Insights in to the Financial Crisis

There was a good collection of (US-centric) insights to the credit crisis in a symposium arranged by the New York Review of Books and PEN World Voices on April 30. The symposium was attended by a good number of people who gave copious warnings prior to the onset of the actual crisis.

Yet all these insights seem to be somehow a bit disconnected. A bigger picture is clearly being formed as all these great minds get to put their thoughts together. Too bad that it has to be in hindsight.

Paul Krugman makes a pointed statement about social safety nets:

The other thing not to miss is the importance of a strong social safety net. By most accounts, most projections say that the European Union is going to have a somewhat deeper recession this year than the United States. So in terms of macromanagement, they're actually doing a poor job, and there are various reasons for that: the European Central Bank is too conservative, Europeans have been too slow to do fiscal stimulus. But the human suffering is going to be much greater on this side of the Atlantic because Europeans don't lose their health care when they lose their jobs. They don't find themselves with essentially no support once their trivial unemployment check has fallen off. We have nothing underneath. When Americans lose their jobs, they fall into the abyss. That does not happen in other advanced countries, it does not happen, I want to say, in civilized countries.

Niall Ferguson tries to make a case for the incompatibility of monetary and fiscal remedies to economic downturns.

There is a clear contradiction between these two policies, and we're trying to have it both ways. You can't be a monetarist and a Keynesian simultaneously—at least I can't see how you can, because if the aim of the monetarist policy is to keep interest rates down, to keep liquidity high, the effect of the Keynesian policy must be to drive interest rates up.

This view is completely bogus, as explained by the other participants. The point of monetary stimulus is not primarily to drive interest rates down. Its point is to drive up the money supply. When the interest rates are solidly against the zero lower bound, fiscal stimulus is actually helpful in increasing the total amount of credit. Additionally, a downturn is a great time to bring forward public investments that would have to be made later anyway. They can now be financed cheaper that ever.

Ferguson is right in worrying about the solvency of the US government. The other panelists claim to be worried as well, but their overall attitude to the deficits tend to have a somewhat worrying level of cavalier indifference.

There is one quite difficult point in this whole dislocation. Because indebted nations have been living beyond their means, there is no escape from the fact that despite any "solution" to these problems, there will be some attrition in overall standards of living.

These changes will not affect all strata of society equally. It is a very bad thing to bail out the most guilty and undeserving parties at the expense of the whole society. Some losses that, as said, are unavoidable, should be shared equally between all holders of imaginary financial "wealth".

Because huge amounts of eventual losses are unavoidable, the governments of debtor nations should not attempt a return to the "old normal". That would be a self-defeating exercise. The focus should instead be on controlled assignment of losses where they belong. And no, the losses do not all belong to the end-user speculators. Those who lend to speculators are making an equally speculative bet on the creditworthiness of the debtors, as well as any collateral that was willingly accepted.

The issue is completely different in creditor nations with low domestic levels of consumption, like China. These governments should apply fiscal measures with abandon.

Then there is the case of Japan, which has already spent its ammunition in trying in vain to uphold its previous bubble economy. This just goes to show the dangers of trying to sustain the unsustainable. In hindsight, Japan should have let financial assets go down. This would have improved the relative value of real assets and given the government more ammunition against unemployment. Unfortunately it would have hurt pension savings, which are highly dependent on financial assets.

Existing financial assets, level of employment and future debt load form a trifecta, of which any one can be improved only at the expense of the other two.

There is a danger in the US that the financial assets (partially earned through an unsustainable debt-powered boost to GDP) of aging baby-boomers will be overzealously protected at the expense of either real economic activity or future debt loads.

If losses are to be metered to financial assets as they deserve, there should be a combination of monetary expansion (effective sovereign default) and limits to bailing out creditors (of either banks or industry). Inflation actually lifts the prices of real assets, including commodities and equity in solid corporations. It hurts non-speculative creditors of solid corporations and households, so it should only be used with extreme caution. Some losses are, however, in order for all creditors, who should take their share of the overall responsibility for the creation of excess credit.

Paul Krugman tries to pin the roots of this crisis on the tired old explanation of a "savings glut".

