Economic Dreams - Economic Nightmares

Capitalism's Fatal Flaws

In The Worldly Philosophers, Robert Heilbroner tells us that all the great economists foresaw a time when capitalism would come to an end. In Stabilizing an Unstable Economy (1986), Hyman Minsky outlines an agenda for ending capitalism as we've know it (what Heilbroner called "Capitalism as a Regime" in Behind the Veil of Economics). Minsky suggests that we replace laissez-faire capitalism (Wiki link) with a less-flawed version of Capitalism that allows for much better automatic stabilizers than found in our current system.

Minsky, following his reading of Keynes, tells us that modern financial institutions (with inherent tendencies toward monopoly) inevitably will turn into predators on other economic subsystems. Minsky also tells us that most economic theories, with emphasis on "equilibrium" while allowing only for occasional shocks to the system, are ill-equipped to deal with the systemic problems stemming from stability that breeds instability. Minsky (p.280):

In a world with capitalistic finance it is simply not true that the pursuit by each unit of its own self-interest will lead an economy to equilibrium. The self-interest of bankers, levered investors, and investment producers can lead the economy to inflationary expansions [including asset inflation] and unemployment-creating contractions. Supply and demand analysis—in which market processes lead to an equilibrium—does not explain the behavior of a capitalist economy, for capitalist financial processes mean that the economy has endogenous destabilizing forces. Financial fragility, which is a prerequisite for financial instability is, fundamentally, a result of internal market processes. …

Institutions such as the Federal Reserve, which were introduced in an effort to control and contain disorderly conditions in banking and financial markets, are now slaves of an economic theory that denies the existence of such conditions.

The "stability breeds instability" process is now well-know to complex systems theorists. As systems age, newly emergent systems first gain, then lose redundancy and therefore resilience—they become fragile, brittle, or tightly-coupled. At some point a shock to the system will cause catastrophic failure (if the system just doesn't get stuck in a "poverty trap"), setting the stage for rebirth of that system or newly emergent systems that arise in the wake of the old. (See, e.g. adaptive cycle, or more generally: Resilience Alliance.)

Minksy's dream is a hard sell in the American culture, with our new-found American values. Minsky's agenda is to relegate market mechanisms to relatively minor roles. Minsky's "solutions" which he offered up humbly, are for bigger government, smaller banking institutions, and an elimination of "welfare" via a government-sponsored "employment strategy". It is an agenda that is still being pitched by some of Minsky's disciples, although there is dissension among the disciples as is always the case with economists. Minsky also advocated for a "balanced budget" — balanced not every year, but over a reasonable time-frame so as to avoid hyper-inflationary possibilities.

Time will tell whether Capitalism will survive (and if it does, In what form?). In the meantime we all watch and wait, cuss and discuss.

For more on Minsky and more on the bankster crisis, see:
Economic Perspectives from Kansas City.
For more on monetary complex systems thought, see:
Macroeconomic Resilience

Naomi Klein on: 'Shock Doctrine' and Greenspan

{Updated 9/30}

Naomi Kleins' book, The Shock Doctrine: The Rise of Disaster Capitalism is nothing if not controversial. So is Klein. Commentary surrounding Klein's book is raising important questions as to what effect activist economists have on politics. Those familiar with Robert Heilbroner's works, e.g. The Worldly Philosophers, Behind the Veil of Economics already know well what impact the most well-known and powerful economists have on politics.

In The Shock Doctrine Klein takes on Milton Friedman and "the Chicago boys", blaming them for planting the seeds of so-called free-market capitalism in the minds of disciples, paving the way for alleged "crony capitalism" that followed. William Grieder's appraisal of Friedman is also damning. So is Joseph Stiglitz's, in his "Bleakonomics" review of Klein's The Shock Doctrine. Here's Alexander Cockburn's review , which views Friedman in a slightly less evil light. Yesterday, Klein took on Alan Greenspan:

Greenspan and the Myth of the True Believer, Naomi Klein, The Nation,Sept. 27: … Since I began touring with my book The Shock Doctrine, I have had a number of exchanges like this, revolving around the same basic question: When hard-right political leaders and their advisers apply brutal economic shock therapy, do they honestly believe the trickle-down effects will build equitable societies--or are they just deliberately creating the conditions for yet another corporate feeding frenzy? Put bluntly, Has the world been transformed over the past three decades by lofty ideology or by lowly greed?

