Economic Dreams - Economic Nightmares

Vampire's Lair or Plato's Cave?

I've spend a bunch of time on this blog trying to understand who played what roles in both the run up to, and the meltdown of the recent financial bubble. But I've not, until now covered Matt Taibbi's exposés, or "screeds" as some call them. [Note: I got 179,000 Google hits on "Matt Taibbi"+screed] Taibbi's, The Great American Bubble Machine, Rolling Stone (07/09/2009), libeled Goldman Sachs as a "great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money."

Ultimately in the court of public opinion, if not in the legal system, we have to come to grips with who among Wall Street players might have been playing the role of bloodmoney-sucking vampires, aided and/or least cheer-led by politicians, regulators, rating agencies, and the media.

However, since it proves too easy to charge others with crimes (or even moral turpitude), we need to introduce a notion that Gillian Tett talked about in Fool's Gold: that many were blind to realities that others readily saw. Some were blinded by their own institutions and subcultures. Some were simply blinded by greed and venality. All were (some still are) among those dwelling in modern-day versions of Plato's Cave (Wikipedia). To these we have to give a pass — I suppose — although we (and they) have lessons to learn about why we need whistleblowers, and why we all need to take responsibility to speak up when we think things seem not right.

In a recent update to his story, Why Isn't Wall Street in Jail?, Rolling Stone (3/3/2011), Taibbi leaves little doubt that a whole bunch of Wall Street players ought to be in jail for their roles in the meltdown of 2007-2009. See also Taibbi's recent interview with Amy Goodman at Democracy Now.

I don't disagree that many ought to be in jail. But "ought to" is easier than "will be." Too many laws (financial regulation, usury, etc.) were relaxed over the last decade or two, and too many people played too many games on both sides of the political aisle as well as on both sides of the regulatory game to make it easy to sort out bad-enough deeds — vampire deeds — to land very many people in jail.

No matter which court (public opinion or legal) we work with, how are we to decide whether folks were knowingly committing fraud? As noted earlier, the media and politicians too were seldom found on the peoples' side of the issue. Regulators and ratings agencies were either hoodwinked or captured. Those few who dared speak up lost their heads, figuratively speaking. Maybe instead we ought to handsomely reward whistleblowers.

Finally, how are we to determine deeds deemed bad enough to constitute fraud, when we know that both organizations and culture trap people into ideological and methodological traps from which few can escape. People become chained as prisoners, and blinded by circumstance in Plato's Cave, as Gillian Tett notes in the epilogue to Fool's Gold (2009):

[T]he financial world's lack of interest in wider social matters cuts to the very heart of what has gone wrong. What social anthropology teaches its adherents is that nothing in society ever exists in a vacuum or in isolation. Holistic analysis that tries to link different parts of a social structure is crucial, be that in respect to wedding rituals or trading floors. Anthropology also instills a sense of skepticism about official rhetoric. In most societies, elites try to maintain their power not simply by garnering wealth, but also by dominating the mainstream ideologies, in terms of both what is said and what is not discussed. Social "silences" serve to maintain power structures, in ways that participants often barely understand themselves let alone plan.

… In recent years, regulators, bankers, politicians, investors, and journalists have all failed to employ truly holistic thought—to our collective cost. Bankers have treated their mathematical models as if they were an infallible guide to the future, failing to see that they were based on a ridiculously limited set of data. A "silo" mentality has come to rule inside banks, leaving different departments competing for resources, with shockingly little wider vision or oversight. The regulators who were supposed to oversee the banks have mirrored that silo pattern, too, in their own fragmented practices. Most pernicious of all, financiers have come to regard banking as a silo in its own right, detached from the rest of society. They have become like the inhabitants of Plato's cave, who could see shadows of outside reality flickering on the walls but rarely encountered that reality themselves. The chain that linked a synthetic CDO [Collatorized Debt Obligation] of ABS [Asset Backed Securities], say, with a "real" person was so convoluted, it was almost impossible for anybody to fit it into a single cognitive map—be they anthropologist, economist, or credit whiz.

Yet the only thing that is more remarkable than this deadly state of affairs was that it went so unnoticed, for so long. [pp.252-3]

Let's leave final words to John Kenneth Galbraith, The Great Crash 1929:

One of the oldest puzzles in politics is who is to regulate the regulators. But an equally baffling problem, which has never received the attention it deserves is who is to make wise those who are required to have wisdom.

Some of those in positions of authority wanted the boom to continue. They were making money out of it, and they may have had an intimation of the personal disaster which awaited them when the boom came to an end. But there were also some who saw, however dimly, that a wild speculation was in progress and that something should be done. For these people, however, every proposal to act raised the same intractable problem. The consequences of successful action seemed almost as terrible as the consequences of inaction, and they could be more horrible for those who took the action.

See also: In Plato's Cave, The Economist, 01/22/2009

[Endnote: By their own admission, neither Taibbi nor Tett got their stories perfectly right. But they came close enough. Their main storylines hold true. And if they don't I suspect I'll hear about it soon.]

Making Sense of Economics

[Updated Mar. 7— Draft: in flux!]

Not too long ago a friend asked how to make sense of economics. After my laughter subsided, I recommended two books by Robert Heilbroner: The Worldly Philosophers:The Lives, Times and Ideas of the Great Economic Thinkers (Wiki Link) and Behind the Veil of Economics: Essays in the Worldly Philosophy (NY Times Books). I said, "Start with these, and then we can talk more." If my friend had been more inclined toward Financial Economics I might have added Peter Bernstein's Against the Gods: The Remarkable Story of Risk (my assessment) to the list.

To effectively make sense of economics one must realize that Economics is both a history of technology and development, and a study of how people in societies provide for their sustenance. Neither of these two studies necessarily relies on money, although in most cultural practice money is near center stage.