One way to think about the global crisis is a vast excess of desired savings over willing investment. We have a global savings glut. Another way to say it is we have a global shortage of demand. Those are equivalent ways of saying the same thing. So we have this global savings glut, which is why there is, in fact, no upward pressure on interest rates. There are more savings than we know what to do with. If we ask the question "Where will the savings come from to finance the large US government deficits?," the answer is "From ourselves." The Chinese are not contributing at all.

Krugman is right in a limited sense. Bad investments have been made because there has been too much money chasing too few investment opportunities. He doesn't shed much light on the root sources of this "savings glut". The glut exists, all right, but it is not individual savers who have created it with their saving decisions.

As surprising as it is, savings are not created by savers. Savings are created by issuance of money and credit. All the money that is in existence is always held by someone. If one person decides not to hold it, it is passed on to the next one, but it is nevertheless always there, until the original debt is paid back, or the money withdrawn by a monetary authority. Society as a whole can not choose not to save if financial institutions just keep on churning out new money.

On the other hand, the "savings glut" is imaginary in a certain sense. Because net savings can not exceed the rate of creation of new base money, every unit of money "saved" beyond that is actually balanced by equal creation of new debt, which is a form of dissaving. Problems are caused when credit and debt are socially or geographically highly separated. This is the cause of the so called "global imbalances". We have seen the world divided between western debt and eastern savings. The problem is also manifested internally in almost all economies in the form of middle and lower class debt "canceling" out saving by the affluent.

George Soros has a good point on the lack of regulation:

About regulation, we have to start by recognizing that the prevailing view is false, that markets actually are bubble-prone. They create bubbles. Therefore, they have to be regulated. The authorities have to accept responsibility for preventing asset bubbles from growing too big. They've expressly rejected that, saying that if the markets don't know, how can the regulators know? And, of course, they can't. They're bound to be wrong, but they get feedback from the market, and then they can make adjustments. Now, it is not enough to regulate the money supply. You have to regulate credit. And that means using tools that have largely fallen into disuse. Of course you have margin requirements, minimum capital requirements; but you actually have to vary them to counteract the prevailing mood of the market, because markets do have moods. It should be recognized that exuberance actually is quite rational. When I see a bubble beginning, forming, I jump on it because that's how I make money. So it's perfectly rational.

It's the job of the regulators to regulate. However, we should try not to go overboard. While markets are imperfect, regulators are even more imperfect: not only are they human, they're also bureaucratic and subject to political influences. So we want to keep regulation to a minimum, but we have to recognize that markets are inherently unstable.

Regulators are human. This is true. And this is the reason that we should strive toward regulations based on fairly stable rules that are equally applied to everyone. We should minimize the role of regulators in making decisions and see them instead as enforcers of regulations. The regulations should thus be clear, transparent and fairly rigid, maybe even a lot more rigid than is optimal in the sense of efficiency. The separation of powers to legislative, executive and judiciary branches has to be enhanced in financial regulation to avoid cognitive capture and arbitrary decisions.

For some reason Soros doesn't mention the one regulatory issue that I somehow feel is the most important of all: reserve requirements. With reasonable reserve requirements there would be a hard limit on the creation of credit, and thus a hard limit on the level of associated imbalances.

One challenge is posed by the shadow banking system (money market accounts, etc.) that has not been operating under the same rules that apply to normal banks. Regulations should be based on the roles that are performed by entities, instead of their legal status.

Paul Krugman puts the issue of regulation in his usually pointed and prosaic style:

As I've written, we need a boring banking sector again. All of this high finance has turned out to be just destructive, and that's partly a matter of regulation. But in the political economy there was also a vicious circle. Because as the financial sector got increasingly bloated its political clout also grew. So, in fact, deregulation bred bloated finance, which bred more deregulation, which bred this monster that ate the world economy.

One thing that was conspicuously missing from the discussion was the unsustainable demand of permanent exponential growth that is required for steady operation of the financial markets. There was no discussion of the limits to growth that are presented by resource exhaustion and climate constraints. In order to have a sustainable financial system, we have to take these limits into account.

The whole structure of the economy has to change away from using credit as a permanent store of value. In a few decades, we will probably have to think about a financial system that can cope with an economy that is actually shrinking steadily. A system where credit is used as a store of value will not be able to cope with such circumstances without significant inflation.

A general move away from the use of money itself as a store of value would be a good idea. Money should be primarily used as a means of exchange, while real assets should take the role of accumulating long term savings. This would be of help in remedying the paradox of thrift that Krugman has repeatedly written about.

