Economic Dreams - Economic Nightmares

Tragedy of the Commons: Finance edition

When Garrett Hardin first proposed The Tragedy of the Commons, Science Dec. 1968, he used an example of nomadic herdsmen overusing land held in common without the "protection" of property rights. The problem posed by Hardin was that without some kind of social contract to prohibit over-selfishness, each individual would gain by adding additional grazing animals to a common pasture. Without some form of social restraint, the pasture would eventually be ruined by overgrazing. No one would have incentive to stop the plunder. All incentives would work toward ruin. Hardin's tragedy was cast up then, and is applicable now to much beyond a commonly held pasture. [Note: Hardin's main message was about unbridled human population growth, pollution of the world's air and watersheds, and other potential environmental horrors. Hardin used the common pasture example only to introduce his broader message.]

In the early 1990s Hardin, along with Herman Daly used the "tragedy" metaphor in the context of common pools of capital. I wonder whether either foresaw the mess that American-led financial titans, along with ideologically blind and/or Bush-Administration-wounded regulators, along with blind politicians, rating agencies that had interests in pumping-up ratings, etc. would lead the world into. Interestingly, Hardin used a bank-robber metaphor in his 1968 article:

The man who takes money from a bank acts as if the bank were a commons. How do we prevent such action? Certainly not by trying to control his behavior solely by a verbal appeal to his sense of responsibility. Rather than rely on propaganda we … insist that a bank is not a commons; we seek the definite social arrangements that will keep it from becoming a commons. That we thereby infringe on the freedom of would-be robbers we neither deny nor regret.

Today (as in times past) bank robbers come in two forms. The "blue collar" variety we all think of when we talk about armed "bank robbers," and the other "white-collar crime variety" that ever-more-frequently seem to be those we fear theses days. William Black's book, The Best Way to Rob a Bank is to Own One comes to mind.

George Ackerlof and Paul Romer refer to this emergent process as "looting," in The Economic Underworld of Bankruptcy for Profit. Many bloggers and commentators spent the better part of the "naughties", 2000-2008 warning of the impending doom, and tracking the misdeeds of the looters. I tracked some of these Cassandras right here from 2005 forward, thinking that I might help a wee bit to the discussion, and that I might learn a bit by forcing myself to write about it. I noted in early 2007 that the Cassandras were growing weary of trumpeting the impending doom. I too was growing weary, and increasingly gloomy about the prospects going forward. Soon enough the wait would be over, and now so many track the mess situation that I have trouble just reading through my Google Reader, some of which I mark as shared.

Meanwhile another group (not bloggers, but bankers and hedge fund managers) was busying themselves preparing to capitalize on the impending doom — prepping to loot the commons for private gain. Matt Taibbi recently covered some of this in Will Goldman Sachs Prove Greed is God?, The Guardian, April 27, portraying some of Wall Street's cleverest as Ayn Rand ideologues, interested only in themselves. These clever few (some herald them as the brightest minds on Wall Street) had figured out a way to finance a continuing string of bets against the market — the bubble housing market basket of collateralized debt obligations, credit default swaps, etc. — by constructing and selling the very debt instruments they were shorting. Clever indeed, and likely perfectly legal, albeit morally reprehensible. We'll see as to the legality of it all, as the Goldman Sachs (and other yet-to-emerge) lawsuits play out. John Cassidy offers a perspective different from Taibbi's in, Goldman Sachs and Rational Irrationality, The New Yorker, April 26. Cassidy also does a good job of explaining "rational irrationality". Just as Garrett Hardin did, 40 years ago.

The few who figured out a self-financing way to play the "shorts" game found a way around Keynes warning that, "Market can stay irrational longer than you can stay solvent." Unfortunately, their game kited the markets along while they waited patiently for the inevitable decline. Their actions, arguably, made the crash worse — much worse perhaps — than it would otherwise have been. See, e.g. Goldman Sachs, Magnetar, and Outrage, The Economist, April 19. And to add insult to injury, we and our children will all get to pay for the crash, if not now then later when the bill will be even bigger.

The fix, if there is one, may again be one that Hardin would endorse. In a May 1998 piece titled Extensions of "The Tragedy of the Commons", Hardin says: "the way to avoid disaster in our global world is through a frank policy of 'mutual coercion, mutually agreed upon.'" Hardin elaborates, again building from bank-robbing:

The morality of bank-robbing is particularly easy to understand because we accept complete prohibition of this activity. We are willing to say "Thou shalt not rob banks," without providing for exceptions. But temperance also can be created by coercion. Taxing is a good coercive device. To keep downtown shoppers temperate in their use of parking space we introduce parking meters for short periods, and traffic fines for longer ones. We need not actually forbid a citizen to park as long as he wants to; we need merely make it increasingly expensive for him to do so. Not prohibition, but carefully biased options are what we offer him. A Madison Avenue man might call this persuasion; I prefer the greater candor of the word coercion.

Coercion is a dirty word to most liberals now, but it need not forever be so. As with the four-letter words, its dirtiness can be cleansed away by exposure to the light, by saying it over and over without apology or embarrassment. To many, the word coercion implies arbitrary decisions of distant and irresponsible bureaucrats; but this is not a necessary part of its meaning. The only kind of coercion I recommend is mutual coercion, mutually agreed upon by the majority of the people affected.

