Economic Dreams - Economic Nightmares

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)

Obama's Big Gambles

Last week's financial news was once-again grim. The Dow sits at 12-year lows, having fallen nearly 2500 points since the beginning of the year. Worse, the index has fallen over 50% in one year, making its worst performance since the Great Depression. Obama and Co. are just beginning the biggest Keynesian stimulus ever seen, that many believe will ultimately run in the three to five trillion dollar range. One BIG gamble! Another gamble will be to see if this and subsequent Administrations and the US Congress can then claw back enough money — new taxes — to cover the near-term push.

Two other gambles are in play. First, US President Barack Obama seeks to do what has proven impossible for many other Administrations: to reform the US health care system, and simultaneously to reform and green-up US energy policy. Second, Obama seeks to end Bush's Iraq war, which Tomas Ricks believes history will record as "the biggest mistake in the history of American foreign policy". Obama also seeks to do something positive relative to the rest of the Middle East, especially focused on Afghanistan and Pakistan. We will leave the latter two gambles for later posts and will today focus on the stimulus gamble. Some stage-setting:

Borrow and Spend

Not many years ago Republicans railed against a Democrat-dominated US Congress for what they believed to be highly wasteful and dangerous Tax and Spend Liberalism. That day is gone. Now we fear Borrow and Spend tactics from both sides of the political aisle. This borrow and spend era began in earnest with Ronald Reagan. It was revisited, mimicked really, with George W. Bush's three trillion adventure into Iraq (See, e.g. Stiglitz and Bilmes, Washington Post, Mar 9, 2008) and the beginning salvos of a bailout in the wake of our recent financial meltdown. (For more see Wikipedia, Public Debt).

Now Barrack Obama intends to lead us further down the Borrow and Spend road into a massive Keynesian Fiscal Stimulus that could cost up to to 5 trillion dollars. (Wikipedia, Keynesian Economics).

The end of capitalism or just the end of Laissez-faire capitalism?

The Obama Administration claims they are doing only what is needed. Maybe. I don't know. My biggest fear is that no matter what "stimulus" is thrown at the problem, we simply can't create enough high paying jobs fast enough to innovate our way out of this crisis. When you listen to pundits telling us how we are going to grow our way out of this crisis — more jobs, more wealth — remember what is happening around us with computerized robotics and networked information systems. And the threat isn't just "manufacturing", but "professional practices" in medicine, law, accounting, and so on. Remember too, that the latest-greatest fad, new jobs in financial engineering just failed too.

The winds of Joseph Schumpeter's creative destruction (Wiki link) might this time blow away capitalism as we've known it. You tell me where the jobs are going to come from. I know that prediction is always flawed, and that historically we've "creatively" come up with jobs whenever our capitalist systems were threatened. But I keep hearing echoes from all the great economists, fearing an end to capitalism. Is it near? In any case I just can't see what these new jobs are going to be shaped from. Likely I'm just being short-sighted and frightened. Amidst it all, the Republican right howls about Obama and socialism (put those two word into Google and see what pops up).

If indeed the end of capitalism is not near then I side with the majority of economists that this rediscovered Keynesian is the way forward. If capitalism is indeed dead, we will have given a gift to the banking community that is largely resposible for getting us once again into this mess. And, maybe set a stage for hyperinflation. Scary thought! In either case, I remain angry about the fact that we really didn't have to get into this mess again. The lessons from the 1920s and 1930s should have kept us from allowing the massive bubbles to form this time around. But prevailing Friedmanite economic ideology (Wiki Link) that has only recently been debunked — for how long? — pretty much silenced dissenting voices and reasoning that might have prevented all. That is, prevented politicians, CEOs, brokers, "quants", lenders, borrowers, from drinking the Kool Aid this time around. Serious students of Keynes know that not only do you have to stimulate big economies sometimes, but you also have to "stabilize" by cooling over-heated economies. On that front, we all need to read more Minsky as Financial Times' Martin Wolf recently noted.

