Highlights Pre-May 2009

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  • The Mon­ster Mash; you got­ta laugh, and this sendup of the whole finan­cial cri­sis to the tune of the old Mon­ster Mash song from the 50’s is a won­der­ful gem.
  • In ear­ly March 2009, Jon Stew­art at “Com­e­dy Cen­tral” put togeth­er a mas­ter­ful rip into the stock mar­ket spruik­ers on the CNBC net­work, expos­ing how their so-called exper­tise was lit­tle more than a blind exhor­ta­tion to join in the euphor­ic excess of the bub­ble, and to keep it alive as it died an inevitable death.

It’s both infor­ma­tive and very amus­ing. Click here to watch it.

Con­gress is cur­rent­ly con­sid­er­ing an emer­gency eco­nom­ic-stim­u­lus mea­sure, ten­ta­tive­ly called the Bub­ble Act, which would order the Fed­er­al Reserve to† begin encour­ag­ing mas­sive pri­vate invest­ment in some fan­tas­ti­cal finan­cial scheme in order to get the nation’s false econ­o­my back on track.

Cur­rent bub­bles being con­sid­ered include the hand­held elec­tron­ics bub­ble, the under­sea-min­ing-rights bub­ble, and the dec­o­ra­tive office-plant bub­ble. Addi­tion­al options include spec­u­la­tive trad­ing in fairy dust—which lob­by­ists point out has the advan­tage of being an entire­ly imag­i­nary com­mod­i­ty to begin with—and a bub­ble based around a hypo­thet­i­cal, to-be-deter­mined prod­uct called “wid­gets.”

Steve Keen, Pre­dict­ing the cri­sis: Medal win­ning ana­lysts. “If they were to hand out medals for pre­dict­ing the glob­al finan­cial cri­sis, the Gold Medal for hav­ing pre­dict­ed the cri­sis must go to Irv­ing Fish­er, who in 1933 devel­oped the “Debt Defla­tion The­o­ry of Great Depres­sions” — a piece which remains the best descrip­tion of what hap­pens to an econ­o­my that suc­cumbs to exces­sive debt in the con­text of low infla­tion. We are now reliv­ing the hor­ror he warned us against…

The aca­d­e­m­ic econ­o­mists who pre­dict­ed this cri­sis were ignored because the main­stream of the eco­nom­ics pro­fes­sion fol­lows what is known as neo­clas­si­cal eco­nom­ics, which ignores debt and mod­els the econ­o­my as if it is always in equi­lib­ri­um. The con­trar­i­ans were ignored because for so long, the way to make mon­ey was to “go with the herd”. Today, con­ven­tion­al neo­clas­si­cal eco­nom­ics is being stark­ly proven wrong by this very cri­sis, while con­trar­i­ans are now the only ones mak­ing mon­ey.”

“Any great fail­ure should force us to rethink. The present eco­nom­ic cri­sis is a great fail­ure of the mar­ket sys­tem… There were three kinds of fail­ure. The first, dis­cussed by John Kay in this issue, was insti­tu­tion­al: banks mutat­ed from util­i­ties into casi­nos. How­ev­er, they did so because they, their reg­u­la­tors and the pol­i­cy­mak­ers sit­ting on top of the reg­u­la­tors all suc­cumbed to some­thing called the “effi­cient mar­ket hypoth­e­sis”: the view that finan­cial mar­kets could not con­sis­tent­ly mis-price assets and there­fore need­ed lit­tle reg­u­la­tion. So the sec­ond fail­ure was intel­lec­tu­al… Behind the effi­cient mar­ket idea lay the intel­lec­tu­al fail­ure of main­stream eco­nom­ics. It could nei­ther pre­dict nor explain the melt­down because near­ly all econ­o­mists believed that mar­kets were self-cor­rect­ing. As a con­se­quence, eco­nom­ics itself was mar­gin­alised. But the cri­sis also rep­re­sents a moral fail­ure: that of a sys­tem built on debt…”

As total bank assets are $2.3 tril­lion, why do Aus­trali­a’s banks have expo­sure to $13 tril­lion of deriv­a­tives posi­tions? All banks hedge to reduce risk, but this is a great deal of hedg­ing.

To put it in per­spec­tive, Aus­trali­a’s GDP is about $1.3 tril­lion, our pool of invest­ment fund assets is $1.2 tril­lion and the freely float­ed mar­ket cap­i­tal­i­sa­tion of the stock mar­ket is $1 tril­lion.

Right now, we are being told Aus­trali­a’s banks are safe. Indeed, on Sun­day night Prime Min­is­ter Rudd will front a tele­vi­sion show with 100 Aus­tralians to answer ques­tions about the finan­cial sys­tem and try and quell fears that the wheels could fall off our bank­ing sys­tem.

Hugh McLer­non from lit­i­ga­tion fun­der IMF, who has spent the past nine months look­ing at CDSs and CDOs as part of a case he is work­ing on, said yes­ter­day: “No mat­ter who are the win­ners and losers out of this mess, it is a deba­cle which will be with us for the next decade, as the CDO and CDS trans­ac­tions come to their full term.

“We engaged the piper and we have to pay,” Mr McLer­non said.

The upshot is that 2008 and 2009 will go down in his­to­ry as the Great Delever­ag­ing.

  • Glover­nomics: sav­ing the nation. Good one Richard Glover! “It now seems ages since the cri­sis first hit — that gold­en time when no one in Aus­tralia had even heard of Fred­die Mac and Fan­nie Mae. Even now, Fan­nie Mae sounds like an Amer­i­can ver­sion of Movem­ber. I imag­ine myself in April, real­ly look­ing for­ward to the com­mence­ment of fes­tiv­i­ties.”

For the ben­e­fit of any US read­ers who can’t under­stand why this is upro­r­i­ous­ly fun­ny (to Aus­tralians): (a) “Movem­ber” is an annu­al men’s health aware­ness event that requires par­tic­i­pants to “Grow a Mo”–as in a moustache–for the month of Novem­ber; (b) Check the final line of the Wikipedia dis­am­bigua­tion of the term Fan­ny: “Fan­ny is also a name used for the …”

  • Top Gear’s Jere­my Clark­son: Vaux­hall Insignia 2.8 V6: An ade­quate way to dri­ve to hell. “I was in Dublin last week­end, and had a very real sense I’d been invit­ed to the last days of the Roman empire. As far as I could work out, every­one had a Rolls-Royce Phan­tom and a coat made from some­thing that’s now extinct…

Every­one appeared to be drunk on naked hedo­nism. I’ve nev­er seen so much jus being driz­zled onto so many improb­a­ble things, none of which was pot­ted her­ring. It was like Barcelona but with beer. And as I careered from bar to bar all I could think was: “Jesus. Can’t they see what’s com­ing?”

I have spo­ken to a cou­ple of pret­ty senior bankers in the past cou­ple of weeks and their sto­ry is rather dif­fer­ent. They don’t refer to the loom­ing prob­lems as being like 1992 or even 1929. They talk about a total finan­cial melt­down. They talk about the End of Days…”

  • Jan­u­ary 15 2007: Gillian Tett, Finan­cial Times: Should Atlas still shrug? The threat that lurks behind the growth of com­plex debt deals. This arti­cle, just brought to my atten­tion by a blog read­er, deserves an award for pre­science: “At a glitzy din­ner in a May­fair hotel in Lon­don last week, prizes were award­ed to the best cap­i­tal mar­kets per­form­ers in 2006. Strik­ing­ly, the group that grabbed the tag “best finan­cial bor­row­er” — mean­ing, most cre­ative in rais­ing funds — was not a bulge-brack­et Wall Street or City name. Instead the hon­our went to North­ern Rock, a lender to home­buy­ers, which is based in north-east Eng­land’s grit­ty New­cas­tle and has become an enthu­si­as­tic issuer of mort­gage-backed bonds.”…
  • Jan­u­ary 3, 2009, FRANK RICH: A Pres­i­dent For­got­ten but Not Gone. This sto­ry has noth­ing to do with debt, but it’s too good not to link to: Frank Rich’s New York Times OpEd (with an abridged ver­sion on the SMH) on the nar­cis­sism that defines and main­tains George W. Bush:

“The man who emerges is a nar­cis­sist with no self-aware­ness what­so­ev­er. It’s that arro­gance that allowed him to tune out even the most calami­tous of real­i­ties, free­ing him to com­pound them with­out miss­ing a step. The pres­i­dent who famous­ly couldn’t name a sin­gle mis­take of his pres­i­den­cy at a press con­fer­ence in 2004 still can’t.”