Since money is center stage in most economic chatter, it proves useful to better understand both the contributions and the blindspots in the various "schools of thought" that make up what we call economics.

Blind Men and the Elephant

Consider "the blind men and the elephant" metaphor as applied to economists. Austrians (Wiki Link) (and Neo-Austrians) emphasize market mechanisms and market cycles. Unfortunately, they tend to overemphasize the importance of markets and under-emphasize the role of government. At least they are accused of such by other economists. Often there is outright hatred of government (sometimes with the exception of National Defense) apparent in their writing.

Monetarists (Wiki Link, NS Link) focus on the role of the "money supply" on national output and longer-term price trends. Monitarists tend to focus too narrowly on money and its supposed ability to heal all social problems. At least they are accused of such by other economists.

Keynesians (Wiki Link) (and Post-Keynesians, and Chartalist cousins) emphasize the role of government in setting up mediums of exchange (currency, monetary accounting systems, credit systems, taxation, etc.) and in moderating market behavior when things get too wild. Unfortunately, Keynesians seem too often to err on the government side of the cultural power balance between government and markets. And some Keynesians, like there monetrist antagonists are prone to overplay the "money card" when faced with economic problems. At least they are accused of such behaviors by other economists.

Complexity-theory economists (Wiki Link), focus on "complex systems" and the complexity of human interaction that is sometimes framed as "wicked problems". They are accused by other economists of bringing too much information into their frames of reference, thereby disabling predictive capabilities that theories/methods from other schools of thought enable. Complexity theorists, like other economists, are often so caught up in the mathematics of their vision quest that they are accused of methodological blindness.

Behavorial economists (Wiki Link) bring psychology to center stage in talking through behavior of individual and group actors. I was particularly glad to see them emerge — so too complexity theorists —to move economics thought forward.

Information economists (Wiki Link) put information and information transfer at center stage. Some emphasize the importance of "information asymmetry" as power in both markets and government.

Finally Institutional economists (Wiki Link) focus on "institutionalist political economy", affording much space for politics and political theory in the study of economics.

But we can't stop here. These few hints just begin to explain the various schools of economic thought. See also: Heterodox Economics, which includes the "schools" where I spend much of my time.
  [ Notes: The word "hate" as used above is probably too strong. Alternates include: despise, belittle, "can't stand", etc. Also, there are practitioners in all of the economic schools of thought who are much better than the caricatures I present. Still, when I wander through the blogs, I'm struck by how nearly the term "hate" fits. I should mention that there is a strong tendency toward turf protection among economists — many spend much time dishing dirt on other schools of thought, and on prominent economists not from their school. This is understandable, since economics sits just behind much of the power money in the world today.]

Too often economists fail to adequately embed political and psychological reasoning into their arguments. In every case they so fail, their reasoning ought to fall on deaf ears. But it doesn't. Witness the mess we are in today and the impact too-blind economic reasoning — pontificating really — has had. Audiences listen too well to half-blind (or worse) economic reasoning. Such arguments are amplified by the media, and continue to befuddle and enrage. This proves true whether we look to the so-called general public or to the halls of legislative, administrative and judicial governments around the world.

Learning from Economists

Despite the chaos of economics, the nastiness of politics, and the aberrant nature of the human psyche, there is much we can learn from economists. Austrians help us to better understand the creative destruction (Wiki Link), to use Schumpeter's words, of market cycles. They help us understand information theory: the use and transmission of knowledge via market mechanisms. [ What else? both here and in other schools] They also help us to be wary of moral hazard (Wiki Link) . Keynesians help us better understand important roles for automatic stabilizers (Wiki Link when market cycles tend toward "irrational exuberance" and "irrational pessimism". Monetarists help us better understand that if we are going to base a social system around money, we had better damn well understand the plumbing of the system. Institutionalists help us better understand that we had better understand much beyond money when we are dealing with political economy. Behavioralists and information theorists help us better understand that there are bounds on individual and group rationality (Wiki Link). Complexity theorists help us better understand the chaos/order balance of the world we live in — i.e. complex systems — and the added individual and group psychological "systems effects" that are inherent in social system.

Other schools of thought add spice, nuance, and sometimes insight to discussions within any school. And remember that many economists don't fit well within any "school".

Policy makers need to better understand the ideological/methodological roots of economics reasoning. They need to better understand, as do we all, the "frames" that economists use to bound their discussions — frames that sometimes blind those who work and talk within them.

[Need to add something about The Shock Docrtine, The Wrecking Crew, etc. and the havoc that half-blind ideology and power can unleash.]

Short take on MuCulley at the Hyman Minsky Conference

I've been meaning to post up a cut-down version Paul McCulley's recent assessment of our current plight: "Reverse Minsky Moment" interview with Kathryn M. Welling, but haven't yet. So yesterday I was glad to see Floyd Norris do a spot on McCulley's talk at the Hyman Minsky Conference for the NY times, titled Ponzi Squared:

… Minsky argued there were three levels of investment as the cycle progresses. First comes hedging, in which investments are made to reduce risk. Then comes the speculative phase, and finally the Ponzi phase, in which the investment can be justified only by the assumption that prices will keep rising, not by the expected income.

Paul McCulley of Pimco, the big bond manager, gave an interesting speech in which he said the recent subprime mortgage fiasco proceeded to a fourth level — one that he called "Ponzi-squared" — before it collapsed.

At the end, he said, the marginal subprime loan was:

No money down
No documentation of income
Initial below-market teaser interest rate
Negative amortization

That is not a loan, he said. Instead, it amounted to giving the home buyer a call option to buy the house at the current market price, coupled with a put option to sell the house back at that price.

If house prices kept rising, the "buyer" could make the small interest payments to keep the option open, and eventually sell the house. That happened for a time, and led to the conclusion by rating agencies that such borrowers were good risks.