To say that we mutually agree to coercion is not to say that we are required to enjoy it, or even to pretend we enjoy it. Who enjoys taxes? We all grumble about them. But we accept compulsory taxes because we recognize that voluntary taxes would favor the conscienceless. We institute and (grumblingly) support taxes and other coercive devices to escape the horror of the commons.

Let's hope that when all is said and done regarding impending finance re-regulation we have not forgotten Hardin's advice. Like many others, Hardin would likely advocate for much fuller disclosure, simpler financial instruments, higher capital requirements, much lower leverage limits, and disallowing people from betting on others' impending disasters. Legislative and administrative reform measures will have to be developed carefully so as to avoid being either unduly regulatory restrictive or unduly lax. The next couple of months (years? decades?) will prove instructive. [Note: Need to look further to see who has advocated what re: "simpler financial instruments" (terms used by Rick Bookstaber in A Demon of our own Design)]

In the meantime we could do worse than to ponder Joseph Stiglitz's Capitalist Fools, and think of the roles played by various actors in building the mess we now find ourselves in.

American Oligarchs and their Minions, take 2

Last Friday, Bill Moyers sat down for an hour with Simon Johnson and James Kwak (authors of The Baseline Scenario and 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown.) Watch it in two parts here. The topic of the day was (and will continue to be for the next month or so) financial regulation in the wake of financial meltdown. Among other arguments, Johnson and Kwak make the case for breaking up America's big banks  financial oligarchy. They, with Bill Moyers ever-thoughtful-guidance, help us better understand the the deeds, misdeeds, and too-often blind ideological missteps that brought us to the edge of the abyss, and that keep us in bondage to those who ought have been more concerned with our collective progress than with lining their own pockets with gold.

I continue to be somewhat agnostic on setting up a "size rule" for large financial institutions, but Johnson and Kwak have me leaning in their direction right now.  Here is a snip (from the transcript) arguing for breaking up the big banks:

SIMON JOHNSON: . . . [I say] to all my Republican friends: on Fannie Mae and Freddie Mac, you were right. They became too big to fail. They captured Congress. They were known as some of the most formidable financial lobbyists in the 1990s. They argued for the rights to take on these kinds of risks, okay?

And the Republicans were right. The Republicans called them on this. But now it's the big private banks that have the same incentive structure. That have bulked themselves up so big that you can't let them fail. That's what we saw in September 2008. Hank Paulson looked at his options. And they are all pretty awful. And I'm not a big fan of Hank Paulson, but I think the moment where he looked at it, he was right. That if you let JPMorgan Chase or Goldman Sachs fail, the consequences would have been devastating, because they're so big. It's a Fannie May and Freddie Mac structure come to Wall Street, come to the top guys on Wall Street. And our Republican colleagues and friends should recognize this, they should acknowledge it. And then we can all fix this together.

I also found this commentary on the hedge fund "Magnetar" particularly interesting. It foreshadows what may yet be revealed about many others in the financial industry:

JAMES KWAK: Magnetar is a hedge fund which means that other people gave them money to invest. And their job is to make as much money as possible. And these were the smart guys in the room. They saw that the system was broken. And they found a specific way to exploit it. And they knew that they could go for example, they could go to Wall Street banks and the banks would collaborate in making these extremely toxic securities. Because they knew what the bankers incentives were. They knew that the banker's incentives were to do the deal, to do the transaction, to get the fees up front. And they knew that there was nobody watching out for the investors. There was nobody watching out to make sure that securities they manufactured were actually good securities. But essentially what they were doing is they wanted to short the housing market. And they shorted the market in such a way that they actually made the problem worse, because what they did is they encouraged they tried to create these very toxic securities explicitly so that they could then short those securities. And that's why in a sense, they were they were shorting the American Dream. But what the real story of Magnetar, I think, is that they were exploiting a system that was deeply broken.

So, we like to think that the financial system we have in Wall Street are set up so that as people try to make lots of money they are they are indirectly helping the economy by making sure their capital goes where it's needed most. What the Magnetar story shows us that this is a casino, where you can make money you can make money exploiting the weaknesses in the casino. And it has nothing to do with the American Dream. It has nothing to do with making sure that capital goes to the places where it's needed most.

 Watch the rest of the story. I'll try to update this post as (or if) I see others commenting on on the Moyers, Johnson, Kwak tale.  American Oligarchs and their Minions, "Take One" is here.

Power Corrupts: Goldman Sachs, US Congress

The old saying, "Power tends to corrupt, and absolute power corrupts absolutely," rings true once more as we see ever-more-clearly what Goldman Sachs has been up to recently, whether it be the Greece mess or their center-stage presence in the US financial implosion, with the latest chapter being Friday's SEC charge of fraud. Who among us doubts that Goldman Sachs is too powerful.

But the old saying also rings true as we ponder why it was that the US Congress in the run-up to our current financial mess, with the blessings of the Clinton Administration, allowed firms to bet on impending tragedies of others without adequately weighing the consequences that such behaviors might have on financial markets. Here is what Lynn Stout had to say Friday in the NY Times "Room for Debate Blog" about the the US Congress and their lack of foresight in marking up The Commodities Futures Modernization Act of 2000:

In one dramatic move, [the Commodities Futures Modernization Act] eliminated a longstanding legal rule that deemed derivatives bets made outside regulated exchanges to be legally enforceable only if one of the parties to the bet was hedging against a pre-existing risk.

