Six Lessons From the Financial Crisis

1. The conclusion seems irresistible that the defenders of capitalism proved its undoing. The most zealous proponents of free markets put them at profound risk. The financial institutions that stood at the epicenter of the world economic order proved to be based on a scam, at the center of which was the privatization of profit and the socialization of risk. Capital markets whose fundamental rationale was the most efficient allocation of scarce resources for investment failed miserably in their basic function. The most egregious rates of executive compensation ever produced the biggest failures of economic leadership ever. To those of us with a sentimental attachment to free markets as against command economies, all this is a blow.

2. We are made aware of how grave a responsibility is the management of a country’s currency. Money and credit are like oxygen; taken for granted in most circumstances, but when withdrawn inducing asphyxia. In terms of economic theory, the whole experience bears out the vital importance the Austrian economists placed on the credit cycle and underlines their skepticism toward fractional reserve banking. This is not to urge a return to the gold standard, but it is to urge derision and contempt upon those who constructed the house of cards and who ignored its vulnerabilities. There are many villains in the piece, but Alan Greenspan will surely stand out in retrospect as bearing the heaviest responsibility. Blithely indifferent to the dangers of debt and derivatives, he led us down the garden path.

3. We move inexorably toward the socialization of credit risk and a much larger role for the state in the direction of the national economy. Courtesy of Bush and Greenspan, Marx has made a comeback. In The Communist Manifesto, the fifth proposal in Marx’s ten point plan for placing the means of production in the hands of the proletariat was the “centralization of credit in the banks of the state, by means of a national bank with state capital and an exclusive monopoly.” Marx didn’t get it quite right; we’re getting there via the dictatorship of the kleptocracy. But hey, it's a start.

4. The collapse of America’s credit bubble is very likely to lead, both here and abroad, to the revival of various forms of national socialism. That is not a prediction of the revival of German National Socialism, but simply that the direction of economic affairs is likely to be swayed much more by the dictates of nationalist and socialist impulses. The Euro is especially vulnerable to the centrifugal forces unleashed by the crisis, with unfavorable consequences for the European experiment. Sheer cronyism may win out over state socialism, to be sure, and financial internationalism will battle to survive against the reassertion of nationalism. Still, I wouldn't underestimate the power of nationalist and socialist tendencies in the new era.

5. The opportunity cost of the financial bailout is huge. Moreover, insofar as it is based on the idea of reflating the financial, insurance, and real estate sectors (the FIRE economy), it is very dangerous to long term economic revitalization. The old Wall Street model is broken because most of the things they made money on (securitization, fees, leverage) turned out, in due time, to be based on a fundamental misapprehension of risk. Real estate remains overvalued by various traditional measures. A far more logical use of public resources is the tackling of our energy and environmental problems, both of them requiring large investments in infrastructure and alternative energy. We face the challenge of a generation in adapting to these challenges; the economic crisis, and the response given to it thus far, constitutes a formidable obstacle in doing so.

6. The financial crisis has opened up a great gap between our aspirations and resources. This must have profound implications for American foreign policy. We have a foreign policy more ambitious than that crafted in the heady days of unipolarity in the late 1990s, when observers marveled at the sheer surfeit of American power in its military, economic, ideological, and cultural dimensions. Though American power has weakened on every count, there is no reconsideration of objectives. The last thing that presidential candidates wish to do is to reconcile themselves to limits on American purposes. It goes entirely against the American grain, which treasures happy talk and fairy tales over the recognition of constraint. But finance is inexorable: it sets limits, diminishes horizons, induces constraint. Surely a profound adjustment in America's world role is coming.

Implications for "Defense"

The national security establishment has barely begun to register the severity of the financial crisis and what it may mean for American foreign and defense policy. The crisis has utterly disordered national finances. It will produce further cascading demands on the public treasury. Given these factors, the constraints on policy are going to be much more exacting than the national security establishment now believes. Defense will not prove to be “recession proof.”

Defining a coherent philosophy in foreign affairs and defense strategy that is respectful of limits is vital. Especially deserving of reconsideration are the grand plans to reorder the Middle East and Central Asia via military power, to make all the world democratic, to expand NATO to embrace Georgia and Ukraine, to threaten or undertake preventive war against suspected proliferators, and to bring the entire world under intimate surveillance. We could save a lot of money if we stopped trying to do what we’re not very good at doing anyway.