This transition, no matter where it takes us will be difficult and many people are going to be hurt, distressed, disgusted, and so on. Doug Noland says

… Today's Post-Bubble Facts of Life [Feb 12] create a serious policymaking dilemma. Unimaginable wealth was shifted to "Wall Street" and their client base during the boom, while millions of regular folk were saddled with unmanageable debt and, now, negative net worth. Those on the right side of the inflationary boom accumulated historic wealth, while millions on the wrong side destroyed their financial health. The runaway boom inflated expectations — and now comes the depressing phase of disappointment and growing despair. Of course the populace is ticked off, spurring politicians to vilify and seek amends and wealth redistribution. In this regard, there are no surprises today to those of us that have studied the post-1929 landscape. …

At minimum, historians are going to have a field day with this moment. For the rest of us, we have to hope that somehow we can find a reasonable path forward.

None Dare Call it Fascism: Moyers and Galbraith

Last Friday, Bill Moyers sat down with Jamie Galbraith to talk about The Predator State and our current mess relative to 1929-. Galbraith says that like 1929-,

The situation today is very similar to the moment of panic and collapse that we saw in 1929. And for very similar reasons. An abandonment of the supervisory responsibility that should have been applied to keep the speculation and the fraud and the abuse from getting out of control. So there's going to be a major period of correction. And dad, [John Kenneth Galbraith, The Great Crash 1929 writing] in 1955, talks about how memory fades and how eventually, although so long as people remembered '29 it wouldn't be repeated, eventually it would be forgotten and the underlying speculative impulse would come back.

Galbraith differs from many who blame our current mess on"the deficit", on the US Government living beyond its means:

BILL MOYERS: But even Barack Obama's website calls the deficit America's "Domestic Enemy." Even he's aware of the fact that the deficit's beyond sight.

JAMES GALBRAITH: Well, the deficit isn't beyond sight. The deficits in the Bush administration in relation to the size of the economy were never all that large. They were certainly larger than they were under Clinton, but that was in part necessary because of the changed economic situation, the collapse of the dot-com bubble in 2000.

The United States government's credit is good. The deficit is a financial number that people are going to have to get used to because there is no way in these circumstances of avoiding an increase in the deficit. One of two things can happen. The government can take action and help stabilize the economy in which case we will have more spending but also more employment.

Or the government cannot take action and let the economy collapse in which case we will have much less tax revenue. The deficit is going to be larger either way. There is no way of avoiding that. The only question is do you work to have a good economy or do you accept a terrible economy?

BILL MOYERS: What are the negative effects of a soaring deficit?

JAMES GALBRAITH: Well, the one thing I would have worried about is that we might not find lenders who are willing to provide funds to the U.S. government, that the Chinese or the Japanese might decide that they would rather be in some other currency and that we'd then have trouble with inflation. But that's not going to happen. It's not going to happen because, as it turns out, the major alternative, the euro, simply isn't viable as a reserve asset for the rest of the world. It's the dollar or nothing. So the United States basically can finance itself to the extent necessary to deal with this crisis. And I'm right now quite sanguine about that, quite confident that we won't face a problem.

At the end of the interview, Moyers gets to Galbraith's new book, The Predator State, and how some like Steve Forbes are already beginning to blame the mess on reformers like Galbraith. Here's a snip

BILL MOYERS: [T]here are capitalists like Steve Forbes, … of "Forbes Magazine," who argue that people like you are going to go too far and that it was actually the government's excesses and failures in the '80s and '90s that contributed to what began to happen in 2007 with the meltdown. And that if you have your way, people like you have your way, you will criminalize business. You will raise taxes and dry up the economy. You will take government unchecked into the same kind of catastrophe that unchecked Wall Street has carried us. How do you answer a Steve Forbes?

JAMES GALBRAITH: Well, first of all, I very much agree with him, that it was failures of government that were responsible for this. It was the actual failure, the abandonment, the neglect of the supervisory regulatory responsibility. That's at the root of this.

Just as you cannot prosper without a private economy, you cannot prosper without an effective autonomous government capable of thinking for itself, capable of balancing things out, of standing for other interests, of standing for labor and consumers and for the public interest as a whole. If you don't have that, you're going to get these pyramids, these bubbles, these epidemics of fraud and abuse, and ultimately the collapse of trust and the collapse of the economy itself. That's what's happened in the predator state.