This traditional derivatives rule against purely speculative derivatives trading has a parallel in insurance law, because insurance, like derivatives trading, is really just a form of betting. A homeowner’s fire insurance policy, for example, is a bet with an insurance company that your house will burn down.

Under the rules of insurance law, you can only buy fire insurance on a house if you actually own the house in question. Similarly, under the traditional legal rules regulating derivatives trading ….

By eliminating this centuries-old rule in the name of “modernization,” Congress created enormous problems of moral hazard in the off-exchange derivatives market. Imagine, for example, if we allow the unscrupulous to buy fire insurance on other people’s houses; the incidence of arson would rise dramatically.

The US Congress may not be too powerful, or maybe it is, but all we have to do is to ponder their approval ratings to wonder whether we Americans are being well-served by our Congress. On the other hand there were very few who were ready to "take to streets" to protest the Commodities Futures Modernization Act when it passed in 2000. Too bad Brooksley Born didn't fare better when she tried to challenge the likes of Alan Greenspan, Larry Summers, and Robert Rubin back in 1998.

Oh well.  At least Born is now a part of the Financial Crisis Inquiry Commission and we all get to watch the ongoing show between now and Memorial Day (end of May) as the US Congress gets down to the business of righting the wrong that it gave us with financial deregulation and the Commodities Futures Modernization Act.

Financial Regulatory Reforms: Neither easy nor politically palatable

Months ago I promised to keep tabs on financial regulatory reform measures. Well, I've tried but it is not easy — and I've been distracted (and generally depressed by American US culture and politics).  Today I begin anew, and renew my promise by referring readers via "snips" to two of my favorite bloggers. Steve Randy Waldman explains why financial reform efforts are not going to be easy, and The Epicurean Dealmaker reiterates and expands his proposal for reform. To Waldman, Capital Can't Be Measured (4/3/2010):

Simon Johnson and James Kwak are absolutely right. Sure, "hard" capital and solvency constraints for big banks are better than mealy-mouthed technocratic flexibility. But absent much deeper reforms, totemic leverage restrictions will not meaningfully constrain bank behavior. Bank capital cannot be measured. Think about that until you really get it. Large complex financial institutions report leverage ratios and "tier one" capital and all kinds of aromatic stuff. But those numbers are meaningless. For any "large complex financial institution" levered at the House-proposed limit of 15×, a reasonable confidence interval surrounding its estimate of bank capital would be greater than 100% of the reported value. In English, we cannot distinguish "well capitalized" from insolvent banks, even in good times, and regardless of their formal statements.

Lehman is a case-in-point. On September 10, 2008, Lehman reported 11% "tier one" capital and very conservative "net leverage". On September 25, 2008, Lehman declared bankruptcy. Despite reported shareholder's equity of $28.4B just prior to the bankruptcy, the net worth of the holding company in liquidation is estimated to be anywhere from negative $20B to $130B, implying a swing in value of between $50B and $160B. That is shocking. For an industrial firm, one expects liquidation value to be much less than "going concern" value, because fixed capital intended for a particular production process cannot easily be repurposed and has to be taken apart and sold for scrap. But the assets of a financial holding company are business units and financial positions, which can be sold if they are have value. Yes, liquidation hits intangible "franchise" value and reputation, but those assets are mostly excluded from bank balance sheets, and they are certainly excluded from "tier one" capital calculations. The orderly liquidation of a well-capitalized financial holding company ought to yield something close to tangible net worth, which for Lehman would have been about $24B.

So Lehman misreported its net worth, right? Not according to the law. . . .

So, for large complex financials, capital cannot be measured precisely enough to distinguish conservatively solvent from insolvent banks, and capital positions are always optimistically padded. Given these facts, and I think they are facts, even "hard" capital and leverage restraints are unlikely to prevent misbehavior. Can anything be done about this? Are we doomed to some post-modern quantum mechanical nightmare wherein "Schrodinger's Banks" are simultaneously alive and dead until some politically-shaped "measurement" by a regulator forces a collapse of the superposition of states into hunky-doriness?

Yes, we are doomed, unless and until we simplify the structure of the banks. When I say stuff like "confidence intervals surrounding measures of bank capital are greater than 100%, what does that even mean? Capital does not exist in the world. It is not accessible to the senses. When we claim a bank or any other firm has so much "capital" we are modeling its assets and liabilities and contingent positions and coming up with a number. Unfortunately, there is not one uniquely "true" model of bank capital. Even hewing to GAAP and all regulatory requirements, thousands of estimates and arbitrary choices must be made to compute the capital position of a modern bank. There is a broad, multidimensional "space" of defensible models by which capital might be computed. When we "measure" capital, we select a model and then compute. If we were to randomly select among potential models (even weighted by regulatory acceptability, so that a compliant model is much more likely than an iffy one), we would generate a probability distribution of capital values. That distribution would be very broad, so that for large, complex banks negative values would be moderately probable, as would the highly positive values that actually get reported. If we want to make capital measurable in any practical sense, we have to dramatically narrow the range of models, so that all compliant models produce values tightly clumped around the number we'll call capital. But every customized derivative, nontraded asset, or unusual liability in a bank's capital structure requires modeling. The interaction between a bank holding company and its subsidiaries requires multiple modeling choices, especially when those subsidiaries have crossholdings. A wide variety of contingent liabilities — of holding companies directly, of subsidiaries, of affiliated or spun-off entities like SIVs and securitizations — all require modeling choices. Given the heterogeneity of real-world arrangements, no "one-size-fits-all" model can be legislated or regulated to ensure a consistent capital measure. We cannot have both free-form, "innovative" banks and meaningful measures of regulatory capital. If we want to base a regulatory scheme on formal capital measures, we'll need to circumscribe the structure and composition of banks so that they can only carry positions and relationships for which we have standard regulatory models. "Banks’ internal risk models" or "internal valuations of Level 3 assets" don't cut it. They are gateways to regulatory postmodernism.