The defense establishment is like a huge ship that is difficult to turn and next to impossible to stop in its tracks. But serious savings could be had by reducing force structure and limiting modernization. The most important step is to repudiate the Bush Doctrine and to rivet US military power to defensive purposes. The ground forces, slated to expand, should be reduced.

Obama is seemingly not ready to do any of this. Biden is more hawkish than dovish and will reinforce the tendency toward business as usual. But stark financial constraints and the accompanying search for limits on external ambition will define Obama’s presidency; he needs to realize that sooner rather than later.

First posted: 11/02/08

Joseph Stiglitz Excoriates Economists

Joseph Stiglitz excoriates the economics profession (along with Wall Street, Greenspan, and Bernanke) in a talk delivered in Germany on October 3, 2008. I've managed to misplace the link, but here are my notes:

Of Bernanke: “To destroy the financial system in so few years was an achievement. Only somebody who had studied the Great Depression could have done it so quickly."

The models that economic students study, Stiglitz says, are irrelevant to the current crisis: “You can’t have a debt crisis in a representative agent model. The model that our students have been studying for the last umpteen years has nothing to say about the current crisis.” Imagine a student studying in a leading American university who is asked the question, “‘What do you think about the current crisis?,’ and he says, ‘Well, I haven’t even thought about that, it’s not in our models. That’s a different subject. We don’t study that in our university.’” Stiglitz says that it’s an embarrassment to the economics profession “that our leading model in macro has absolutely nothing to say about these issues.”

Stiglitz then goes on to microeconomics, just to be “even-handed.” Most economists, he comments, still believe in the neo classical synthesis, which says: “Once we solve the macro problems, the market solves efficiently the allocation problems, the micro allocation problems.” He goes on to reject the assumption that failures only come in huge doses and identifies plenty of massive inefficiencies at the micro level, such as General Motors spending $100 billion and ending up with a company worth $10 billion. (Alas, he said that on October 3. Its market value was in the next week sliced in half). After commenting on some of his early academic work showing inefficiencies in how corporations approach taxation (doing that which is economically less advantageous in order to please unknowing shareholders), he comes to the main course: the massive misallocation of resources that preceded the bust in housing especially, but across other credit markets as well.

“What are financial markets supposed to do? They’re supposed to mobilize capital, allocate capital, manage risk, and in return for that, for providing those social services, they get compensated. Well, they got compensated; in recent years they’ve gotten over thirty percent of corporate profits….but that doesn’t include executive pay and bonuses, which themselves were huge.” While reaping immense rewards, the industry failed in its essential tasks of rational capital allocation and the management of risk.

Stiglitz notes that the financial services industry resisted innovations that would make the economy more efficient, that the incentive structures were fubared (a rough translation), and that the investors who bought those securitized mortgages with AAA ratings acted irrationally. There was an "irrationality and stupidity" that was pervasive and that “goes beyond information asymmetry.” The bizarre feature of the situation is that Wall Street had living proof, in the collapse of Long Term Capital Management in 1998, of the dangers of placing credence in the “probability distributions” hawked as science in the models. But the experience taught Wall Street nothing.

There was a logical contradiction here. The inventors of these sophisticated instruments claimed that they were creating new products to manage risk that transformed financial markets. But they used data collected before the creation of the products. “So they believed that their model had changed the world, but they used prices as if it had not changed the world.”

Stiglitz notes the ways in which securitization created a new moral hazard problem and failed to provide real diversification. “You don’t get diversification if you have correlated systemic risk.” Bad models as used by credit rating agencies and banks, with the idea that they were managing risk, did nothing of the kind.

He also makes an excellent point about the intellectual incoherence of Wall Street. The idea behind securitization was that it made markets more efficient. “As you slice and dice models, you don’t change fundamentals, you just bring down transaction costs.” That was the economic theory. In practice, however, Wall Street made enormous profits from the fees derived from securitization. In other words, they were raising transaction costs!

Stiglitz asks why Wall Street didn’t act in a more prudent way and failed to see that the originators had an incentive to write bad mortgages. By lending, say $100,000 in a nonrecourse mortgage, which would allow the buyer to walk away if the price went down, banks were in effect giving options to poor people. Since it’s not the normal practice of banks to give money away to poor people, it didn’t make sense. But very few on Wall Street saw it, until nearly the bitter end.