“In Rus­sell Hoban’s nov­el Rid­dley Walk­er, the descen­dents of nuclear holo­caust sur­vivors seek amid the rub­ble the key to recov­er­ing their lost civil­i­sa­tion. They end up believ­ing that the answer is to re-invent the atom bomb. I was remind­ed of this when I read the government’s new plans to save us from the cred­it crunch. It intends — at gob-smack­ing pub­lic expense — to per­suade the banks to start lend­ing again, at lev­els sim­i­lar to those of 2007. Isn’t this what caused the prob­lem in the first place? Is insane lev­els of lend­ing real­ly the solu­tion to a cri­sis caused by insane lev­els of lend­ing?…

the projects which have proved most effec­tive were those inspired by the Ger­man econ­o­mist Sil­vio Ges­sell, who became finance min­is­ter in Gus­tav Landauer’s doomed Bavar­i­an repub­lic. He pro­posed that com­mu­ni­ties seek­ing to res­cue them­selves from eco­nom­ic col­lapse should issue their own cur­ren­cy. To dis­cour­age peo­ple from hoard­ing it, they should impose a fee (called demur­rage), which had the same effect as neg­a­tive inter­est. ”

“The Unit­ed States and the Unit­ed King­dom stand on the brink of the largest debt cri­sis in his­to­ry.

While both gov­ern­ments exper­i­ment with quan­ti­ta­tive eas­ing, bad banks to absorb non-per­form­ing loans, and state guar­an­tees to restart bank lend­ing, the only real way out is some com­bi­na­tion of wide­spread cor­po­rate default, debt write-downs and infla­tion to reduce the bur­den of debt to more man­age­able lev­els. Every­thing else is win­dow-dress­ing.”

“We’re cer­tain­ly in the midst of a once-in-a-life­time set of eco­nom­ic con­di­tions. The per­spec­tive I would bring is not one of reces­sion. Rather, the econ­o­my is reset­ting to low­er lev­el of busi­ness and con­sumer spend­ing based large­ly on the reduced lever­age in econ­o­my,” said Chief Exec­u­tive Steve Ballmer dur­ing a con­fer­ence call. For con­sumers, that may mean less dis­cre­tionary income to spend on a sec­ond or third home com­put­er, he said.

Ordi­nar­i­ly I’d only file a report like this in the Rolling Parade sec­tion, but this is such a per­cep­tive sum­ma­ry of the root of the cri­sis by such a promi­nent exec­u­tive that it deserves high­light­ing. Maybe I’ll winge less about Microsoft prod­ucts in future…

  • 19 Jan­u­ary: Ambrose Evans-Pritchard, Tele­graph UK. Bib­li­cal debt jubilee may be the only answer. Final­ly, the scale of the prob­lem, and the impos­si­bil­i­ty of solv­ing it while still hon­our­ing all the debt, is start­ing to be acknowl­edged.

“There is no guar­an­tee that the mea­sures will suc­ceed. The vast scale of gov­ern­ment bor­row­ing may exhaust the stock of glob­al cap­i­tal. Mar­kets are already begin­ning to ques­tion the cred­it-wor­thi­ness of sov­er­eign states. The Fed may find it hard­er than it thinks to dis­en­gage from colos­sal inter­ven­tion in the bond mar­kets. In the end, the only way out of all this glob­al debt may prove to be a Bib­li­cal debt Jubilee. Cred­i­tors are not going to like that.”

“Nobody (or only a scant few) wants to see the gov­ern­ment take con­trol over the bank­ing sys­tem, which would sig­nal the end of mar­ket-based cap­i­tal­ism as we know it.

But the real­i­ty is we have a creep­ing form of nation­al­iza­tion going on already via the ini­tial injec­tion of cap­i­tal into big banks, and the intense gov­ern­ment over­sight of how banks oper­ate that is almost cer­tain to accom­pa­ny TARP II (and III and IV) funds.

Mean­while, banks are main­ly just sit­ting on the TARP funds, as The Wall Street Jour­nal details…”

“The worst eco­nom­ic tur­moil since the Great Depres­sion is not a nat­ur­al phe­nom­e­non but a man-made dis­as­ter in which we all played a part. In the sec­ond part of a week-long series look­ing behind the slump, Guardian City edi­tor Julia Finch picks out the indi­vid­u­als who have led us into the cur­rent cri­sis.”

“OUR finan­cial cat­a­stro­phe, like Bernard Madoff’s pyra­mid scheme, required all sorts of impor­tant, plugged-in peo­ple to sac­ri­fice our col­lec­tive long-term inter­ests for short-term gain. The pres­sure to do this in today’s finan­cial mar­kets is immense. Obvi­ous­ly the greater the mar­ket pres­sure to excel in the short term, the greater the need for pres­sure from out­side the mar­ket to con­sid­er the longer term. But that’s the prob­lem: there is no longer any seri­ous pres­sure from out­side the mar­ket. The tyran­ny of the short term has extend­ed itself with fright­en­ing ease into the enti­ties that were meant to, one way or anoth­er, dis­ci­pline Wall Street, and force it to con­sid­er its enlight­ened self-inter­est…

IT’S not hard to see why the S.E.C. behaves as it does. If you work for the enforce­ment divi­sion of the S.E.C. you prob­a­bly know in the back of your mind, and in the front too, that if you main­tain good rela­tions with Wall Street you might soon be paid huge sums of mon­ey to be employed by it.”

  • Jan­u­ary 31: Clan­cy Yeates and Scott Rochfort, SMH. Drop the anchor and furl the sails, we’re going over the edge. Good to see my fel­low bear Ger­ard Minack being giv­en a sol­id run here. It’s not easy being sober when all around you are drunk, and Ger­ard raised the alarm before even I did, in his reg­u­lar “Down Under Dai­ly” reports for Mor­gan Stan­ley.

An econ­o­mist at Mor­gan Stan­ley, Ger­ard Minack, also blunt­ly rejects any argu­ment that Aus­tralia can avoid being dragged down with the rest of the world.

“The rea­son that Kevin Rud­d’s GFC [glob­al finan­cial cri­sis] is hit­ting us is not because we were sim­ply an island of inno­cence get­ting hit by evil off­shore influ­ences,” says Minack.

“The idea that we were a pru­dent, sen­si­ble coun­try that nev­er indulged in the reck­less excess­es that the rest of the world did — that is com­plete crap,” he says. “We par­tied as hard, if not hard­er.”

Brushed off for his bleak fore­casts in the boom times by many in the mar­ket, Minack­’s views have been tak­en more seri­ous­ly in recent times.

Minack says our addic­tion to debt makes us just as vul­ner­a­ble as the rest of the world to the melt-down in cap­i­tal mar­kets, and recent prof­it warn­ings are only the ear­ly stages in the down­turn. Tum­bling com­mod­i­ty prices will only make the trough deep­er, he says.

“I had din­ner last night with a guy whose career wan­dered through near­ly a half-dozen major bro­ker­ages. He was at ground zero of the secu­ri­ti­za­tion and cre­ation of the alpha­bet soup of the real estate mar­ket…

Wall Street and the bank­ing sys­tem is every bit as nuts as we all think… You want lever­age? Imag­ine a 20 bil­lion dol­lar port­fo­lio of mort­gage backed secu­ri­ties with a cap­i­tal base of $10k–literally 2 mil­lion-fold lever­age. Imag­ine the shock of the inven­tor as he watch­es as his suc­ces­sors expand sim­i­lar port­fo­lios up to $900 bil­lion…

So where are we now, and where are we head­ing? This is the bad part: I thought I was the pes­simist. Sheesh. He was describ­ing a sys­tem infect­ed by flesh eat­ing bac­te­ria. Every day looks more dire than the pre­vi­ous day. The solu­tions being pro­posed look fee­ble, and the Fed looks both pow­er­less and con­fused”

  • 16 decem­ber 2008: News Kon­tent. My open let­ter to Prime Min­is­ter Rudd. The let­ter itself is worth a read, but what I’d pre­fer to high­light here is the com­ment from James Cumes that accom­pa­nies it, writ­ten pri­or to the elec­tion:

” In 1929, no one, least of all James Scullin and his min­is­ters, had any idea that the world was about to crash into the great­est eco­nom­ic depres­sion the world had known. They had even less idea of how they should react to any such cri­sis. Intrigu­ing­ly, two of the key issues which con­front­ed them were irre­spon­si­ble debt and indus­tri­al rela­tions.

The same seems to be true of the prospec­tive Rudd Gov­ern­ment. He has pro­claimed him­self to be a “con­ser­v­a­tive econ­o­mist.” He has spo­ken, dur­ing the cam­paign, main­ly about inter­est rates and hous­ing costs in con­ven­tion­al terms. He will amend indus­tri­al leg­is­la­tion to be more accept­able to work­ers. He says it all in the obvi­ous expec­ta­tion that the next few years – the next ten years per­haps – will be much the same as the last ten years under Howard.