Regulation by formal capital has a proud and reasonably successful history, but has been rendered obsolete by the complexity of modern financial institutions. The assets and liabilities of a traditional commercial bank had straightforward, widely acceptable book values. For the corner bank, discretionary modeling mattered only in setting credit loss reserves, and the range of estimates that bank officers, external auditors, and regulators would produce for those reserves was usually pretty narrow (except when all three colluded to fake and forbear in a general crisis). But model complexity overwhelms and destroys regulatory capital as a useful measure for large complex financial institutions. We need either to resimplify banks to make them amenable to the traditional approach, or come up with other approaches more capable of reigning in the brave new world of banking.

So what is to be done? The Epicurean Dealmaker gives us fleeting hope in Poachers Turned Gamekeepers (3/16/2010), but there may be a political flaw in his reasoning. The problem is that the proposed solution requires very highly paid, highly skilled, 'seasoned' regulators. That may not fly in the US where we expect our "civil servants" to be moderately paid as per the usual GS pay-scale or even the moderately higher Senior Executive Service pay-scale. Still, his ideas of general regulatory rules that allow for regulatory discretion (by competent government regulators) seems much better than overly complex government legislative and/or administrative "rules". I wish that the highly debated healthcare reform could have been effected that way.  To the "dealmaker":

. . . [I]nspired by readings among several of the more rational and composed voices in said bloggy peanut gallery, including David Merkel, Mike Konczal, and Felix Salmon. . . .

Like Felix, I agree with David that "dumb regulation"—or, in less pejorative language, simple and relatively inflexible regulation—is far more likely to do the trick than the kind of complex, encyclopedic, tick-all-the-boxes regulation exemplified by the bloated pig currently wending its way through the legislative python in Congress. But I also agree with Felix (and, so it would seem, with David) that simple regulation will only work if it is overseen, enforced, and modified as necessary by extremely intelligent and motivated regulators.

I have argued in these pages before that delivering regulations which are comprehensive, detailed, and complex only encourages the institutions being regulated to immediately try to engineer their way around them. Simple, broad-brush regulations have a much better chance to operate as a set of principles which are well understood by both regulator and regulatee alike. But having such principles-based regulation is not enough. They must be enforced, as financial collapse in the face of a decidedly principles-based regulatory regime in the United Kingdom amply demonstrated. Not only does this mean, in Felix's example, that regulators must have the authority to make up rules, tests, and procedures on the fly on behalf of preserving systemic stability, they must also have the balls to take that phone call from Dick Fuld. And, moreover, to tell him in no uncertain terms to go fuck himself if he doesn't like it. . . .

[R]egulators [should] get hired from Wall Street banks, big law firms, and elsewhere. An effective wholesale financial regulator ¹ should be comprised of forensic accountants, corporate and securities lawyers, investment bankers, derivative structurers, and the like. They should all be paid market rates for their services, which will make their compensation much, much closer to that of the people they regulate. They should be prohibited from accepting positions in private financial industry—and, most especially, at any individual firm they ever directly or indirectly regulated—or firms working for financial firms (law firms, accountancies, etc.) for a minimum of at least three years after they leave government service. Five would be preferable.

While individually expensive, I don't believe you would need to hire many such people to make this kind of regulatory regime work. Given that you really only need high-powered regulators for the very biggest institutions, I am guessing you could get away with fewer than 100 to start. In fact, it might be less, because you really only need these people to direct and train their junior staff, and to interface directly with senior executives of the regulated entities. Fully loaded, I imagine you could fund a financial regulatory SWAT team like this for less than $150 million per year. That's a drop in the bucket compared to the financial losses these supposedly regulated institutions have already inflicted on the American taxpayer, not to mention in comparison with the normal run rate of your average stodgy, inefficient, and ineffective government bureaucracy.² Even better, you could fund such an agency with a levy indexed to the size of each financial institution under its jurisdiction. The larger and more complex a bank, the more fire-breathing, table-throwing, nail-spitting investment bankers and lawyers you could afford to throw at it. Talk about an incentive to shrink your balance sheet.