Stiglitz doesn’t comment here on the Paulson Plan, but he does look toward ways in which the financial sector should be regulated. The leading ideas are that asymmetric short term incentive structures should not be allowed, that we need a “Financial Products Safety Commission” that would bar “weapons of mass destruction inside our financial system,” and that speed limits need to be placed on the rapid expansion of financial institutions, because experience shows that this invariably causes net losses when they bust at the end of the day.

There is more, but this gives the main points.

Anatole Kaletsky also weighs in on the need for an intellectual revolution in the economics profession.

Paper Topics

Hey college students, let’s talk paper topics.

Here’s one idea: Compare and contrast the diagnoses of the Great Depression offered by Neoclassical economists, Keynesians, monetarists, and the Austrian economists, reading as much of John Maynard Keynes, Milton Friedman, Friedrich Hayek, and Ludwig von Mises as you can. Then speculate on how they would analyze the contemporary crisis and seek to resolve it. Identify their contemporary followers and use them as a guide to this question. This would get you into the deep waters of contemporary economic theory, and it is of vital contemporary importance to figure out which school offers the best interpretation. Infinite variations could be played on this basic paper idea, mixing and matching as you like. What would Schumpeter think? What would Minsky say?

Next topic: Financial regulation. How did it evolve over last two decades, and with what consequences? Assess nature of contemporary market dysfunctions that it is the responsibility of regulatory bodies to mitigate. Assign responsibility for decisions taken, whether for good or ill. Propose sensible reform. There you have your four-part paper. Financial regulation is a big topic--look at this snarl. You could narrow it by centering your investigation on one regulatory body (e.g. Federal Reserve, Securities and Exchange Commission, CFTC). The thing is: you want to keep your focus on that which keeps the entire system viable, so don’t get too narrow minded on me.

There are a few other paper ideas set forth in this presentation, one on housing, another on how public opinion in other countries is interpreting what is going on.

Finally, think about this: Evaluate the response of the Bush administration to the financial crisis. Compare its response to insolvent banks with previous bailouts in the United States and abroad. Identify a template of responses that nations have made to banking crises and assess, respectively, their equity and efficiency. In other words, what is most fair? What solves the problem with the least expenditure of public resources? Then use your conclusions to assess the wisdom of the approach from Bush, Paulson, Bernanke and Cox. If appropriate, suggest an alternative approach tailored to the immediate crisis. On the scale of financial fraud and gross iniquity, of moral turpitude and political corruption, of fatal incomprehension and stark ineptitude, where does it rank? At the bottom? Or at the top?

OK, so it’s a loaded question. Please draw your own conclusions without fear or favor.

11/01/08

The Ten Commandments

No, these were not delivered by Moses, but by the blogger Hellasious ("Hell as IOUs") at suddendebt.com, near the top of the bubble on March 5, 2007. These very useful admonitions took the form of "Ten Things I Need To Remember":

"1. The stock market is not the economy. Just because a whole generation has grown up following rising stock quotes, it does not mean they are good indications of copper output or computer sales.
2. Financial services are not creators of economic activity. Just because people can get yet another 0% introductory APR credit card, or a 0%-down mortgage with negative amortization for 12 months, that does not mean the economy is expanding.
3. Central bankers are not magicians. No matter what they say or do, they cannot create jobs, income or wealth. All they can do is raise or lower short-term interest rates; sometimes they can't even do that (just ask BOJ).
4. Foreign central banks are not perennial lenders of last resort to OCC (Other Countries' Consumers). They cease to be when it's not to their own countries' benefit (just ask BOJ and PBOC).
5. Tax cuts are like rat poison: judiciously applied they get rid of excess government meddling in the economy. Overdoses, however, end up killing the future.
6. Globalization is also like rat poison: judiciously applied it gets rid of lumbering, inefficient producers. Overdoses, however, end up killing domestic middle classes.
7. Shopping is not equivalent to producing. Just because GDP figures are still calculated using decades-old methodology (when most "things" were still made locally), it does not mean that the national economy benefits from frequent trips to the MartMall.
8. Credit Default Swaps are not equivalent to bonds. They are not even counterfeit bonds. They are simply naked puts on someone else's credit.
9. Always ask for more return for assuming higher risk. Just because I'm a fool, it doesn't mean my neighbor is one, too.
10. Excess always corrects and frequently begets the opposite excess."

Venture forth into the wilderness, my children, with these glad tidings.