There is not the slight­est pos­si­bil­i­ty that they will be…

Unless the incom­ing gov­ern­ment – let’s assume it will be a Rudd Gov­ern­ment – is extreme­ly lucky, the crash will become man­i­fest in the next few weeks or lat­est by March 2008. The Unit­ed States is almost cer­tain­ly in reces­sion already – con­cealed only by spu­ri­ous offi­cial sta­tis­tics – the dol­lar has fall­en sharply and almost cer­tain­ly will fall fur­ther and faster as the weeks go by. House­hold, cor­po­ra­tion and pub­lic debt is mon­strous, unprece­dent­ed and all those adjec­tives that we thought we would nev­er have to use. Con­sumer and asset infla­tion is high. Cred­it is tight and get­ting tighter – large­ly because, in the casi­no world that the glob­al econ­o­my has become, too many have already lost their shirts and far too many more fear that the shirt hangs far too loose­ly on their own back and on the backs of those who already do or might want to owe them mon­ey…

With those prospects, Labor – and Kevin Rudd — might be well advised to dis­dain any offer of pow­er to gov­ern and so avoid going down in his­to­ry as anoth­er well-mean­ing but feck­less Scullin-type Gov­ern­ment. Let Howard and his ret­inue take the blame and just oppro­bri­um for a cat­a­stro­phe to which they have con­tributed with such unbri­dled gen­eros­i­ty.

It won’t hap­pen of course. On the night of 24 Novem­ber 2007, Labor, led by Rudd, will prob­a­bly be declared the vic­tor and they will con­front their unen­vi­able des­tiny. For Aus­tralia, it won’t be any worse than hav­ing Howard’s Coali­tion as the vic­tor. Indeed, it might be rather bet­ter. How­ev­er, who­ev­er is the vic­tor, I – as one who grew up in the last Great Depres­sion – can only offer a prayer and express a hope. That hope is that we Aus­tralians may come through this new and even more ter­ri­ble chal­lenge, with the same spir­it and for­ti­tude that we did sev­en­ty years and more ago.”

  • Jan­u­ary 2, 2009: Risk Mis­man­age­ment, New York Times

There are many such mod­els, but by far the most wide­ly used is called VaR — Val­ue at Risk. Built around sta­tis­ti­cal ideas and prob­a­bil­i­ty the­o­ries that have been around for cen­turies, VaR was devel­oped and pop­u­lar­ized in the ear­ly 1990s by a hand­ful of sci­en­tists and math­e­mati­cians — “quants,” they’re called in the busi­ness — who went to work for JPMor­gan. VaR’s great appeal, and its great sell­ing point to peo­ple who do not hap­pen to be quants, is that it express­es risk as a sin­gle num­ber, a dol­lar fig­ure, no less.

VaR isn’t one mod­el but rather a group of relat­ed mod­els that share a math­e­mat­i­cal frame­work. In its most com­mon form, it mea­sures the bound­aries of risk in a port­fo­lio over short dura­tions, assum­ing a “nor­mal” mar­ket. For instance, if you have $50 mil­lion of week­ly VaR, that means that over the course of the next week, there is a 99 per­cent chance that your port­fo­lio won’t lose more than $50 mil­lion.

BUT…

That $50 mil­lion wasn’t just the most you could lose 99 per­cent of the time. It was the least you could lose 1 per­cent of the time.

  • Feb­ru­ary 5: David Hirst, The Age. US gam­bles free­dom on risky print­ing press pol­i­cy. I would­n’t have cho­sen the title, tone or slant of this arti­cle myself, but the data is unmis­take­able: Bernanke is putting into prac­tice his “log­ic of the print­ing press” anal­o­gy (se e Debt­watch No. 31).

Keen, who last week was inter­viewed by The Wall Street Jour­nal and is fast becom­ing a world-recog­nised eco­nom­ic author­i­ty, out­lined in his recent Debt Watch Report that Bernanke’s famous “heli­copter drop dou­bling of base mon­ey will be impo­tent against the US’s cred­it crunch”.

Most econ­o­mists believe the US and Chi­na are bound irrev­o­ca­bly by US debt and Chi­na’s con­tin­ued pur­chase of that debt. They assume the US, with 46 states insol­vent or approach­ing insol­ven­cy, will suf­fer imme­di­ate MAD if Chi­na ends the long finan­cial arrange­ment.

But with the US enter­ing a peri­od of defla­tion, its eco­nom­ic lead­er­ship appears to be doing the unthink­able — going it alone and let­ting the elec­tron­ic print­ing press­es take care of the huge sums required to keep the nation afloat. The con­se­quences for the world econ­o­my are incom­pre­hen­si­ble as Chi­na’s pur­chas­es of US trea­suries under­write the US’s unquench­able demand for mon­ey to ser­vice its mul­ti­tril­lion-dol­lar pub­lic debt, which Pres­i­dent Oba­ma said recent­ly would reach $US11 tril­lion ($A17 tril­lion) this year.

Faced with the huge sink­hole cre­at­ed by the finan­cial melt­down and the prospect of defla­tion, US Fed boss Ben Bernanke has been print­ing mon­ey so rapid­ly that the US is being flood­ed with liq­uid­i­ty. This is beyond unprece­dent­ed.

Many Amer­i­cans believe print­ing mon­ey can free the coun­try from the suf­fo­cat­ing embrace of mutu­al depen­dence with Chi­na. In his blog ear­li­er this week, Brad Setser from the US Coun­cil on For­eign Rela­tions, and one of the world’s most respect­ed Chi­na com­men­ta­tors, out­lined the US posi­tion: “Exchange rate poli­cies can also influ­ence the allo­ca­tion of resources across sec­tors. Chi­na’s de fac­to dol­lar peg is an obvi­ous exam­ple … it is hard for me to believe that as much would have been invest­ed in Chi­na’s export sec­tor if Chi­na had had a dif­fer­ent exchange rate regime …

“Those who attribute the growth of the past sev­er­al years sole­ly to the mar­ket miss the large role the state played in many of the world’s fast grow­ing economies.”

Setser and oth­ers close to pol­i­cy­mak­ers are real­is­ing the boom in Chi­na may not be a rerun of the Japan­ese and Ger­man post­war eco­nom­ic mir­a­cles but more akin to the cre­ation of a giant sweat­shop for the ben­e­fit of West­ern com­pa­nies and the Chi­nese Com­mu­nist Par­ty. But this required US con­sumers to play their role as the linch­pins. Now the linch­pin has bro­ken. There is no way the old arrange­ment can con­tin­ue and the US is real­is­ing the sys­tem will end. By revert­ing to the print­ing press it can free itself from depen­den­cy on Chi­na.

Now that Prime Min­is­ter Kevin Rudd has hailed in his “Month­ly’ essay a new polit­i­cal era of ”social cap­i­tal­ism” and embarked on anoth­er stim­u­lus pack­age it mere­ly remains to find an eco­nom­ic the­o­ry to accom­pa­ny it.

Eco­nom­ics has failed man­i­fest­ly to see the glob­al finan­cial cri­sis com­ing. Only those once derid­ed as doom­say­ers and crack­pots were any­where near the mark. An entire gen­er­a­tion of rich­ly-remu­ner­at­ed experts got it wrong, once again

A few years ago, Uni­ver­si­ty of West­ern Syd­ney’s Pro­fes­sor Steve Keen took up the cud­gels for real estate and finance, sup­port­ed by the the­o­ries of Min­sky and col­leagues back at the Merewether Build­ing at Syd­ney Uni­ver­si­ty, hav­ing long held an inter­est in the math­e­mat­ics of polit­i­cal econ­o­my.

Keen, whose pre­dic­tions of reck­less lever­age and spec­u­la­tion in recent years have been vin­di­cat­ed over­all through the present cred­it cri­sis, declared this week that Aus­tralia was bound for a Japan­ese-style expe­ri­ence of drawn out reces­sion. Stim­u­lus mea­sures were not resolv­ing the prob­lem, he said, sim­ply adding to the Gov­ern­ment debt.

The same theme was cur­rent in Boughton’s ear­li­er work, along with oth­er cor­re­spon­dents in the Unit­ed States such as Charles R Mor­ris and Low­ell Bryan, though he dif­fers from Keen on the role of gov­ern­ment.

While cit­ing Marx on the pro­cliv­i­ty of the ”par­a­sites”, the banks, to ”peri­od­i­cal­ly despoil indus­tri­al cap­i­tal­ists” and ”inter­fere in actu­al pro­duc­tion”, Keen not­ed that he did not expect cap­i­tal­ism to col­lapse.

  • Feb­ru­ary 6: Jim Manzi, Stim­u­lus pre­dic­tions: put up or shut up. Jim calls on econ­o­mists who are mak­ing pre­dic­tions about what Oba­ma’s stim­u­lus pack­age will or won’t do to present their mod­els on which these pre­dictins are based. In part, he says:

So here’s what we would need to fal­si­fy a pre­dic­tion. Any­one who claims to know the impact should escrow a copy of the source code of the econo­met­ric mod­el that is used to make the pre­dic­tion, along with a stat­ed con­fi­dence inter­val, oper­a­tional scripts, and assump­tions for all required non-stim­u­lus inputs that pop­u­late the mod­el with a named third-par­ty. Upon reach­ing the date for which the pre­dic­tion is made, the third-par­ty should run the mod­el with the actu­al data for all non-stim­u­lus assump­tions and com­pare the mod­el result to actu­al. Any dif­fer­ence would be due to mod­el error. We actu­al­ly still would not be able to par­ti­tion the sources of error between “error in pre­dict­ing causal impact of stim­u­lus” and “oth­er”, but at least we would have a real mea­sure­ment of mod­el accu­ra­cy for this instance.

