Economic Dreams - Economic Nightmares

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.

On Sheep and Greedy, Corrupt Shepherds

As I've watched the Securitization Mess unfold since last August, and opined about its inevitability prior, I have been awestruck by the silence from those who ought to have spoken loudly about the systemic corruption at work. I have been disgusted by the wanton greed from those who were knowingly profiteering from what inevitably would hurt those drawn into the deception. I have been dumbfounded by the blind faith of true believers in so-called "new economy" thinking, whether pundits, politicians, or CEOs. In all it brings to mind a couple of my favorite quotes:

Those who give no thought to that which is distant will find sorrow near at hand. Confucius (paraphrased)

People don't learn from the mistakes of others. They seldom learn from their own mistakes. Never underestimate the power of human stupidity. Robert Heinlein (paraphrased)

As to why we don't learn from mistakes, we need not look further than what cognitive psychologists and decision theorists have been yarding together for years under headers like Self-deception Biases, Heuristic Simplification (information processing errors), Emotion/Affect Disorders, and Social Interaction Disorders.

As to the systemic nature of this Securitization Mess, I'll leave you with Doug Noland's recent words:

Confirmations, Doug Noland, Credit Bubble Bulletin, Feb. 22: … [T]he unfolding Credit Crisis has made a major leap toward the heart of the Credit system. I have no way of knowing to what degree widening spreads are being dictated by "technical" hedging-related trading dynamics, as opposed to fundamental issues with respect to the faltering U.S. economy; rapidly deteriorating corporate balance sheets; a highly susceptible leveraged speculating community; the vulnerable GSEs; a distressingly illiquid Credit market; and heightened systemic risk more generally. To be sure, a strong case can be made that the current backdrop is quite detrimental to a highly leveraged and speculative Credit system. The markets rallied late this afternoon — and perhaps they will rally further next week — on talk of a bailout for troubled Ambac. Unfortunately, there has been ample Confirmation that the Evolving Credit Crisis has quickly spiraled way beyond the "monolines."

Related: Flock Mentality, from Alea

P.S. I'm now pulling together recent "finds" from others on the sidebar of my blog. Or you can find them here, via Google Reader "Shared Items" (along with a feed).

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.

Squandered Trust

Those wishing to understand why systems seemingly as corrupt as ours here in the US seem so resilient and resistant to change, ought to read or re-read John Kenneth Galbraith's The Great Crash 1929 — as I have recommended before. Yesterday, over at Information Arbitrage, Roger Ehrenberg suggested that our financial system is badly in need of governance both at the corporate and government levels. Ehrenberg asked, then answered this fundamental question: "Who is at fault? Everybody." I agreed, in follow-up comments, noting that:

Maybe, finally the shit has hit the fan in a big enough way that people will demand change — eventually after enough pain has been felt by enough people — as they did after the mess that began in the eurphoria of the 1920s and ended with the mess of the 1930s. Only after a big-enough mess will the corruption within the various, connected systems be dealt with and cleaned up. … Good governance is needed from within (corporations) and from without (government, press, academia).

After the cleansing, if and when we get such, we can once again expect honesty from corporations and government agencies who will be trying hard to win back the respect they have squandered during [the] "looting" — the "main play" of the recent-past era (assuming that it began to end in August (and continued to end this week)).

"Everybody" includes corporate boards, managers, investors, auditors, appraisers, "rating agencies", the Press, government overseers (e.g. the Congress, the Administration, federal agencies, the Fed).

Ehrenberg noted in another recent post, again echoing my own sentiments, that the problem is one of squandered trust. Ehrenberg and I disagree on minor points, like the national debt being such a big problem, but we do see eye to eye that many have squandered much-needed trust in our systems — and not just our financial systems!

Here is a little added perspective from Galbraith's The Great Crash 1929 that I left as a comment on James Hamilton's Econbrowser early this year, responding to his post, The New Deal and the Great Depression:

[Me:] It proves interesting to reread John Kenneth Galbraith's The Great Crash 1929. It is as though history is being rewritten before our eyes. Substitute hedge funds for "investment trusts" and it reads pretty much parallel. Frightening! I keep hoping to see daylight beyond what I perceive to be a gathering storm. Daylight will indeed be forthcoming [sometime after] a storm, but the interim may be ugly.

The Great Crash 1929
Chapter II, "Something Should Be Done":

"…like all booms, it had to end. When prices stopped rising—when the supply of people who were buying for an increase was exhausted—then ownership on margin would become meaningless and everyone would want to sell. The market wouldn't level out; it would fall precipitately.

"All this being so, the position of the people who had at least nominal responsibility for what was going on was a complex one. One of the oldest puzzles of politics is who is to regulate the regulators. But and equally baffling problem, which has never received the attention it deserves is who is to make wise those who are required to have wisdom.

Some of those in positions of authority wanted the boom to continue. They were making money out of it, and they may have had an intimation of the personal disaster which awaited them when the boom came to an end. "But there were also some who saw, however dimly, that a wild speculation was in progress and that something should be done. For these people, however, every proposal to act raised the same intractable problem. The consequences of successful action seemed almost as terrible as the consequences of inaction, and they could be more horrible for those who took the action.

… "The real choice was between an immediate and deliberately engineered collapse and a more serious disaster later on. Some one would certainly be blamed for the ultimate collapse when it came. "There was no question whatsoever as to who would be blamed should the boom be deliberately deflated. …

… "Clearly the Federal Reserve was less interested in checking speculation than in detaching itself from responsibility for the speculation.


Chapter III, "In Goldman, Sachs We Trust"

… ""The most notable piece of speculative architecture of the late twenties, and the one by which, more than any other device, the public demand for common stocks was satisfied, "was the investment trust or company. The investment trust did not promote new enterprises or enlarge old ones. It merely arranged that people could own stock in old companies through the medium of new ones. …

"Knowledge, manipulative skill, or financial genius were not the only magic of the investment trust. There was also leverage. … Leverage, it was later to develop, works both ways.”

Chapter IV, "The Twilight of Illusion"

… "To a few alarmed observers it seemed as though Wall Street were by way of devouring all the money of the entire world. However, in accordance with the cultural practice, as the summer passed, the sound and responsible spokesmen decried not the increase in brokers’ loans, but those who insisted on attaching significance to this trend. There was a sharp criticism of the prophets of doom." (empahsis added)

{Update, Nov 9}

I might as well add Bill FLeckenstein's gloom to this already gloomy post:

Yesterday's Flip Flop, William Fleckenstein, Nov 9, Minyanville … I've talked about a dislocation [or "crash"] fairly often and it hasn't happened. Such events have an extremely low probability of occurring. But for folks to think it's not possible would be wrong. The stage has been set, such that the low probability is far, far higher than "normal."

