Economic Dreams - Economic Nightmares

October, The Month of the Crash: Bill Moyers

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

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

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

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

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

BILL MOYERS: And the middleman is?

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

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

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

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

ROBERT KUTTNER: For most people.

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

ROBERT KUTTNER: Yeah, I agree.

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

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

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

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

BILL MOYERS: We can't see it.

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

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

ROBERT KUTTNER: Right, and the risk--

WILLIAM DONALDSON: --"to bail you out.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Note that I have been consistently surprised by consumer resilience.

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

Oligarchic Capitalism: New Trend?

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

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

China's Shenzhen Index: Shades of Nasdaq Bubble

(via Michael Panzner's Financial Armageddon)

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

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

Panzner has more.

Deconstructing the 'Financial Revolution'

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

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

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

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

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

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

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

Subrprime: A Disaster in the making?

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

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

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

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

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

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

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

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

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

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

A Minsky-like Restatement of Keynes Market Irrationality Warning

Among famous statements attributed to John Maynard Keynes, this one is my favorite: "Markets can stay irrational longer than you can stay solvent." As I learn more about Hyman Minsky, I wonder how he might have restated Keynes' warning. Here is an attempt: "The market is irrational, is not prone toward equilibrium, but instead is subject to cycles of irrational exuberance and irrational pessimism."

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{Update Jan. 5}
A second attempt: "The market is a complex, adaptive social system, is therefore not prone toward equilibrium, but instead subject to phase shifts, cycles, and transfomation. Groups of people who play in the market are prone to cycles of irrational exuberance and irrational pessimsim."

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As to 'equilibrium' Elisabetta De Antoni says, ( "The (too?) optimistic 'financial Keynesianism' of Hyman Minsky," [PDF] p. 6 )

...Minsky totally rejects the 'crutch' represented by the concept of equilibrium. Instad of speaking of equilibrium or disequilibrium, Minsky ... 1986 p. 176— just like Joan Robinson — prefers to refer to states of tranquility hiding within themselves disruptive forces destined to gain strength with the passing of time. In his view: "instability is determined by mechanisms within the system, not outside it; our economy is not unstable because it is shocked by oil, wars or monetary surprises, but because of its nature" (Minsky 1986 [Stabilizing an Unstable Economy] p. 172)...

On 'irrational markets' De Antoni says, (p. 24)

...From a cyclical perspective, rescessions can be traced back to the preceding boom. Quoting Minsky "In some important sense, wha was lost from the insights of the 1920s and 1930s is more significant than what has been retained ... The spectacular panics, debt deflations, and deep depressions that historically followed a speculative boom as well the recovery from depressions are of lesser importance in the analysis of instability than the developments over a period characterized by sustained growth that lead to the mergence of fragile and unstable financial structures." (Minsky, 1986 p. 173).

Minsky advocates for 'big government' to act as a stabilizer to the excessive exuberance of 'free market capitalism,' But Minsky was also aware that 'big government,' if imprudent might destabilize rather than stabilize.

On 'big government stabilization,' De Antoni says (pp.18-19):

Given the tendency of capitalist economies to financial crises, followed by debt deflations and deep depressions, the issue of the efficacy of economic policies acquires a crucial role. From this point of view, Minsky does not place much faith in monetary policy. Given that a great part of the money supply is endogenously created by banks and given the innovative capacity of the financial system, the central bank has only a limited control over the supply of money. In any case money influences the demand for assets, rather than or goods. Thus, the central bank intervention may turn out to be harmful as well as ineffective. Quoting Minsky, (1986), "Monetary policy to constrain undue expansion and inflation operates by way of disruptiong financial markets and asset values. Monetary policy to induce expansion operates by interest rates and the availability of credit, which do not yield increased investment if current and anticipated profits are low" (p. 303-4). Instead of aiming to control the money supply or the behaviour of the economy, the central bank should focus on its function as lender of last resort. By enabling the financing of financial institutions and by sustaining asset prices, the central bank might prevent financial crisis, so removing the threat of debt deflations and deep depressions.

In fact, Minsky assigns to fiscal policy the task of promoting full employment and stabilizing the economy. As he puts it, "fiscal policies are more powerful economic control weapons tha monetary manipulations" (1986 p. 304). ...

No doubt Minsky didn't get everything right, as none of the great economists have. They are human, after all. They lived in times different our own. The complexity and novelty that arise spontaneously from the workings of the complex systems (physical, biological and social) that enfold us guarantee that each of us perceives the world a bit differently, depending on when we live. Still, Minsky got enough right, building particularly from Keynes (who built from foundations laid down earlier) to seriously challenge status-quo financial economics and central bank practices.

For further explorations/extensions of Minsky's financial economics, see particularly the works of Eric Tymoigne and L Randall Wray, The Levy Economics Institute, Bard College.."

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{Update Jan 5, edited Jan. 23}
In Extending Minsky's Classifications of Fragility to Government and the Open Economy, L. Randall Wray argues that "the U.S. is in an increasingly precarious position" ... "[I]t is likely that many individual units have moved from hedge to speculative positions, and even to Ponzi positions…."

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

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

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

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

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

Mr. Risk

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

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

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

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

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

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

Exploring Roots and Dangers of Global Economic Balancing

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

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

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

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

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