Of course, I sin­cere­ly doubt this will hap­pen. I won­der why not?

“As par­al­lels to the 1930s mul­ti­ply, Fish­er is rel­e­vant again. As it was then, the Unit­ed States is now awash in debt. No mat­ter that it is most­ly “inside” or “inter­nal” debt—owed by Amer­i­cans to oth­er Amer­i­cans. As the under­ly­ing col­lat­er­al declines in val­ue and incomes shrink, the real bur­den of debt ris­es. Debts go bad, weak­en­ing banks, forc­ing asset sales and dri­ving prices down fur­ther. Fish­er showed how such a spi­ral could turn mere busts into depres­sions. In 1933 he wrote:

Over invest­ment and over spec­u­la­tion are often impor­tant; but they would have far less seri­ous results were they not con­duct­ed with bor­rowed mon­ey. The very effort of indi­vid­u­als to lessen their bur­den of debts increas­es it, because of the mass effect of the stam­pede to liquidate…the more debtors pay, the more they owe. The more the eco­nom­ic boat tips, the more it tends to tip.”

This cri­sis, like most oth­ers in rich coun­tries, emerged from a prop­er­ty bub­ble and a cred­it boom. The scale of the bubble—a dou­bling of house prices in five years—was about as big in America’s ten largest cities as it was in Japan’s metrop­o­lis­es. But nation­wide, house prices rose fur­ther in Amer­i­ca and Britain than they did in Japan (see first chart). So did com­mer­cial-prop­er­ty prices. In absolute terms, the cred­it boom on top of the hous­ing bub­ble was unpar­al­leled. In Amer­i­ca pri­vate-sec­tor debt soared from $22 tril­lion in 2000 (or the equiv­a­lent of 222% of GDP) to $41 tril­lion (294% of GDP) in 2007 (see sec­ond chart).

Judged by stan­dard mea­sures of bank­ing dis­tress, such as the amount of non-per­form­ing loans, America’s trou­bles are prob­a­bly worse than those in any devel­oped-coun­try crash bar Japan’s. Accord­ing to the IMF, non-per­form­ing loans in Swe­den reached 13% of GDP at the peak of the cri­sis. In Japan they hit 35% of GDP. A recent esti­mate by Gold­man Sachs sug­gests that Amer­i­can banks held some $5.7 tril­lion-worth of loans in “trou­bled” cat­e­gories, such as sub­prime mort­gages and com­mer­cial prop­er­ty. That is equiv­a­lent to almost 40% of GDP.

These are just a few exam­ples of the cre­ative think­ing that has start­ed again in eco­nom­ics after 20 years of stag­na­tion. But the aca­d­e­m­ic estab­lish­ment, dis­cred­it­ed though it is by the present cri­sis, will fight hard against new ideas. The out­come of this bat­tle does not just mat­ter to aca­d­e­m­ic econ­o­mists. With­out a bet­ter under­stand­ing of eco­nom­ics, finan­cial crises will keep recur­ring and faith in cap­i­tal­ism and free mar­kets will sure­ly erode. Changes in reg­u­la­tion are not suf­fi­cient after this finan­cial cri­sis — it is time for a rev­o­lu­tion in eco­nom­ic thought.

  • Feb­ru­ary 13: Dodgy loans, unjust con­tracts and the pub­lic inter­est, Richard Ack­land, SMH. This reports the fail­ure on appeal of the Cooks case that ini­tial­ly moti­vat­ed me to raise the alarm about exces­sive debt. Unfor­tu­nate­ly it appears that, as Richard sum­maris­es below, “The pub­lic inter­est can be a step too far for some judges.”

Act­ing Jus­tice Pat­ten, who ini­tial­ly heard the case, found that the con­tract was unjust. The lender, Per­ma­nent Mort­gages, should have been aware on mak­ing the most per­func­to­ry of inquiries that the Cooks were inca­pable of ser­vic­ing this debt.

The judge rewrote the loan so as to remove the default inter­est rate. The appeal was about whether the Cooks’ equi­ty in their home should be restored and the inter­est debt can­celled. Par­lia­ment has said that con­tracts can be unwound where they are unfair, and one of the con­sid­er­a­tions to be tak­en into account is “the pub­lic inter­est”.

There was evi­dence before the court that the loans to the Cooks were of the “equi­ty-strip­ping” species — the lenders did not care whether the mon­ey could be repaid, as long as the prop­er­ty could be sold.

Econ­o­mists gave evi­dence that these trans­ac­tions could be cat­e­gorised as “Ponzi loans” — which could only ever be repaid by tak­ing out a larg­er loan or by sell­ing the asset.

There was evi­dence that, were the prac­tice of Ponzi loans to become wide­spread, “it would sub­stan­tial­ly increase the ten­den­cy of the Aus­tralian finan­cial sys­tem to asset bub­bles and sub­se­quent finan­cial cri­sis”, Pro­fes­sor Steve Keen told the court — some­thing, you might think, that would be a mat­ter of “pub­lic inter­est”. Invari­ably, though, the phrase is sub­ject­ed to maul­ing at the hands of the judi­cia­ry. And so it was here. The appeal judge Roger Giles said in a nar­row­ing flour­ish: “I have some dif­fi­cul­ty in see­ing that the health of the econ­o­my falls with­in the pub­lic inter­est to which regard may be had in deter­min­ing injus­tice of the par­tic­u­lar trans­ac­tion.”

The pub­lic inter­est can be a step too far for some judges.

  • Tues­day, 10 Feb­ru­ary: Nigel Mor­ris, Deputy Polit­i­cal Edi­tor, and Sean O’Grady, Eco­nom­ics Edi­tor, The Inde­pen­dent (UK). This is the worst reces­sion for over 100 years. Ed Balls, the PM’s clos­est ally, warns that down­turn is fero­cious and says impact will last 15 years.

In an extra­or­di­nary admis­sion about the sever­i­ty of the eco­nom­ic down­turn, Ed Balls even pre­dict­ed that its effects would still be felt 15 years from now. The Schools Sec­re­tary’s com­ments car­ry added weight because he is a for­mer chief eco­nom­ic advis­er to the Trea­sury and regard­ed as one of the Prime Min­is­ter­s’s clos­est allies.

Mr Balls said yes­ter­day: “The real­i­ty is that this is becom­ing the most seri­ous glob­al reces­sion for, I’m sure, over 100 years, as it will turn out.”

He warned that events world­wide were mov­ing at a “speed, pace and feroc­i­ty which none of us have seen before” and banks were los­ing cash on a “scale that nobody believed pos­si­ble”.

The min­is­ter stunned his audi­ence at a Labour con­fer­ence in York­shire by fore­cast­ing that times could be tougher than in the depres­sion of the 1930s, when male unem­ploy­ment in some cities reached 70 per cent. He also appeared to hint that the reces­sion could play into the hands of the far right.

The U.S. bank­ing sys­tem is close to being insol­vent, and unless we want to become like Japan in the 1990s — or the Unit­ed States in the 1930s — the only way to save it is to nation­al­ize it.

As free-mar­ket econ­o­mists teach­ing at a busi­ness school in the heart of the world’s finan­cial cap­i­tal, we feel down­right blas­phe­mous propos­ing an all-out gov­ern­ment takeover of the bank­ing sys­tem. But the U.S. finan­cial sys­tem has reached such a dan­ger­ous tip­ping point that lit­tle choice remains. And while Trea­sury Sec­re­tary Tim­o­thy Gei­th­n­er’s recent plan to save it has many of the right ele­ments, it’s basi­cal­ly too late.

  • Feb­ru­ary 2009: The Cri­sis of Cred­it Visu­al­ized. It’s not per­fect and blames the cri­sis sole­ly on subprimes–ignoring the long run up of debt beforehand–but this visu­al por­tray­al of the cri­sis is still pret­ty good.
  • Feb­ru­ary 22, 2009: Paul Krug­man, New York Times. Bank­ing on the Brink.

Com­rade Greenspan wants us to seize the economy’s com­mand­ing heights.

O.K., not exact­ly. What Alan Greenspan, the for­mer Fed­er­al Reserve chair­man — and a staunch defend­er of free mar­kets — actu­al­ly said was, “It may be nec­es­sary to tem­porar­i­ly nation­al­ize some banks in order to facil­i­tate a swift and order­ly restruc­tur­ing.” I agree…

The Oba­ma admin­is­tra­tion, says Robert Gibbs, the White House spokesman, believes “that a pri­vate­ly held bank­ing sys­tem is the cor­rect way to go.” So do we all. But what we have now isn’t pri­vate enter­prise, it’s lemon social­ism: banks get the upside but tax­pay­ers bear the risks. And it’s per­pet­u­at­ing zom­bie banks, block­ing eco­nom­ic recov­ery.

For many years it was my con­sci­en­tious belief that the worst prac­ti­tion­ers in the media were celebri­ty reporters who did lit­tle more than rewrite press hand­outs sup­plied by agents for lime­light-seek­ing B‑grade actors and pop stars.