* * *No plan is without its drawbacks, however, and I knew I could rely on my intelligent and well-meaning interlocutors on Twitter to supply some. Among the more cogent of these, Graeme Hein noted that "Smart regulators can always make more money in [the] private sector." This has always been true, and always will be so, but my plan could be structured to minimize this defect. For one thing, you do not need "the best" investment bankers, traders, or lawyers—whatever that's supposed to mean—on the regulatory case. All you really need is good ones, and there are plenty of those. A certain doggedness, and a commitment to preserve systemic stability and enforce rules and regulations regardless of the wealth, prestige, or lung power of their charges would be necessary as well. Remember, you are not looking for the best traders, or the best M&A advisors, or the best derivatives structurers out there; you are looking for people who can understand what those people do and who can stand up to their counterparts across the negotiating table.³

For another, while pay should be very attractive, and likely many multiples of current front-line regulators' salaries, it does not need to equal that of industry practitioners. It can be paid 100% in cash, which dramatically shrinks the gap with nominally much bigger pay packets stuffed to the gills with unvested, restricted funny money. It can also be far less volatile than industry pay, since it should not depend on the vagaries of market performance the way real investment bankers do. Add to that the psychic compensation from working at a powerful, elite organization which generates fear and respect among its regulatees, and you will have a potent package. You might just be surprised how many top flight industry professionals apply for the job.

Now some people might object to the prospect of a federal agency staffed with lots of employees pulling down half a million dollars or more a year, as loadeddice observed. But the answer here is simple: for socially critical functions, money has never been an object when it comes to government spending. Just look at the military. By the same token, I would find it very easy to argue that the cost of a several dozen government employees earning more than the President of the United States is a very reasonable price to pay for financial and economic security. Unlike the military, however, you don't need to spend millions or billions on hardware to do the job. Instead, you spend millions on the software walking around in wingtips and Gucci loafers.

The most frequent objection among those who deigned to comment, however, was simply that—regardless of the attractiveness of my proposal—such a radical change "would never happen." Perhaps these naysayers are right. It certainly would ruffle a lot of feathers, both in the finance industry itself and in Washington, D.C. But I tend to think that is a good thing, and a reliable indicator of the value and importance of the plan, rather than a defect.

At the end of the day, I do believe most Americans actually prefer their government bureaucrats to be slow, bumbling, and ineffective. It reassures them they can stay one step ahead of City Hall, which, as we all know, you ordinarily should not try to fight. Smart, aggressive, and committed government employees terrify most people, because they have so many natural advantages without such personal qualities. The only solution to this, of course, is constant oversight, which is a sine qua non of my proposal.

¹ "Wholesale" means big commercial, investment, and universal banks, and any other systemically important financial entity. As opposed to retail oriented firms, which should be regulated by the CFPA or whatever bastardized, emasculated entity the political meat grinder decides to come up with. My focus here is on institutions which can bring the system down, not on the ones trying to screw Grandma out of her last $50,000.
² Even less in comparison to the tens of billions of dollars in compensation the systemically important financial institutions pay their own employees. A pittance, I tell you.
³ Sadly, given the revelations coming out of the Lehman examiner's report and other sources, this may actually be a very low bar. Perhaps we need regulators who are better than the "best" investment bankers.

Time to rethink 'Smoot-Hawley Myths'?

Today I found this from Ambrose-Evans Prichard, Telegraph:

The long-simmering clash between the world's two great powers is coming to a head, with dangerous implications for the international system. China has succumbed to hubris. It has mistaken the soft diplomacy of Barack Obama for weakness, mistaken the US credit crisis for decline, and mistaken its own mercantilist bubble for ascendancy. There are echoes of Anglo-German spats before the First World War, when Wilhelmine Berlin so badly misjudged the strategic balance of power and over-played its hand.

Within a month the US Treasury must rule whether China is a "currency manipulator", triggering sanctions under US law. This has been finessed before, but we are in a new world now with America's U6 unemployment at 16.8pc.

"It's going to be really hard for them yet again to fudge on the obvious fact that China is manipulating. Without a credible threat, we're not going to get anywhere," said Paul Krugman, this year's Nobel economist. …

I let others discuss the rights and wrongs of this, itself a response to the US report card on China. Clearly, Beijing is in denial about is own part in the global imbalances behind the credit crisis, specifically by running structural trade surpluses, and driving down long rates through dollar and euro bond purchases. No doubt the West has made a hash of things, but the Chinese view of events is twisted to the point of delusional. …

We have talked ourselves into believing that China is already a hyper-power. It may become one: it is not one yet. China is ringed by states - Japan, Korea, Vietnam, India - that are American allies when push comes to shove. It faces a prickly Russia on its 4,000km border, where Chinese migrants are itching for Lebensraum across the Amur. Emerging Asia, Brazil, Egypt and Europe are all irked by China's yuan-rigged export dumping.

Michael Pettis from Beijing University argues that China's reserves of $2.4 trillion - arguably $3 trillion - are a sign of weakness, not strength. Only twice before in modern history has a country amassed such a stash equal to 5pc-6pc of global GDP: the US in the 1920s, and Japan in the 1980s. Each time preceeded depression. …

Contrary to myth, the slide to protectionism after the 1930 Smoot-Hawley Tariff Act did not cause the Depression. Trade contracted more slowly in the 1930s than this time. The Smoot-Hawley lesson is that tariffs have asymmetrical effects. They devastate surplus countries: then America. Deficit Britain did well by retreating into Imperial Preference. …

I have recently thought that both the irony and the tragedy of The Smoot-Hawley Tarriff Act of 1930 (Wikipedia) was that the US imposed the tariff at precisely the wrong moment in history—the US then being a "surplus country". Perhaps now is the right time. Or perhaps some diplomacy in advance of a trade war will prove a better approach going forward. That way world leaders can talk through all the tough economic issues, including trade flow, capital controls, and finance channeling (i.e. whether or not to reinstate some sort of 21st Century Glass-Steagall (Wikipedia), country by country or worldwide). It will prove interesting to see what the blogosphere makes of Prichard's thesis.