But when prices went down, the "buyer" would suffer no loss if he exercised the put and gave the house to the lender. That is just what happened.

As Paul Simon wrote in 1975, said Mr. McCulley, the strategy became:

Drop off the key, Lee,
And set yourself free.

Here is the written version of McCulley's April 17 talk at the Minsky Conference. Oddly, the "Drop off the Key" remarks are not included, although they are in the longer, Welling-McCulley rendition above. Some tidbits:

… [I]n what I call a "Reverse Minsky Journey" … Ponzi Units evaporate. Then many Speculative Units morph into Ponzi Units and are shot. Surviving Speculative Units are only those with explicit liquidity support from banks, who have explicit liquidity support from the Federal Reserve. Hedge Units, of course, remain standing tall, fundamentally sound, though cheaper in price, providing an excellent long-term buying opportunity.

This has been precisely the process in place since almost a year ago, and particularly since last August, when the shadow banking system — defined as any levered lender who does not have access to (1) deposit insurance and/or (2) the Fed’s discount window — experienced a modern-day run, with asset-backed commercial paper holders refusing to roll over their paper. It has not been fun. It has not been pretty. And it is not over.

Along the way, policy makers have slowly recognized the Minsky Moment followed by the unfolding Reverse Minsky Journey. But I want to emphasize "slowly," as policy makers, collectively, still suffer from more than a thermos full of denial. Part of the reason is human nature: to acknowledge a Reverse Minsky Journey, it is first necessary to acknowledge a preceding Forward Minsky Journey — a bubble in asset and debt prices — as the marginal unit of debt creation morphed from Hedge to Speculative to Ponzi.

That is difficult for policy makers to do, especially ones who claim an inability to recognize bubbles while they are forming and, therefore, don’t believe that prophylactic action against them is appropriate. Nobody likes to admit they were blind, dumb, or asleep at the switch. Or all three. …

That's not to say that Minsky had confidence that regulators could stay out in front of short-term profit-driven innovation in financial arrangements. Indeed, he believed precisely the opposite:

"In a world of businessmen and financial intermediaries who aggressively seek profit, innovators will always outpace regulators; the authorities cannot prevent changes in the structure of portfolios from occurring. What they can do is keep the asset-equity ratio of banks within bounds by setting equity-absorption ratios for various types of assets. If the authorities constrain banks and are aware of the activities of fringe banks and other financial institutions, they are in a better position to attenuate the disruptive expansionary tendencies of our economy."

Minsky wrote those words in 1986! Twenty-two years later, we can only bemoan that his sensible counsel was ignored. …

Minsky's insight that financial capitalism is inherently and endogenously given to bubbles and busts is not just right, but spectacularly right. And when the financial regulators are not only asleep but actively cheerleading financial innovation outside their direct purview, a disaster is in the making, as the last year has taught us. We have much to learn and relearn from the great man as we collectively restore prudential common sense to bank regulation — both for conventional banks and shadow banks.

On Sheep and Greedy, Corrupt Shepherds

As I've watched the Securitization Mess unfold since last August, and opined about its inevitability prior, I have been awestruck by the silence from those who ought to have spoken loudly about the systemic corruption at work. I have been disgusted by the wanton greed from those who were knowingly profiteering from what inevitably would hurt those drawn into the deception. I have been dumbfounded by the blind faith of true believers in so-called "new economy" thinking, whether pundits, politicians, or CEOs. In all it brings to mind a couple of my favorite quotes:

Those who give no thought to that which is distant will find sorrow near at hand. Confucius (paraphrased)

People don't learn from the mistakes of others. They seldom learn from their own mistakes. Never underestimate the power of human stupidity. Robert Heinlein (paraphrased)

As to why we don't learn from mistakes, we need not look further than what cognitive psychologists and decision theorists have been yarding together for years under headers like Self-deception Biases, Heuristic Simplification (information processing errors), Emotion/Affect Disorders, and Social Interaction Disorders.

As to the systemic nature of this Securitization Mess, I'll leave you with Doug Noland's recent words:

Confirmations, Doug Noland, Credit Bubble Bulletin, Feb. 22: … [T]he unfolding Credit Crisis has made a major leap toward the heart of the Credit system. I have no way of knowing to what degree widening spreads are being dictated by "technical" hedging-related trading dynamics, as opposed to fundamental issues with respect to the faltering U.S. economy; rapidly deteriorating corporate balance sheets; a highly susceptible leveraged speculating community; the vulnerable GSEs; a distressingly illiquid Credit market; and heightened systemic risk more generally. To be sure, a strong case can be made that the current backdrop is quite detrimental to a highly leveraged and speculative Credit system. The markets rallied late this afternoon — and perhaps they will rally further next week — on talk of a bailout for troubled Ambac. Unfortunately, there has been ample Confirmation that the Evolving Credit Crisis has quickly spiraled way beyond the "monolines."

Related: Flock Mentality, from Alea

P.S. I'm now pulling together recent "finds" from others on the sidebar of my blog. Or you can find them here, via Google Reader "Shared Items" (along with a feed).

Jim Cramer's Rant: 'Fiction in Financials'

Normally I'm not one to recommend financial madman Jim Cramer's rants. But I'll make an exception today for: Cramer Rages on Banks: 'Where's the SEC?!'. The video feed (embedded in the CNBC post) is well-worth a few minutes of your time, even to endure a short ad at the beginning. The CNBC post begins, "Why isn't the Securities and Exchange Commission getting more involved in the whole banking sector writedown situation? Especially since the numbers are likely to get worse, not better? That's what Jim Cramer, CNBC's resident stock guru, wants to know." Then continues:

… "It's all fiction!" [Cramer] declared during a forceful exchange ….