I’ve now revised my views and am con­vinced that the medi­a’s bot­tom-feed­ers are the eco­nom­ics writ­ers.

In so-called nor­mal times, these eru­dite com­men­ta­tors wrote very lit­tle and not very often. Indeed, they rarely came to work and weren’t seen around news­rooms. They sat at home in their book-lined stud­ies mou­s­ing their way through inter­na­tion­al web­sites look­ing for ideas for some­thing to write about.

David X. Li, it’s safe to say, won’t be get­ting that Nobel any­time soon. One result of the col­lapse has been the end of finan­cial eco­nom­ics as some­thing to be cel­e­brat­ed rather than feared. And Li’s Gauss­ian cop­u­la for­mu­la will go down in his­to­ry as instru­men­tal in caus­ing the unfath­omable loss­es that brought the world finan­cial sys­tem to its knees.

How could one for­mu­la pack such a dev­as­tat­ing punch? The answer lies in the bond mar­ket, the mul­ti­tril­lion-dol­lar sys­tem that allows pen­sion funds, insur­ance com­pa­nies, and hedge funds to lend tril­lions of dol­lars to com­pa­nies, coun­tries, and home buy­ers.

  • Feb­ru­ary 27: Econ­o­my shrinks at fastest pace in 26 years, Yahoo Finance.
  • 27 Feb: Christo­pher Joye, Busi­ness Spec­ta­tor. Dis­man­tle and start again. Christo­pher and I fre­quent­ly find our­selves on oppo­site sides of an eco­nom­ic argu­ment, but he reached some very inter­est­ing con­clu­sions about the caus­es of the cred­it bub­ble dur­ing his recent trip to the USA.

I began to realise that there is a fun­da­men­tal frailty that rests at the heart of the US finan­cial archi­tec­ture, which sets it apart from almost all oth­er devel­oped coun­tries, and which has been large­ly respon­si­ble for both pre­cip­i­tat­ing the cur­rent cri­sis and sub­se­quent­ly prop­a­gat­ing it around the rest of our increas­ing­ly inter­con­nect­ed world.

In spite of all the (usu­al­ly con­ser­v­a­tive) rhetoric about the prob­lems with the gov­ern­ment-spon­sored enter­pris­es (GSEs), Fan­nie Mae and Fred­die Mac, I have heard no dis­cus­sion of this much more far-reach­ing flaw sit­ting in the foun­da­tions of the US cred­it cre­ation sys­tem.

The prob­lem is a sim­ple one: the vast bulk of all home loans in the US (around 70 per cent) are fund­ed not using the bal­ance-sheets of large transna­tion­al banks, and in turn the region­al­ly diver­si­fied deposits of their cus­tomers, but via the far more com­plex, unsta­ble and some­times con­flict­ed process of “secu­ri­ti­sa­tion”…

My advice to Pres­i­dent Oba­ma, Tim­o­thy Gei­th­n­er, Shaun Dono­van, and Austin Gools­bee is that mere­ly apply­ing myopic ban­dages to the symp­toms of these prob­lems, and rein­vig­o­rat­ing the GSEs, is emphat­i­cal­ly not the long-term answer. The entire sys­tem of hous­ing finance needs to be trans­formed to a bank-based bal­ance-sheet focus…

“US stocks fell and the S&P 500 closed at a 12-year low on Fri­day, after the gov­ern­ment said it will take a large stake in Cit­i­group’s com­mon shares, fan­ning fears it will increase its role in oth­er major banks.

The decline closed out a grim month on Wall Street, with the Dow indus­tri­als hit­ting the low­est lev­el since May 1997 as the blue-chip index fell for a sixth straight month.”

“There is some­thing des­per­ate about the way peo­ple on both sides of the Atlantic are cling­ing to their dog-eared copies of Keynes’s Gen­er­al The­o­ry. Uneasi­ly aware that their dis­ci­pline almost entire­ly failed to antic­i­pate the cri­sis, econ­o­mists seem to be regress­ing to macro-eco­nom­ic child­hood, clutch­ing the mul­ti­pli­er like an old ted­dy bear.

The harsh real­i­ty that is being repressed is this: the West­ern world is suf­fer­ing a cri­sis of exces­sive indebt­ed­ness…”

“The idea of mod­i­fy­ing mort­gages appalls legal purists as a vio­la­tion of the sanc­ti­ty of con­tract. But, as with the prin­ci­ple of emi­nent domain, there are times when the pub­lic inter­est requires us to hon­our the rule of law in the breach. Repeat­ed­ly in the course of the 19th cen­tu­ry, gov­ern­ments changed the terms of bonds that they issued through a process known as con­ver­sion. A bond with a 5 per cent coupon would sim­ply be exchanged for one with a 3 per cent coupon, to take account of falling mar­ket rates and prices. Such pro­ce­dures were sel­dom stig­ma­tised as default. Today, in the same way, we need an order­ly con­ver­sion of adjustable rate mort­gages to take account of the fun­da­men­tal­ly altered finan­cial envi­ron­ment.

No doubt those who lose by such mea­sures will not suf­fer in silence. But the ben­e­fits of macro-eco­nom­ic sta­bil­i­sa­tion will sure­ly out­weigh the costs to bank share­hold­ers, bank bond­hold­ers and the own­ers of mort­gage-backed secu­ri­ties.

Amer­i­cans, Churchill once remarked, will always do the right thing — after they have exhaust­ed all the oth­er alter­na­tives. But if we are still wait­ing for Keynes to save us when Davos comes around next year, it may well be too late. Only a Great Restruc­tur­ing can end the Great Repres­sion. It needs to hap­pen soon.”

There were four mas­sive stock bub­bles in the 20th Cen­tu­ry: 1901, 1929, 1966, and 2000. Dur­ing each of these bub­ble peaks, the S&P 500 neared or exceed­ed 25X on pro­fes­sor Robert Shiller’s cycli­cal­ly adjust­ed P/E ratio.* After the first three of these peaks, the S&P 500 PE did not bot­tom until it hit 5X-8X. We’re still in the mid­dle of the last one.

Shillers Ten Year Lagging Price/Earnings indicator

Shiller’s Ten Year Lag­ging Price/Earnings indi­ca­tor

The most recent bub­ble peak, 2000, was by far the most extreme we have ever expe­ri­enced. In 2000, the S&P 500 by prof. Shiller’s mea­sure exceed­ed 40X (it had nev­er before exceed­ed 30X). With the S&P 500 hit­ting 700 today, the PE has now fall­en back to 12X. (See chart above.)

”This is inevitably the first quar­ter of Aus­trali­a’s reces­sion, that it’s cur­rent­ly in,” said Matt Robin­son of Moody’s Economy.com.

”It makes a mock­ery of the com­ment from RBA yes­ter­day that Aus­tralia has­n’t seen the size­able con­trac­tion in demand that oth­er economies have seen.”

In recount­ing how he began the fraud, whose col­lapse erased as much as $65 bil­lion that his cus­tomers thought they had in their accounts, Mr. Mad­off said: “I believed it would end short­ly and I would be able to extri­cate myself and my clients from the scheme. How­ev­er, this proved dif­fi­cult, and ulti­mate­ly impos­si­ble.”

He con­tin­ued, stum­bling slight­ly over the word order in his pre­pared remarks, “As the years went by I real­ized this day, and my arrest, would inevitably come.”

This week, the gov­ern­ment said Mr. Mad­off had 4,800 client accounts at the end of Novem­ber, sup­pos­ed­ly con­tain­ing $64.8 bil­lion in cus­tomer sav­ings. But the gov­ern­ment said Mr. Madoff’s busi­ness “held only a small frac­tion of that bal­ance.”

March 12: Debate–Is Mad­off Wall Street’s Great­est Vil­lain?, New York Times. With a com­ment by Mitchell Zuck­off, the author of the superb his­to­ry of Charles Ponzi, Ponz­i’s Scheme: the True Sto­ry of a Finan­cial Leg­end.

More impor­tant, there was a wide­spread per­cep­tion that the affect­ed investors were the sort of peo­ple who are usu­al­ly insu­lat­ed from huge rever­sals. Put anoth­er way, for once the tor­na­do wiped out the hous­es on the hill and missed the trail­er park in the val­ley…

When Charles Ponzi pulled off his scheme in 1920, he tapped into a wide­spread belief that pros­per­i­ty was a new Amer­i­can birthright. When it col­lapsed, the public’s out­rage was as much about the fear that some peo­ple would always be denied the brass ring as it was about the mon­ey he lost. After years of Amer­i­cans believ­ing that the stock mar­ket was a ris­ing tide that would lift all boats, Bernard Mad­off is liv­ing proof that the tide has gone out…

When the music stops — which it invari­ably does — there’s an under­stand­able need to reaf­firm the bound­aries between good and bad cap­i­tal­ism, between the Mad­offs of the world and the rest of us. And that’s what is going on now. While that sense of bound­aries may be reas­sur­ing to us, let us not lose sight that Mr. Mad­off had plen­ty of com­pa­ny in recent years. 