I agree with Galbraith on much, including the fact that both private (e.g. so-called "rating agencies") and public regulators (e.g. government agencies, the US Congress, and US Adminsitrations dating back to Ronald Reagan) were asleep at the wheel. I hope Galbraith is right about the US dollar's non-endangered "reserve currency" status for the near term. I also hope he and other reformers are able in the next few years to restructure the world's financial systems to set a stage for thoughtful investment rather than unbridled speculative excess.

Note: My title might better have been written "None Dare Call it Corporatism." Here is a Wikipedia link to Corporatism. See also Wikipedia on The Economics of Fascism.

Just Before the Dawn of a New Era?

I'm not the only "Perma Bear" who is now beginning to hope for another New Deal — by reregulating global finance and banning the wildcat speculation that has been the mainstay of particularly American-led investment banking and finance. No doubt there is still some tough sledding both on Wall Street and Mainstreets around the world. But at least central bankers around the world now know that the old order was indeed as unsustainable as many have been telling them that it was. Here's some of the latest from Doug Noland:

Hoping There's Hope, Doug Noland, Credit Bubble Bulletin, 10/09/2008: This is the first all-encompassing global dislocation of contemporary finance, impacting virtually all economies, markets and asset classes. The media is now all over the "Wall Street" and "banking" crisis. I am of the view, however, that the collapse of the hedge fund industry has moved to the forefront — that it is now at the epicenter of global market upheaval. To watch silver lose more than 20% of its value today in intraday trading; to see the collapse in energy prices; to see the entire commodities complex absolutely routed; to view global currency markets in complete disarray, with double-digit intraday drops in the Brazilian real and Mexican peso; to witness major currencies such as the Australian and Canadian dollars suffer precipitous declines; for benchmark Fannie Mae MBS yields to surge 62 bps in three days; to see Brazilian dollar bond yields jump almost 200 bps in four sessions; for global equities indices to suffer rapid double-digit drops throughout both the developed and "emerging" markets; to witness a 1,000 point intraday swing in the DJIA. All the favorite trades are blowing up, and the leveraged speculating community is in a panic de-leveraging.



There is no doubt that markets are in the midst of an unprecedented liquidation of positions across virtually all asset classes and a vicious unwind of a multitude of investment and trading strategies. The Massive Pool of Global Speculative Finance is being drained. Having watched the ballooning of the hedge fund industry over the past few years in absolute awe, I can say today that an industry collapse would entail the sale (voluntary and forced by the margin clerk) and unwind of literally Trillions of positions. Investors and speculators alike are desperate to flee risk. Having watched the ballooning of the hedge fund industry over the past few years in absolute awe, I can say today that an industry collapse would entail the sale (voluntary and forced by the margin clerk) and unwind of literally Trillions of positions. It has been history's most spectacular speculative Bubble and, especially over the past few years, it became very much global in nature and infiltrated virtually all asset classes. This Bubble is in a full-fledged collapse — entailing unprecedented liquidations — and it's taking global markets down with it. …

Perhaps things will stabilize once the hedge fund liquidations run their course. Treasury (TARP) purchases will commence soon. Fannie and Freddie will be aggressively expanding their market purchases. The Fed is now buying commercial paper, and the Fed and Treasury are working to resolve the dislocation in the "repo" market. Across the globe, governments are in full crisis management mode. There appears universal resolve to bolster financial sectors and stem the collapse. And there were actually some positive indications of stabilization in our Credit system late in the week.



I also hold out Hope that the Trillions of reserves held by global central bankers will provide some buffer to stem financial system collapse. In particular, I am Hoping that China, India, Russia, Brazil and the Middle East have today sufficient reserves to somehow avoid a '90s style financial and economic meltdown. I am Hoping that demand from China, India, Asia and Latin America will help offset inevitable economic downturns in the U.S. and Britain and, hopefully to a lesser extent, Europe. I am hoping that the collapse in energy and commodities prices is more a reflection of acute financial market dislocation rather than a harbinger of synchronized global economic upheaval. I am hoping there is more substance to the dollar’s rally than simply an unwind of bearish dollar bets. And I am hoping that with large capital infusions our deeply impaired banking system will retain the capacity to finance a much less robust but at least functioning U.S. economy. I really Hope everything is not as dire as it appears.

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

Another Frightening Show About the Economy: NPR Edition

If you want to get really scared/mad about our current financial mess, take an hour and listen to last Friday's version of Chicago Public Radio's This American Experience, titled Another Frightening Show About the Economy.

