapse, usually decline to the point where prices are undervalued relative to incomes and rents.

A 20+% declince in housing prices would be devastating, both because America hasn't seen anything like it, and because so many people view their home equity as a usable part of their balance sheet (e.g., they use it for home equity loans, they depend on it to fund retirement).

But that also means the powers that be will do anything they can to stop that from happening. The unknown question is whether they will be effective. In the past, when the monetary authorities have provided liquidity to the markets, investors have piled back in. If for some reason investors didn't respond the same way, we could fall into what is called the liquidity trap, where interest rates are so low that no one has any incentive to invest. That happened in Japan in the post bubble years.

With Fed fund rates at over 5%, the Fed has a good bit of room to rates if the wheels came off (but of course, that just keeps the Ponzi scheme going and probably make the eventual day of reckoning even worse, unless the Fed is able to moderate the decline, rather than attempting to prevent it from happening). So things likely won't get quite as awful as Rogers forecasts. But directionally, we believe he is right. Things will get a lot worse than most people are willing to consider.

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."

---

{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."

---

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.."

---

{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…."

---

The Bell Tolls Differently for Wall Street Tycoons v. Middle Class

Whether from Chris Matthews or Stephen Roach, we are seeing folks once again talking about the plight of the middle class. When I listened to Matthews last Sunday I thought his commentary apt. There are millions of Americans missing out on the speculative run on Wall Street, and falling further behind economically. As expected, Matthews has been berated by the far right as working a political stunt, e.g. here. So I was glad to Stephen Roach add more detail in a similar commentary on Monday. I wonder whether the problem has any "nice" resolution, given that one way or another the middle class looks more and more like an "endangered species."

What might this mean for America's future as per capitalism and democracy such as they are, such as they have been, and as they may become? Brad Setser is not optimistic for a good outcome, stating in follow-up comments to a 10/23 post, that he thinks "it rather unlikely that the US will retain its financial preeminance; the rules of global finance are not usually set by debtors."

Setser's comments were in response to reader JohnH's comment: "One of the lessons of history, I believe, is that great powers typically see their mature productive sectors decline as the finance industry becomes dominant. As other countries build their productive capacity, they emerge as great powers, accumulate wealth and ultimately supplant the reigning financial power. Genoa, for example, was a great financial power after its other economic sectors withered. Britain through much of the 20th century followed the same pattern. Is there any reason the US shouldn't be following this pattern now? Why wouldn't Japan, China, and the Gulf States learn to dispense with the need for intermediaries and consign New York and London to the dustbin of history?" (See Setser's 10/23 post titled One more sign we live in a new gilded age – Europe is once again the world’s financial center … )

{Update: See too Mark Thoma's The Rise and Fall of the Managerial Class (w/ 62 comments so far) }

Mr. Risk

Business Week's June 12 cover story is Mr. Risk Goes to Washington. It opens, "What does a Treasury Secretary do?" After exploring that question, the article continues:

… Think of Paulson as Mr. Risk. He's one of the key architects of a more daring Wall Street, where securities firms are taking greater and greater chances in their pursuit of profits. By some key measures, the securities industry is more leveraged now than it was at the height of the 1990s boom. It has also extended its global supremacy since then. …what Paulson brings to the Treasury Dept., the Bush Administration, and, in fact, all of Washington, in addition to his understanding of risk, is an ability to communicate its upside and downside. ...

But the story that caught my eye is titled Inside Wall Street's Culture of Risk Here is a sampler:

...Wall Street has always been about taking risk. But never has the "R" word been such an obsession for the men and women who rule the nation's biggest investment banks. Never have they had to reconcile so many bets made on so many fronts. The conditions have been ripe. Historically low interest rates and relatively calm markets in the last few years have allowed a new type of firm to flourish, one that acts primarily as a trader and only secondarily as a traditional investment bank, underwriting securities and advising on mergers.