That is thanks to the reckless policies pursued by the Greenspan Fed for the last decade and a half, which have enabled the risks to pile up while rewarding folks for ignoring them. The Fed's efforts to stave off small forest fires from happening has only guaranteed that we will have a gigantic one.

So, we are at a moment in time where a crash is far more likely to happen than at any time before. Does this mean it will happen? Not necessarily. But for folks to think it's not possible would be wrong. It feels to me like that could be right around the corner.

I am not rooting for this, but it seems to be inevitable. What I am rooting for is the return of sanity, which is something that only a large wipeout might bring about. "We have to stop the cycle of bailing out risk-takers, and that is where we are now. At some point, "too big to fail" will become "too big to bail out." And it feels like we may be at that point.

First Real Crisis of Financial Globalization and Securitization

Nouriel Roubini as in prime form today, not only still preaching the gospel of 'hard landings' but also explaining how this marks a first real crisis for the new world order. Roubini's warning, albeit frightening, is made worse if one can believe Randall Wray's latest on the impotence of the Fed and the ongoing charades that are, arguably, increasingly responsible for ever-more-frequent and severe booms and busts around the world.

Wray advocates for simplicity in monetary policy—that would "set the overnight rate at zero, and keep it there." Although I've not laid bare the basics of Wray's arguments, I'd appreciate any feedback as to holes in his reasoning. Even if a Fed Chairman were to believe Wray, getting past inflammaroty rhetoric, an interesting and perplexing question is: How does one get from where we are to where Wray and others would have us be?

The Coming U.S. Hard Landing, Nouriel Roubini: … On top of a weakening of the real economy the current financial markets turmoil will get worse — not better — in the next few months. This was never just a sub-prime problem as the same reckless and toxic lending practices in sub-prime — no down-payment, no verification of income and assets, interest rate only mortgages, negative amortization, teaser rates – were occurring in near prime mortgages, Alt-A loans, piggyback loans, home equity loans, and prime hybrid ARMs. About 50% of all mortgage origination in the last two years was made of this toxic waste and utterly junk lending practices.

And now what started as a credit crunch in the sub-prime mortgage market has spilled over to near prime and prime mortgages and to a variety of other credit markets: money markets, interbank lending markets, asset backed commercial paper, structured investment vehicles (SIVs) of banks, CDO markets, other securitization markets, and the LBO market. All these markets are now literally frozen with a dearth of liquidity, serious refinancing problems and severe credit problems. The mess in the SIV products is particularly serious and dramatic as it is generating severe liquidity and capital problems for both banking and non-banking institutions.

And this liquidity and credit crunch will get worse in the weeks ahead as this financial markets crisis is much more severe than the liquidity crisis of 1998 when LTCM — the largest US hedge fund — almost collapsed. In 1998 you had only a liquidity problem as the economy was strong — growing at 4% plus — and we were still in the rising cycle of the internet boom. Today, in addition to severe liquidity problems in the financial system (a near total freezing of the entire financial system liquidity plumbing), we have serious credit and insolvency problems too. The credit and solvency problems derive from a massive credit boom that lead to excessive borrowing that, in turn fed for a while rising asset prices that are now going bust, in a typical Minsky credit cycle. It is a insolvency problem as you have now millions of US households that are near insolvent and will default on their mortgages; dozens of sub-prime mortgage lenders who have already gone bankrupt; dozen of home building companies that are under distress; many financial institutions in the US and abroad — such as hedge funds and other highly leveraged institutions — that have already gone belly up; and the rise in credit spreads will also lead soon to a rise in corporate defaults that had been artificially low in the last few years given the excessively easy credit conditions. So we do not face only a most severe liquidity crisis; we are also observing a serious credit crisis and credit crunch. And you cannot resolve credit problems — as opposed to liquidity problems with liquidity injections. That is why the forthcoming cuts in the Fed Funds rate by the Fed will be ineffective in stemming the real and financial problems of the economy.

Indeed, the forthcoming easing of monetary policy by the Fed will not rescue the economy and financial markets from a hard landing as it will be too little too late. The Fed underestimated the severity of the housing recession, its spillovers to other sectors, and the contagion of the sub-prime carnage to other mortgage markets and to the overall financial markets. Fed easing will not work for several reasons: the Fed will cut rate too slowly as it is still worried about inflation and about the moral hazard of perceptions of rescuing reckless investors and lenders; we have a glut of housing, autos and consumer durables and the demand for these goods becomes relatively interest rate insensitive once you have a glut that requires years to work out; serious credit problems and insolvencies cannot be resolved by monetary policy alone; and the liquidity injections by the Fed are being stashed in excess reserves by the banks, not relent to the parts of the financial markets where the liquidity crunch is most severe and worsening. The Fed provided liquidity to banking institutions but it cannot provide direct liquidity to hedge funds, investment banks, other highly leveraged institutions and parts of the credit markets — such as asset backed commercial paper — where the crunch is severe. Thus, the liquidity crunch in most credit markets remains severe, even in the usually most liquid interbank markets.

Unfortunately, financial globalization together with securitization and mushrooming of complex credit instruments has lead to greater opacity and less transparency in the financial system. And this lack of transparency breeds unmeasurable uncertainty rather than priceable risk. Risk can be priced as you have a distribution of probabilities on various events. But unmeasurable uncertainty causes higher risk aversion under conditions of market distress. This generalized uncertainty is now coming from two sources: first, we do not know the size of the overall losses in credit markets: sub-prime alone could lead to losses of $100 billion or much higher depending on how much home prices will fall. And other losses from other illiquid financial instruments remain unmeasured in a world where institutions were marking to model rather than marking to market and where credit rating agencies were mis-rating complex credit instruments. Second, as securitization implies that financial risks have been spread out of banks and to the corners of the global financial system we do not know which firms are holding the toxic waste and thus which firms will go belly up next. It is like walking blind in a minefield where you have no idea of where the mines are. This uncertainty breeds large fear — after the massive greed of the previous credit and asset bubble has now burst — and lack of trust of financial counterparties, even otherwise respected ones: everyone want to hoard liquidity and hold the safest assets as even large financial institutions do not trust each other and are unwilling to lend to each other. This greater opacity of financial globalization and securitization implies that the re-pricing of risk that we have observed in the last few weeks is a permanent rather than a transitory phenomenon. And the sharp spike in the cost of credit will further weaken an already weakened economy. This is thus the first real crisis of the new world of financial globalization and securitization.