Act One: The Day the Market Died
Act Two: Out of the Hedges and into the Woods
Act Three: Swap Cops
Act Four: What's Next

A few quick notes:

Act One helps us better understand how the very boring arena of Commercial Paper recently caught the attention of high government officials when the arena suddenly dried up, threatening businesses small and large, state governments, and more.

Act two delves deep into Credit Default Swaps and might be subtitled: How 'Insurance' morphed into 'Speculation' on a massive, unprecendented scale. If you want to get a good feel for these arcane instruments, listen closely. A Snip: "If bad mortgages got the financial system sick, [Credit Default Swaps] helped spread the sickness into an epidemic."

Act Three helps us better understand Regulation (or the lack of it). For example, Why were CDSs not regulated, say, way back in 1998 when Michael Greenberger, then with the U.S. Commodities Futures Trading Division, and others tried to get such regulation? Many in the Clinton Administration and Congress argued, according to Greenburger, "These products are entered into by very sophisticated financial institutions … you and I couldn't buy them … and these people are very, very smart and it is a mistake to let government get in the way." In Dec. 2000, Congress passed a law — as a little-discussed 262 page rider to an Omnibus Appropriations Bill — that credit default swaps and things like them could not be regulated. So it went! So it goes… Nobody was even trying to restrain the investors, turned 'speculators.'

Greenburger concludes, "… The idea that you can have $60 Trillion in a financial market which is more than all the stock sold anywhere in the world and not have any oversight whatsoever is self-evidently absurd, and we are seeing the end result of that today."

Act Four give us some insight into the Bailout Bill as it was, and as it transformed into Law.

And if that whets your appetite, listen/read to Michael Greenberger's Sept. 17 Was Adult Supervision Needed on Wall Street?, also from NPR.

HT: Calculated Risk

Speculative Orgy Gone Bust: Bogle and Noland

This morning on NPR, John Bogle, founder of The Vanguard Group, said that we have a "Speculative orgy like nothing we've ever seen before in the history of the United States. … We've become a market dominated by speculators not by investors.

"I don't know if [the bailout] can succeed. I mean Goldman Sachs collecting deposits from investors, putting an ATM on every corner. I can't imagine it. … I worry about mixing banking — commercial banking — and investment banking, just like they worried about when they put in the Glass Steagall Act back in1933 or 1934."

Meanwhile, Prudent Bear's Doug Noland weighs in, particularly on the over-leveraged nature or our system:

The Wall Street Bust, 10/02: … It is today impossible to comprehend the full ramifications from The Bust in Wall Street Finance. Yet we can be rather certain that for the foreseeable future much less Credit and liquidity will be directed to the asset markets. And, at the same time, there will be significantly less Credit Availability for riskier loans of all varieties — for the household, business, financial and the government sectors. Few appreciate that these dynamics are extremely problematic for the U.S. Bubble Economy — an economic system that had come to a large extent to be governed by asset-based and high-risk lending. These dynamics are at the heart of today's Acute Financial and Economic Fragility and the resulting imploding markets.

The leveraged speculating community played such an integral role in the overall Credit Bubble and, more specifically, to the Bubble in Wall Street Finance. They were instrumental in both spurring financial sector Credit creation/leveraging, while directing this Flood of Finance to the asset markets. And the more the leverage and the greater the Flow to inflating markets, the higher the returns generated by this expanding pool of speculative finance. And the greater the returns, the more robust the "investment" flows into the hedge fund community — spurring more leverage and more potent fuel for additional self-reinforcing asset inflation. Well, this historic speculative Bubble is now in the process of blowing up. One of the greatest manias ever — surely The World's Greatest Episode of "Ponzi Finance" — is absolutely coming apart. And the wreckage is accumulating in all markets — everywhere.


Here at home, our maladjusted economic system will only be sustained by somewhere in the neighborhood of $2.0 TN of new Credit. It's simply not going to happen. The $700bn from Washington would seem like an enormous amount of support. In reality, it's nowhere even close to the amount necessary for systemic stabilization. To the $2.0 TN or so of new Credit required this year (and next) add perhaps as much as several Trillion more necessary to accommodate speculative de-leveraging (liquidations forced by huge losses). Importantly, the Bust in Wall Street Finance has ensured that insufficient liquidity will be forthcoming to maintain inflated asset prices and sustain the Bubble economy — creating catastrophe for the leveraged speculating community.