Goldman Sachs' CEO Henry M. Paulson Jr. has led the charge. Major Wall Street firms have watched with envy as Goldman has repeatedly racked up record earnings on the strength of its trading business. The biggest stunner came in March when Goldman announced that in three months it had tossed off $2.6 billion in profits -- nearly half as much as it earned in all of 2005 -- on $10 billion in revenues. Not coincidentally, Goldman also put a record amount of the firm's capital at risk of evaporating on any given trading day. Its so-called value at risk jumped to $92 million, up 135% from $39 million in 2001. "[Goldman is] a horse of a different color now," says Samuel L. Hayes III, professor emeritus of investment banking at Harvard Business School.

As Paulson prepares to move to Washington to serve as U.S. Treasury Secretary, Goldman shows no sign of easing up. Nor do its followers. This trading boom, fueled by cheap money, is fundamentally different from the ones of the past. When traders last ruled Wall Street, during the mid-'90s, few banks put much of their own balance sheets at risk; most acted mainly as brokers, arranging trades between clients. Now, virtually all banks are making huge bets with their own assets on many more fronts, and using vast sums of borrowed money to jack up the risk even more. They're shouldering risks for their clients to an unprecedented degree. They're dabbling in remote markets from Brasilia to Jakarta, and in arcane products like credit-default swaps and catastrophe bonds. Led by Goldman, many investment banks now do more trading than all but the biggest hedge funds, those lightly regulated investment pools that almost brought down the financial system in 1998 when one of them, Long-Term Capital Management, blew up. …

Exploring Roots and Dangers of Global Economic Balancing

The Wall Street Journal Online reported today thoughts from economists Michael Dooley of Deutsche Bank and Brad Setser of RGE Monitor exploring the roots and potential dangers of this global economic balancing act.

Dooley lays out the case for a soft landing, adhering to his longstanding position. Setser holds serve on his case too, slightly modified from a year ago, that there is a "meaningful risk" of a hard landing sometime soon. In Setser’s words,

Nouriel [Roubini] and I never said that the system would collapse by the end of 2006, only that there was a meaningful risk. But 'tis true that the probability I attach to that outcome has fallen somewhat, largely because China has been more able than I expected to absorb a massive reserve increase without excessive credit growth or domestic inflation. ….

Both Dooley and Setser make a good case. Faith-based complex systems are the stuff to keep the best minds debating, and the best of speculators (and investors) monies tied up betting on what may happen next.

The rest of us continue to watch this battle of world powers in this most recent foray into globalization. We see a world changing as rapidly as the wildest of science fiction writers have imagined. See also Setser’s post on this matter.

One More Worry: Flu pandemic could shut down world trade

My recent List of Worries didn’t include the Pandemic Worry. Maybe it should have, at least in a some generic form. Or maybe the list is too long already. Who knows. But today’s headlines include yet-another-scare-reference to a possible future flu pandemic. Being a bit bored here at lunchtime, I thought I’d share it:

In the July/August issues of Foreign Affairs, Michael T. Osterholm give us, “Preparing for the Next Pandemic.”

The summary reads,

“If an influenza pandemic struck today, borders would close, the global economy would shut down, international vaccine supplies and health-care systems would be overwhelmed, and panic would reign. To limit the fallout, the industrialized world must create a detailed response strategy involving the public and private sectors”

Moving to the main text, we can snip this:

What would happen today in the office of every nation's leader if several cities in Vietnam suffered from major outbreaks of H5N1 infection, with a five percent mortality rate? First, there would be an immediate effort to try to sort out disparate disease-surveillance data from a variety of government and public health sources to determine which countries might have pandemic-related cases. Then, the decision would likely be made to close most international and even some state or provincial borders -- without any predetermined criteria for how or when those borders might be reopened. Border security would be made a priority, especially to protect potential supplies of pandemic-specific vaccines from nearby desperate countries. Military leaders would have to develop strategies to defend the country and also protect against domestic insurgency with armed forces that would likely be compromised by the disease. Even in unaffected countries, fear, panic, and chaos would spread as international media reported the daily advance of the disease around the world.