Of course, these ideas are not new.

The whole discussion was also centered around the ordinary economic phenomena of savings and investment. I would have expected more discussion of the "paradox of risk" (as so dubbed by Charles Hugh Smith) that is so aggressively manifesting itself at the derivatives market.

Central Bank Profligacy and Massive Malinvestment

I stumbled upon a newly interesting paragraph in an article about IMF fiscal advice from 1990 by Alan Tait:

Central banks are not expected to make losses. In industrialized economies, central bank profligacy is rare. In the last few years, however, significant central bank deficits have become not uncommon in developing countries (central bank losses in Costa Rica were 5.6 percent of GDP in 1982; in the Philippines, 5.2 percent in 1984; in Uruguay, 7.6 percent in 1983; and, in Argentina, 2.5 percent in 1984). This largely occurs when a central bank undertakes quasi-fiscal activities (e.g., net lending or guaranteeing foreign exchange losses) that show up, initially, as a change in the composition of central bank's assets.

The US Federal Reserve has been working overtime to achieve an exception to the first sentence. Sure puts them in an interesting new group of peers.

A later paragraph states:

Frequently, the public sector has undertaken massive investment programs, often with an eye on the symbolic need to "think big." But some of this investment may prove unproductive if the initial capital commitment is not followed up by maintenance. Donors will give capital but are reluctant to fund maintenance costs. Fund and Bank advice may well be to forego some large new projects for the sake of maintaining and operating efficiently the existing capital stock.

Massive investment programs? Yes, sir! Unproductive? You bet.

IMF's Anti-Stimulus Rules

Mark Weisbrot writes in the Guardian of how the IMF is hurting poor countries by imposing tough rules on government deficits and interest rates at the face of a severe economic downturn. He refers to the anti-stimulative and deflationary conditions that are associated with IMF loans as "punishment". This seems to be quite justified at the face of the fact that even a 40 % budget cut in Latvia is not enough for the IMF.

Mr. Weisbrot points to the severe additional tension that IMF's diktats might potentially cause in already volatile Pakistan: "Slowing Pakistan's economy at a time when the global economic crisis is already doing that may not be the best policy from the point of view of political stability."

Getting away from government deficits is without doubt necessary in the long run, but the severity of the measures are and should be up for debate. Application of such measures should be postponed until the end of the economic downturn. They should also be associated with at least some concessions from creditors.

It also seems that American and European economists are not quite so ready to apply their "scientific" doctrines at home. This creates the inevitable appearance of high hypocrisy. Forcing some nations to tighter their belts 'till they pass out, while others freely splurge on trillion-dollar government deficits is very ugly to look at.

Western economists are quite easily throwing about the notion that these measures are for the good of the target nations, and that they must "swallow the bitter pill". What is easily forgotten is that some people's lives will be permanently ruined by such measures. When your children are about to die for the lack of medical services, the "long run" can be surprisingly short.

How the IMF works can only be described with the term "predatory lending". The whole point seems to be the creation of a permanent debt relationship, with all of the resources of a nation directed at paying the interest on the debt.

IMF strongly opposes progressive taxation as a way of escaping government debt. The regressive cuts to the most productive parts of the target governments' budgets, like education and health care, keep the debtor nations at the status of quasi-colonized sources of free labour and raw materials.

Individual Advantages as a Cause of Systemic Weakness, a Parallel in Biodiversity

BBC News reports of a study that comes to a conclusion that increased nutrients decrease biodiversity by letting the fastest growing plants grab all the sunlight, while slower growing species suffocate. In a more nutrient-constrained environment, plants that use nutrients efficiently succeed alongside plants that make effective use of light. (Hat tip to Yves Smith)

I think this is a more general game-theoretic phenomenon: the higher the number of binding constraints there are in a system, the higher the number of successful strategies. The individual constraints can be seen as objectives for a multi-objective optimization problem, thus controlling the degrees of freedom in the world of Pareto-optimal solutions.

I have been thinking of the role that this phenomenon has had on the financial world. Before 1980's, the financial world was comfortably resting on limits of liquidity, in the form of binding reserve requirements, and leverage, in the form of binding limits of bank capital.