A definitive answer would require reading the minds of men like Dick Cheney and Paul Bremer, so I tend to dodge. The ideology in question holds that self-interest is the engine that drives society to its greatest heights. Isn't pursuing their own self-interest (and that of their campaign donors) compatible with that philosophy? That's the beauty: They don't have to choose. Unfortunately, this rarely satisfies graduate students looking for deeper meaning. Thankfully I now have a new escape hatch: quoting Alan Greenspan.

His autobiography, The Age of Turbulence, has been marketed as a mystery solved: The man who bit his tongue for eighteen years as head of the Federal Reserve was finally going to tell the world what he really believed. And Greenspan has delivered, using his book and the surrounding publicity as a platform for his "libertarian Republican" ideology, chiding George W. Bush for abandoning the crusade for small government and revealing that he became a policy-maker because he thought he could advance his radical ideology more effectively "as an insider, rather than as a critical pamphleteer" on the margins. Yet what is most interesting about Greenspan's story is what it reveals about the ambiguous role of ideas in the free-market crusade. Given that Greenspan is perhaps the world's most powerful living free-market ideologue, it is significant that his commitment to ideology seems rather thin and perfunctory--less zealous belief, more convenient cover story.

Much of the debate around Greenspan's legacy has revolved around the matter of hypocrisy, of a man preaching laissez-faire who repeatedly intervened in the market to save the wealthiest players. The economy that is Greenspan's legacy hardly fits the definition of a libertarian market but looks very much like another phenomenon described in his book: "When a government's leaders routinely seek out private-sector individuals or businesses and, in exchange for political support, bestow favors on them, the society is said to be in the grip of 'crony capitalism.'" He was talking about Indonesia under Suharto, but my mind went straight to Iraq under Halliburton. Greenspan is currently warning the world about a dangerous looming backlash against capitalism. Apparently, this has nothing at all to do with the policies of negligent deregulation that were his trademark. Nothing to do with stagnant wages due to free trade and weakened unions, nor with pensions lost to Enron or the dot-com crash, or homes seized in the subprime mortgage crisis. According to Greenspan, rampant inequality is caused by lousy high schools (which also has nothing to do with his ideology's war on the public sphere). I debated Greenspan on Democracy Now! recently and was stunned that this man who preaches the doctrine of personal responsibility refuses to take any at all.

Yet ideological contradictions are only relevant if Greenspan really is a true believer. I'm not convinced. Greenspan writes that as a student he had no interest in big ideas. Unlike his classmates who were in the thrall of Keynesianism with its promise of building a better world, Greenspan was simply good at math. He started doing research for powerful corporations; it was profitable, but Greenspan made no claims to a higher social contribution.

Then he discovered Ayn Rand. "What she did…was to make me think why capitalism is not only efficient and practical, but also moral," he said in 1974.

Rand's ideas about the "utopia of greed" allowed Greenspan to keep doing what he was doing but infused his corporate service with a powerful new sense of mission: Making money wasn't just good for him; it was good for society as a whole. Of course, the flip side of this is the cruel disregard for those left behind. "Undeviating purpose and rationality achieve joy and fulfillment," Greenspan wrote as a zealous new convert. "Parasites who persistently avoid either purpose or reason perish as they should." Was it this mindset that served him well as he supported shock therapy in Russia (72 million impoverished) and in East Asia after the 1997 economic crisis (24 million pushed into unemployment)?

Rand has played this role of greed-enabler for countless disciples. According to the New York Times, Atlas Shrugged, her novel that ends with the hero tracing a dollar sign in the air like a benediction, stands as "one of the most influential business books ever written." Since Rand is simply pulped-up Adam Smith, her influence on men like Greenspan suggests an interesting possibility. Perhaps the true purpose of the entire literature of trickle-down theory is to liberate entrepreneurs to pursue their narrowest advantage while claiming global altruistic motives--not so much an economic philosophy as an elaborate, retroactive rationale.

What Greenspan teaches us is that trickle-down isn't really an ideology after all. It's more like the friend we call after some embarrassing excess so that they will tell us, "Don't beat yourself up: You deserve it."

For more Shock Doctrine (and commentary) see:

The Guardian, Shock Doctrine minisite

Joseph Stiglitz's NY Times review, "Bleakonomics",Sept 30:

… Some readers may see Klein's findings as evidence of a giant conspiracy, a conclusion she explicitly disavows. It’s not the conspiracies that wreck the world but the series of wrong turns, failed policies, and little and big unfairnesses that add up. Still, those decisions are guided by larger mind-sets. Market fundamentalists never really appreciated the institutions required to make an economy function well, let alone the broader social fabric that civilizations require to prosper and flourish. Klein ends on a hopeful note, describing nongovernmental organizations and activists around the world who are trying to make a difference. After 500 pages of "The Shock Doctrine," it's clear they have their work cut out for them.