 

  • March 17: Chi­na flex­es, and the US catch­es a chilly reminder. Peter Hartch­er, SMH. I don’t often put posts from Peter here, but this was a very good and per­cep­tive piece. The USA is not in a posi­tion to reneg on its own debts, what­ev­er it might ulti­mate­ly be forced to do about pri­vate debt.

The Chi­nese pre­mier, Wen Jiabao, expressed con­cern about his coun­try’s $US1 tril­lion ($1.5 tril­lion) hold­ings of US gov­ern­ment bonds.

“We’ve lent a huge amount of cap­i­tal to the US, and of course we’re con­cerned about the secu­ri­ty of our assets. And to speak truth­ful­ly, I am a lit­tle bit wor­ried.”

That was all it took.

It marked a thresh­old moment in rela­tions between the cur­rent super­pow­er and the poten­tial one — Bei­jing demon­strat­ed that it is pre­pared to use its finan­cial pow­er over the US as an instru­ment of pres­sure.

US offi­cials, includ­ing Barack Oba­ma him­self, has­tened to reas­sure the Chi­nese over the week­end. “Not just the Chi­nese Gov­ern­ment, but every investor can have absolute con­fi­dence in the sound­ness of invest­ments in the US.”

Wen’s remark was not ran­dom. It was made in answer to a pre-approved ques­tion at his annu­al news con­fer­ence. It came just as his For­eign Min­is­ter, Yang Jiechi, was in Wash­ing­ton to nego­ti­ate with the US the approach the two coun­tries would take to the Group of 20 sum­mit in Lon­don on April 2.

And it emerged a few weeks after Hillary Clin­ton went to Bei­jing and explic­it­ly called on the Gov­ern­ment to keep buy­ing US bonds — the Oba­ma Trea­sury is hop­ing to sell the world anoth­er $1.7 tril­lion in trea­suries this year to pay for the US Gov­ern­men­t’s deficit.

  • March 18: Japan’s lost decade is a les­son for us all, Peter Costel­lo. Costel­lo is quite right here: a stim­u­lus pack­age or a dozen won’t solve this crisis–though the first one might soft­en the ini­tial blow of a very severe down­turn. But you can’t solve a prob­lem caused by too much (pri­vate sec­tor) debt by adding more (pub­lic sec­tor) debt.

Then the Japan­ese prop­er­ty bub­ble burst. Japan­ese banks were swamped by bad debts. The val­ue of their secu­ri­ties plum­met­ed. The Japan­ese gov­ern­ment announced a stim­u­lus plan. When it did­n’t do much good, it con­clud­ed that the first plan had­n’t been large enough. It announced a sec­ond, larg­er plan. When that failed, a third plan larg­er again was announced. Over the decade from 1990, Japan had at least 10 stim­u­lus plans which in total amount­ed to about 30 tril­lion Yen. There were at least three reces­sions dur­ing the decade — a decade described as a lost decade for Japan. Japan emerged with crip­pling gov­ern­ment debt — greater than the size of its GDP.

No one thinks Japan is the like­ly glob­al eco­nom­ic super pow­er of tomor­row.

Now, the Unit­ed States has seen a prop­er­ty bub­ble col­lapse, its banks are rid­dled with bad debts and it is in reces­sion. It has react­ed with mas­sive stim­u­lus pack­ages. When Japan was receiv­ing this treat­ment in the 1990s, the Clin­ton admin­is­tra­tion was in office. Two of the key fig­ures urg­ing Japan on to large bud­get stim­u­lus were Lar­ry Sum­mers and Tim Gei­th­n­er. Now they are key advis­ers in the Oba­ma Admin­is­tra­tion.

But the spend, spend, spend mantra is meet­ing some resis­tance in Europe, par­tic­u­lar­ly from Ger­many. Per­haps the Ger­mans remem­ber the Japan­ese expe­ri­ence of the 1990s. Fis­cal stim­u­lus is no answer to struc­tur­al prob­lems in an econ­o­my. It’s the struc­tur­al prob­lems that have to be dealt with.

When all the stim­u­lus pack­ages are over, the debt is still there. And it has to be bor­rowed from some­one. And when con­fi­dence returns to the mar­ket, and there are high­er com­pet­ing returns on offer, the inter­est rate to ser­vice that debt will be so much high­er.

For years econ­o­mists who have chal­lenged free mar­ket the­o­ry have been the Rod­ney Dan­ger­fields of the pro­fes­sion. Often ignored or belit­tled because they ques­tioned the ortho­doxy, they say, they have been shut out of many eco­nom­ics depart­ments and the most pres­ti­gious eco­nom­ics jour­nals. They got no respect…

That was before last fall’s crash took the eco­nom­ics estab­lish­ment by sur­prise…

Yet promi­nent eco­nom­ics pro­fes­sors say their aca­d­e­m­ic dis­ci­pline isn’t shift­ing near­ly as much as some peo­ple might think. Free mar­ket the­o­ry, math­e­mat­i­cal mod­els and hos­til­i­ty to gov­ern­ment reg­u­la­tion still reign in most eco­nom­ics depart­ments at col­leges and uni­ver­si­ties around the coun­try. True, some new approach­es have been explored in recent years, par­tic­u­lar­ly by behav­ioral econ­o­mists who argue that human psy­chol­o­gy is a cru­cial ele­ment in eco­nom­ic deci­sion mak­ing. But the belief that peo­ple make ratio­nal eco­nom­ic deci­sions and the mar­ket auto­mat­i­cal­ly adjusts to respond to them still pre­vails…

To Mr. Gal­braith and L. Ran­dall Wray, an econ­o­mist at Mis­souri, the two thinkers whose work is most rel­e­vant today are John May­nard Keynes, who argued that the gov­ern­ment should spend its way out of the Great Depres­sion, and Hyman Min­sky, who main­tained that finan­cial insti­tu­tions could prompt ruinous crash­es by tak­ing on too much risk. Nei­ther, Mr. Gal­braith said, is part of the core cur­ricu­lum in most eco­nom­ics grad­u­ate pro­grams.

When asked why grad­u­ate stu­dents don’t study Keynes or Minksy, Mr. Reny replied that grad­u­ate stu­dents work on sub­jects — like real mod­els of busi­ness cycles — that are at the fron­tier of the field; by con­trast Keynes and Min­sky are not on the fron­tier any­more.

Mr. Wray prefers to call such math­e­mat­i­cal mod­el­ing “the fron­tier of non­sense.” For more than a decade Mr. Wray has assert­ed that both the the­o­ry and the mod­els used by risk-rat­ing agen­cies are wrong. He has been invit­ed to speak at the Uni­ver­si­ty of Chica­go, he said, but by social sci­ence grad­u­ate stu­dents, not by the eco­nom­ics depart­ment.

We think Gei­th­n­er is suf­fer­ing from five fun­da­men­tal mis­con­cep­tions about what is wrong with the econ­o­my:

The trou­ble with the econ­o­my is that the banks aren’t lend­ing.  The real­i­ty: The econ­o­my is in trou­ble because Amer­i­can con­sumers and busi­ness­es took on way too much debt and are now col­laps­ing under the weight of it…

The banks aren’t lend­ing because their bal­ance sheets are loaded with “bad assets” that the mar­ket has tem­porar­i­ly mis­priced.  The real­i­ty: The banks aren’t lend­ing (much) because they have decid­ed to stop mak­ing loans to peo­ple and com­pa­nies who can’t pay them back…

Bad assets are “bad” because the mar­ket does­n’t under­stand how much they are real­ly worth.  The real­i­ty: The bad assets are bad because they are worth less than the banks say they are…

Once we get the “bad assets” off bank bal­ance sheets, the banks will start lend­ing again.  The real­i­ty: The banks will remain cau­tious about lend­ing, because the hous­ing mar­ket and econ­o­my are still dete­ri­o­rat­ing…

Once the banks start lend­ing, the econ­o­my will recov­er.  The real­i­ty: Amer­i­can con­sumers still have debt com­ing out of their ears, and they’ll be work­ing it off for years…

Like it or not, many peo­ple seem to be resigned to the idea there’s no alter­na­tive to the pub­lic-pri­vate invest­ment fund scheme Trea­sury Sec­re­tary Gei­th­n­er detailed this morn­ing. (Click here for part one of our dis­cus­sion of the plan.) 

That’s hog­wash, says Uni­ver­si­ty of Texas pro­fes­sor James Gal­braith, author of The Preda­tor State. Of course there’s an alter­na­tive: FDIC receiver­ship of insol­vent banks.

From Oba­ma to Gei­th­n­er to Bernanke, pol­i­cy­mak­ers are like doc­tors deal­ing with a “mild­ly ill” patient vs. treat­ing one who is “grave­ly” ill, says James Gal­braith, Uni­ver­si­ty of Texas pro­fes­sor and author of The Preda­tor State.

The econ­o­mist fears the econ­o­my is in ter­mi­nal con­di­tion requir­ing much more inter­ven­tion than already pre­scribed. He believes gov­ern­ment “doc­tors” are engaged in a lot of “hap­py talk” about recov­ery based on a “fun­da­men­tal­ly flawed mod­el,” hinged on the idea the econ­o­my is self-heal­ing and only needs a boost­er shot before it “nat­u­ral­ly” returns to trend growth and unem­ploy­ment in the 5% range.