After removing the important constraint of reserve requirements, especially after 1994, when retail sweep programs were allowed, leverage has been the only major remaining limit, and was thus taken to the maximum.

After the weakening of even that limit, by changes in rules and active avoidance of regulations, actual solvency is now the only remaining factor to limit the growth of financial institutions. This is not a good limiting factor for a system built mostly of institutions that are “too big to fail”.

Naomi Klein on Wall Street Cronyism and “Free Market” Fundamentalism

There is a really great, long interview of Naomi Klein at wowowow.com by Joan Juliet Buck:

JOAN: And can Obama provide the real deal?

NAOMI: What gave me hope was that when the economic crisis hit, Obama got serious and his analysis became more concrete. It’s really worth remembering that he started winning the election when Lehman collapsed and he started putting the ideology of Reaganism on trial. He started saying, “This economic crisis is the result of the policies of deregulation and trickle-down economics that have dominated this country.” But he said, “for the last eight years.” That was wrong. And that was part of the problem.

JOAN: Because it’s the last 30.

NAOMI: It’s the last 30 and, you know, that was a piece of intellectual dishonesty that I think has cost us dearly. That was a good electoral line because we all wanted to be able to blame it all on Republicans, because that was a much more sellable election slogan. “Everything was fine in the ‘90s when you had Clinton and we just need to get back to that.” And what that did was gloss over the absolutely central role that Robert Rubin and Larry Summers played in creating this crisis. And lo and behold, they’re back with their protégés in tow. There’s really a shared responsibility, and it’s an argument for more intellectual honesty, more principled stands and fewer strategic calculations. What worries me so much is that it’s fine for politicians to be strategic. But social movements should be principled. They shouldn’t always be thinking about what’s the right strategy, what’s the sellable message, what’s the talking point, because then you end up in a situation like this. Larry Summers is back. Larry Summers was given a pass during the entire election.

Ms. Klein makes some very deep observations on the dynamics of politicized mass movements:

JOAN: Just start with the Icelandic protests. Why are there no protests in the streets in America?

NAOMI: This comes back to the problems of hero worship. It’s hard to protest your hero. But it’s more than that. It’s also that the virulence of the Right in the United States is so frightening and the problem is that it is the merger of the extreme far right and large corporations, in the form of media conglomerates. So Glenn Beck on Fox or Lou Dobbs on CNN have these unbelievable megaphones to attack Obama, and to spread fear, which makes reasonable people feel that their main political role is to defend the Obama administration against this very frightening right-wing onslaught. It’s understandable but it’s also hard to do that while being in the streets protesting that administration’s bailout – which is what’s happening in Britain, which is what’s happening in France, what’s happening in Italy. I think the problem in the U.S. is that many people who were part of the campaign to get Obama into power now see their role as being kind of an unofficial arm of the administration, with some groups even taking talking points from the White House. It’s a recipe for political failure, because what actually makes space for Obama to do more of what we want him to do is to make him look less radical, by being more radical ourselves.

This is a very acute problem in two-party systems like the one in the US. It’s very hard to critique one party without the fear of playing into the hands of the other one.

I am totally dumbfounded at the lack of campaigning for a true multi-party political system in the US. What makes the idea such a non-starter? Are Americans just so used to the system that they have that they don’t even consider any alternatives?

It is natural that neither of the two power parties are going to embrace a multi-party system. Maybe this crisis could act as a lightning rod for a new multi-party revolution, as it becomes ever more clear that both parties are in the pockets of moneyed interests: employers for Republicans and Wall Street for Democrats.

Naomi presents some of the issues as a gender bias.

NAOMI: Brooksley Born [chairwoman of the Commodity Futures Trading Commission], who, during the Clinton administration, blew the whistle on the unregulated derivative industry and wanted to regulate it like any other banking sector. For her prescience she was bullied by Rubin and Greenspan and Summers, who’s actually the enforcer of the three. He was the one who called her. They argued that just by talking about the need to regulate derivatives, she was going to create market panic. So not only wouldn’t they consider it, they wouldn’t even let her talk about it. She saw this whole crisis coming. You often hear this: “Well, no one saw this coming.” And that is such a reflection on who these men believe is someone. But there are so many people who saw this coming, and they’re considered nobodies. The only way you get to be a somebody is if you agree with them. Brooksley Born saw it coming. Elizabeth Warren has been an incredible watchdog. Sheila Bair, chair of the FDIC, also had a much more principled and ethical vision of what the bailout should be, in arguing that they should be offering direct aid to homeowners, as opposed to this top-down bailout. I feel like this gender split is not coincidental. There’s a need for more of a feminist analysis in understanding how we got here.