Crash Proof: New Book

Crash Proof: How to Profit from the Coming Economic Crash recently hit the streets. Author Peter Schiff unveils his book with a sigh of angst:

Inflation is the unhappy result of our monetary mismanagement and the ultimate cause of the coming economic collapse. When will the collapse happen? … Unfortunately, it's not the kind of question we can answer with any degree of precision. … Who knows when the breaking point will come? All I know for sure is that it will come and when it does it will be calamitous. For all I know, it may have already happened by the time this book is published. If not, then you're in luck, a there is still time to implement the strategies outlined in later chapters.

Given market jitters around the world in the past two weeks, we must wonder whether Schiff was 'spot on' with his angst. But maybe not, and if not some of the advice in the last chapters of his book may prove helpful now. If so, the advice may prove helpful later on, as the woes of this age give way to the hopes of the next. Either way, Schiff's book, written with John Downs, is worth a look.

I have to admit up front that I was a bit put off by Schiff's title. How could anyone in good conscience knowingly seek to profit from impending calamity? Schiff knows this too, and only wants people to protect what they can to help loved ones and others get through tough times ahead that he and I believe are all but inevitable. And he wants people to have 'enough' to be able to contribute to the rebuilding that inevitably follows a crash.

I have one more quibble with the book, one that oddly enough will endear it to many readers. Crash Proof is written from an Austrian economics perspective: Markets are good, except when they turn to manias, which in turn are blamed on the government. But Schiff, true to his Austrian' roots doesn't lay the blame entirely on the government. He saves some of the blame for Wall Street and other crony capitalists including media moguls. And Schiff includes the usual Austrian' pining for the good old pre-inflationary days of the gold standard.

Never mind that those days were not all that good, and that during moments of irrational exuberance market players found ways to expand credit beyond good sense and create asset bubbles nevertheless. {See Charles Kindleberger and Robert Aliber's Manias, Panics, and Crashes: A History of Financial Crises for more on ever-more-clever financial innovations through the ages to allow over-optimistic and sometimes unscrupulous players to kite credit on top of credit in one form or another.}

Quibbles aside, I'm glad to have had the chance to read Crash Proof. I have a whole bunch of 'Yes' comments in the margins to compliment my few 'No' and '?' comments. And my 'No' comments usually have to do with Hyman Minsky/John Keynes influences in my own economic philosophy that in the end has a lot in common with the Austrians, while still allowing for the possibility of prudently managed fiat currency. And allowing for differing post-Keynesian views as to the impetus for, and workings of market cycles.

Ideological differences aside, both the post-Keynesian and the Austrian schools of economic thought recognize that 'prudence' is the key to proper financial management, and that prudence tends to be in short supply during manias, panics, and crashes no matter who is entrusted with the care of 'other people's money.'

Some quotable quotes to whet the appetite:

According to Greenspan, the Great Depression of the 1930s resulted from the unwinding of the speculative imbalances caused by the excess liquidity created by the Fed during the 1920s. Given that Greenspan created even more excess liquidity during his tenure and that the speculative imbalances that resulted were that much greater, what dire consequences might the Maestro [Greenspan] … believe await the United States today? …

My goal here is not simply to provide an investment guide, but to expose and illuminate the grave economic weaknesses that make survival the issue. A proper understanding of the true state of the American economy is vital to investors and noninvestors alike.

The fatal flaw in the modern economy is that any attempt to save and under consume, which would surely bring about a badly needed recession, is resisted by government policy, the sole purpose of which is to postpone the inevitable day of reckoning. In their selfish attempt to secure reelection, American politicians have persuaded their constituents that they should indulge their every whim and that self-sacrifice or underconsumption are somehow Un-American ….

Baby Boomers Are Consumers, Not Savers

Born to a generation of people who lived through the depressions and then returned from a world war to a victorious country offering the GI Bill and a future filled with possibility, the baby boomers, as the bulging population born following World War II became known, grew up knowing affluence and building it into their life expectations. Those expectations naturally became the promises of the politicians they elected. Amid a business boom driven by leverage and making credit an integral and acceptable part of modern life, financial service organizations, now deregulated and free to expand and diversify, relaxed their lending standards and aggressively foisted auto loans, credit cards, mortgages, and home equity loans on a market as vulnerable as it was demographically irresistible. With personal expectations now tantamount to a sense of entitlement, the next stage was clearly set for the spending binge we have today.