Related (Smoot-Hawley):
Is Smoot-Hawley Coming Back? Michael Pettis, Seeking Alpha, Nov. 2008
China's Smoot-Hawley, Yves Smith, Naked Capitalism, Nov. 2008
Smoot-Hawley Fiction, Bob Powell, Feb. 2009
US-China Trade Relations—The Next Dispute?, Michael Pettis, Feb. 2010
Greg Mankiw says NO!, March 2010, and points to a NY Times column from a year ago: It's No Time for Protectionsim, February, 2009. Mankiw's point is, in part, that China's currency had already appreciated 21% by early 2009.
{Update}:Joesph Stiglitz says No! in It's No Time for a Trade War, Project Syndicate, April, 6, 2010

Related (Capital Controls):
The End of an Era in Finance, Dani Rodrik, Project Syndicate, March 2010

Chartalist Sense and Nonsense

I have been struggling with economics and economists for many years—I'm a slow learner. Recently I have been trying to figure out neo-chartalists and neo-monetarists, and watching their interchanges on the blogs. [Note: I need to quit using "neo"]

Today I want to focus on the Chartalists (Wikipedia). I want to lay out what I believe to be sense from their writings and what I believe to be nonsense. The nonsense, if it is indeed nonsense, stems from where Chartalist reasoning departs from Garrett Hardin's first law of ecology, paraphrasing: "You can never do just one thing." Hardin's law ought to have guided the US Federal Reserve's failed attempts to control the money supply and later interest rates. But it didn't, as we are painfully learning, living through the worst contraction since the Great Depression.

To compliment Hardin's First Law we need to add two more from Barry Commoner: First, "Everything depends on everything." It comes with a corollary, "Every thing comes from something." Second, "There is no such thing as a free lunch." Again with a corollary, "Everything must go somewhere." Now we need to see how things work in our world.

I suspect that Chartalists will correct me on my allegations of nonsense, and tell me that they are not guilty of falling into the narrow-focus trap that other economists fall into—that they don't violate laws of ecology. But I remain puzzled. Sometimes, at least, they sound like they do. First let's note what the Chartalists get right.

Chartalist Sense

Chartalists provide an accurate picture of how money and credit operate in banking. As such they can — and we can too, following their accounting — easily point out silliness, even danger in trying to "balance the budget" by, say, cutting government spending. All that single move will do is to drive private saving further into the red. Again, "You can never do just one thing." Now, let's see what Chartalists get wrong.

Chartalist Nonsense (or not?)

I have been trying to wrap my mind around government "deficits" and "debt" for some time, (e.g., here). I remember my anger when Dick Cheney said "deficits don't matter. Now it seems there are more and more economists who at least pretend that deficits are a positive good. See posts from, e.g. Jamie Galbraith, Marshall Auerback, Randall Wray, among others. These are economists who I follow, so I'm struggling to better understand how they could come to conclusions that seem untenable.

My guess is that most Chartalists agree with me (maybe they don't?) that there is only so much "papering over problems" that is acceptable in a society, and to other societies that any society is indebted to. Internally, people will only accept so much inflation; externally, too much debt and/or too much debt evasion via inflation (or devaluation) will also be met with hostility. But Chartalist writings — particularly their popular writings — lead to the opposite conclusion that "deficits are always good." This certainly can't be the case, as Heilbroner and Bernstein so aptly demonstrate in The Debt and the Deficit.

As I understand it, if a government seeks to expand its monetary base under what is commonly called Modern Monetary Theory (MMT) (via Bill Mitchell,YouTube video) there is a likelihood of expanding future job production. I get that. But we must pay attention to the word "likelihood." Assuming that new jobs actually happen and are beyond "subsistence level", expanding future job production provides a bigger base from which to extract taxes to pay for government services and government debt. Such is the nature of growth economics for countries that have their own currency. But problems arise when jobs are being destroyed in epoch numbers via Schumpeter's Creative Destruction (Wikipedia) and are not being replaced with similar quality jobs, and when jobs are sent to other countries too rapidly.

There are also problems when finance gets too far out in front of the so-called real economy. George Ackerlof and Paul Romer call it looting. As does Joseph Stiglitz. So does Michael Hudson, and so do the Chartalists.

Financialization-of-Everything

The US has recently played hegemon on the world financial stage and has presided over a world of financial bubbles. US-led financialization-of-everything allowed money to flow to wherever speculators felt they could inflate the next bubble make a quick buck. All in the name of efficiency. There were no, or at least not enough productive distribution channels for the liquidity that the US was providing (as a base) to the world's money markets. So being good bad "capitalists," CEOs and top traders kited markets and took the booty. Many economists and politicians were cheer-leading this as a new era of globalization, a new-found economic miracle. As we are now learning, however, it was neither. And now we are in the middle of a credit bust, with a major-league private debt hangover.