The "Freidmanites" thought they understood the (post-crash) policy mistakes that led to The Great Depression. They believed the "Roaring Twenties" was the "Golden Age of Capitalism." The great bust could have been avoided with a simple ($5bn or so) banking system recapitalization. As we are witnessing today, the issue is not some manageable amount of new "capital" to replenish banking system losses. Instead, the predicament is the massive and unmanageable amount of new Credit necessary to, on the one hand, sustain a mal-adjusted Bubble Economy and, on the other, the Trillions more required to accommodate a gigantic speculative de-leveraging. I have a very difficult time seeing a way out of this terrible mess.

I too have a difficult time seeing a way forward. It looks like we will have to do what Sweden did, but on a far larger scale — nationalize our financial system for a time — that either will bring hedge funds under the regulatory umbrella along with commercial banks, kill hedge funds outright, else ensure that hedge funds individually or collectively can't themselves be the next too-big-to-fail excuse for yet another government bailout. And let's hope that we get rid of the idea of Government Sponsored Enterprises (GSEs) and either keep Fannie Mae and Freddie Mac as government entities, else (not my preference) privatize them.

Kicking the Can Down the Road

The US House of Representatives Just passed what is best know as 'The $700 Billion Bailout Bill', now "larded up" sunstantially. Yves Smith, in an hour-long videoblog interview with Megan McArdle (Oct 1), argues that all that they have done is to kick the can done the road — problems will return again as early as November/December. Watch the hour-long interchange to gain a better pespective as to how we got into this mess over the last 40 years, what it means now and going forward.

Paul Krugman seems to agree that all this Bill will do, at best, is to buy time saying in The Edge of the Abyss (NY Times Oct 2)

… [A]t best, the plan will buy some time to seek a real solution to the crisis.

And that raises the question: Do we have that time?

A solution to our economic woes will have to start with a much better-conceived rescue of the financial system — one that will almost surely involve the U.S. government taking partial, temporary ownership of that system, the way Sweden’s government did in the early 1990s. Yet it’s hard to imagine the Bush administration taking that step.

We also desperately need an economic stimulus plan to push back against the slump in spending and employment. And this time it had better be a serious plan that doesn’t rely on the magic of tax cuts, but instead spends money where it’s needed. (Aid to cash-strapped state and local governments, which are slashing spending at precisely the worst moment, is also a priority.) Yet it’s hard to imagine the Bush administration, in its final months, overseeing the creation of a new Works Progress Administration.

So we probably have to wait for the next administration, which should be much more inclined to do the right thing — although even that’s by no means a sure thing, given the uncertainty of the election outcome. (I’m not a fan of Mr. Paulson’s, but I’d rather have him at the Treasury than, say, Phil "nation of whiners" Gramm.)

Nobody I read likes the "Plan" much, but many seem to think it will buy time. Some like Dean Baker don't think it was needed at all. See Baker's Sept. 29 Wall Street Held a Gun to our Heads. We'll never know whether those who wanted us to let-it-ride were correct. But we can wait and see whether this does little long-term to solve the big problems of tightly-coupled, structured-finance markets that were badly designed to cope with the mechanisms by which Wall Street insiders, big Hedge Fund managers, and others stole so much from too many of us.

A Trillion Here, A Trillion There

Rumor has it that former US Congressman Everett Dirksen once quipped "… a billion here, a billion there, and pretty soon you are talking about some real money." In the last few years we've upped the ante. Now it's a trillion here, a trillion there — on the Wall Street Bailout, on the Iraq War, for instance. It looks like the NeoCons have at least insured that the government will be squeezed in times to come. Their dark dream of Starving the Beast, however, is not a short-term outcome though. Looks like the US government is getting ever-more-powerful by the day and by the year, in both military and financial arenas. Or maybe that was their real dream after all. Sad but likely true: Too few NeoCons will go to jail. Too many of the rest of us will suffer.

