Economic Dreams - Economic Nightmares

US Oligarchs and their Minions

Simon Johnson, former chief economist for the International Monetary Fund and co-author of The Baseline Scenario takes American oligarchs to task in The Quiet Coup, Atlantic Monthly, May 2009. Johnson believes, going forward, that we should seek smaller, better-regulated banking/finance houses incapable of doing systemic damage, and overseen by a different set of oligarchs (Wiki link). Maybe? Or maybe we'll find a way to regulate bigger entities effectively? Or maybe we'll just set the stage for the next big mess? Who knows?

In any case we certainly need to find something to hope for. Burning existing oligarchs at the stake is likely out. So maybe just replacing them, rewriting regulatory rules, and starting over is the best we can hope for. Somehow I think that is where Team Obama will ultimately attempt to take us. In any case, read Simon's thought provoking, controversial article. Here is a somewhat-lengthy excerpt:

Becoming a Banana Republic
In its depth and suddenness, the U.S. economic and financial crisis is shockingly reminiscent of moments we have recently seen in emerging markets (and only in emerging markets): South Korea (1997), Malaysia (1998), Russia and Argentina (time and again). In each of those cases, global investors, afraid that the country or its financial sector wouldn't be able to pay off mountainous debt, suddenly stopped lending. And in each case, that fear became self-fulfilling, as banks that couldn't roll over their debt did, in fact, become unable to pay. This is precisely what drove Lehman Brothers into bankruptcy on September 15, causing all sources of funding to the U.S. financial sector to dry up overnight. Just as in emerging-market crises, the weakness in the banking system has quickly rippled out into the rest of the economy, causing a severe economic contraction and hardship for millions of people.

But there's a deeper and more disturbing similarity: elite business interests—financiers, in the case of the U.S.—played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive. The government seems helpless, or unwilling, to act against them.

Top investment bankers and government officials like to lay the blame for the current crisis on the lowering of U.S. interest rates after the dotcom bust or, even better—in a "buck stops somewhere else" sort of way—on the flow of savings out of China. Some on the right like to complain about Fannie Mae or Freddie Mac, or even about longer-standing efforts to promote broader homeownership. And, of course, it is axiomatic to everyone that the regulators responsible for "safety and soundness" were fast asleep at the wheel.

But these various policies—lightweight regulation, cheap money, the unwritten Chinese-American economic alliance, the promotion of homeownership—had something in common. Even though some are traditionally associated with Democrats and some with Republicans, they all benefited the financial sector. Policy changes that might have forestalled the crisis but would have limited the financial sector's profits—such as Brooksley Born's now-famous attempts to regulate credit-default swaps at the Commodity Futures Trading Commission, in 1998—were ignored or swept aside.

The financial industry has not always enjoyed such favored treatment. But for the past 25 years or so, finance has boomed, becoming ever more powerful. The boom began with the Reagan years, and it only gained strength with the deregulatory policies of the Clinton and George W. Bush administrations. Several other factors helped fuel the financial industry's ascent. Paul Volcker's monetary policy in the 1980s, and the increased volatility in interest rates that accompanied it, made bond trading much more lucrative. The invention of securitization, interest-rate swaps, and credit-default swaps greatly increased the volume of transactions that bankers could make money on. And an aging and increasingly wealthy population invested more and more money in securities, helped by the invention of the IRA and the 401(k) plan. Together, these developments vastly increased the profit opportunities in financial services.

Not surprisingly, Wall Street ran with these opportunities. From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Pay rose just as dramatically. From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007.

The great wealth that the financial sector created and concentrated gave bankers enormous political weight—a weight not seen in the U.S. since the era of J.P. Morgan (the man). In that period, the banking panic of 1907 could be stopped only by coordination among private-sector bankers: no government entity was able to offer an effective response. But that first age of banking oligarchs came to an end with the passage of significant banking regulation in response to the Great Depression; the reemergence of an American financial oligarchy is quite recent.

Financial Regulation – Principles

This morning I am watching CSPAN's coverage of US Treasury Secretary Geithner at a House Committee on Financial Services hearing on financial regulation and systemic risk. Watch Geithner's opening statment here (via Yahoo! News).

Yesterday, over at Mother Jones Kevin Drum laid out some principles to guide new financial regulation. Drum suggested three and asked readers for more:

- Firmer Regulation Over Leverage, wherever and however it occurs. [To increase] capital adequacy ratios, … lead to similar oversight of hedge funds; ̷ overhaul how capital and assets are calculated; [regulate] effective leverage embedded in complex derivatives; [add] rules about off-balance-sheet vehicles; and so forth.