"How can we have these levels of fiction in financials after Sarbanes-Oxley? How do people get away with this? How do they live with themselves?"

Cramer made his comments while reviewing results from Merrill. But his real consternation surrounded the insurers who cover banking investments. Some of those insurers haven't come clean about their liabilities, Cramer speculated. Eventually they will, and then the "fiction" will disappear, he said.

The banking sector and its related industries are all too chummy, Cramer accused. That led the numbers related to mortgage investments -- investments that are currently souring -- to break from reality.

"I think the financial guys all belong to the same club and they got to protect each other," he said.

Worse, those executives behind the current credit crunch are unlikely to get any punishment for their mistakes and disingenuousness about their numbers, Cramer opined.

"I'm fed up with it. The American people should be fed up with it. And the SEC should be fed up with it," Cramer said.

"This is what the SEC is supposed to protect us from," he added. …

P.S. Cramer takes aim too at so-called "mortgage insurers".

Hat Tip: Paul Kedrosky, Infectious Greed.

Squandered Trust

Those wishing to understand why systems seemingly as corrupt as ours here in the US seem so resilient and resistant to change, ought to read or re-read John Kenneth Galbraith's The Great Crash 1929 — as I have recommended before. Yesterday, over at Information Arbitrage, Roger Ehrenberg suggested that our financial system is badly in need of governance both at the corporate and government levels. Ehrenberg asked, then answered this fundamental question: "Who is at fault? Everybody." I agreed, in follow-up comments, noting that:

Maybe, finally the shit has hit the fan in a big enough way that people will demand change — eventually after enough pain has been felt by enough people — as they did after the mess that began in the eurphoria of the 1920s and ended with the mess of the 1930s. Only after a big-enough mess will the corruption within the various, connected systems be dealt with and cleaned up. … Good governance is needed from within (corporations) and from without (government, press, academia).

After the cleansing, if and when we get such, we can once again expect honesty from corporations and government agencies who will be trying hard to win back the respect they have squandered during [the] "looting" — the "main play" of the recent-past era (assuming that it began to end in August (and continued to end this week)).

"Everybody" includes corporate boards, managers, investors, auditors, appraisers, "rating agencies", the Press, government overseers (e.g. the Congress, the Administration, federal agencies, the Fed).

Ehrenberg noted in another recent post, again echoing my own sentiments, that the problem is one of squandered trust. Ehrenberg and I disagree on minor points, like the national debt being such a big problem, but we do see eye to eye that many have squandered much-needed trust in our systems — and not just our financial systems!

Here is a little added perspective from Galbraith's The Great Crash 1929 that I left as a comment on James Hamilton's Econbrowser early this year, responding to his post, The New Deal and the Great Depression:

[Me:] It proves interesting to reread John Kenneth Galbraith's The Great Crash 1929. It is as though history is being rewritten before our eyes. Substitute hedge funds for "investment trusts" and it reads pretty much parallel. Frightening! I keep hoping to see daylight beyond what I perceive to be a gathering storm. Daylight will indeed be forthcoming [sometime after] a storm, but the interim may be ugly.

The Great Crash 1929
Chapter II, "Something Should Be Done":

"…like all booms, it had to end. When prices stopped rising—when the supply of people who were buying for an increase was exhausted—then ownership on margin would become meaningless and everyone would want to sell. The market wouldn't level out; it would fall precipitately.

"All this being so, the position of the people who had at least nominal responsibility for what was going on was a complex one. One of the oldest puzzles of politics is who is to regulate the regulators. But and equally baffling problem, which has never received the attention it deserves is who is to make wise those who are required to have wisdom.

Some of those in positions of authority wanted the boom to continue. They were making money out of it, and they may have had an intimation of the personal disaster which awaited them when the boom came to an end. "But there were also some who saw, however dimly, that a wild speculation was in progress and that something should be done. For these people, however, every proposal to act raised the same intractable problem. The consequences of successful action seemed almost as terrible as the consequences of inaction, and they could be more horrible for those who took the action.

… "The real choice was between an immediate and deliberately engineered collapse and a more serious disaster later on. Some one would certainly be blamed for the ultimate collapse when it came. "There was no question whatsoever as to who would be blamed should the boom be deliberately deflated. …

… "Clearly the Federal Reserve was less interested in checking speculation than in detaching itself from responsibility for the speculation.


Chapter III, "In Goldman, Sachs We Trust"

… ""The most notable piece of speculative architecture of the late twenties, and the one by which, more than any other device, the public demand for common stocks was satisfied, "was the investment trust or company. The investment trust did not promote new enterprises or enlarge old ones. It merely arranged that people could own stock in old companies through the medium of new ones. …

"Knowledge, manipulative skill, or financial genius were not the only magic of the investment trust. There was also leverage. … Leverage, it was later to develop, works both ways.”

Chapter IV, "The Twilight of Illusion"

… "To a few alarmed observers it seemed as though Wall Street were by way of devouring all the money of the entire world. However, in accordance with the cultural practice, as the summer passed, the sound and responsible spokesmen decried not the increase in brokers’ loans, but those who insisted on attaching significance to this trend. There was a sharp criticism of the prophets of doom." (empahsis added)

{Update, Nov 9}

I might as well add Bill FLeckenstein's gloom to this already gloomy post:

Yesterday's Flip Flop, William Fleckenstein, Nov 9, Minyanville … I've talked about a dislocation [or "crash"] fairly often and it hasn't happened. Such events have an extremely low probability of occurring. But for folks to think it's not possible would be wrong. The stage has been set, such that the low probability is far, far higher than "normal."

That is thanks to the reckless policies pursued by the Greenspan Fed for the last decade and a half, which have enabled the risks to pile up while rewarding folks for ignoring them. The Fed's efforts to stave off small forest fires from happening has only guaranteed that we will have a gigantic one.