Here is Gretchen Morgenson's take on the latest phase of the mess in today's NY Times, subtitled Fixing Others' Mistakes:

…Treasury Secretary Henry M. Paulson Jr. [Paulson] has called the fund the "troubled asset relief program." I'll just call it TARP for short (you know, the kind of thing they spread over muddy fields so you don’t soil your Guccis). [Iverson note: Yesterday, Willem Buiter called it a TAD: Toxic Asset Dump ].

And depending on how TARP is operated, and how the assets are valued before taxpayers are forced to buy them, it could bloat our final bill for this mess while benefiting the very institutions that got us into it.
Yes, we need a smart plan and a concerted effort to get the frozen credit markets up and running. But we also have to be certain that the types of conflicts of interest that riddle Wall Street aren't visited upon TARP.

Consider: A bank wants to sell the TARPistas (also known as TAXPAYERS) a pile of stinky mortgage securities that it currently values at 60 cents on the dollar. Let’s assume that the most recent actual trade between market participants for similar assets was struck at 30 cents on the dollar.

So what's a fair price that we TARPistas should pay for the assets?

If we bought at 60 cents, a price that the bank would argue is appropriate, we would most likely face a loss. The bank, however, would be much better off than if it had to dump at 30 cents.

Conversely, if the assets were sold at 30 cents, taxpayers could wind up making a profit on the purchase if the assets performed better than expected over time. But the bank would have to write down the value of the assets as a result of the sale, possibly threatening its financial standing yet again.

Do you think, perchance, that financial services lobbyists might be working their Hill contacts right this very
minute to ensure that the TARP valuations are rigged in their favor?

You know the answer to that.

And you also know that we should steel ourselves for heavy losses as the TARP gets pulled over our eyes. Never mind that it was the banks, with their reckless lending and monumental leverage, that drove us into this ditch.

Such is our lot today: They break it. We own it. …

For background, here is yesterday's NY Times look at Hank Paulson and Ben Bernanke's recent takeover of the US financial system: A Professor and a Banker Bury Old Dogma on Markets .

Today Paul Krugman tells us that he isn't sure that the TARP isn't instead just the perverbial 'wool pulled over our eyes':

Thinking the Bailout Through: … Even without panic asset selling, the financial system would be seriously undercapitalized, causing a credit crunch — and this plan does nothing to address that.

Or I should say, the plan does nothing to address the lack of capital unless the Treasury overpays for assets. And if that's the real plan, Congress has every right to balk.

So what should be done? Well, let's think about how, until Paulson hit the panic button, the private sector was supposed to work this out: financial firms were supposed to recapitalize, bringing in outside investors to bulk up their capital base. That is, the private sector was supposed to cut off the problem at stage 2.

It now appears that isn’t happening, and public intervention is needed. But in that case, shouldn't the public intervention also be at stage 2 — that is, shouldn’t it take the form of public injections of capital, in return for a stake in the upside?

Let's not be railroaded into accepting an enormously expensive plan that doesn’t seem to address the real problem.

Yves Smith hates the Paulson/Bernanke plan too, and tries to help us better understand why:

Why You Should Hate the Treasury Bailout Proposal …First, let's focus on the aspect that should get the proposal dinged (or renegotiated) regardless of any possible merit, namely, that it gives the Treasury imperial power with respect to a simply huge amount of funds. $700 billion is comparable to the hard cost of the Iraq war, bigger than the annual Pentagon budget. And mind you, $700 billion is not the maximum that the Treasury may spend, it's the ceiling on the outstandings at any one time. It's a balance sheet number, not an expenditure limit.

But here is the truly offensive section of an overreaching piece of legislation:

Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

This puts the Treasury's actions beyond the rule of law. This is a financial coup d'etat, with the only limitation the $700 billion balance sheet figure. The measure already gives the Treasury the authority not simply to buy dud mortgage paper but other assets as it deems fit. There is no accountability beyond a report (contents undefined) to Congress three months into the program and semiannually thereafter. The Treasury could via incompetence or venality grossly overpay for assets and advisory services, and fail to exclude consultants with conflicts of interest, and there would be no recourse. Given the truly appalling track record of this Administration in its outsourcing, this is not an idle worry.