A big problem was that the "new world order" was achieved by destroying high paying jobs in the developed world. This may have been inevitable. But a question lingers as to whether or not it might have happened rather slowly, rather than all at once. I'm inclined to believe that given world and US psychology/politics it had to happen as a crisis. The question that lingers is,"What next?"

I'm going to give second-to-last words to Heilbroner, as a challenge to Chartalists in terms of better "framing" (Wikipedia) for their arguments that I call nonsense above:

Public investment creates public debt, exactly as private investment normally creates private debt. One hears much these days about the "burden" this public debt will impose on our children. We hear less about the consequence of removing that burden by retiring our debt. Retiring debt means that there will exist fewer and fewer government bonds, which are our debt. When there is no longer any debt, there will no longer exist any securities backed by the full financial capability of government. In what bonds will our children then invest the Social Security retirement trust? What will their banks, or businesses, or they themselves use as giltedged securities? Zero public debt would not be a blessing; it would be an unmitigated catastrophe

I get the last words, and they are simply these: I am trying to learn what I can from economists, ecologists and more—in recent days particularly from Chartalists. I apologize in advance for errors I make in the process of "writing to learn."

Can Chartalism Get a Fair Hearing?

L. Randall Wray has been a long-time critic of orthodox monetary economics and US economic policy. Recently he continued his crusade in a paper titled Alternative Approaches to Money [pdf], Theoretical Inquires into Law (11:1), January 2010. Wray is among many Chartalists (Wikipedia) who are active both in published forums and blogs.

Given the state of the world's finances, it seems to me that Chartalist thinking needs to be given a fair hearing — at least an open-forum rebuttal — by "orthodox" economists in academia and government. To date, as Wray notes in the paper, Chartalist thinking has not been given such a hearing.

A fair appraisal of orthodox v. Chartalist thought is especially important since we are into three decades of failed economic policy in the US. A first mistake, according to Wray and others was to base economic reasoning on notions of efficiency and equilibrium, when in fact our financial systems are complex, adaptive systems that are better thought of as "far from equilibruim", at least at some important phase shifts. A second mistake, was to attempt to control complex financial systems via US monetary policy. When money supply control via "monetary targets" failed, the US Fed switched to interest rate targeting. That too failed, Wray claims. Now we are faced with PIIGS that don't fly — at least their currencies don't — and at least five US states that are threatening default. What better time for orthodox economists, along with government policy-makers to think outside the box?

To Wray:

By the end of the 1980s, orthodox policy was also in disarray, as central banks were unable to control the money supply, while money was not closely linked to nominal GDP or to inflation. Furthermore, to many observers it seemed that money matters, in the sense that monetary policy affects unemployment and growth in predictable — even if moderate — ways. Without monetary rules to guide them, central banks cast about for alternatives, including gold prices, real or nominal interest rates, inflation rates, or exchange rates. The overriding belief was that monetary policy somehow is responsible for maintaining the value of money. The trick was to find the right policy rule to maintain a stable value for money.

During the 1990s, orthodoxy developed a "New Monetary Consensus" (NMC) in regard to theory and policy. There are several versions, but all reject monetary targets in favor of interest rate targets. Policy consists of adjusting the overnight interest rate in response to deviations of inflation and output growth from desired performance. Unlike 1960s Keynesianism, fiscal policy plays a small role, while monetary policy controls demand and hence growth. When the economy grows too fast, fueling inflation, the central bank dampens demand by raising interest rates; when it grows too slowly (causing unemployment and deflation), the central bank lowers rates to stimulate demand.

Private banks and financial markets accommodate, following the central bank's lead. The NMC encourages central bank transparency because effective monetary policy requires the cooperation of financial markets; this, in turn, requires consistency of expectations so that central bank intentions can be quickly incorporated in expectations and thus in market behavior, making policy more effective. Further, policy changes are implemented gradually to avoid disruptive surprises that generate instability. In this way, the central bank slows growth and inflation through a limited series of small interest rate hikes — avoiding the problems created in the early 1980s when the Fed raised rates above twenty percent to fight inflation, precipitating the U.S. thrift crisis and developing country debt crises.

The combination of the NMC and the Efficient Markets Hypothesis had a synergistic effect from the mid-1990s until the current global financial crisis. Greenspan was acclaimed as the world's greatest central banker ever. After discovering the NMC as a pragmatic response to the demise of Friedmanian monetarism, he sought to manage expectations to control real world outcomes by building credibility as an inflation-fighting free market proponent. With inflation expectations checked, robust growth became possible without a Phillips Curve tradeoff; growth in turn was promoted through deregulation and reduced government oversight. When self-interested pursuit of profits threatened financial and economic stability, the Fed quickly intervened with the "Greenspan put" — lowering interest rates and arranging a resolution. His replacement, Ben Bernanke, proclaimed the era of "the great moderation": economic stability and better economic policy (at the hands of the central bankers) lowered risks. Innovators further reduced risks by creating financial instruments to hedge and diversify, and to allocate risk to those best able to bear it. Highly complex quantitative models assessed risk so that opaque instruments could be rated. These models, in turn, relied on theoretical advances derived from the efficient markets hypothesis.