W. Randall Wray, A Post-Keynesian View of Central Banking Indepencence, Policy Targets, and the Rules-versus-Discretion Debate, August 2007 [PDF]: … Blaming the Fed for subpar economic performance is fun sport, albeit not very useful. At least some members of the FOMC have been delightful and irresistible targets. Who could repress a chuckle when FRB-Dallas President Robert McTeer recommended that consumers run out and buy Humvees to jumpstart the economy? Or when Governor John LaWare likened monetary policy to reading tea leaves and called for gold price targets? (Bradsher 1994 ["Bigger Role for Intuition Seen at Fed." New York Times. February 28]). The "Maestro" (Chairman Greenspan) always kept Fed watchers guessing with his preternaturally glum demeanor, his penchant for recitation of unimportant factoids, his habitual claims that "history shows" something that it does not, and his carefully cultivated manner of speaking without saying anything. His marriage to Andrea Mitchell, as well as his practice of studying reports in daily extended baths, added a patina of celebrity mixed with a dose of repulsiveness to his aura, reinforced by his previous incarnation as a "gold bug" and Ayn Rand acolyte. Some cracks in his reputation as "the most powerful man in the universe" began to show with the collapse of the "new economy" bubble, when the curtain was raised to reveal a somewhat clueless and impotent Wizard, spinning dials and yanking levers while professing faith in the almighty invisible hand, until it was time to escape into retirement via a hot air balloon (appropriately, green to match the cash for his memoir) and turn the whole thing over to Ben "the brainy Scarecrow" Bernanke to rule in his stead (Wikipedia).

As was often the case, John Kenneth Galbraith got it exactly right when he said:

To limit unemployment and recession in the United States and the risk of inflation, the remedial entity is the Federal Reserve System, the central bank. For many years (with more to come) this has been under the direction from Washington of a greatly respected chairman, Mr. Alan Greenspan. The institution and its leader are the ordained answer to both boom and inflation and recession or depression… Quiet measures enforced by the Federal Reserve are thought to be the best approved, best accepted of economic actions. They are also manifestly ineffective. They do not accomplish what they are presumed to accomplish. Recession and unemployment or boom and inflation continue. Here is our most cherished and, on examination, most evident form of fraud. (John Kenneth Galbraith 2004, [The Economics of Innocent Fraud: Truth for Our Time Boston: Houghton Mifflin.] pp. 43–44)

The truth about monetary policy is rather simple: it usually doesn't matter much. Unexpected rate changes can affect financial markets, and, as the New Classicals say, random policy has larger impacts, but there isn’t much to recommend it. In the current institutional environment, mostly free of regulations, supervision, and international financial borders, interest rate changes within usual ranges have small impacts on aggregate demand; larger policy changes have larger impacts, but are now avoided due to the policy of gradualism, based in the fear that big changes have undesirable impacts on financial markets. Further, policy changes—especially if gradual—promote innovations and evolution of financial institutions and practices that minimize the impact of policy. To make matters worse, we usually have no a priori reason for guessing the sign of the impact of rate changes, much less the precise magnitude. Given these considerations, as well as the arguments advanced by Keynes, a monetary policy rule is preferred—set the overnight rate at zero, and keep it there. A properly programmed Tin Man robot ought to do the trick.

After reading these, maybe I'll have to re-appraise my current thinking about Bernanke being a better Fed Charman than was Greenspan. But for now I'll continue to hope — and to prod.

Predatory Oligarchy

Hervé Kemph is a French environmental journalist and a student of global capitalism. His book, How the Rich are Destroying the Planet has caused a bit of a stir thus far, and will likely have more impact once translated into English. Some will call Kemph's writing just another extremist environmental rant. Others, like me, will welcome it as an opportunity to examine ourselves and our culture. We will no doubt be hearing more about Kemph as time goes by. In the meantime, we have a couple of Truthout.org articles to draw from. In part:

The Rich Stand Accused, Louis-Rilles Francoeur, Le Devoir, (via Truthout.org, 01/07/07): …"We cannot understand the simultaneity of the ecological and social crises if we do not analyze them as two facets of the same disaster. This disaster derives from a system piloted by a dominant social stratum that today has no drive but greed, no ideal but conservatism, no dream but technology. This predatory oligarchy is the principal agent of the global crisis," writes Kempf. "The present form of capitalism," he adds in an interview, "has lost its former historic ends, that is to say the creation of wealth and innovation, because it has become a financial capitalism, disparaged even by capitalist economists. This capitalism, which destroys jobs by rationalizations, new technologies and globalizations, overall and everywhere increases the disparities between rich and poor within each country and between different countries," the journalist observes.

…This oligarchy he targets is not satisfied with blindly consuming and wasting the planet's material resources with its big cars, its airplane trips, its unbridled consumption of living products, its uselessly vast houses, its unrestrained energy wastage. It has also, adds Hervé Kempf, spawned a model of hyper-consumption that the lower and especially the middle classes now attempt to imitate, just as developing countries try to imitate Western countries - even though, whether instinctively or rationally, everyone clearly knows that "this ideology of waste" and its drain on planetary resources will inevitably come to an abrupt end. …

… Although he does not address the impact of unchecked [human population growth] on the decline of the planet's "biological services" in his essay, Hervé Kempf immediately acknowledges that this factor certainly has an impact that is greater overall than any hyper-consumption by this oligarchy, composed of several hundred thousand millionaires and billionaires who control the bulk of income and of financial capital. However, he explains, it's this oligarchy that creates an unsustainable model for the planet, the indirect impact of which on other social groups exceeds its direct consumption. "And," he says dryly, "not all humans have the same impact on the planet at birth: a Westerner carries more weight in the planet's fate than a baby from Niger or from India."

It's to put an end to this ostentatious consumption that he advocates radical control of wealth through "a ceiling on maximum salaries and on the accumulation of wealth," a sort of matching piece for the minimum wage, but on the upper side.

"Everyone," Kempf comments, "knows that China will never be able to reach a level of consumption per inhabitant comparable to that of the Americans, with two cars per family, three televisions, four computers and cell phones, a house three times too big for its inhabitants, which generates energy consumption that would be sufficient to the needs of ten, even twenty people on other continents." The environmental chronicler proposes that a reduction of its consumption be imposed on this oligarchy that has globalized poverty, so that it no longer feeds this unsustainable dream, which numbs the critical faculties of the entire planet to the point that it closes its eyes to the wall into which it is careening full speed ahead. …

… [K]nown for his rigor and level-headedness, [Kempf] nevertheless concludes: "It is still necessary for ecological concerns to be based on a radical political analysis of present relationships of domination. We will not be able to reduce global material consumption if the powerful are not brought down and if inequality is not combated. To the ecological principle so useful at the dawning of awareness - "Think globally, act locally" - we must add the principle that the present situation imposes: "Consume less, share better."