- Stronger Commitment to Act Countercyclically. …to force the Fed to keep an eye on asset inflation as well as goods inflation; a dedication to limiting credit expansion as well as credit destruction; capital adequacy rules that weren't merely stronger, but that tightened during expansions and loosened during contractions; and stronger down payment requirements for mortgage loans.

- A recognition that the global financial system could stand to have a little more sand in its gears. Something to slow it down just a little bit, … like a small transaction tax [Iverson here: e.g. a Tobin Tax (Wiki link) -- that could act in part as an insurance premium to tax payers against the risk that the tax payer will be required to bail them out]; exchange trading for credit derivatives; and stronger transparency rules.

Here is a combined "Eight Regulatory Principles" list, edited slightly:

• Firmer Regulation Over Leverage, (wherever and however it occurs, e.g. higher capital and margin (leverage) requirements that might be even higher for very large firms/entities that pose potential systemic risk)
• Stronger Commitment to Act Countercyclically (to lean against the wind during both "irrational exuberance" and "irrational pessimism", including adding "asset bubbles to diagostic toolkit)
• Better Control of Cross-border Capital Flows
• Better Firewalls Between Financial Businesses
• Holding Credit Rating Agencies and Auditors Accountable for their Judgments
• Making Financial Transactions as Transparent as Possible (like making them exchange traded, or having adequate clearing houses outside exchanges)
• Better Means to Discourage Speculative-runs-to-ruin (on corporations that show signs of relative weakness during market breakdowns)
• Reformed Incentives for Financial Executives, large in-house traders, etc. (e.g. require some bonuses to be paid in restricted stock that can only be liquidated in say 10 years.)
  

One of Drum's reader suggested three tactical moves. I'll add a fourth:

- Reinstate the Glass-Steagall Act in its final form (prior to repeal)
- Repeal the Gramm-Leach-Bliley Act
- Repeal Commodity Futures Modernization Act of 2000, which enabled unregulated market in credit default swaps, among other things
- Develop more flexibility in"Fair Value Accounting", mark-to-market accounting (e.g. to disallow entities to appear ever-more-wounded during bear raids)

From written testimony and verbal responses to questions, it looks to me like Geithner and Co. intend to cover most if not all the bases outlined in the principles above. But intentions must turn to action! We need to keep watch, as well as to add voice to make for better regulation, better action, and better oversight not only of government but of the private entities entrusted with our money.

PS. In March 23 WSJ online, George Soros offers insight into "Means to Discourage Speculative-runs-to-ruin" by regulating Credit Default Swaps.

Why I Still Believe in Team Obama

For quite some time I have been giving Ben Bernanke and Tim Geithner passes, every bit as much as I did not give passes to Alan Greenspan. I believe that Team Obama—Larry Summers, Christina Romer, Ben Bernanke, Tim Geithner—see the error of their past ways, AND are savvy enough to guide us, in concert with others, however painfully into the next era of regulated finance.

I am not yet ready to declare capitalism dead. Still, I am very glad to see the gleeful "free market screech-monkey" chatter quieted.

But I just watch this stuff. I'm no expert. I glean advice and seek wisdom from post-Keynesian and other economists, from financial historians, and from those who dabble in complex system theory. I am first to recognize that what I hope to be true will likely not be—In this case trusting my (and your) fate to Team Obama.

If Paul Krugman is right, then I'm wrong to trust in Team Obama. If Jamie Galbraith is right, then I will be most certainly proven wrong if only for this reason:

…The most likely scenario, should the Geithner plan go through, is a combination of looting, fraud, and a renewed speculation in volatile commodity markets such as oil. Ultimately the losses fall on the public anyway, since deposits are largely insured. There is no chance that the banks will simply resume normal long-term lending. To whom would they lend? For what? Against what collateral? And if banks are recapitalized without changing their management, why should we expect them to change the behavior that caused the insolvency in the first place?

End Note on Free Market Fundamentalism: While looking for a good source on Free Market Fundamentalism, I found this note (5/23/2007) I dropped into Yves Smith's naked capitalism:

[W]e Americans have gravitated to a faith-based society/culture. And a big part of that "faith" transfers directly from religious fundamentalism to free-market fundamentalism (Wiki link): Government sucks, markets do it best/right.