It is difficult to convey how much doubt has been thrown on the entire corpus of orthodox theory by the current global crisis. Events rated by models as 25 standard deviation possibilities (once in 100,000 years) have become common. It seems that debt does matter, after all — it is not a good substitute for equity or income — as do leverage and liquidity ratios.

Monetary (interest rate) policy is impotent, although money does appear to be important in the sense that the whole crisis began with deflating nominal values of assets and debts — which generated a run into the most liquid assets. In short, it is hard to see the crisis as an "equilibrium" outcome (Real Business Cycle), as a suboptimal position that resulted from sticky wages or prices (New Keynesian), or as a result of excessive government regulation. Markets never took seriously attempts by Treasury Secretary Paulson or Chairman Bernanke to downplay problems — each new policy announced to deal with the crisis only led to another round of catastrophic collapses. Those outside the discipline legitimately wonder whether economic "science" has advanced at all since the 1930s.

Perhaps it has not. It could be argued that the direction taken by orthodoxy with respect to money was entirely wrong. There was already a viable alternative (with an already long tradition) that was virtually ignored by postwar economists. … [footnotes omitted here]

So is it time yet to get a full airing of Chartalist thinking? And while we are at it, ought we not shed more daylight on the fact that our economic systems, especially our money/credit systems are complex, adaptive systems and ought to be modeled as such.

For those not familiar with Chartalist thinking, I recommend that readers begin with Rogue Economist's Questions About Chartalism and/or Responses to my questions About Chartalism. Decline and Fall of Western Civilization's The Tail Risk to the United States in the GFC is worth a look too.

For even more, see New Economic Perspectives from Kansas City … and beyond.

Necessary Evils: Government, Markets

Around 1980 I went to work for the US federal government, the US Forest Service to be specific. I was then a libertarian economist (Austrian School). Many people I knew were puzzled as to why I chose the Forest Service over private industry. The answer was simple and personal: I believed then that the financial collapse that happened in 2007 (or 2001 depending on perspective) was imminent. I also believed that the government might be a better safe-haven than private industry during a financial hurricane. And I loved the public lands, which was a chink in my libertarian armor.

During my early years in the Forest Service I adjusted my ideology, drifting left. I was never a fan of government bureaucracy, but I came to view government as a necessary evil. Despite being embedded within bureaucracy I continued (and continue now in retirement) to rail against bureaucratic bungling (e.g. here, here, here).

After thirty years studying markets and market mechanisms, I believe that capitalism (Wiki link) too is a necessary evil, at least for the foreseeable future. Capitalism is necessary because it is the best way to deliver the type and amount of "goods" people desire. It is evil because it is "cruel, unjust, and turbulent", as noted long ago by Joan Robinson. My dream is that someday (distant "Star Treck" future) we will be able to transcend capitalism, but that is only a dream. We would at minimum, have to find a means (read "incentives") to unleash the creative innovations that market mechanisms now unleash, and to transfer effective "price signals" and other signals that market mechanism now transfer when markets function effectively.

I also believe both government and markets to be necessary and good. That is, when functioning well they both serve necessary functions in society.

But both government and capitalism tend toward abuses of power, sometimes intertwined, that lead to evil. This is particularly true when we fail to recognize this tendency. Crony capitalism (Wiki link) is only one of these. Our challenge is to find means to thwart evil tendencies in both government and capitalism, and to find means to enhance the good in each — in both. Our challenge it to quit thinking "either, or" and start to face the reality of "both, and".

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

Rediscovering Values

On Doug Fabrizio's "Radio West" this morning (Podcast here), Jim Wallis talked us through his new book, Rediscovering Values. The book and the podcast is about what is wrong with our American value system and how to begin to "find a way out". Seems we have, once again, bowed down to a god of our own making. This time it is 'The Market', run by unbridled selfishness and greed.

Wallis (Wikipedia link), a theologian and activist, asks this important question, "What do you do when the invisible hand lets go of the common good?"

Referring to our recession/depression Wallis points out that most people ask "When will the crisis be over?" Wallis notes that this is the wrong question. Instead we ought to be asking "How will the crisis change us?"

Wallis says that we now act on these values: "Greed is good. It's all about me. I want it now."  Wallis notes that "Wealth doesn't trickle down, but bad values do." Instead of the values that seem to drive our society/economy, Wallis argues that we ought to be acting on "new old virtues": "Enough is enough. We are in this together.  … [And the] Native American indigenous peoples' ethic that you evaluate decisions today by their impact on the seventh generation out."

Instead of "keeping up with the Joneses", Wallis suggests why not "Let's check with the Joneses, and see if they are OK." Wallis is no anti-market zealot, rather he wants to see markets relegated to their proper place in society.

Pointing to one indicator of our values crisis Wallis asks rhetorically, Does anyone think it is a good idea when CEO pay goes from 30 times average workers' salary to 415 times? This happened in just 30 years. How does this single notion erode the values of a culture? Wallis has much more.

Wallis ends with something I too pitched long ago, Gandhi's Seven Deadly Sins:

• Wealth without work.
• Pleasure without conscience.
• Knowledge without character.
• Commerce without morality.
• Science without humanity.
• Worship without sacrifice.
• Politics without principles.

We are there! Where do we go from here? One more book to add to my long list of yet-to-read: Rediscovering Values: On Wall Street, Main Street, and Your Street, by Jim Wallis.