So, we are at a moment in time where a crash is far more likely to happen than at any time before. Does this mean it will happen? Not necessarily. But for folks to think it's not possible would be wrong. It feels to me like that could be right around the corner.

I am not rooting for this, but it seems to be inevitable. What I am rooting for is the return of sanity, which is something that only a large wipeout might bring about. "We have to stop the cycle of bailing out risk-takers, and that is where we are now. At some point, "too big to fail" will become "too big to bail out." And it feels like we may be at that point.

First Real Crisis of Financial Globalization and Securitization

Nouriel Roubini as in prime form today, not only still preaching the gospel of 'hard landings' but also explaining how this marks a first real crisis for the new world order. Roubini's warning, albeit frightening, is made worse if one can believe Randall Wray's latest on the impotence of the Fed and the ongoing charades that are, arguably, increasingly responsible for ever-more-frequent and severe booms and busts around the world.

Wray advocates for simplicity in monetary policy—that would "set the overnight rate at zero, and keep it there." Although I've not laid bare the basics of Wray's arguments, I'd appreciate any feedback as to holes in his reasoning. Even if a Fed Chairman were to believe Wray, getting past inflammaroty rhetoric, an interesting and perplexing question is: How does one get from where we are to where Wray and others would have us be?

The Coming U.S. Hard Landing, Nouriel Roubini: … On top of a weakening of the real economy the current financial markets turmoil will get worse — not better — in the next few months. This was never just a sub-prime problem as the same reckless and toxic lending practices in sub-prime — no down-payment, no verification of income and assets, interest rate only mortgages, negative amortization, teaser rates – were occurring in near prime mortgages, Alt-A loans, piggyback loans, home equity loans, and prime hybrid ARMs. About 50% of all mortgage origination in the last two years was made of this toxic waste and utterly junk lending practices.

And now what started as a credit crunch in the sub-prime mortgage market has spilled over to near prime and prime mortgages and to a variety of other credit markets: money markets, interbank lending markets, asset backed commercial paper, structured investment vehicles (SIVs) of banks, CDO markets, other securitization markets, and the LBO market. All these markets are now literally frozen with a dearth of liquidity, serious refinancing problems and severe credit problems. The mess in the SIV products is particularly serious and dramatic as it is generating severe liquidity and capital problems for both banking and non-banking institutions.

And this liquidity and credit crunch will get worse in the weeks ahead as this financial markets crisis is much more severe than the liquidity crisis of 1998 when LTCM — the largest US hedge fund — almost collapsed. In 1998 you had only a liquidity problem as the economy was strong — growing at 4% plus — and we were still in the rising cycle of the internet boom. Today, in addition to severe liquidity problems in the financial system (a near total freezing of the entire financial system liquidity plumbing), we have serious credit and insolvency problems too. The credit and solvency problems derive from a massive credit boom that lead to excessive borrowing that, in turn fed for a while rising asset prices that are now going bust, in a typical Minsky credit cycle. It is a insolvency problem as you have now millions of US households that are near insolvent and will default on their mortgages; dozens of sub-prime mortgage lenders who have already gone bankrupt; dozen of home building companies that are under distress; many financial institutions in the US and abroad — such as hedge funds and other highly leveraged institutions — that have already gone belly up; and the rise in credit spreads will also lead soon to a rise in corporate defaults that had been artificially low in the last few years given the excessively easy credit conditions. So we do not face only a most severe liquidity crisis; we are also observing a serious credit crisis and credit crunch. And you cannot resolve credit problems — as opposed to liquidity problems with liquidity injections. That is why the forthcoming cuts in the Fed Funds rate by the Fed will be ineffective in stemming the real and financial problems of the economy.

Indeed, the forthcoming easing of monetary policy by the Fed will not rescue the economy and financial markets from a hard landing as it will be too little too late. The Fed underestimated the severity of the housing recession, its spillovers to other sectors, and the contagion of the sub-prime carnage to other mortgage markets and to the overall financial markets. Fed easing will not work for several reasons: the Fed will cut rate too slowly as it is still worried about inflation and about the moral hazard of perceptions of rescuing reckless investors and lenders; we have a glut of housing, autos and consumer durables and the demand for these goods becomes relatively interest rate insensitive once you have a glut that requires years to work out; serious credit problems and insolvencies cannot be resolved by monetary policy alone; and the liquidity injections by the Fed are being stashed in excess reserves by the banks, not relent to the parts of the financial markets where the liquidity crunch is most severe and worsening. The Fed provided liquidity to banking institutions but it cannot provide direct liquidity to hedge funds, investment banks, other highly leveraged institutions and parts of the credit markets — such as asset backed commercial paper — where the crunch is severe. Thus, the liquidity crunch in most credit markets remains severe, even in the usually most liquid interbank markets.

Unfortunately, financial globalization together with securitization and mushrooming of complex credit instruments has lead to greater opacity and less transparency in the financial system. And this lack of transparency breeds unmeasurable uncertainty rather than priceable risk. Risk can be priced as you have a distribution of probabilities on various events. But unmeasurable uncertainty causes higher risk aversion under conditions of market distress. This generalized uncertainty is now coming from two sources: first, we do not know the size of the overall losses in credit markets: sub-prime alone could lead to losses of $100 billion or much higher depending on how much home prices will fall. And other losses from other illiquid financial instruments remain unmeasured in a world where institutions were marking to model rather than marking to market and where credit rating agencies were mis-rating complex credit instruments. Second, as securitization implies that financial risks have been spread out of banks and to the corners of the global financial system we do not know which firms are holding the toxic waste and thus which firms will go belly up next. It is like walking blind in a minefield where you have no idea of where the mines are. This uncertainty breeds large fear — after the massive greed of the previous credit and asset bubble has now burst — and lack of trust of financial counterparties, even otherwise respected ones: everyone want to hoard liquidity and hold the safest assets as even large financial institutions do not trust each other and are unwilling to lend to each other. This greater opacity of financial globalization and securitization implies that the re-pricing of risk that we have observed in the last few weeks is a permanent rather than a transitory phenomenon. And the sharp spike in the cost of credit will further weaken an already weakened economy. This is thus the first real crisis of the new world of financial globalization and securitization.