Ecologists, he adds, have not often conducted an inquiry into the "ecological misery" that parks the poor next to industrial neighborhoods, polluted and at risk, next to highways or noisy activities, in the most insalubrious houses and in sectors generally the least well-served by public services, including public transportation. It is wrong, he says, to act as though the economic system must grow more to bring these people out of poverty or to allow more poor people to attain greater wealth. The economic system works in the other direction, by monopolizing wealth and power at the expense of those who have the least, and of the middle classes that dream - ever more vainly - of hoisting themselves into the cocoon of the present financial oligarchy, Kempf maintains.

That's why, he says, we must "bring down the rich" rather than pull up the poor, in order to begin to respect the thresholds of irreversible deterioration of the planet's resources.

He takes aim, moreover, at the concept of sustainable development and the alibi it now constitutes for governments and companies that use it to justify other drains on resources in the name of this new rationale that is supposedly harmless for the planet. Sustainable development, he writes, has become "a semantic weapon to remove the dirty word, 'ecology.' Moreover, is there any need to still develop France, Germany, or the United States? The concept has meaning, he concluded in an interview yesterday, but only in developing countries, because it can help them to avoid a development as brutal and lawless as the one we have effected in the West. But in the West, he says, the first of our environmental responsibilities "consists of reducing our consumption of material goods" to attain a level of well-being based rather on values, knowledge, in sum on immaterial, but nonetheless very real, riches.

See also: How the Rich Are Destroying the Planet: A Review by Leslie Thatcher, Truthout.org, 03/15/07

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.

On Learning, Risk and More: Stability Breeds Instability

Just before this week's volatility, WSJ's Holman Jenkins caught Myron Scholes' warning about dangers lurking in stability-land. Doug Noland added yet-another similar warning just after:

Risk Manager, HOLMAN W. JENKINS JR., WSJ, 3/3/2007: [Myron Scholes operates the Platinum Grove Asset Management hedge fund. He has a Nobel Prize in economics and was a principal of the Long Term Capital Management (LTCM) hedge fund, that failed notoriously in 1990.] …[C]onversation… takes place just before the recent market gyrations ….

"Right now," according to Mr. Scholes, "we're quiet because the lion is tame, and maybe it's the central bankers of the world who are keeping it tame." And thus, "Individuals will say, oh, things are now quiescent and will be forever, and they'll take more risk again."

He adds: "My belief is that because the system is now more stable, we'll make it less stable through more leverage, more risk taking." …

What if Scholes' belief is true and self-reinforcing? Then as central bankers "reassure" with each passing phase of an ever-more risky situation, speculators take on ever-more risk. Isn't that exactly what many of those libeled as "permabears" have been telling us for some time? Ticking time bomb?
Here is Doug Noland, 3/2/2007,:

… Credit Bubbles (and attendant asset inflation) tend to turn conventional analysis on its head, with "good" policies deemed those that work to prolong the fateful boom. Self-reinforcing asset Bubbles and policymaker complicity are virtually guaranteed — and pose a great systemic dilemma.

When it comes to so-called "prosperity killers," a prolonged bout of rampant Credit and speculative excess has no equal. Moreover, a decent case can be made that, for example, cutting taxes and reducing regulator burdens during a burgeoning Credit Bubble will only exacerbate excess and resulting economic maladjustment. Promote "pro-growth" programs in the midst of terminal "blow-off" excesses and you're hankering for a real mess. And, as we appreciate, confusing moderate consumer price inflation for astute policymaking and stable finance is a hallmark of the disasters back in the late-twenties in the U.S. and late-eighties in Japan. These are not a political views, but analyses of Credit, inflation, and speculation dynamics.

… This week saw a tenuous backdrop lurch (as we've witnessed previously) into a significant event for highly correlated global risk markets. I'll make a few observations: First, we've clearly reached the point where global Bubble excesses are so egregious and prevailing that overextended markets have basically lost their capacity for pullbacks that don't incite fears of attempted mass exits and dislocations. Second, the principal contagion mechanisms are the hedge funds, "brokerage" proprietary trading desks, rampant capricious speculative flows, and ballooning global derivatives markets. Third, and significantly, The Confluence of several key developments quickly pushed the risk markets to a state of heightened tumult.

The breakneck meltdown of the subprime originators; Freddie Mac and others scurrying to exit the business; and the great uncertainty associated with tightened mortgage Credit conditions comprised a major Credit market development. The hasty rally in the yen was a second major market occurrence with negative ramifications for global leveraged speculation. At the same time, Treasury prices spiked higher on safe haven buying, the reversal of spread trades, and interest-rate hedging-related buying (unwind of previous hedges as well as MBS-related hedging). Top this off with a synchronized drop in global equities prices and selling in metals and other commodities, and you have a series of market gyrations that epitomizes the nightmare scenario for the leveraged speculating community. …

Peter Bernstein: Against the Gods

Peter Bernstein's Against the Gods: The Remarkable Story of Risk (1996) is a fine read. It is a book that helps us better understand the games of chance and gain we play in capitalist economies. We also learn about key historical figures who have devoted their lives to better understanding these games. Bernstein continues his study in two latter books that I have not yet read, Capital Ideas and Capital Ideas Evolving (forthcoming). Finally, he gives us some insight into the problems with our new-found love affair (and/or "hate affair") with derivatives, hedge funds, risk concentration, and possible governmental regulation of such.

In the introduction Bernstein lets us know exactly why investment decision-making is both art and science:

…[T]he story I have to tell is marked all the way through by a persistent tension between those who assert that the best decisions are based on quantification and numbers, determined by the patterns of the past, and those who base their decisions on more subjective degrees of belief about the uncertain future. This is a controversy that has never been resolved.

The issue boils down to one's view about the extent to which the past determines the future. We cannot quantify the future, because it is an unknown, but we have learned how to use numbers to scrutinize what happened in the past. But to what degree should we rely on patterns of the past to tell us what the future will be like? Which matters more when facing a risk, the facts as we see them or our subjective belief in what lies hidden in the void of time? Is risk management a science or an art? Can we even tell for certain precisely where the dividing line between the two approaches lies? …

Our lives teem with numbers, but we sometimes forget that numbers are only tools. They have no soul; they may indeed become fetishes. Many of our most critical decisions are made by computers, contraptions that devour numbers like voracious monsters and insist on being nourished with ever-greater quantities of digits to crunch, digest, and spew back. …

Near the end of the book, Bernstein revisits his introduction: Here are a few highlights, (pp. 300-336):

Capital markets have always been volatile, because they trade in nothing more than bets on the future, which is full of surprises. … [E]veryone is as the mercy of everyone's else's expectations and buying power.