But far worse is the precedent it sets. This Administration has worked hard to escape any constraints on its actions, not to pursue noble causes, but to curtail civil liberties: Guantanamo, rendition, torture, warrantless wiretaps. It has used the threat of unseen terrorists and a seemingly perpetual war on radical Muslim to justify gutting the Constitution. The Supreme Court, which has been supine on many fronts, has finally started to push back, but would it challenge a bill that sweeps aside judicial review? …

And Robert Reich said on Thursday that The Bailout of All Bailouts leaves too much room for future Wall Street shenanigans, for future "moral hazard."

… A better idea would be for the Fed and Treasury to organize a giant workout of Wall Street — essentially, a reorganization under bankruptcy, for whatever firms wanted to join in. Equity would be eliminated, along with most preferred stock, creditors would be paid off to the extent possible. And then the participants would start over with clean balance sheets that reflected new, agreed-upon rules for full disclosure, along with minimum capitalization. Everyone would know where they stood. Bad debts would be eliminated. Taxpayers wouldn't get left holding the bag. And there would be no "moral hazard" incentive for future financial wizards to take giant risks with other taxpayers' money.

Today Reich lays out five conditions that ought to be placed on any Bailout:

What Wall Street Should Be Required to Do, to Get A Blank Check From Taxpayers … 1. The government (i.e. taxpayers) gets an equity stake in every Wall Street financial company proportional to the amount of bad debt that company shoves onto the public. So when and if Wall Street shares rise, taxpayers are rewarded for accepting so much risk.

2. Wall Street executives and directors of Wall Street firms relinquish their current stock options and this year’s other forms of compensation, and agree to future compensation linked to a rolling five-year average of firm profitability. Why should taxpayers feather their already amply-feathered nests?

3. All Wall Street executives immediately cease making campaign contributions to any candidate for public office in this election cycle or next, all Wall Street PACs be closed, and Wall Street lobbyists curtail their activities unless specifically asked for information by policymakers. Why should taxpayers finance Wall Street’s outsized political power – especially when that power is being exercised to get favorable terms from taxpayers?

4. Wall Street firms agree to comply with new regulations over disclosure, capital requirements, conflicts of interest, and market manipulation. The regulations will emerge in ninety days from a bi-partisan working group, to be convened immediately. After all, inadequate regulation and lack of oversight got us into this mess.

5. Wall Street agrees to give bankruptcy judges the authority to modify the terms of primary mortgages, so homeowners have a fighting chance to keep their homes. …

I can't wait to see what the next few weeks/months bring. "Interesting Times" indeed! Looks like a good time for me to resume this blog…

Minsky on 'Flawed Capitalism', 'Flawed Economics'

I am a fan of Hyman Minsky's work, but have not read — until now — any of his books. I am currently reading Stabilizing an Unstable Economy. Here is a timely quote, from Chapter 12, "Introduction to Policy", emphasizing our current plight both as to our political economy and misguided economic ideology/methodology. It could have been written yesterday but was first published in 1986:

… We need to embark on a program os serious change even as we need to be aware that a once-and-for-all resolution of the flaws in capitalism cannot be achieved. Even if a program of reform is successful, the success will be transitory. Innovations, particularly in finance, assure that problems of instability will continue to crop up; the result will be equivalent but not identical bouts of instability to those that are so eviedent in history.

Political leaders and the economists who advise them are to blame for promising more than they or the economy can deliver. The established advisers have failed to make the political leadership and the public aware of the limitations that economics processes and the the ability to administer impose on what policy can achieve. … [O]ur economic leadership does not seem to be aware that the normal functioning of our economy leads to financial trauma and crises, inflation, currency depreciations, unemployment, and poverty in the midst of what could be virtually universal affluence—in short, that financially complex capitalism is inherently flawed.

Economic advisors, whether liberal or conservative, believe in the fundamental "soundness" of the economy. Finding fault with one thing or another, they may advocate policies such as changing Federal Reserve operating techniques, tax reforms, national health insurance, and wars on poverty, but all in all they are satisfied with the basic institutions of modern capitalism. According to today's gospel [extant faults] are due to secondary, not to fundamental, characteristics.

[T]he economists of the policy-advising establishment differ about details: some propose to fine-tune the economy by fiscal tinkering, others want to achieve a natural rate of employment through steady monetary growth. Neither, however, sees anything basically wrong with capitalism as such. The credit crunch of 1966, the liquidity squeeze of 1970, the banking crises of 1974-75, the inflationary spiral of 1979-80 and the distress, national and international, of 1981-82 are, in their view, aberrations, due to either "shocks" or "errors." Since nothing is basically wrong, they also hold that incisive corrective measures are not needed.