If that thesis is correct, then American politicians (whether pandering to the religious right or themselves "true believers" in free-market fundamentalism) tend to shy away from redistributive policies/practices.

What will shake the faith, I don't know. I've been a believer for quite some time that we've got a hell of a problem here in the US with theological Millennium fever. Free-market fundamentalism is symptomatic of the bigger problem.

See also Market Fundamentalism v. Sustainable Development and my Economic Fundamentalism: Too Many False Prophets.

{Update, 3/24/07}: Better Still, read Steve Keen's recent Neoclassical Economics: Mad, Bad, and Dangerous to Know

Ten Trillion and Counting!

Tuesday, PBS Frontline will investigate what it means to add, in the next five years, 10 trillion dollars more debt to the American banking, political and social systems. See Ten Trillion and Counting. In the meantime we experience each day an ever-weakening US dollar, and ever-shrinking job/income picture for middle-class Americans, and an ever-more-anemic US consumption engine for the world economy.

What are to make of it?  One view, see Brad DeLong for example, paints this as a Keynesian economists dream.  DeLong see this as a chance to flood the world with money just in time to avert a total system collapse.  And then a chance to monitor the situation closely to ward off any hyperinflationary consequences that might accrue from the move. (Or maybe I'm putting words/ideas into DeLong's mouth?)

On the left, Paul Krugman sees the situation more darkly. Krugman believes that the Obama Administration, following the lead from the Fed (Ben Bernanke) and the Treasury (Tim Geithner)  continues to dither

…[I]f you think that the banks really, really have made lousy investments, this won't work at all; it will simply be a waste of taxpayer money. To keep the banks operating, you need to provide a real backstop — you need to guarantee their debts, and seize ownership of those banks that don’t have enough assets to cover their debts; that's the Swedish solution, it's what we eventually did with our own.

On the right, Doug Noland sees this as hopelessly misguided as well:

…Washington fiscal and monetary policies are completely out of control.  Apparently, the overarching objective has evolved to one of rejuvenating the securities and asset markets and inciting quick economic recovery.  I believe the principal objective should be to avoid bankrupting the country … our policymakers and pundits are operating from flawed analytical frameworks … completely oblivious to the risks associated with the current course of policymaking.

There is indeed great hope policymakers will succeed in preserving the current economic structure.  On the back of massive stimulus and monetization, the expectation is that the financial system and asset prices will stabilize.  The economy will be, it is anticipated, not far behind.  And the seductive part of this view is that unprecedented policy measures may actually be able to somewhat rekindle an artificial boom — perhaps enough even to appear to stabilize the system.  But seeming "stabilization" will be in response to massive Washington stimulus and market intervention — and will be dependent upon ongoing massive government stimulus and intervention.  It's called a debt trap.  …Hyman Minsky would view it as the ultimate "Ponzi Finance."

… [O]ur highly inflated and distorted system requires $2.0 TN or so of Credit creation to hold implosion at bay.  It is my belief that this will ONLY be possible with Trillion-plus annual growth in both Treasury debt and Federal Reserves liabilities.  Private sector Credit creation simply will not bounce back sufficiently to play much of a role.  Mortgage, consumer, and business Credit — in this post-Bubble environment — will not re-emerge as much of a force for getting total system Credit near this $2 TN bogey.  In this post-Bubble backdrop, only government finance has a sufficient inflationary bias to get Trillion-plus issuance.  But the day that policymakers try to extract themselves from massive stimulus and monetization will be the day they risk an immediate erosion of confidence and a run on both government and private Credit instruments.  Also as I've written, once the government "printing press" gets revved up it's very difficult to slow it down.  This week currency markets finally took this threat seriously.

I don't know.  For some strange reason, given what I've written here on this blog the last few years, I am still pinning my hopes on Bernanke and Geithner.  I hate the idea of $10 trillion more debt, but I hope that it serves as a systems stabilization mechanism while the longer-term deals are worked out to reset our financial systems (see Ken Rogoff interview noted below.)