Such an environment provides a perfect setting for nonrational behavior; uncertainty is scary. If the nonrational actors in the drama overwhelm the rational actors in numbers and in wealth, asset prices are likely to depart far from equilibrium levels and to remain there for extended periods of time. Those periods are often long enough to exhaust the patience of the most rational of investors. …

[E]xplicit attention to invesment risk and to the tradeoff between risk and return is a relatively young notion. Harry Markowitz laid out the basic idea for the first time only in 1952 …. Academic interest speeded up during the 1960s, but it was only after 1974 that practitioners sat up and took notice. … [R]isk management became the biggest game in town. First came a major emphasis on diversification, not only in stock holdings, but across the entire portfolio, ranging from stocks to bonds to cash assets. … [T]he 1970s and 1980s gave rise to new uncertainties that had never been encountered by people whose world view had been shaped by the benign experiences of the postwar era. Calamities struck, including the explosion of oil prices, ….

Along with financial deregulation and a wild inflationary sleighride, the environment generated volatility in interest rates, foreign exchange rates, and commodity prices that would have been unthinkable during the preceding three decades. Conventional forms of risk management were incapable of dealing with a world so new, so unstable, and frightening. …

Fortuitously perhaps, impressive technological innovation coincided with the urgent demand for novel methods of risk control. Computers were introduced into investment management just as concerns about risk were escalating. Their novelty and extraordinary power added to the sense of alienation, but at the same time computers greatly expanded the capacity to manipulate data and to execute complex strategies. … [A] new age of risk management was about to open….

The Fantastic System of Side Bets

Derivatives are the most sophisticated of financial instruments, the most intricate, the most arcane, even the most risky. Very 1990s, and to many people a dirty word. …

Despite the mystery that has grown up about these instruments in recent years, there is nothing particularly modern about them. Derivative go back so far in time that they have no identifiable inventors. …

Combined with the risk-reducing features of diversification, the ingenuity of the financial markets has transformed the patterns of volatility in the modern age into risks that are far more manageable for business corporations than would have been the case [without derivatives and other recent innovations].

In 1994, a few of these apparently sound, sane, rational, and efficient risk-management arrangements suddenly blew up, causing enormous losses among the customers that the risk-management dealers were supposedly sheltering from disaster. …

There is no inherent reason why a hedging instrument should wreak havoc on its owner. On the contrary, significant losses on a hedge should mean that the company's primary bet is simultaneously providing a big payoff. …

These disasters in derivative deals among big-name companies occurred for the simple reason that corporate executives ended up adding to their exposure to volatility rather than limiting it. They turned the company's treasury into a profit center. They treated low probability events as being impossible. When given a choice between a certain loss and a gamble, they chose the gamble. They ignored the most fundamental principle of investment theory: you cannot expect to make large profits without taking the risk of large losses.

What are we to make of all this? Are derivatives a suicidal invention of the devil or the last word in risk management? Bad enough that fine companies … can get into trouble, but is the entire financial system at risk because so many people are trying to shed risks and slough them off onto someone else? How well can the someone else manage that responsibility? In a more fundamental sense, as the twentieth century draws to a close, what does the immense popularity of derivatives tell us about society's view of risk and the uncertain future that lies ahead? …

Awaiting the Wildness

…The past seldom obliges by revealing to us when wildness will break out in the future. … After the fact, however, when we study the history of what happened, the source of the wildness appears to be so obvious to us that we have a hard time understanding how people on the scene were oblivious to what lay in wait for them.

Surprise is endemic above all else in the world of finance. … [If events are] unpredictable, how can we expect the elaborate quantitative devices of risk-management to predict them? How can we program into the computer concepts that we cannot program into ourselves, that are even beyond our imagination? …

Finally, the science of risk management sometimes creates new risks even as it brings old risks under control. Our faith in risk management encourages us to take risks that we would not otherwise take. On most counts that is beneficial, but we must be wary of adding to the amount of risk in the system.

And add systemic risk we have! Bernstein is only one of many who have so noted, and continue to warn: beware! See, in particular: Markowitz Bites Back: The Failure of CAPM, Compression of Risky Asset Spreads and Paths Back to Normalcy, by Vineer Bhansali, January 2007.

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."}

Decision-Making Bias Toward Optimism

Ever wonder why politicians, government administrators and policy-makers, CEOs and other power-brokers tend toward over-optimism and illusions of control? Daniel Kahneman and Jonathan Renshon help us understand why. A sampler:

Why Hawks Win, Daniel Kahneman, Johathan Renshon, Foreign Policy, Jan/Feb 2007: Why are hawks so influential? The answer may lie deep in the human mind. People have dozens of decision-making biases, and almost all favor conflict rather than concession. A look at why the tough guys win more than they should…. Social and cognitive psychologists have identified a number of predictable errors (psychologists call them biases) in the ways that humans judge situations and evaluate risks. Biases have been documented both in the laboratory and in the real world, mostly in situations that have no connection to international politics. For example, people are prone to exaggerating their strengths: About 80 percent of us believe that our driving skills are better than average. In situations of potential conflict, the same optimistic bias makes politicians and generals receptive to advisors who offer highly favorable estimates of the outcomes of war. Such a predisposition, often shared by leaders on both sides of a conflict, is likely to produce a disaster. And this is not an isolated example.

In fact, when we constructed a list of the biases uncovered in 40 years of psychological research, we were startled by what we found: All the biases in our list favor hawks. These psychological impulses—only a few of which we discuss here—incline national leaders to exaggerate the evil intentions of adversaries, to misjudge how adversaries perceive them, to be overly sanguine when hostilities start, and overly reluctant to make necessary concessions in negotiations. In short, these biases have the effect of making wars more likely to begin and more difficult to end.

None of this means that hawks are always wrong…. The biases that we have examined, however, operate over and beyond such rules of prudence and are not the product of thoughtful consideration. Our conclusion is not that hawkish advisors are necessarily wrong, only that they are likely to be more persuasive than they deserve to be.

Several well-known laboratory demonstrations have examined the way people assess their adversary's intelligence, willingness to negotiate, and hostility, as well as the way they view their own position. The results are sobering. Even when people are aware of the context and possible constraints on another party’s behavior, they often do not factor it in when assessing the other side’s motives. Yet, people still assume that outside observers grasp the constraints on their own behavior. With armies on high alert, it’s an instinct that leaders can ill afford to ignore.

…Even when alerted to context that should affect their judgment, people tend to ignore it. Instead, they attribute the behavior they see to the person's nature, character, or persistent motives. This bias is so robust and common that social psychologists have given it a lofty title: They call it the fundamental attribution error.