In short order, the global economy would shut down. The commodities and services countries would need to "survive" the next 12 to 36 months would have to be identified. Currently, most businesses' continuity plans account for only a localized disruption -- a single plant closure, for instance -- and have not planned for extensive, long-term outages. The private and public sectors would have to develop emergency plans to sustain critical domestic supply chains and manufacturing and agricultural production and distribution. The labor force would be severely affected when it was most needed. Over the course of the year, up to 50 percent of affected populations could become ill; as many as five percent could die. The disease would hit senior management as hard as the rest of the work force. There would be major shortages in all countries of a wide range of commodities, including food, soap, paper, light bulbs, gasoline, parts for repairing military equipment and municipal water pumps, and medicines, including vaccines unrelated to the pandemic. Many industries not critical to survival -- electronics, automobile, and clothing, for example -- would suffer or even close. Activities that require close human contact -- school, seeing movies in theaters, or eating at restaurants -- would be avoided, maybe even banned.

Vaccine would have no impact on the course of the virus in the first months and would likely play an extremely limited role worldwide during the following 12 to 18 months of the pandemic. …

So, there we have it. If we add add this to the list, we’ll have all the threats in the Universe now packed into my list of recession/depression worries. Well, not quite. Consider this, from the movie Men in Black:

JAY: Can we drop the cover-up bullshit?!
There's an Alien Battle Cruiser that's
gonna blow-up the world if we don't...

KAY: There's always an Alien Battle Cruiser...or
a Korlian Death Ray, or...an intergalactic
plague about to wipe out life on this
planet, and the only thing that lets people
get on with their hopeful little lives is
that they don't know about it.

Stephen Roach on China slowdown: US refi boom, far more treacherous endgame?

Stephen Roach just changed his mind regarding whether the US or China would be first to bow out of what I've referred to at their geopolitical "death dance." In his Global: Re-sequencing (Jun 13, 2005) Roach says, in part:

A lopsided world economy continues to be dominated by two growth engines -- the American consumer on the demand side of the equation and the Chinese producer on the supply side. Both of these engines are overheated and in need of cooling off. I had long thought the American consumer would be the first to slow. But now the sequencing looks different -- with China likely to lead the way. This could keep the US growth engine in high gear for a while longer -- but at a cost that could make for an even more treacherous endgame than might have otherwise been the case. ...

The problem with this leadership dynamic is that it has long rested on an American consumer who has been consuming well beyond his/her means as delineated by the income side of the US economy. …

But.if a China slowdown rules out a move at the long end of the yield curve, it could also pin down the Fed at the short end. The possibility of a China-led global growth scare means that the US central bank risks triggering an inversion of an already very flat yield curve if it keeps on tightening while the long end remains contained. That, in turn, would prove to be a most problematic development for levered investors, US banks, and the real economy. Despite all its bluster about policy normalization, I believe that a pro-growth, pro-market Fed will be reluctant to tighten much more if a China-led slowdown unfolds first, as I now suspect. The net result could be a surprisingly benign US interest rate climate for some time to come.

If such an outcome occurs, it would undoubtedly provide the interest-rate-, asset-dependent American consumer with yet another breath of life. While that might offer some support to the near-term US growth outlook, this would not be a constructive development over the longer haul for an unbalanced global economy. It could lead to a final blow-out in already frothy US property markets, along with a last-gasp surge of refi activity to tap such newfound wealth. Not only would that push household indebtedness to ever-higher highs, but it would undoubtedly depress income-based saving even more. The result would be a further widening of an already record current US account deficit -- setting the stage for a far more treacherous endgame. All this means that the ever-present excesses of America’s Asset economy could be seriously compounded by the seemingly bullish interest rate implications of a China slowdown. In the end, such a re-sequencing of global rebalancing is the last thing an unbalanced world needs.