March 5, 2006: AMSTERDAM HOUSE: This Very, Very Old House. New York Times. The Heren­gracht Canal House Price Index.

From the time the Heren­gracht was devel­oped in the ear­ly 17th cen­tu­ry, how­ev­er, it has been Ams­ter­dam’s prime real estate, the place where pow­er bro­kers — 17th-cen­tu­ry mer­chants deal­ing in spices and slaves or 21st-cen­tu­ry bankers and inter­na­tion­al con­sul­tants — have cho­sen to base them­selves. Look­ing at real-estate trans­ac­tions over four cen­turies on this canal on which Pieter Fran­sz built his home gives a qual­i­ty con­stant of unpar­al­leled dura­tion.

This is what attract­ed Piet Eich­holtz, a pro­fes­sor of real-estate finance at Maas­tricht Uni­ver­si­ty in the Nether­lands, to study the Heren­gracht in the 1990’s. Eich­holtz’s work — the so-called Heren­gracht index — has become a touch­stone in recent dis­cus­sions about real-estate prices. He began with a sense of frus­tra­tion. “If you look at most research on real-estate mar­kets,” he said, “papers will typ­i­cal­ly say they are tak­ing ‘a long-run look,’ and then they go back 20 years. I was­n’t impressed with that. I thought you had to go back fur­ther to get a real­ly good pic­ture of what a hous­ing mar­ket per­forms like.”


Excel­lent ana­lyt­ic overview of the cri­sis by a non-ortho­dox win­ner of the Nobel Prize in Eco­nom­ics.

Bub­bles have been fre­quent in eco­nom­ic his­to­ry, and they occur in the lab­o­ra­to­ries of exper­i­men­tal eco­nom­ics under con­di­tions which — when first stud­ied in the 1980s — were con­sid­ered so trans­par­ent that bub­bles would not be observed.

We econ­o­mists were wrong: Even when traders in an asset mar­ket know the val­ue of the asset, bub­bles form depend­ably. Bub­bles can arise when some agents buy not on fun­da­men­tal val­ue, but on price trend or momen­tum. If momen­tum traders have more liq­uid­i­ty, they can sus­tain a bub­ble longer.

But what sparks bub­bles? Why does one large asset bub­ble — like our dot-com bub­ble — do no dam­age to the finan­cial sys­tem while anoth­er one leads to its col­lapse? Key char­ac­ter­is­tics of hous­ing mar­kets — momen­tum trad­ing, liq­uid­i­ty, price-tier move­ments, and high-mar­gin pur­chas­es — com­bine to pro­vide a fair­ly com­plete, sim­ple descrip­tion of the hous­ing bub­ble col­lapse, and how it engulfed the finan­cial sys­tem and then the wider econ­o­my.

In just the past 40 years there were two oth­er hous­ing bub­bles, with peaks in 1979 and 1989, but the largest one in U.S. his­to­ry start­ed in 1997, prob­a­bly sparked by ris­ing house­hold income that began in 1992 com­bined with the elim­i­na­tion in 1997 of tax­es on res­i­den­tial cap­i­tal gains up to $500,000. Ris­ing val­ues in an asset mar­ket draw investor atten­tion; the ear­ly stages of the hous­ing bub­ble had this usu­al, self-rein­forc­ing fea­ture.

The 2001 reces­sion might have end­ed the bub­ble, but the Fed­er­al Reserve decid­ed to pur­sue an unusu­al­ly expan­sion­ary mon­e­tary pol­i­cy in order to coun­ter­act the down­turn…

The caus­es of the Great Depres­sion need more study, but the claims that loss­es on stock-mar­ket spec­u­la­tion and a mon­e­tary con­trac­tion caused the decline of the bank­ing sys­tem both seem inad­e­quate. It appears that both the Great Depres­sion and the cur­rent cri­sis had their ori­gins in exces­sive con­sumer debt — espe­cial­ly mort­gage debt — that was trans­mit­ted into the finan­cial sec­tor dur­ing a sharp down­turn.

What we’ve offered in our dis­cus­sion of this cri­sis is the back sto­ry to Mr. Bernanke’s analy­sis of the Depres­sion. Why does one crash cause min­i­mal dam­age to the finan­cial sys­tem, so that the econ­o­my can pick itself up quick­ly, while anoth­er crash leaves a dev­as­tat­ed finan­cial sec­tor in the wreck­age? The hypoth­e­sis we pro­pose is that a finan­cial cri­sis that orig­i­nates in con­sumer debt, espe­cial­ly con­sumer debt con­cen­trat­ed at the low end of the wealth and income dis­tri­b­u­tion, can be trans­mit­ted quick­ly and force­ful­ly into the finan­cial sys­tem. It appears that we’re wit­ness­ing the sec­ond great con­sumer debt crash, the end of a mas­sive con­sump­tion binge.

Recent­ly — Pro­fes­sor Paul Krug­man of Prince­ton Uni­ver­si­ty wrote with­in a brief New York Times arti­cle Bub­ble Blind­ness: “The big mys­tery is the (econ­o­mists) fail­ure to see the hous­ing bub­ble. The data screamed “bubble”even in real time. And there was no excuse for think­ing that such things don’t hap­pen in effi­cient mar­kets, not with the dead body of the dot-com bub­ble still warm.”

“So why did so few peo­ple point out the obvi­ous? One answer may be that macro­econ­o­mists, in par­tic­u­lar, didn’t want to go up against bub­ble denier Alan Greenspan, which might get them black­balled from Jack­son Hole and all that. But over­all, the fail­ure to see the most obvi­ous bub­ble in my life­time remains a puz­zle.”

This inex­cus­able fail­ure is not a “puz­zle” Pro­fes­sor Krug­man.

With­in a recent Boston Globe arti­cle Par­a­digm Lost, Drake Ben­nett wrote –

“But aca­d­e­m­ic econ­o­mists are (experts). And with very few excep­tions, they did not pre­dict the cri­sis either. Some warned of a hous­ing bub­ble, but almost none fore­saw the result­ing cat­a­clysm. An entire field of experts, ded­i­cat­ed to study­ing the behav­ior of mar­kets, failed to antic­i­pate what may prove to be the biggest eco­nom­ic col­lapse of our life­time. And now that we are in the mid­dle (or is it the start?) of it, many admit they are not sure how to pre­vent things from get­ting worse.”

“As a result, there’s a sense among some econ­o­mists that, as they try to fig­ure out how to fix the econ­o­my, they are also try­ing to fix their own pro­fes­sion”.

By no means how­ev­er, did the eco­nom­ics pro­fes­sion have a monop­oly on “hous­ing bub­ble blind­ness”…

This is an excel­lent statistical/graphical com­par­i­son of the sever­i­ty of this cri­sis ver­sus the Great Depres­sion. On almost every met­ric, this one is much worse–as I’ve been argu­ing here for some time, with the cause (exces­sive debt lev­els rel­a­tive to GDP) at least twice as bad as last time, the dis­ease will in all prob­a­bil­i­ty be at least as bad–allowing that per­haps “Big Gov­ern­ment” will soft­en the blow to some degree, as Min­sky used to argue.

“Often cit­ed com­par­isons – which look only at the US – find that today’s cri­sis is milder than the Great Depres­sion. In this col­umn, two lead­ing eco­nom­ic his­to­ri­ans show that the world econ­o­my is now plum­met­ing in a Great-Depres­sion-like man­ner. Indeed, world indus­tri­al pro­duc­tion, trade, and stock mar­kets are div­ing faster now than dur­ing 1929–30. For­tu­nate­ly, the pol­i­cy response to date is much bet­ter…”

 

7 April 2009: The Finan­cial War Against Ice­land, by Michael Hud­son.

Ice­land is under attack – not mil­i­tar­i­ly¬ but finan­cial­ly. It owes more than it can pay. This threat­ens debtors with for­fei­ture of what remains of their homes and oth­er assets. The gov­ern­ment is being told to sell off the nation’s pub­lic domain, its nat­ur­al resources and pub­lic enter­pris­es to pay the finan­cial gam­bling debts run up irre­spon­si­bly by a new bank­ing class. This class is seek­ing to increase its wealth and pow­er despite the fact that its debt-lever­ag­ing strat­e­gy already has plunged the econ­o­my into bank­rupt­cy. On top of this, cred­i­tors are seek­ing to enact per­ma­nent tax­es and sell off pub­lic assets to pay for bailouts to them­selves…

In Ice­land – but nowhere else – home mort­gages have a unique­ly bad twist. Cred­i­tors have man­aged to pro­tect the weight of their claims on debtors by index­ing mort­gage loans to the nation’s con­sumer price infla­tion (CPI) rate. Each month the debt prin­ci­pal is increased by the CPI increase – and so is the inter­est charge. Dur­ing 2008 that index rose by 14.2%, so a 100,000-euro mort­gage at the start of 2008 would have grown to 114,230 euros by yearend. These month­ly adjust­ments also would added an entire per­cent­age point onto the inter­est pay­ment – an extra 100 euros to be paid to cred­i­tors month­ly, in addi­tion to the grow­ing prin­ci­pal to be amor­tized. Talk about mak­ing mon­ey with­out effort …!

Such heavy debt charges would shrink any econ­o­my, and that is what is hap­pen­ing in Ice­land. Prices for real estate declined by an esti­mat­ed 21 per­cent for hous­ing in 2008. So in the above exam­ple, the mar­ket price of the house worth 100,000 euros at the begin­ning of the year would have been worth only 79,000 at yearend, while the mort­gage would have grown by 14% to 114,230. This would have plunged the home­own­er 35,000 euros into neg­a­tive equi­ty – a remark­able 35% change.

 

Just as it is dif­fi­cult to con­ceive why sane peo­ple through­out Europe staked their for­tunes on tulips in the late 1630s, heads will one day shake at the naivety of those who were seduced into putting their mon­ey into heav­i­ly indebt­ed trust struc­tures that nom­i­nal­ly owned toll roads, air­ports and the like.

In the past decade, infra­struc­ture became the fod­der for a Ponzi scheme — an elab­o­rate­ly con­struct­ed and com­plex one, but a Ponzi scheme just the same. BrisCon­nec­tions was mere­ly one of the last and more brazen, and the one to implode most spec­tac­u­lar­ly.

The idea was fair­ly sim­ple. Buy some­thing, any­thing, for a ridicu­lous amount of mon­ey, using a raft of over­ly opti­mistic assump­tions stretch­ing out for decades. Bor­row almost all the pur­chase price. Sell it into a tax-effec­tive trust. The high­er the price, the big­ger the fees. When the busi­ness does­n’t gen­er­ate enough income to cov­er the inter­est, bor­row even more so you can pay investors a div­i­dend and main­tain inter­est pay­ments.

 

The eco­nom­ics pro­fes­sion must bear a lot of the blame for the cur­rent cri­sis. If it is to become use­ful again it must under­go an intel­lec­tu­al revolution—becoming both broad­er and more mod­est.

The scan­dal of mod­ern eco­nom­ics is that these two false theories—rational expec­ta­tions and the effi­cient mar­ket hypothesis—which are not only mis­lead­ing but high­ly ide­o­log­i­cal, have become so dom­i­nant in acad­e­mia (espe­cial­ly busi­ness schools), gov­ern­ment and mar­kets them­selves. While nei­ther the­o­ry was total­ly dom­i­nant in main­stream eco­nom­ics depart­ments, both were found in every major text­book, and both were impor­tant parts of the “neo-Key­ne­sian” ortho­doxy, which was the end-result of the shake-out that fol­lowed Mil­ton Friedman’s attempt to over­throw Keynes. The result is that these two the­o­ries have more pow­er than even their adher­ents realise: yes, they under­pin the think­ing of the wilder fringes of the Chica­go school, but also, more sub­tly, they under­pin the analy­sis of sen­si­ble econ­o­mists like Paul Samuel­son.

Fred­er­ick Sod­dy, born in 1877, was an indi­vid­u­al­ist who bowed to few con­ven­tions, and who is described by one biog­ra­ph­er as a dif­fi­cult, obsti­nate man. A 1921 Nobel lau­re­ate in chem­istry for his work on radioac­tive decay, he fore­saw the ener­gy poten­tial of atom­ic fis­sion as ear­ly as 1909. But his dis­qui­et about that power’s poten­tial wartime use, com­bined with his revul­sion at his discipline’s com­plic­i­ty in the mass deaths of World War I, led him to set aside chem­istry for the study of polit­i­cal econ­o­my — the world into which sci­en­tif­ic progress intro­duces its gifts. In four books writ­ten from 1921 to 1934, Sod­dy car­ried on a quixot­ic cam­paign for a rad­i­cal restruc­tur­ing of glob­al mon­e­tary rela­tion­ships. He was round­ly dis­missed as a crank.

He offered a per­spec­tive on eco­nom­ics root­ed in physics — the laws of ther­mo­dy­nam­ics, in par­tic­u­lar. An econ­o­my is often likened to a machine, though few econ­o­mists fol­low the par­al­lel to its log­i­cal con­clu­sion: like any machine the econ­o­my must draw ener­gy from out­side itself. The first and sec­ond laws of ther­mo­dy­nam­ics for­bid per­pet­u­al motion, schemes in which machines cre­ate ener­gy out of noth­ing or recy­cle it for­ev­er. Sod­dy crit­i­cized the pre­vail­ing belief of the econ­o­my as a per­pet­u­al motion machine, capa­ble of gen­er­at­ing infi­nite wealth — a crit­i­cism echoed by his intel­lec­tu­al heirs in the now emer­gent field of eco­log­i­cal eco­nom­ics.

 

By Janet L. Yellen, Pres­i­dent and CEO, Fed­er­al Reserve Bank of San Fran­cis­co

It’s a great plea­sure to speak to this dis­tin­guished group at a con­fer­ence named for Hyman P. Min­sky. My last talk here took place 13 years ago when I served on the Fed’s Board of Gov­er­nors. My top­ic then was “The ‘New’ Sci­ence of Cred­it Risk Man­age­ment at Finan­cial Insti­tu­tions.” It described inno­va­tions that I expect­ed to improve the mea­sure­ment and man­age­ment of risk. My talk today is titled “A Min­sky Melt­down: Lessons for Cen­tral Bankers.” I won’t dwell on the irony of that. Suf­fice it to say that, with the finan­cial world in tur­moil, Minsky’s work has become required read­ing. It is get­ting the recog­ni­tion it rich­ly deserves. The dra­mat­ic events of the past year and a half are a clas­sic case of the kind of sys­temic break­down that he—and rel­a­tive­ly few others—envisioned…

[This speech by a Fed­er­al Reserve Pres­i­dent eat­ing hum­ble pie, and eulo­gis­ing Min­sky, so it belongs here on Gems. But it is also on the Brick­bats page. Why? Because her under­stand­ing of Min­sky is so flawed. Read­ing this was rather like read­ing Hick­s’s “Mr Keynes and the Clas­sics” (1937), in which the deeply neo­clas­si­cal young John Hicks com­plete­ly man­gled Key­nes’s argu­ments in the Gen­er­al The­o­ry to argue that Keynes was com­pat­i­ble with neo­clas­si­cal thought:

“Income and the rate of inter­st are now deter­mined togeth­er at P, the point of inter­sec­tion of the curves LL and IS. They are deter­mined togeth­er; just as price and out­put are deter­mined togeth­er in the mod­ern the­o­ry of demand and sup­ply. Indeed, Mr. Keynes’ inno­va­tion is close­ly par­al­lel, in this respect, to the inno­va­tion of the mar­gin­al­ists.” (p. 153)

Yellen did­n’t claim any­thing quite as brazen as this, but her unin­ten­tion­al emas­cu­la­tion of Min­sky’s argu­ment was, to me breath­tak­ing.

 

This morn­ing, Sec­re­tary of the Trea­sury Tim Gei­th­n­er tes­ti­fied before the Con­gres­sion­al Over­sight Pan­el (COP) head­ed by Eliz­a­beth War­ren. In gen­er­al, the ques­tions were excel­lent; unfor­tu­nate­ly, the answers were not forth­com­ing.

 

One excel­lent ques­tion was, “How does pro­tect­ing the com­mon share­hold­ers of Cit­i­group © help the econ­o­my?” There was no real answer to that ques­tion — just a dance about how it was not appro­pri­ate for him to talk about any indi­vid­ual finan­cial insti­tu­tion. The true answer to the ques­tion is: it does­n’t.

He said in response to ques­tion­ing about the asym­met­ric risks and returns in the Pub­lic Pri­vate Invest­ment Plan (PPIP) that if you had to sell your house imme­di­ate­ly but there were no mort­gages avail­able, you would not get a very good price. I think that this is fun­da­men­tal­ly the wrong anal­o­gy to use, and it reflects a flawed assump­tion that under­lies the PPIP pro­gram — name­ly that the buy­ers in the mar­ket are wrong.

It assumes that the rea­son that there is no vol­ume in the mar­ket for these “lega­cy assets,” the new term for “tox­ic assets,” is that there are no buy­ers, rather than that there are no sell­ers. This is an unproven assump­tion at best, although one of the bet­ter fea­tures of the PPIP is that it should help answer the ques­tion of a lack of buy­ers vs. a lack of sell­ers.

A bet­ter anal­o­gy (or at least one that is equal­ly valid) is: sup­pose you want­ed to sell your home, but it has suf­fered major water dam­age and is now infest­ed with ter­mites. How­ev­er, you owe $500,000 on it, and no buy­er is will­ing to pay more than $250,000 for it, and you can­not afford to sell it at that price. Sim­ply because mort­gages are avail­able at rea­son­able inter­est rates will not make buy­ers want to buy your house for any­thing like $500,000.

END