The effect of this failure in conflict situations can be pernicious. A policymaker or diplomat involved in a tense exchange with a foreign government is likely to observe a great deal of hostile behavior by that country's representatives. Some of that behavior may indeed be the result of deep hostility. But some of it is simply a response to the current situation as it is perceived by the other side. What is ironic is that individuals who attribute others' behavior to deep hostility are quite likely to explain away their own behavior as a result of being "pushed into a corner" by an adversary. The tendency of both sides of a dispute to view themselves as reacting to the other's provocative behavior is a familiar feature of marital quarrels, and it is found as well in international conflicts….

If people are often poorly equipped to explain the behavior of their adversaries, they are also bad at understanding how they appear to others. This bias can manifest itself at critical stages….

Excessive optimism is one of the most significant biases that psychologists have identified. Psychological research has shown that a large majority of people believe themselves to be smarter, more attractive, and more talented than average, and they commonly overestimate their future success. People are also prone to an "illusion of control": They consistently exaggerate the amount of control they have over outcomes that are important to them—even when the outcomes are in fact random or determined by other forces….

Indeed, the optimistic bias and the illusion of control are particularly rampant in the run-up to conflict….

If optimism is the order of the day when it comes to assessing one's own chances in … conflict, however, gloom usually prevails when evaluating another side's concessions. Psychologically, we are receptive not only to hawks' arguments … but also to their case against negotiated solutions. The intuition that something is worth less simply because the other side has offered it is referred to in academic circles as "reactive devaluation." The very fact that a concession is offered by somebody perceived as hostile undermines the content of the proposal. What was said matters less than who said it. … Some of that skepticism could be the rational product of past experience, but some of it may also result from unconscious—and not necessarily rational—devaluation.

Evidence suggests that this bias is a significant stumbling block in negotiations between adversaries…. [U]nderstanding the biases that most of us harbor can at least help ensure that the hawks don't win more arguments than they should.

Main Street America Thinks Economy Stinks

Although still generally optimistic when looking at their own prospects, more and more Americans believe that the middle class is slipping away. Not only do Americans worry a lot about retirement, health care, immigration, globalization, and effective represention in the workplace, they also think they are not being listened to by American politicians. The "new economy" has created "new insecurities," says a report [PDF] from the Economic Policy Institute.

Talking Past Each Other: What Everyday Americans Really Think (and Elites Don't Get) About the Economy: …For most people today, their greatest anxiety is not that they will lose their job and be unable to find another, and their greatest hope is not that they will be able to get and keep a job. Instead, they have more complex concerns: Will their jobs be outsourced to a subcontractor or off-shored to another country? Will a full-time, permanent job be converted into a part-time or temporary job? Will their health insurance be cut back or their premiums or co-payments increased? Will they receive regular raises or earn merit raises? Will they be able to stretch their paychecks to cover their family's expenses? Will their employer continue to provide pensions that offer guaranteed retirement benefits? And can they keep their skills current so that they can hold onto their current job and qualify for a promotion or for a new and better job? These uncertainties are more complicated than what worried their parents and can be summarized as a concern about both regular wages and other aspects of "job quality."

Stephen Roach on Pitfalls of Partial Analysis, Dangers of Confluent Shocks

Stephen Roach's latest, The Pitfallls of Ceteris Paribus echoes Philip Tetlock's criticism of "expert advice' in Expert Political Judgement and Robert Jervis's cautions in Systems Effects: Complexity in Political and Social Life. A bit more on both books here.

Roach's take home message is "As bad luck would have it, a confluence of three potentially powerful shocks — oil, housing, and Fed tightening -- is now in play. All other things the same, the US or global economy may not have been dealt a lethal blow by any one of these shocks. But that may well be beside the point. This is not the time for ceteris paribus." Here's more:

Ceteris paribus may well be the two most dangerous words in the economist's toolkit. Loosely translated from Latin as "all other things being the same," this concept has become a foil for partial-equilibrium analysis — an increasingly fruitless and misleading approach in today's complex and interdependent world. With oil prices rising, the housing cycle turning, and central banks tightening, the pitfalls of ceteris paribus have never been greater.

The US economy is the most obvious and important case in point. There is no lack of rules of thumb to gauge the impacts of shocks. For example, Federal Reserve staff estimates put the impact of a $10 increase in the oil price at -0.2% of forgone GDP growth and +0.2% on the headline CPI — with both impacts spread out over roughly a three-year time period … At the same time, residential construction activity has risen to a post-1960 record of 6.2% of nominal GDP — well above its longer-term mean of 4.5% (over the 1960 to 1995 period). Under the sugar-coated presumption of asymptotic mean reversion, a post-bubble shakeout of homebuilding could knock at least 1.7 percentage points off overall economic growth. A "non-asymptotic" correction would obviously be a different matter altogether. Meanwhile, the Fed has taken the federal funds rate up from 1% to 5.25% over the past two years — a monetary tightening that the Fed's own rules of thumb suggest should already be knocking at least one percentage point off aggregate growth in real GDP.... [W]e have a reasonably clear understanding of how to gauge the impacts of any one of these developments. Unfortunately, it is the interplay that matters in the real world.

… Our penchant for partial analysis is an outgrowth of the event- and sound-bite-driven culture that shapes the day-to-day debate in the media, financial markets, and political circles. I am as guilty as the rest in that respect. War breaks out in the Middle East and the telephone instantly lights up with requests for impact analysis as seen through the lens of the oil price. New home sales disappoint — as they did once again in the just-released June report (a 3% monthly drop to a level that now stands 11% below the year-earlier pace) — and the calls come in for an assessment of the post-housing bubble carnage in the US economy. Same thing happens every time the Fed tightens — or, more aptly these days, changes its mind on monetary policy. We answer these well-intended questions because they fall within the job description of the economist, market strategist, analyst, or pundit. But in doing so, we compartmentalize our answers in a fashion that does great disservice to the ultimate truth.

Yet "context is key" in going from the partial to the broader answer. That's especially the case for the American consumer — quite conceivably the most important call in the global economy these days. Energy prices go up and we typically assess the impact of that development by looking at the energy-related portion of personal consumption expenditures. Currently that share stands at 6.2%, well above the 10-year average of 4.9%. Under alternative geopolitical and oil price scenarios, we then typically model different trajectories of the energy portion of total consumption and render the macro verdict accordingly (see Dick Berner’s 17 July essay, "Tipping Point? "). But here's where the context point is absolutely critical — there is much more going on here than just an increase in oil-related expenditures. The housing market is rolling over, ultimately denying income- and saving-short households the wealth effects they have been aggressively converting into purchasing power and consumption in recent years. Moreover, courtesy of Fed tightening, a resolution of the great bond market conundrum, and "resets" of cut-rate mortgage loans, debt service obligations of overly indebted consumers are also on the rise. In other words, there are a number of other things currently happening to US consumers that render the partial analysis of an oil shock almost meaningless.