10/26/08

The Ten Steps

Jeremy Grantham was a Cassandra warning against the excesses of the boom. In his October 2008 report, "Reaping the Whirlwind," he summarizes, in ten key points, his perspective on the causes, consequences, and remedies of the financial crisis:


1. “We had an intended period of excess increase in money supply, loan growth, leverage, and below normal interest rates.”

2. This produced “‘the first truly global asset bubble’ in all assets everywhere with only a few modest exceptions.”

3. The authorities, rather than tightening regulations, “partially dismantled them.” Attempts to rein in the growing risks were ignored by Democrats and Republicans alike. When the bubble broke, authorities mischaracterized what was happening: “all was said to be contained and the economy was claimed to be strong.”

4. The ultimate bubble was in risk-taking itself. “The asymmetry here was that if things worked out badly they would help you out . . . but if all went well you were on your own . . . Ah, the joys of pure capitalism.”

5. Investors and authorities were deluded “by the concept of rational expectations, or market efficiency,” which postulated “that we were all far too sensible for major bubbles to appear.” Lulled by these beliefs, investors “were actually paying to take risks for the first time in history” in the last year of the mania.

6. It was not the breaking of the Nasdaq bubble in 2000 nor the breaking of the housing/credit bubble in 2007 that were the outlier events. The true outliers were “the bubbles forming in 1998 and 1999 and in 2003 through 2007.”

7. “If everything goes right (as a bubble breaks) there will always be lots of pain. If anything is done wrong there will be even more. It is increasingly impressive and surprising how much we have done wrong this time!”

8. By far the biggest failing of the financial system “has been its unwillingness to deal with important asset bubbles as they form.” Both Greenspan and Bernanke are the villains in this rogues’ gallery. If you want to avoid a devastating bust, you have to limit manias in their ascent.

9. Addressing the lethal blow given to financial institutions by the destruction of trust is imperative. “Concern about moral hazard is secondary and must be put into abeyance for the time being.”

10. The market is like “an impetuous river that, when turbulent, inundates the plains, casts down trees and buildings, removes earth from this side and places it on the other; every one flees before it, and everything yields to its fury without being able to oppose it; and yet though it is of such a kind, still when it is quiet, men can make provision against it by dykes and banks, so that when it rises it will either go into a canal or its rush will not be so wild and dangerous.” OK, that’s Machiavelli on fortune, and not the esteemed Mr. Grantham on the markets, but this seems to be what JG has in mind here.

I have my doubts about point 9b, but may be mistaken. Take these dicta into the wilderness, too.

Grantham’s valuable reports are available to the public, though access to the GMO site requires registration.

10/26/08

Further Reading

On the history of financial crises, two classics are Charles R. Kindleberger, Manias, Panics, and Crashes: A History of Financial Crises (Basic Books, 1978), and Edward Chancellor, Devil Take the Hindmost: A History of Financial Speculation (Penguin, 2000). Peter L. Bernstein, Against the Odds: The Remarkable Story of Risk (Wiley, 1996) comes highly recommended, but I haven't read it.

On the various idiocies propounded in the name of economic science, but which ignored elementary common sense, see Richard Bookstaber, A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation (Wiley, 2007), and Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly Improbable (Random House, 2007).

Check out the good amazon bookstore maintained by Hellasious at Sudden Debt.

On the social and political questions raised by the financial crisis, the best books are Kevin Phillips, Bad Money: Reckless Finance, Failed Politics, and The Global Crisis of American Capitalism (Viking, 2008) and Michael Panzer, Financial Armageddon: Protecting Your Future From Economic Collapse. Panzer is incredibly pessimistic on the social and political fallout, but has been vindicated thus far. His recent announcement that Financial Armageddon will appear in Japanese and Korean translation makes me think that we will soon see new variations on this theme in the history of cinema.

Two magisterial biographies of two great economists are Thomas K. McCraw: Prophet of Innovation: Joseph Schumpeter and Creative Destruction (Harvard, 2007) and Robert Skidelsky, John Maynard Keynes 1883-1946: Economist, Philosopher, Statesman (Penguin, 2005).

I breathlessly await James Grant, Mr. Market Miscalculates: The Bubble Years and Beyond, due at the end of November 2008.

11/01/08

Man, Did I Screw Up

This is a portfolio tracking screen from MarketWatch that has only one position. It is a naked put on the Dow Jones Industrial Average, with a strike price of 130 (corresponding to 13,000 on the Dow Jones), with a December 2009 expiration. When I sold it back last winter and collected $4.85 billion, I frankly had no idea that the markets were going to collapse. Otherwise, I wouldn't have done it. You can see that the premium of $4.85 billion, which seemed easy pickings at the time, had become a deep red liability of $21.86 billion on November 21, 2008.

How can that be possible, you ask? The chart below shows the general vector.

When you sell a put at 10 and it goes to 55, this is not an auspicious development, believe me.

Warren Buffett made a transaction similar to mine, except that his company, Berkshire Hathaway, doesn't have to pay off for 13 or so years, when the puts expire. Surely the government will debase the currency, making 13,000 on the Dow easily obtainable. Thank goodness, too, that Barron's believes Berkshire is only underwater by $5 billion on the trade, because on basically the same deal yours truly was hurting to the tune of $21.86 billion. How does Buffett collect such a large premium from that naked put without being underwater like I am?

Here are some facts about Berkshire's financial position from the bullish Barron's article.



11/23/08

We Value What We Save in a Crisis

The following extracts from an eloquent post by London Banker get to the nub of what is wrong with the response of US and Western authorities to the financial crisis: They have done nothing to shield essential economic "sectors from the ill effects of the financial sector implosion while giving virtually unlimited funds to the banks authoring the collapse." The contrast between US and Chinese responses is telling. He begins with an anecdote from Sherlock Holmes:

“When a woman thinks that her house is on fire, her instinct is at once to rush to the thing which she values most. It is a perfectly overpowering impulse, and I have more than once taken advantage of it. . . . A married woman grabs at
her baby; an unmarried one reaches for her jewel-box.”-- A Scandal in Bohemia, by Arthur Conan Doyle

When a central bank thinks its house is on fire, it too will rush to save the thing valued most. In the United States, the central bank has rushed to save the bonuses and dividends of its Wall Street clientele by hiding away the bad assets that can no longer be foisted on gullible investors. In Europe too the response of central banks has been to save the wholesale banking and securities industry rather than the consumers and businesses underlying the real economy’s longer term productive strength.

For a comparative of what is valued elsewhere, it is worthwhile to look at what is being saved. I received in my inbox yesterday documents outlining the efforts being taken by the Hong Kong and Chinese authorities to address the liquidity crisis in their respective jurisdictions. They are available online here (Hong Kong) and here (PRC). The contrasts with the West are striking, and humbling. Hong Kong is swiftly introducing a scheme to guarantee credit to SMEs (small and medium enterprises) and exporters. China is introducing controls to limit bank credit to over-extended speculative sectors, accelerate rebuilding in the regions affected by the earthquake earlier this year, and promote improvements in local infrastructure, education and economic adjustment.

Holmes would have been disgusted by a married woman who grabbed her jewel-box in preference to her baby. In the same way, I am disgusted by the central banks preserving the privileges of the financial elite in preference to the jobs, incomes and businesses powering the real economy. The US and UK authorities may criticise the banks for their inaction in freeing up lending to commercial businesses constrained by the credit crunch. The Hong Kong and Chinese authorities are
implementing guarantee schemes and innovating initiatives to rapidly address the problem. . . .

The crisis in debt markets has been rolling since the sub-prime collapse of August 2007. The increasing illiquidity of commercial paper, trade credit, municipal finance and other debt markets was foreseeable and inevitable. And yet the central banks and treasury authorities of the Western nations have done nothing to shield these essential sectors from the ill effects of the financial sector implosion while giving virtually unlimited funds to the banks authoring the collapse.

Any discussion of China always invites criticism of its anti-democratic governance. It is worth remembering that the philosophical defense of democracy lies in the proposition that it is more likely over time to serve the interests of the electorate than a system which disenfranchises the people from the determination of their leadership. If the democratically elected governments - through their appointed executives and central bankers - are free over an extended timespan to ignore the interests of the people, then how is a Western democracy superior to a Chinese bureaucracy? From looking at the policies and practices of the past year, the merits of Western democracy are not immediately apparent in ensuring that policy responses to the financial crisis are aligned with the interests of the people. Even over the past decade, it is not clear that the policies of the democratic Western governments have aimed to strengthen and broaden the economy to benefit of the electorate rather than a narrow, self-serving elite. . . .

If the promoters of democracy want to strengthen their case, they might best do so by ensuring that their leadership adheres to policies which promote the longer term health and well being of the economy as a whole rather than the short term enrichment of an undemocratic elite."

11/28/08