W. Randall Wray, A Post-Keynesian View of Central Banking Indepencence, Policy Targets, and the Rules-versus-Discretion Debate, August 2007 [PDF]: … Blaming the Fed for subpar economic performance is fun sport, albeit not very useful. At least some members of the FOMC have been delightful and irresistible targets. Who could repress a chuckle when FRB-Dallas President Robert McTeer recommended that consumers run out and buy Humvees to jumpstart the economy? Or when Governor John LaWare likened monetary policy to reading tea leaves and called for gold price targets? (Bradsher 1994 ["Bigger Role for Intuition Seen at Fed." New York Times. February 28]). The "Maestro" (Chairman Greenspan) always kept Fed watchers guessing with his preternaturally glum demeanor, his penchant for recitation of unimportant factoids, his habitual claims that "history shows" something that it does not, and his carefully cultivated manner of speaking without saying anything. His marriage to Andrea Mitchell, as well as his practice of studying reports in daily extended baths, added a patina of celebrity mixed with a dose of repulsiveness to his aura, reinforced by his previous incarnation as a "gold bug" and Ayn Rand acolyte. Some cracks in his reputation as "the most powerful man in the universe" began to show with the collapse of the "new economy" bubble, when the curtain was raised to reveal a somewhat clueless and impotent Wizard, spinning dials and yanking levers while professing faith in the almighty invisible hand, until it was time to escape into retirement via a hot air balloon (appropriately, green to match the cash for his memoir) and turn the whole thing over to Ben "the brainy Scarecrow" Bernanke to rule in his stead (Wikipedia).

As was often the case, John Kenneth Galbraith got it exactly right when he said:

To limit unemployment and recession in the United States and the risk of inflation, the remedial entity is the Federal Reserve System, the central bank. For many years (with more to come) this has been under the direction from Washington of a greatly respected chairman, Mr. Alan Greenspan. The institution and its leader are the ordained answer to both boom and inflation and recession or depression… Quiet measures enforced by the Federal Reserve are thought to be the best approved, best accepted of economic actions. They are also manifestly ineffective. They do not accomplish what they are presumed to accomplish. Recession and unemployment or boom and inflation continue. Here is our most cherished and, on examination, most evident form of fraud. (John Kenneth Galbraith 2004, [The Economics of Innocent Fraud: Truth for Our Time Boston: Houghton Mifflin.] pp. 43–44)

The truth about monetary policy is rather simple: it usually doesn't matter much. Unexpected rate changes can affect financial markets, and, as the New Classicals say, random policy has larger impacts, but there isn’t much to recommend it. In the current institutional environment, mostly free of regulations, supervision, and international financial borders, interest rate changes within usual ranges have small impacts on aggregate demand; larger policy changes have larger impacts, but are now avoided due to the policy of gradualism, based in the fear that big changes have undesirable impacts on financial markets. Further, policy changes—especially if gradual—promote innovations and evolution of financial institutions and practices that minimize the impact of policy. To make matters worse, we usually have no a priori reason for guessing the sign of the impact of rate changes, much less the precise magnitude. Given these considerations, as well as the arguments advanced by Keynes, a monetary policy rule is preferred—set the overnight rate at zero, and keep it there. A properly programmed Tin Man robot ought to do the trick.

After reading these, maybe I'll have to re-appraise my current thinking about Bernanke being a better Fed Charman than was Greenspan. But for now I'll continue to hope — and to prod.

Predatory Oligarchy

Hervé Kemph is a French environmental journalist and a student of global capitalism. His book, How the Rich are Destroying the Planet has caused a bit of a stir thus far, and will likely have more impact once translated into English. Some will call Kemph's writing just another extremist environmental rant. Others, like me, will welcome it as an opportunity to examine ourselves and our culture. We will no doubt be hearing more about Kemph as time goes by. In the meantime, we have a couple of Truthout.org articles to draw from. In part:

The Rich Stand Accused, Louis-Rilles Francoeur, Le Devoir, (via Truthout.org, 01/07/07): …"We cannot understand the simultaneity of the ecological and social crises if we do not analyze them as two facets of the same disaster. This disaster derives from a system piloted by a dominant social stratum that today has no drive but greed, no ideal but conservatism, no dream but technology. This predatory oligarchy is the principal agent of the global crisis," writes Kempf. "The present form of capitalism," he adds in an interview, "has lost its former historic ends, that is to say the creation of wealth and innovation, because it has become a financial capitalism, disparaged even by capitalist economists. This capitalism, which destroys jobs by rationalizations, new technologies and globalizations, overall and everywhere increases the disparities between rich and poor within each country and between different countries," the journalist observes.

…This oligarchy he targets is not satisfied with blindly consuming and wasting the planet's material resources with its big cars, its airplane trips, its unbridled consumption of living products, its uselessly vast houses, its unrestrained energy wastage. It has also, adds Hervé Kempf, spawned a model of hyper-consumption that the lower and especially the middle classes now attempt to imitate, just as developing countries try to imitate Western countries - even though, whether instinctively or rationally, everyone clearly knows that "this ideology of waste" and its drain on planetary resources will inevitably come to an abrupt end. …

… Although he does not address the impact of unchecked [human population growth] on the decline of the planet's "biological services" in his essay, Hervé Kempf immediately acknowledges that this factor certainly has an impact that is greater overall than any hyper-consumption by this oligarchy, composed of several hundred thousand millionaires and billionaires who control the bulk of income and of financial capital. However, he explains, it's this oligarchy that creates an unsustainable model for the planet, the indirect impact of which on other social groups exceeds its direct consumption. "And," he says dryly, "not all humans have the same impact on the planet at birth: a Westerner carries more weight in the planet's fate than a baby from Niger or from India."