And those, of course, are just the first-round implications. If the American consumer finally caves under the weight of this confluence of forces, I suspect business capital spending — the widely presumed next source of recovery — will be quick to follow. I come to that conclusion fully mindful of all the positives that seem to support a much more resilient outlook for this sector — namely, record corporate earnings and cash flows, long-deferred capacity expansion programs, ongoing productivity strategies driven by IT-enabled capital deepening, and the heavy replacement needs of a shorter-lived, increasingly IT-intensive capital stock. Notwithstanding these important considerations, they miss the essence of the capital spending decision: Fixed investment is a "derived demand" highly dependent on expectations of the prospective trajectory of end-market demand. As such, the demand forecast is, itself, an excellent predictor of future pressures on the existing stock of productive capacity — apprising business decision makers of the need to increase the scale of their operations. If demand expectations are marked down in any meaningful fashion —- as could well be the case if the US consumer fades — the investment cycle could quickly shift to the downside. And if capital spending weakens, so, too, will capex-related employment and income generation — putting further pressure on consumers. Yet you won't reach that conclusion by sticking with the rules of ceteris paribus in analyzing the impacts of higher oil prices. …

Why Don't We Learn from our Mistakes?

John Mauldin's 7/2 Outside the Box Newsletter highlights James Montier's …Limits to Learning. Montier says that "The major reason we don't learn from our mistakes (or the mistakes of others) is that we simply don't recognise them as such. We have a gamut of mental devices all set up to protect us from the terrible truth that we regularly make mistakes." Don't we ever!

I have decided that in government, in large industry, and in personal endeavors people don't want to study decision-making in part or in whole because it proves much easier to pretend that they know more than they can, or at least to pretend to others that they know more than they do.

In either case, the lucky get rich and or famous, proving up on Kurt Vonnegut's line: "If you would be unloved and forgotten, be reasonable." PS.. The "unlucky" are just collateral damage from the systems, never to be remembered, never to be mourned except by the few who knew them personally and who also tend to be disgusted by the "systems that be," by the "powers that be."

Montier continues by identifying several "biases" that thwart learning:

Self attribution bias: heads is skill, tails is bad luck

We have a relatively fragile sense of self-esteem; one of the key mechanisms for protecting this self image is self-attribution bias. This is the tendency for good outcomes to be attributed to skill and bad outcomes to be attributed to sheer bad luck. This is one of the key limits to learning…. This mechanism prevents us from recognizing mistakes as mistakes, and hence often prevents us from learning from those past errors. …

Hindsight bias: I knew it all along

One of the reasons I suggest that people keep a written record of their decisions and the reasons behind their decisions, is that if they don't, they run the risk of suffering from the insidious hindsight bias. This simply refers to the idea that once we know the outcome we tend to think we knew it was so all along. …

Illusion of control

We love to be in control. We generally hate the feeling of not being able to influence the outcome of an event. It is probably this control freak aspect of our nature that leads to us to behave like [B.F.] Skinner's pigeons. ["Skinner's theory was based around operant conditioning. As Skinner wrote, 'The behavior is followed by a consequence, and the nature of the consequence modifies the organism's tendency to repeat the behavior in the future.'"] ...

Feedback distortion

Not only are we prone to behave like Skinner's pigeons but we also know how to reach the conclusions we want to find (known as 'motivated reasoning' amongst psychologists). …

We have outlined four major hurdles when it comes to learning from our own mistakes. Firstly, we often fail to recognize our mistakes because we attribute them to bad luck rather than poor decision making. Secondly, when we are looking back, we often can't separate what we believed beforehand from what we now know. Thirdly, thanks to the illusion of control, we often end up assuming outcomes are the result of our actions. Finally, we are adept at distorting the feedback we do receive, so that it fits into our own view of our abilities.

Some of these behavioural problems can be countered by keeping written records of decisions and the 'logic' behind those decisions. But this requires discipline and a willingness to re-examine our past decisions. Psychologists have found that it takes far more information about mistakes than it should do, to get us to change our minds.

In a more broadly framed article titled "Part man, part monkey" [PDF: 12 pp.], James Montier helps us understand how our decision-making errors can be traced to four common causes: self-deception, heuristic simplification, emotion, and social interaction. Looking for biases that limit our learning, Montier develops a broader list under his four categories, that he calls a "Taxomony of Biases."

Why Don't We Learn from our Mistakes?

John Mauldin's 7/2 Outside the Box Newsletter highlights James Montier's …Limits to Learning. Montier says that "The major reason we don't learn from our mistakes (or the mistakes of others) is that we simply don't recognise them as such. We have a gamut of mental devices all set up to protect us from the terrible truth that we regularly make mistakes." Don't we ever!

I have decided that in government, in large industry, and in personal endeavors people don't want to study decision-making in part or in whole because it proves much easier to pretend that they know more than they can, or at least to pretend to others that they know more than they do.

In either case, the lucky get rich and or famous, proving up on Kurt Vonnegut's line: "If you would be unloved and forgotten, be reasonable." PS.. The "unlucky" are just collateral damage from the systems, never to be remembered, never to be mourned except by the few who knew them personally and who also tend to be disgusted by the "systems that be," by the "powers that be."

Montier continues by identifying several "biases" that thwart learning:

Self attribution bias: heads is skill, tails is bad luck

We have a relatively fragile sense of self-esteem; one of the key mechanisms for protecting this self image is self-attribution bias. This is the tendency for good outcomes to be attributed to skill and bad outcomes to be attributed to sheer bad luck. This is one of the key limits to learning…. This mechanism prevents us from recognizing mistakes as mistakes, and hence often prevents us from learning from those past errors. …

Hindsight bias: I knew it all along

One of the reasons I suggest that people keep a written record of their decisions and the reasons behind their decisions, is that if they don't, they run the risk of suffering from the insidious hindsight bias. This simply refers to the idea that once we know the outcome we tend to think we knew it was so all along. …

Illusion of control

We love to be in control. We generally hate the feeling of not being able to influence the outcome of an event. It is probably this control freak aspect of our nature that leads to us to behave like [B.F.] Skinner's pigeons. ["Skinner's theory was based around operant conditioning. As Skinner wrote, 'The behavior is followed by a consequence, and the nature of the consequence modifies the organism's tendency to repeat the behavior in the future.'"] ...

Feedback distortion

Not only are we prone to behave like Skinner's pigeons but we also know how to reach the conclusions we want to find (known as 'motivated reasoning' amongst psychologists). …

We have outlined four major hurdles when it comes to learning from our own mistakes. Firstly, we often fail to recognize our mistakes because we attribute them to bad luck rather than poor decision making. Secondly, when we are looking back, we often can't separate what we believed beforehand from what we now know. Thirdly, thanks to the illusion of control, we often end up assuming outcomes are the result of our actions. Finally, we are adept at distorting the feedback we do receive, so that it fits into our own view of our abilities.

Some of these behavioural problems can be countered by keeping written records of decisions and the 'logic' behind those decisions. But this requires discipline and a willingness to re-examine our past decisions. Psychologists have found that it takes far more information about mistakes than it should do, to get us to change our minds.

In a more broadly framed article titled "Part man, part monkey" [PDF: 12 pp.], James Montier helps us understand how our decision-making errors can be traced to four common causes: self-deception, heuristic simplification, emotion, and social interaction. Looking for biases that limit our learning, Montier develops a broader list under his four categories, that he calls a "Taxomony of Biases."

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. …

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.

Empire of Debt: Small Chance of Imploding?

Today's CBS News Sunday Morning aired a segment titled In Debt . The take-home message is:

The United States is a nation of debt. Americans have accrued billions of dollars worth of personal consumer credit, and the number is rising via credit cards, innovative mortgage packages, home equity lines, student loans, etc. At the same time, the U.S. had a negative savings rate last year. Translation: We're spending more than we're earning. Cynthia Bowers says that's like any bubble: The credit bubble can only end one way -- badly.

Addison Wiggin said, if I heard right, that we have a "small chance" of falling into a banking crisis wherein savers as well as debtors need to worry. My question is, "How does Wiggin or anyone else know?"

I thought about flying blind in a snowstorm, worrying about running into a mountain and not knowing whether you were over Alaska or Nebraska. Or worse still not knowing whether your had, say, one chance in a hundred of being over Alaska v. Nebraska or vice versa. It seems to me that we are so far away from anything that has happened historically, that we don't really have a means to know whether or not the chance of crash-landing our economy is small or large.

Addison: How do you know? I want to know. I would sleep much more soundly if I knew that the chance really was "small." My immersion in Complexity Theory denies me the luxury of making statements like "the chances are small" when dealing with geopolitical dealings. My guess is that either I mistook Wiggin's intent else he spoke in haste. But maybe not.

I have taken to Karl Weick's notion that "believing is seeing" (see also) more often than "seeing is believing." And when dealing with matters economic and geopolitical, I find much more of the former than the latter.

Efficient Markets, Spin, Speculative frenzy, …

I’ve been reading The Father of Spin. It’s about Edward L. Bernays and others who lay claim to the title in the USA. Bernays was the nephew of Sigmund Freud, who would likely have been displeased to see how Bernays used Freud’s ideas not on individuals but on broader groups, even whole societies to create preferences for products as diverse as bacon, cigarettes, and even political candidates. The point for us to remember is that preference are not “given” but are molded and shaped in the course of public deliberation and, regrettably, by advertising and other propaganda campaigns. But what does any of this have to do with efficient markets?

The efficient market hypothesis (EMH) has, arguably, guided much of the thinking and theorizing about market mechanisms for some years. According to “The Efficient Market Hypothesis on Trial: A Survey,” by Philip S. Russel and Violet M. Torby,

“The EMH has provided the theoretical basis for much of the financial market research during the seventies and the eighties.” But the EMH is being questioned more and more again because of the influence of psychological behavioral studies.

Bernays “spin” is but one of the problems with the framing that sits behind the efficient market hypothesis, and other neoclassical economics assumptions. The point here is to cast doubt both on the short-term efficiency of markets and on assumptions of human rationality that underlie much of economic theorizing. It isn’t that it’s all wrong, but that it ought to be taken with a grain of salt if not aspirin. Neoclassical theory is one way to think about humans, and for longer term views it may have some value, but one ought not to bet one’s life or one’s retirement on it. As the ‘EMH on Trial’ points out, it may be better to be informed by the fact that in the long run things tend to work around an efficient market trend, but remember, as did Keynes that markets can stay aberrant longer than any of us can stay solvent.

Speculative frenzy or irrational optimism, and irrational pessimism that often sets in after bubbles burst, and wrenches its way deeper into the mind whey secular bear markets play themselves out, are part of the cognitive psychology that sits in the mind of “efficient markets” critics. So each of us ought not to let such thinking be far from our thoughts either.

When we hear economists laying claim to ideas of improving efficiency, or stock market cheerleaders telling us stories of new economy, we had better beware. We had better remember that spin and politics go hand in hand, that crony capitalism is the name of at least part of the game here, and that kleptocracy is the name of the game writ large throughout history.

Government is not all bad. Business is not all bad. Even corporations are not bad (well we might draw a line here unless the court system repeals excessive rights now granted to corporations).
But none is all good either. Neither can any of us as individuals claim to be other than an enigma—some good, some evil.

With that in mind, let’s look at contemporary America through the eyes of William Greider, author of Secrets of the Temple: How the Federal Reserve Runs the Country, and One World Ready or Not. Greider’s “America’s Truth Deficit” tells us to beware of media spin. Greider also tells us to beware of economics spin, political spin, …. Here are the concluding paragraphs of Greider’s article:

…Washington defines "national interest" primarily in terms of advancing the global reach of our multinational enterprises. Elites are persuaded by the reigning orthodoxy that subsidiary domestic interests will ultimately benefit too. The distinctive power of America's globalized companies is reflected in trade patterns. Nearly half of American exports and imports are not traded in open markets - the price auction idealized by neoclassical economics - but within the companies themselves, moving materials and components back and forth among their far-flung factories. A trade deficit does not show on the company's balance sheet, only on the nation's. In recent years, much of the trade deficit has reflected the value-added production and jobs that companies moved elsewhere.

The United States is thus especially vulnerable to the downward pressures on working-class wages that exist on both ends of the global system. American producers are generally free - and even encouraged by Washington - to shift production to low-wage locations. Companies regularly use this cost-cutting technique as a competitive weapon without regard to the domestic consequences. The practice works for companies and investors, but not so well for a nation.

INDEED, the cumulative effects of retarding labor incomes worldwide repeatedly threatens stagnation or worse for the entire system. Workers, to put it crudely, cannot buy what the world can make. Too much capital leads to the speculative "bubbles" that bounce around the world, visiting financial crisis on rich and poor alike.

At a different moment in history, American leader