Savings? Who needs savings when you own stocks that can only go up in price and a home that gains equity every year? Let the dismal scientists worry that stock values or home equity might simply be the result of inflationary bubbles created by an irresponsible Federal Reserve, or that when the bubbles burst, all that will remain are the debts they collateralized.

In a chapter titled "What Uncle Sam, the Mass Media, and Wall Street Don't Want you to Know", Schiff introduces us to some prevailing MYTHS:

THE BALLOONING TRADE DEFICIT

The comforting distortion: Large trade deficits are a sign our economy is creditworthy, strong, and growing faster than the economies of our trading partners.

The disturbing reality: Our trade deficit is a huge and growing problem and threatens to ruin us.

INFLATION: THE CORE AND THE BUBBLE

The comforting distortion: Core inflation is moderate and well under control.

The disturbing reality: Core inflation excludes food and energy from producer and consumer price indexes that understate real inflation to begin with. Actual inflation is considerably higher and also exists big-time in the form of a housing bubble being represented as a strong housing market.

THE DEFLATION RUSE

The comforting distortion: Increases in the CPI are an indication that the risk of deflation is being successfully combated.

The disturbing reality: Deflation risk is pure bunk and designed to distract us from the real problem, which is inflation and which the Fed can't effectively counter by raising interest rates because consumers are too close to the edge.

THE PRODUCTIVITY MYTH

The comforting distortion: Productivity gains mean higher sustainable growth rate, lower inflation, and lower unemployment.

The disturbing reality: What productivity gains?

… [Key questions nowhere answered]: (1) how significant a factor higher productivity has actually been and (2) why, if it is true that we are more productive than our trading partners, our trade deficit gets bigger, not smaller.

GROSSLY PADDED DATA, OR AS WE KNOW THEM, GDP NUMBERS

The comforting distortion: Increases in the gross domestic product (GDP) signify a healthy, growing economy.

The disturbing reality: The GDP is too full of fluff to ba an accurate measure of economic health and vitality.

CONSUMER CONFIDENCE: THE CRUELEST IRONY

The comforting distortion: Consumer confidence drives the healthy economy.

The disturbing reality: Consumer confidence drives it the wrong way. The consumer is misdirected and consumer confidence is an utterly useless statistic.

In a chapter titled "For a Few Dollars More: Our Declining Currency", Schiff serves up a problem well-known to those who watch closely and too-little-known by the general American public:

The declining dollar is the result of an American economy characterized by declining production, inadequate savings, reckless consumption, soaring household debt, ballooning federal budget deficits, and an overly accommodating Fed.

… The Fed is now trapped between inflation and recession and it's too late to stop the consequences of either.

… Those of you still holding dollars had better do some serious reflection and ignore the talk about a mythical strong dollar policy. …

Once the dollar loses its reserve currency status and the collapse ensues, the process of returning to economic viability will be a painful one, requiring substantial austerity from both the government and its citizens. Whether the United States is up to the task remains to be seen. … In any event, you can protect yourself from the collapse and prepare yourself to profit in the reconstruction of economic health. I'm going to show you how.

As Schiff tells readers throughout, he concludes the book with some pointers to help people navigate rough financial waters ahead. Before he lays out his 'personal finance' recommendations, however, Schiff spends two chapters trashing the Fed and Wall Street, then another on bursting bubbles in the real estate market, and finally a chapter on debt, and how we became a nation of debtors. On that latter topic, Schiff notes, sagely,

Nineteenth-century America borrowed to produce. Now we borrow to consume. Investment debt is self-liquidating, while consumer debt is self-debilitating.

In the final three chapters Schiff fulfills his promises to help us protect ourselves from the impending "collapse" and to "profit from the reconstruction of economic health." Some will find these chapters too self-promoting. Maybe true, Schiff is president and CEO of Euro Pacific Capital. After he warns us to beware of financial advisors and stockbrokers, Schiff asks us to trust his advice.

Still, I will study what he presents in the next few months as I prepare to help may children and grand children follow this bit Schiff's advice: "Take charge of your own financial destiny before it is too late."

Schiff's advice chapters suggest: First, reevaluate your portfolio, and don't be afraid to invest abroad. But be careful and prudent in these investments. And he gives good pointers if/when you reevaluate. Second, think seriously about putting some of your money into gold, silver, etc. Again, he has good, if a bit self-serving pointers on how to do it. Third, stay liquid and get out of debt! Schiff believes, that we may see some major-league inflation in the not distant future. If we do, you'll want to move from "cash" to "assets" then (not now, since assets, particularly US assets may well be collapsing).