It's to put an end to this ostentatious consumption that he advocates radical control of wealth through "a ceiling on maximum salaries and on the accumulation of wealth," a sort of matching piece for the minimum wage, but on the upper side.

"Everyone," Kempf comments, "knows that China will never be able to reach a level of consumption per inhabitant comparable to that of the Americans, with two cars per family, three televisions, four computers and cell phones, a house three times too big for its inhabitants, which generates energy consumption that would be sufficient to the needs of ten, even twenty people on other continents." The environmental chronicler proposes that a reduction of its consumption be imposed on this oligarchy that has globalized poverty, so that it no longer feeds this unsustainable dream, which numbs the critical faculties of the entire planet to the point that it closes its eyes to the wall into which it is careening full speed ahead. …

… [K]nown for his rigor and level-headedness, [Kempf] nevertheless concludes: "It is still necessary for ecological concerns to be based on a radical political analysis of present relationships of domination. We will not be able to reduce global material consumption if the powerful are not brought down and if inequality is not combated. To the ecological principle so useful at the dawning of awareness - "Think globally, act locally" - we must add the principle that the present situation imposes: "Consume less, share better."

Ecologists, he adds, have not often conducted an inquiry into the "ecological misery" that parks the poor next to industrial neighborhoods, polluted and at risk, next to highways or noisy activities, in the most insalubrious houses and in sectors generally the least well-served by public services, including public transportation. It is wrong, he says, to act as though the economic system must grow more to bring these people out of poverty or to allow more poor people to attain greater wealth. The economic system works in the other direction, by monopolizing wealth and power at the expense of those who have the least, and of the middle classes that dream - ever more vainly - of hoisting themselves into the cocoon of the present financial oligarchy, Kempf maintains.

That's why, he says, we must "bring down the rich" rather than pull up the poor, in order to begin to respect the thresholds of irreversible deterioration of the planet's resources.

He takes aim, moreover, at the concept of sustainable development and the alibi it now constitutes for governments and companies that use it to justify other drains on resources in the name of this new rationale that is supposedly harmless for the planet. Sustainable development, he writes, has become "a semantic weapon to remove the dirty word, 'ecology.' Moreover, is there any need to still develop France, Germany, or the United States? The concept has meaning, he concluded in an interview yesterday, but only in developing countries, because it can help them to avoid a development as brutal and lawless as the one we have effected in the West. But in the West, he says, the first of our environmental responsibilities "consists of reducing our consumption of material goods" to attain a level of well-being based rather on values, knowledge, in sum on immaterial, but nonetheless very real, riches.

See also: How the Rich Are Destroying the Planet: A Review by Leslie Thatcher, Truthout.org, 03/15/07

Financial Armageddon: New Book

Michael Panzner's Financial Armageddon: Protecting Your Future from Four Impending Catastrophes doesn't pull any punches. The book is a hard-hitting exposé of what may be our future, as events that have been wound up by more than a decade of irrational exuberance wind down in reverse. Against this frightening backdrop — made all the more frightening by this week's market jitters — Panzner concludes with book with some pointers to help average people navigate the treacherous waters of what may well be an inevitably dark near-term future. And to prepare them to better set a stage for brighter days on the other side of darkness for themselves and for their children.

Panzner's graphic depiction of future events is more detailed than I have seen before. In this it reminds me a lot of John Kenneth Galbraith's The Great Crash: 1929, which leaves Panzner in a great position to do a historical follow-up after the fact much like Galbraith did. For the rest of us, the book paints a picture to hold in front of us, and to test against as the future unfolds.

Clearly the future will not exactly follow the book. But that is not the point. Rather, Panzner wants us to better understand the complexities, the leverage-built-upon leverage, the gleefulness and gullibility of the actors, and more of what constitutes America's house-of-cards financial community that too many celebrate as America's highly-resilient economy.

On the run-up side we are led through the saga of America's decades-long party that has depleted the personal savings of many of our citizens. We are exposed to corporate shenanigans and government complicity in over-promising retirement and health care entitlements. We witness the mess that the government and "we the people" have made of our ever-more-bubbly housing sector, and how the Greenspan Fed misled average people into Adjustable Rate Mortgages in an era when interest rates could not fall, or at least would not fall further.

Among other misdeeds, Americans have forgotten that they need savings for security and they have used their houses (via refinancing) as giant ATM machines to buy new cars and other consumer goods. The party, as egged on by corporations and the government, seems never-ending. But, of course, the party must end. And it must end badly, in part due to too much greed, too much leverage, too little attention to prudent risk, and too much related "innovation" in the financial services sector that mislead many and their bankers, brokers, and commentators to believe that a new era had arrived, when all that was happening was a repeat of an age old penchant for mania, albeit with modern twists.

Add to this the never-ending consolidation in the financial services industry that helped keep stock prices pumped ever-higher and, when coupled with the perception that the true giants were now Too-Big-To-Fail, the stage was set for dominos to fall when one or more of the TBTFs actually begins to falter. Add in the recent Congressional and Administrative undoing of the many financial checks and balances put in place after the Great Crash and we see a stage set for disaster. Panzner elaborates:

There are too many links in the chain and too many points of vulnerability in the financial system, especially for commercial banks, which have been some of the most aggressive contributors to the recent credit bubble expansion. Ironically, a 2006 report that the FDIC was disbanding many bank closure teams because of a lack of failures may well have been one of the most ironic moments in the long and sorry saga of moral hazard and unintended consequences. Like dominos, when one begins to fall, the others won't soon be far behind.

If readers aren't shaken enough by the moral failures of the traditional banking community and supposed government overseers, Panzner devotes an entire chapter to derivatives, hedge funds, leverage, and risk concentration — and the seeming calm-before-the-storm that collectively they have wrought on the markets. His devotion is that of an "insider," with more than 25 years experience in stock, bonds, and security markets working with some of the biggest players including HSBC, Soros Fund, ABN Amro, Dresdner Bank, and JPMorgan Chase. Here is how Panzner sums up the problem:

… [D]espite recent efforts to address at least some of the concerns, past and present structural deficiencies have laid the groundwork for a chaotic and possibly nightmarish scenario. Thos who believed they were covered might be left scrambling to hedge their sudden and unexpected exposure, desperate to make up the shortfall under conditions of duress.

But the systemic risks do not only stem from a particular instrument or market. They exist also because of the concentration of exposure at certain large commercial banking groups, including JPMorgan Chase, Bank of America, Citibank, Wachovia, and HSBC. According to data collected by the U.S. Comptroller of the Currency, as of the fourth quarter of 2005, these five institutions accounted fo 96 percent of the more than $100 trillion of derivatives contracts outstanding among 836 U.S. Banks. Remember too, the exposure of Fannie Mae and Freddie Mac, who have $1.5 trillion of derivatives between them to hedge against risks in their massive portfolios.

Panzner follows with thorough looks into possible depression and hyperinflation, investigating the economic, financial, social and geopolitical aspects of these possible nightmares.

In the last part of the book, Panzner help us better understand necessary planning for these depressing contingencies. His philosophy parallels mine: Better that we heed an old maxim: "Assume the worst, hope for the best, and be prepared for whatever happens." Panzner gives us insights (and hope) in terms of investments, relationships, and lifestyles.

Having just finished both Peter Bernstein's Against the Gods and Charles Kindleberger and Robert Aliber's Manias, Panics, and Crashes I didn't expect to be impressed with Financial Armageddon. But I was impressed! Don't take my word for the worth of Panzner's book. Wander over to his blog and take a look at the advance praise from the back cover. Then explore the rest of his website, including Panzner as Featured Guest on Jim Puplava's Financial Sense Newshour, 3/3/2007.

On Learning, Risk and More: Stability Breeds Instability

Just before this week's volatility, WSJ's Holman Jenkins caught Myron Scholes' warning about dangers lurking in stability-land. Doug Noland added yet-another similar warning just after:

Risk Manager, HOLMAN W. JENKINS JR., WSJ, 3/3/2007: [Myron Scholes operates the Platinum Grove Asset Management hedge fund. He has a Nobel Prize in economics and was a principal of the Long Term Capital Management (LTCM) hedge fund, that failed notoriously in 1990.] …[C]onversation… takes place just before the recent market gyrations ….

"Right now," according to Mr. Scholes, "we're quiet because the lion is tame, and maybe it's the central bankers of the world who are keeping it tame." And thus, "Individuals will say, oh, things are now quiescent and will be forever, and they'll take more risk again."

He adds: "My belief is that because the system is now more stable, we'll make it less stable through more leverage, more risk taking." …

What if Scholes' belief is true and self-reinforcing? Then as central bankers "reassure" with each passing phase of an ever-more risky situation, speculators take on ever-more risk. Isn't that exactly what many of those libeled as "permabears" have been telling us for some time? Ticking time bomb?
Here is Doug Noland, 3/2/2007,:

… Credit Bubbles (and attendant asset inflation) tend to turn conventional analysis on its head, with "good" policies deemed those that work to prolong the fateful boom. Self-reinforcing asset Bubbles and policymaker complicity are virtually guaranteed — and pose a great systemic dilemma.

When it comes to so-called "prosperity killers," a prolonged bout of rampant Credit and speculative excess has no equal. Moreover, a decent case can be made that, for example, cutting taxes and reducing regulator burdens during a burgeoning Credit Bubble will only exacerbate excess and resulting economic maladjustment. Promote "pro-growth" programs in the midst of terminal "blow-off" excesses and you're hankering for a real mess. And, as we appreciate, confusing moderate consumer price inflation for astute policymaking and stable finance is a hallmark of the disasters back in the late-twenties in the U.S. and late-eighties in Japan. These are not a political views, but analyses of Credit, inflation, and speculation dynamics.

… This week saw a tenuous backdrop lurch (as we've witnessed previously) into a significant event for highly correlated global risk markets. I'll make a few observations: First, we've clearly reached the point where global Bubble excesses are so egregious and prevailing that overextended markets have basically lost their capacity for pullbacks that don't incite fears of attempted mass exits and dislocations. Second, the principal contagion mechanisms are the hedge funds, "brokerage" proprietary trading desks, rampant capricious speculative flows, and ballooning global derivatives markets. Third, and significantly, The Confluence of several key developments quickly pushed the risk markets to a state of heightened tumult.

The breakneck meltdown of the subprime originators; Freddie Mac and others scurrying to exit the business; and the great uncertainty associated with tightened mortgage Credit conditions comprised a major Credit market development. The hasty rally in the yen was a second major market occurrence with negative ramifications for global leveraged speculation. At the same time, Treasury prices spiked higher on safe haven buying, the reversal of spread trades, and interest-rate hedging-related buying (unwind of previous hedges as well as MBS-related hedging). Top this off with a synchronized drop in global equities prices and selling in metals and other commodities, and you have a series of market gyrations that epitomizes the nightmare scenario for the leveraged speculating community. …