The truth of the matter is that something is fundamentally wrong with our economy. As we have shown, a capitalist economy is inherently flawed because its investment and financing processes introduce endogenous destabilizing forces. The markets of a capitalist economy are not well suited to accommodate specialized, long-lived, expensive capital assets. In fact, the underlying economic theory of the policy establishment does not allow for capital assets and financial relations such as exist. The activities of Wall Street and the inputs of bankers to production and investment are not integrated into, but are added onto, the basic allocation-oriented theory.

Economic policy discussions in recent years have centered on how much more (or less) on the one—fiscal policy—and how much less (or more) of the other—monetary policy—is necessary for economic stability and growth. If we are to do better in the future, we must launch a serious debate that looks beyond the level and the techniques of fiscal and monetary policy. Such a debate will acknowledge the instability of our economy and inquire whether this inherent instability is amplified or attenuated by our system of institutions and policy interventions. ….

Today's economic crisis is as profound … as that of the 1930s. … There is no consensus as to what we should do. Conservatives call for freeing up the markets even as their corporate clients lobby for legislation [to] institutionalize and legitimize their market power…. [C]orporate America pays lip service to Adam Smith, while striving to sustain and legitimize the very thing that Smith abhorred—state-mandated market power.

Liberals, instead of articulating and incisive critique of our capitalism as such and pioneering innovative experimentation and change, are wedded to the past. They support minimum-wage increases without questioning whether these laws have served any real purpose since the Great Depression, when reflation was the policy objective. Liberals are unwilling to face up to the shortcomings of policies inherited from the past and are, fundamentally, timid about setting forth in new directions.

As a consequence, instead of analysis and ideas, we get slogans: free markets, economic growth, national planning, supply-side, industrial policy—imprecise phrases that face up to neither the what nor the how of policy objectives. The various programs for change are based on misconceptions of both the strengths and the weaknesses of market processes. One of the reasons for the intellectual poverty of policy proposals is that they continue to be based on ideas drawn from neoclassical theory. Although economic theory is relevant to policy (without an understanding of how our economy works we cannot find cures), for an economic theory to be relevant what happens in the world must be a possible even in the theory. On that score alone, standard economic theory is a failure; the instability so evident in our system cannot happen if the core of standard theory is to be believed.

Today's economic policy is a patchwork. Every change designed to correct some shortcoming has side effects that adversely affect some other aspect of economic and social life. Every ad hoc intervention breeds further intervention. If we wish to improve upon what we now have, we must embark upon an age of institutional and structural reforms that will check the tendencies toward instability and inflation. Standard theory, however, offers us no guidance on that score; for the problems are outside the domain of relevance of the theory. A new era of reform cannot be simply a series of piecemeal changes. Rather, a thorough, integrated approach to our economics problems must be developed; policy must range over the entire economic landscape and fit the pieces together in a consistent, workable way: Piecemeal approaches and patchwork changes will only make a bad situation worse.

Poverty in the midst of plenty and joyless affluence are but symptoms of a profound disorder [Tibor Scitovsky, The Joyless Economy (New York: Oxford University Press, 1976)]. As we have pointed out, persistent financial and economic instability is normal in our capitalist economy. The commitment to growth through private investment—combined with government transfer payments and exploding defense spending—amplifies financial instability and chronic inflation. Indeed, our problems are in part the result of how we have chosen, inadvertently and in ignorance of the consequences, to run the economy. An alternative policy strategy is needed now. We have to go back to square one — 1933 — and build a structure of policy that is based upon a modem [modern?] understanding of how our type of economy generates financial fragility, unemployment, and inflation. [pp. 319-23]

Note: whereas in Minsky's day inflation tended to be more self-grown, today's inflation tends to wander the globe accompanying unfettered capital mobility. Note further that Minsky was careful to introduce his policy 'remedies' with this caution: "Even as I warn against the handwaving that passes for much policy prescription I must warn the reader that I feel much more comfortable with my diagnosis of what ails our economy and analysis of the causes of our discontents than I do with the remedies I propose."