For those who want a very good refresher as to why we got into this mess, see Joseph Stiglitz, 'Capitalist Fools', Vanity Fair, Jan 2009  Here is a timeline of events, drawn from Stiglitz that ought to be (hope springs eternal) the subject of an upcoming Congressional hearing:

• 1987 - Reagan administration decided to remove Paul Volcker as chairman of the Federal Reserve Board and appoint Alan Greenspan in his place … "Volcker … understood that financial markets need to be regulated. Reagan wanted someone who did not believe any such thing, and he found him in a devotee of the objectivist philosopher and free-market zealot Ayn Rand. … Greenspan presided over not one but two financial bubbles. After the high-tech bubble popped, in 2000–2001, he helped inflate the housing bubble."
• 1993 – "When I [Stiglitz] was chairman of the Council of Economic Advisers, during the Clinton administration, I served on a committee of all the major federal financial regulators, a group that included Greenspan and Treasury Secretary Robert Rubin. Even then, it was clear that derivatives [credit-default swaps, and so forth] posed a danger. We didn't put it as memorably as Warren Buffett —who saw derivatives as 'financial weapons of mass destruction'—but we took his point. And yet, for all the risk, the deregulators in charge of the financial system—at the Fed, at the Securities and Exchange Commission, and elsewhere—decided to do nothing, worried that any action might interfere with "innovation" in the financial system.
• 1998 - Brooksley Born, head of the Commodity Futures Trading Commission called for derivatives regulation—"a concern that took on urgency after the Fed, in that same year, engineered the bailout of Long-Term Capital Management, a hedge fund whose trillion-dollar-plus failure threatened global financial markets. But Secretary of the Treasury Robert Rubin, his deputy, Larry Summers, and Greenspan were adamant—and successful—in their opposition."
• 1999 (November) - Congress repealed the Glass-Steagall Act. "Glass-Steagall had long separated commercial banks (which lend money) and investment banks (which organize the sale of bonds and equities); it had been enacted in the aftermath of the Great Depression and was meant to curb the excesses of that era, including grave conflicts of interest."
  … "The most important consequence of the repeal of Glass-Steagall was indirect—it lay in the way repeal changed an entire culture. Commercial banks are not supposed to be high-risk ventures; they are supposed to manage other people’s money very conservatively. It is with this understanding that the government agrees to pick up the tab should they fail. Investment banks, on the other hand, have traditionally managed rich people’s money—people who can take bigger risks in order to get bigger returns. When repeal of Glass-Steagall brought investment and commercial banks together, the investment-bank culture came out on top. There was a demand for the kind of high returns that could be obtained only through high leverage and big risktaking."
• 2001 (June) - "[W]ith a follow-on installment two years later, [President bush] and his advisers seemed to believe that tax cuts, especially for upper-income Americans and corporations, were a cure-all for any economic disease—the modern-day equivalent of leeches."
  … "The cut in the tax rate on capital gains contributed to the crisis in another way. It was a decision that turned on values: those who speculated (read: gambled) and won were taxed more lightly than wage earners who simply worked hard. But more than that, the decision encouraged leveraging, because interest was tax-deductible. If, for instance, you borrowed a million to buy a home or took a $100,000 home-equity loan to buy stock, the interest would be fully deductible every year. Any capital gains you made were taxed lightly—and at some possibly remote day in the future. The Bush administration was providing an open invitation to excessive borrowing and lending—not that American consumers needed any more encouragement."
• 2002 (July 30) - "[I]n the wake of a series of major scandals—notably the collapse of WorldCom and Enron—Congress passed the Sarbanes-Oxley Act. … "[I]n the negotiations over what became Sarbanes-Oxley a decision was made not to deal with what many, including the respected former head of the S.E.C. Arthur Levitt, believed to be a fundamental underlying problem: stock options. Stock options have been defended as providing healthy incentives toward good management, but in fact they are 'incentive pay' in name only. If a company does well, the C.E.O. gets great rewards in the form of stock options; if a company does poorly, the compensation is almost as substantial but is bestowed in other ways. This is bad enough. But a collateral problem with stock options is that they provide incentives for bad accounting: top management has every incentive to provide distorted information in order to pump up share prices.
  "The incentive structure of the rating agencies also proved perverse. Agencies such as Moody's and Standard & Poor's are paid by the very people they are supposed to grade. As a result, they’ve had every reason to give companies high ratings, in a financial version of what college professors know as grade inflation. The rating agencies, like the investment banks that were paying them, believed in financial alchemy—that F-rated toxic mortgages could be converted into products that were safe enough to be held by commercial banks and pension funds."
• 2004 (April) - the Securities and Exchange Commission "allowed big investment banks to increase their debt-to-capital ratio (from 12:1 to 30:1, or higher) so that they could buy more mortgage-backed securities, inflating the housing bubble in the process."
• 2008 (October 3) - The Bush administration's response to the crisis itself. "Both the administration and the Fed had long been driven by wishful thinking, hoping that the bad news was just a blip, and that a return to growth was just around the corner. As America's banks faced collapse, the administration veered from one course of action to another. Some institutions (Bear Stearns, A.I.G., Fannie Mae, Freddie Mac) were bailed out. Lehman Brothers was not. Some shareholders got something back. Others did not. The original proposal by Treasury Secretary Henry Paulson, a three-page document that would have provided $700 billion for the secretary to spend at his sole discretion, without oversight or judicial review, was an act of extraordinary arrogance. He sold the program as necessary to restore confidence. But it didn’t address the underlying reasons for the loss of confidence. The banks had made too many bad loans. There were big holes in their balance sheets. No one knew what was truth and what was fiction. The bailout package was like a massive transfusion to a patient suffering from internal bleeding—and nothing was being done about the source of the problem, namely all those foreclosures. Valuable time was wasted as Paulson pushed his own plan, 'cash for trash,' buying up the bad assets and putting the risk onto American taxpayers. When he finally abandoned it, providing banks with money they needed, he did it in a way that not only cheated America’s taxpayers but failed to ensure that the banks would use the money to re-start lending. He even allowed the banks to pour out money to their shareholders as taxpayers were pouring money into the banks.
  "The other problem not addressed involved the looming weaknesses in the economy. The economy had been sustained by excessive borrowing. That game was up."