Whether or not you are inclined to agree with all Schiff's negativity and ideology, his ideas are worth a look. He is only the latest to suggest that the road ahead is not going to be an easy one.

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For a bit more perspective on Crash Proof, see/hear Jim Puplava's 3/10/07 Financial Sense Newshour.

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.

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.

Financial Armageddon: The Blog

Late last year Michael Panzner unveiled Financial Armageddon as a blog to compliment his latest book. Here are a few highlights:

Prepare for Repricing, [1/29/2007]: In "Prepare for Asset Repricing, Warns Trichet," the Financial Times' Gillian Tett describes what seems to be a quickening sense of alarm among some policymakers.

Current conditions in global financial markets look potentially "unstable", suggesting that investors need to prepare themselves for a significant "repricing" of some assets, Jean-Claude Trichet, president of the European Central Bank, warned at the weekend in Davos.

The recent explosion of structured financial products and derivatives had made it more difficult for regulators and investors to judge the current risks in the financial system, Mr Trichet said.

"We are currently seeing elements in global financial markets which are not necessarily stable," he said, pointing to the "low level of rates, spreads and risk premiums" as factors that could trigger a repricing.

"There is now such creativity of new and very sophisticated financial instruments … that we don't know fully where the risks are located," he added. "We are trying to understand what is going on — but it is a big, big challenge."…

Malcolm Knight, managing director of the Bank for International Settlements, said: "Financial innovation has produced vehicles for leverage which are very hard to measure … liquidity is increasing very rapidly and this is affecting asset prices."

Central banks were scrambling to address the problem by intensifying their joint discussions via forums linked to the BIS, he said, but he warned that international co-operation and data gathering efforts "need to be deepened".

A few have even started voicing once unthinkable concerns about who will clean up the mess if and when policymakers' worst fears are realized. …

Unknowable and Uncontrollable, [1/15/2007]: Proponents argue that the benefits of derivatives far outweigh the dangers. In particular, these synthetic securities allow risks to be transferred from those who don't want them to those who do. In their view, such activity makes the financial system healthier and more resistant to shocks.

However, this perspective fails to take account of at least some current realities. Turnover and open interest outstanding have expanded at a mind-boggling rate, making it difficult for anyone, let alone regulators and policymakers, to gain a solid handle on what is going on. Moreover, much of the activity is centered in lightly regulated over-the-counter markets, and increasingly involves instruments that are breath-taking in their complexity. …

"The Stability of the World Financial System May Be More Apparent than Real", [12/26/2006]: Nowadays, optimists pooh-pooh the notion that the failure of a major global financial operator could easily trigger a far-reaching systemic crisis because those in charge have plans in place to deal with such an event. They argue that when circumstances call for level-headed leadership, clarity of purpose, and seamless cooperation between regulators and policymakers, someone will quickly grab the baton and step in resolve the situation — just as the New York Fed President did when he orchestrated a bailout of failed hedge fund LTCM back in 1998.

Perhaps.

Then again, when it comes to the realities of modern global finance, maybe things are different this time …

… Roche's conclusion is that this essentially leaves central bankers increasingly powerless to control liquidity — meaning that not only are they unable to prick the current credit bubble, but will be equally impotent to combat its future collapse.

Financial Armageddon looks to be "one more blog" to watch closely.

As soon as I finish reading the latest edition of Charles Kindelberger's classic Manias, Panics and Crashes: A History of Financial Crises, and take one more look at Peter Bernstein's Against the Gods: The Remarkable Story of Risk, I'll tackle Panzner's book Financial Armageddon. More on all three, later.

PS. Don't expect too much blogging from me in the the next couple of weeks. I'm going on the road (for work) and will be spending evenings with books.

Beware of 'Expert' Forecasts

Early this week a colleague told me about Philip Tetlock's recent book on experts and their biases, Expert Political Judgment: How Good Is It? How Can We Know? I immediately thought of the old adage, "Those who think they Know, Don't Know…". Adding to the intrigue, Robert Jervis bills Tetlock's Expert Political Judgement book a "must read." Jervis' Systems Effects: Complexity in Political and Social Life is one of my main compass bearings in professional life. Both factors suggest that I am once again seeking to confirm my own professional biases in adding this book to my library. So be it. Ironically, "confirming evidence bias" is itself covered in the book. I'm still on track to get it.

Last November, Louis Menand posted a book review at The New Yorker: