October 26, 2008

Onion: Bush Calls for Panic

The Onion proves once again that is truly is the [US] Nation's Finest News Source in a great piece of satire titled: "Bush Calls for Panic".
In a nationally televised address to the American people Wednesday night, President Bush called upon every man, woman, and child to spiral uncontrollably downward into complete and utter panic.
It sure has been looking like inducing panic is the Bush administration's goal. The way that they suddenly switched from "everything is all right, our banking system is save and sound" to "we are doomed, unless we get to blow the lid off the national debt, in which case we are doomed anyway" is a sure way to create a massive panic.

This is not the first time, either. After September 11th, there was an equally sudden turn to scaremongering from absolute indifference. The initial approach to the threat of terrorism in the Bush administration was highly dismissive, even though the departing Clinton officials tried to raise awareness of the situation. This dismissive attitude was then suddenly switched to claims of existential threat.

If the purpose was not to create a state of panic, it can only be explained by complete incompetence. Maybe the administration will next produce a colour-coded economic warning system, directing the citizenry to selling into coordinated panics, followed by buying at the tops.

October 25, 2008

Learning from the Great Depression

N. Gregory Mankiw, the economics professor from Harvard, writes in the New York Times about the lessons learned by economists since the Great Depression. He takes issue with overconfident rhetoric from IMF's chief economist, Olivier Blanchard.

Like most economists, those at the International Monetary Fund are lowering their growth forecasts. The financial turmoil gripping Wall Street will probably spill over onto every other street in America. Most likely, current job losses are only the tip of an ugly iceberg.

But when Olivier Blanchard, the I.M.F.’s chief economist, was asked about the possibility of the world sinking into another Great Depression, he reassuringly replied that the chance was “nearly nil.” He added, “We’ve learned a few things in 80 years.

Yes, we have. But have we learned what caused the Depression of the 1930s? Most important, have we learned enough to avoid doing the same thing again?

The Depression began, to a large extent, as a garden-variety downturn. The 1920s were a boom decade, and as it came to a close the Federal Reserve tried to rein in what might have been called the irrational exuberance of the era.

So professor Mankiw clearly recognizes the significance of the prior excess. He then goes on to discuss the effects of the stock market crash.

But things took a bad turn after the crash of October 1929. Lower stock prices made households poorer and discouraged consumer spending, which then made up three-quarters of the economy. (Today it’s about two-thirds.)

Here Professor Mankiw is putting the carriage way ahead of the horse. The fact that the economy was almost completely built on consumption is clearly the primary cause of the depression, just as it is now. Such "hollowness" of the economy was the reason for the market implosion, not vice versa.

Is Professor Mankiw really trying to say that if only consumption could have been kept going, a downturn would have never come? Have we really learned so very little in those 80 years?

But such an assumption is partially correct. The consumption could have continued in a less diminished form, only not without a massive recognition of losses for those that had amassed huge savings in the form of debt receivables during the previous decade or two. Those savings were mostly imaginary. The "wealth" that was supposed to be so great in the roaring twenties was mainly a mirage. It was not backed up by actual assets, just a whole lot of credit.

But there was actual wealth, even though it was not up to the level of credit in the banking system. People can't eat credit. There was real production. Real buildings were built.

What resulted in losses to the real economy was the panicky scramble by the owners of the financial system to realize as much as possible of their inherently imaginary wealth. This resulted in factory closures, cuts to production and overall liquidations of everything in sight.

But preserving the imaginary value of the financial system in general was impossible. The value just wasn't there. Even if a few early birds might have salvaged an out-sized piece of the pie, liquidations of productive assets made the overall situation catastrophic, and actually reduced the pool of real wealth in existence.

The only way to prevent such a panic of liquidations is an abrupt and early recognition of the true base of value in the economy, combined with equitable distribution of losses to holders of imaginary wealth. This much is clearly understood by professor Mankiw.

Probably the most important source of recovery after 1933 was monetary expansion, eased by President Franklin D. Roosevelt’s decision to abandon the gold standard and devalue the dollar. From 1933 to 1937, the money supply rose, stopping the deflation. Production in the economy grew about 10 percent a year, three times its normal rate.

It is nice to see that Professor Mankiw recognizes the value of giving up on the gold standard. After all, the standard was effectively given up much earlier by letting the financial system grow so far ahead of its reserves.

Monetary stimulus can not be trusted to perform the delivery of losses in an equitable way. It hurts savers in actual assets and favours the owners of imaginary wealth in the financial system. Monetary stimulus must be accompanied by distribution of losses to all levels of the financial system, including depositors and other creditors. Professor Mankiw kind of admits this in a later paragraph.

The Fed and the Treasury Department, intent on avoiding the early policy inaction that let the Depression unfold, have been working hard to keep credit flowing. But the financial situation they face is, arguably, more difficult than that of the 1930s. Then, the problem was largely a crisis of confidence and a shortage of liquidity. Today, the problem may be more a shortage of solvency, which is harder to solve.

The comment about 1930's not being mostly about shortage of solvency is quite frankly puzzling.

It must be recognized that the free market does not much help us here. In a free market of rational people, there will be a completely rational panic in a widespread insolvency situation. This puts us in a prisoner's dilemma situation where the common good is seriously neglected by individuals acting out of rational self-preservation. If we are additionally ready to accept, as the economic theory of late has been very loath to do, that people in general are not very rational, or have no access to the necessary information for rational decision-making, we can assume that there will be complete carnage.

An equitable distribution of losses, as a necessary but inherently repulsive proposition, requires some kind of coordination. This includes taking bad banks out of business as early as possible, instead of letting them pile on the losses.

But human nature is not very well suited for early recognition of losses, even if that would be rational. Overall deposit guarantees has been the unfortunate (and very late) first reaction from governments in Europe. It just makes the situation worse and further delays the recognition of the differences in the values of the financial system and the real economy.

Instead of guaranteeing all deposits, there should be a way to rearrange all bank liabilities, including deposits, into new equity, while the old equity would be wiped out.

Deposits above a suitable threshold, which could be quite high, should be converted to new equity in a bank failure. This would directly address the solvency issues without causing a need for fire-sale disposition of the assets of the failed bank. This would also be useful for keeping bank management in a healthy state of fear: "Do your job properly, or face a mob of angry ex-depositors in the next general meeting of shareholders."

A solution to too much credit is not more credit. It is conversion of credit to equity and realizing losses from imaginary wealth.

October 13, 2008

Fannie and Freddie no Longer Run to Minimize Taxpayer Losses

MarketWatch reports of Fannie Mae and Freddie Mac getting new marching orders from the US government:
Regulators initially restricted Fannie and Freddie's growth when they seized control. To "promote stability" and lower mortgage costs to borrowers, Treasury Secretary Henry Paulson said the two companies would be allowed to "modestly increase'' their mortgage portfolios to as much as $1.7 trillion through the end of next year and said they would no longer be run "to maximize shareholder returns."
Since no returns of any kind are to be expected in a little while, the last sentence should actually be translated to a more accurate wording: They are no longer run to minimize shareholder losses. And "shareholder" now practically means the US government. Isn't that nice and reassuring. And a good way to promote the "free market".

October 12, 2008

Moral Factors in the Free Market

There is a very interesting review in Time magazine of an article, from a forthcoming Oxford University Press book, titled "The Recession of 2008: The Moral Factor — A Jewish Law Analysis.", by Aaron Levine, who is both a rabbi and an economics professor.

The article comes up with a pro-regulatory stance that has its basis on the ancient principles of Judeo-Christian ethics, including not putting a stumbling-block before the blind (economically so in this case), disclosure (of hidden flaws) and over-charging.

That economics professors start to discuss ethics is a much needed step towards creating a principled compromise between freedom and moral restrictions in the prevailing "free market" ideology.

The old adage of "no freedom without responsibility" has been greatly manifested by the current financial crisis. The free agents in a marketplace are suddenly not so free after all, when confronted with margin calls. If one does not act in a responsible way, one's freedom will we taken away, one way or another.

In our usual feelings of self-importance and entitlement, we could take a word from Abraham Lincoln: "I like to see a man proud of the place in which he lives. I like to see a man live so his place will be proud of him."

October 7, 2008

Cyclic History in Action

Finance professionals have had quite a negative attitudes to talk of paralles between the current situation and that prior to the Great Depression of the 1930's. Now that such comparisons are starting to appear in many mainstream publications, Scott Reynolds Nelson, a professor of history, in a guest post in iTulip.com, makes a claim that the 1930's depression is not the correct parallel with the current situation. Instead he makes direct parallels with the Real Great Depression that started with the panic of 1873. (Hat tip to Tim of The Mess That Greenspan Made)
When commentators invoke 1929, I am dubious. According to most historians and economists, that depression had more to do with overlarge factory inventories, a stock-market crash, and Germany's inability to pay back war debts, which then led to continuing strain on British gold reserves. None of those factors is really an issue now. Contemporary industries have very sensitive controls for trimming production as consumption declines; our current stock-market dip followed bank problems that emerged more than a year ago; and there are no serious international problems with gold reserves, simply because banks no longer peg their lending to them.

In fact, the current economic woes look a lot like what my 96-year-old grandmother still calls "the real Great Depression." She pinched pennies in the 1930s, but she says that times were not nearly so bad as the depression her grandparents went through. That crash came in 1873 and lasted more than four years. It looks much more like our current crisis.
He also provides a nice lithograph from 1875 that shows the get-rich-quick attitude of the time as people chasing bubbles that are blown by a devil-looking character. I have reproduced the lithograph here in a less compressed format from the US Library of Congress.

He also draws analogies to the global imbalances caused by unequal cost factors across the global marketplace.
Wheat exporters from Russia and Central Europe faced a new international competitor who drastically undersold them. The 19th-century version of containers manufactured in China and bound for Wal-Mart consisted of produce from farmers in the American Midwest. They used grain elevators, conveyer belts, and massive steam ships to export train loads of wheat to abroad.


The echoes of the past in the current problems with residential mortgages trouble me. Loans after about 2001 were issued to first-time home buyers who signed up for adjustable rate mortgages they could likely never pay off, even in the best of times. Real-estate speculators, hoping to flip properties, overextended themselves, assuming that home prices would keep climbing. [...] As in 1873, a complex financial pyramid rested on a pinhead. Banks are hoarding cash. Banks that hoard cash do not make short-term loans. Businesses large and small now face a potential dearth of short-term credit to buy raw materials, ship their products, and keep goods on shelves.
Wow. I hope that he is not proven right in this assessment.

October 6, 2008

Blowback from Economic Black Ops?

I've been reading John Perkins' book "Confessions of an Economic Hit Man". It has made me think how much the oversized financial trouble in the economies of the developed world is at least partly an instance of blowback from economic operations that were initiated in the 1970's.

Perkins claims in his book that he was approached by people from the NSA in the beginning of his career as an economist in a big energy engineering company. (Chas. T. Main, now part of The Parsons Corp.). He was encouraged by the government people and his superiors to produce overly optimistic economic forecasts to encourage foreign governments to take huge amounts of debt for oversized development projects. The aim of this was to bring nations into debtor relationships with the US and the World Bank, thus retaining significant political control.

One paragraph in a chapter that is otherwise focused on the problems of modern Ecuador lit up a lingering thought that had been floating around my head for some time:
"During those tree decades, thousands of men and women participated in bringing Ecuador to the tenuous position it found itself in at the beginning of the millennium. Some of them, like me, had been aware of what they were doing, but the vast majority had merely performed the tasks they had been taught in business, engineering, and law schools, or had followed the lead of bosses in my mold, who demonstrated the system by their own greedy example and through rewards and punishments calculated to perpetuate it. Such participants saw the parts they played as benign, at worst; in the most optimistic view, they were helping an impoverished nation." [emphasis mine]
If this "operation" was as widespread as Mr. Perkins claims, it might actually have had an influence in the behaviour of underlings that observed their bosses coming up with and encouraging the most hyper-optimistic assumptions of economic development.

Because people do not just stay at a single job, untold numbers of workers might have participated in operations that were led by people secretly but intentionally working towards creating financial hardship. These people would take this behaviour as the normal way to do business. Some of those people that had early in their careers in the 1970's unwittingly worked in such projects are now on the very top of the business world.

The stream of thought in the financial world that just like that crosses straight over into hubris has been somewhat a mystery to me. This explanation, though only partial at best, is a very tempting one.

Naturally such operations could not be single-handedly responsible for the psyche of a whole generation. But it could have produced an additional amount of cultural acceptance for seemingly short-sighted practices of financial overreach.

It is, of course, also perfectly feasible that Perkins' book is not completely honest, but an elaborate attempt at trying to clean his own image. It can be a drag on one's conscience to witness the economic ruins left behind by sloppy or self-serving economic assessments.

Perkins' writing style does have a certain bit of self-centredness. (I was a hit man, but a conscious one.) The story also project an image of a person with such a level of cognitive dissonance that makes it somewhat hard to believe. Perkins' possible exaggerations of his moral discomfort in the early years doesn't necessarily mean that he is lying about the alleged government collusion.

As an idea, especially knowing of other operations of the US intelligence apparatus, the situation described by Perkins has some credibility. If these operations did indeed happen, a part of the financial trouble today can surely be ascribed to blowback from these (hopefully foregone) misdeeds.