If such a Congressional hearing were to happen, I'd like to see some name-economists, Administration supporters and detractors from left and right, as well as US government officials past and present, asked at each point along the timeline:What were you thinking? Why were you thinking it? And how would you now rethink it?

For perhaps the best insights as to where this may go, see the Ken Rogoff video interview on PBS NOW, Mar 14 (23 min)

Blame it on Greenspan and Bush

The blame game will go on and on, particularly as the mess world financial crisis deepens. But this, almost a month old from the Financial Times needs to be part of the record. Particularly since the Republican contenders for US President keep blaming it on the GSEs, Fannie Mae and Freddie Mac:

Oxley hits back at ideologues, Greg Farrell, Financial Times, Sept. 9: … Ohio Republican [Mike Oxley] who headed the House financial services committee until his retirement after mid-term elections last year, blames the mess on ideologues within the White House as well as Alan Greenspan, former chairman of the Federal Reserve.

The critics have forgotten that the House passed a GSE reform bill in 2005 that could well have prevented the current crisis, says Mr Oxley, now vice-chairman of Nasdaq.

He fumes about the criticism of his House colleagues. “All the handwringing and bedwetting is going on without remembering how the House stepped up on this,” he says. “What did we get from the White House? We got a one-finger salute.”

The House bill, the 2005 Federal Housing Finance Reform Act, would have created a stronger regulator with new powers to increase capital at Fannie and Freddie, to limit their portfolios and to deal with the possibility of receivership.

Mr Oxley reached out to Barney Frank, then the ranking Democrat on the committee and now its chairman, to secure support on the other side of the aisle. But after winning bipartisan support in the House, where the bill passed by 331 to 90 votes, the legislation lacked a champion in the Senate and faced hostility from the Bush administration.

Adamant that the only solution to the problems posed by Fannie and Freddie was their privatisation, the White House attacked the bill. Mr Greenspan also weighed in, saying that the House legislation was worse than no bill at all. …

HT: Paul Krugman

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.

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.

Blackstone, Bagmen, and Your Pension Fund

This week Robert Reich warns investors to watch their future wallets — to watch their pension fund managers. Big players can take care of themselves, but many of the rest of us are vulnerable to the whims of pension fund managers. Reich says:

… [C]orporate and government pension plans are increasingly investing in [hedge funds and private equity funds that get high returns from risky deals unavailable to mutual funds or publicly-traded companies], with money that was previously invested conservatively on behalf of their beneficiaries. Some states are now putting 20 percent or more of public employee pension savings into them. Corporate pension plans, as much as 40 percent of employee savings. But the individuals counting on retirement checks are neither big enough nor tough enough to take care of themselves.

Meanwhile, just as Bear Stearns is threatening a Long Term Capital Management redo, Blackstone is going public — going fishing for bagmen and/or just trying to rake in even more cash as the US Congress is threatening, finally, to declare illegal what should have been declared illegal long ago.

Here is Roger Ehrenberg's 3/27/07 Financial Times commentary on what I'll refer to as "Blackstone and Bagmen":

… Will Blackstone pull off a wildly successful IPO? It is almost a certainty. Will Blackstone trade at a multiple that implies rapid growth in assets under management and therefore in management and performance fees? Absolutely. What will happen when the debt markets grow less friendly and additional equity is required to get deals done? Returns will fall. What will happen to those who have invested in private equity funds? They will not be happy. And those who have invested in common shares of the private equity management company? Unhappier still.

Mr Schwarzman knows this full well, as do his colleagues at Kohlberg Kravis Roberts, Texas Pacific Group, Apollo and others thinking about following in Blackstone's footsteps. They understand that the risk/reward calculus of the private equity business (largely being borne by debt holders in today's frothy environment) could shift rapidly, closing a historically attractive window for them to monetise their franchises. They see the private equity bubble and want to extract value before it pops. But where does that leave the rest of us? Unhappy, indeed. …

Heading for a Credit Bubble Crackup? I still think so, and recommend Doug Noland Doug Noland's 06/22-07 Credit Bubble Bulletin in its entirety. Here is a soundbite:

… [O]ver-zealous financiers and speculators have greatly exacerbated late-stage Bubble risk and Uncertainty. The [Merger & Acquistion] boom got too hot. Global stock, real estate and assets markets turned too hot. The Chinese, Asian and general global economy became too hot. Billions were made too effortlessly; the CDO game was too easy. And robust economies and myriad spectacular asset and debt Bubbles are by their nature gluttons for additional Credit and marketplace liquidity. Inevitably, things turn tenuous, and the line between runaway boom and unwinding Bubble turns troublingly thin. For the semblance of order is maintained only as long as speculation and leverage-induced demand for risky debt instruments meets the ever escalating supply.

Most of the ingredients for Credit crisis are within reach, yet heightened volatility is likely still the best short-term bet. I would expect the gigantic pool of speculative finance to be increasingly keen to short securities and bet on/hedge against systemic stress. This is a notably unbullish dynamic, one that likely alters that nature of speculative flows - and that could at any point initiate a rush for the exits, market dislocation and panic. Big down days seem inevitable, the kind that really shake confidence and instill fears that the "wheels are coming off." But there will almost surely also be days of panicked short covering and euphoric buying. And those days will reinvigorate notions of goldilocks, New Eras and unlimited finance. There will be days when the hedge funds and sovereign wealth funds are perceived as bull market friendly and days when their supporting role is seriously questioned. Uncertainty Reigns Supreme.

Now a question? Since Doug Noland is a Hyman Minsky disciple (as am I), in what sense does Ben Bernanke understand Minsky's Financial Fragility Hypothesis? Certainly it seems that to the extent Bernanke does understand it he understands it differently than I do. Else he is being very, very quiet just now so as not to scare the markets into depression. Here is Barkley Rosser on Bernanke and Minsky (via Brad DeLong):

… [B]ringing this back to Bernanke, clearly he is an example of somebody who fits this non-orthodox mainstream category. He made his fame by reviving a non-orthodox idea, financial fragility.... I will give him credit that apparently he did cite Minsky and Kindleberger, as well as Fisher... brought the idea out of the shadows of non-respectability where the ratex "revolution" had put it… [and] to the attention of policymakers... although as I previously noted, many such policymakers never stopped taking it seriously.

For final words on Blackstone, Americans and the rest of the world's speculators, we will leave them to Keynes (via Michael Perelman ):

… "[W]hen he purchases an investment, the American is attaching his hopes, not so much to its prospective yield, as to a favourable change in the conventional basis of valuation, i.e. that he is, in the above sense, a speculator. Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done." [John Maynard Keynes, The General Theory ]

The Politics of Future Promises

Over at Econbrowser, James Hamilton has been detailing his concerns about meeting future pension and health care obligations, interrelating them with the subprime meltdown, the derivatives/hedge fund 'problematic', etc. Today, Hamilton points to several contemporary examples — in California, Tenessee, New Jersey — and concludes:

If there were just one or two such stories, one might regard it as a mistake here or a miscalculation there. But the phenomenon is too widespread to be dismissed as accidental. I am forced to conclude that a pervasive feature of modern American politics is for elected officials to lavish benefits on their current power base, promising or in many cases legally obligating the government to make future payments that will prove to be extraordinarily costly to deliver. I conclude that the reason elected officials keep doing this is because that is what voters want.

I have not read Bryan Caplan's new book, but I must say the cover does a nice job of conveying what the issue may be.

Deconstructing the 'Financial Revolution'

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

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

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

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

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

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

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