I think Ms. Klein exaggerates the issue a bit. There were a lot of men who saw this coming. But in some cases the men were not tossed aside as easily as the women.

I do think that it is a lot easier for men to leverage their positions. It is not as easy for women to get the benefit of the doubt. It is usually men who are treated with “for his position, he has to know what he’s talking about”. Just look at the deification of Alan Greenspan. If he had been a woman, his speeches would have received a whole lot more criticism.

Somehow, I also think that women are more readily accepted as having rigidly ideological views, even when they make great and reasonable analysis based on facts and research. It is also a lot more easy to brush aside pessimistic analysis from a woman as just instinctive worrying, which is seen as a feminine trait and a weakness of mind in the irrational macho culture that is still dominant, especially in the financial world.

The dominance of macho culture and euphoric over-optimism is quite understandable in modern finance. People with normal attitudes to risk simply can not function in an industry so clearly based on an unsustainable bubble. It’s pretty much a case of self-enhancing adverse selection. At the start of an irrational boom, people who see it as such are pushed aside or drop out voluntarily, which just makes the boom stronger.

Ms. Klein presents some unfounded opposition to market-based solutions to climate change:

And at this point, I think there’s a lot of rightful cynicism about the Kyoto protocol because the whole question of "How are we going to respond to climate change?" was entirely infected by market fundamentalism. Bringing it back full circle to where we started, the ideas that have dominated for the past 30 years have utterly shaped the environmental debate during the Kyoto era. So the idea was to always find “market-based solutions” to climate change, which meant that we couldn’t really legislate, and everything had to be creating market incentives for the private sector to solve the problem for us. And I think that’s a much harder sell today in the context of people rightfully losing faith in the ability of the market to solve our most pressing problems. So I think you’re going to see a lot of very different, non-market-based solutions being proposed ahead of the Copenhagen Summit, which is in December 2009.

There is nothing wrong in principle in market-based solutions, but markets have to have clear, fair and binding rules to work properly. Solutions that would be based on unregulated markets obviously don’t work, but a well-thought-out, competitive, non-oligopolistic market solution would not be against the goals of social development.

It is truly unfortunate that people are losing their faith in the market. What they really should be losing their faith in, is the concept of “free market” as practised on Wall Street. Really free markets have strong and fair rules in effect that everybody is bound to. The modern “free market” is a mix of the law of the jungle, with a firm and unfair control from above by a semi-private block of financial interests, represented by central banks.

Principled opposition to markets is like opposition to the rule of law, because of bad laws. Anarchy is not a solution. The progressive movement is badly hurt by people who propose price controls as a way to social goals. There is really no alternative to the market in some aspects of human behaviour. We should instead be focused on the rules that govern the market.

The “free market” fundamentalism as teached by the Chicago school of economics is a perversion of the ideas of Adam Smith. David Korten wrote in his book When Corporations Rule the World:

These practices were strongly condemned by Adam Smith in The Weath of Nations. Smith saw corporations, much as he saw governments, as instruments for suppressing the beneficial competitive forces of the market. His condemnation of corporations was uncompromising. He specifically mentioned them twelve times in his classic thesis, and not once did he attribute any favorable quality to them. Typical is his observation that: “It is to prevent this reduction of price, and consequently of wages and profit, by restraingin that free competition which would most certainly occcasion it, that all corporations, and the greater part of corporation law, have been established.”

It is easy to forget, that the world of Adam Smith was very much different from ours. Back then, it was the government that had actively granted very profitable monopolies to favored corporations. Now, corporations mostly gain monopoly positions by utilizing the lack of willingness to enforce regulations that would limit their growth in size.

Smith was against monopolization, not all government action. He was not an anarchist. He was all for sensible regulation of finance, for example. In the current business atmosphere, Adam Smith would have strongly supported anti-trust legislation, which has not been properly enforced in a long time.

Economist Dean Baker recently made a good point about incorporation being a privilege:

Finally, the article asserts that: "certain very large companies must organize as separate entities that are taxed twice -- on profits and shareholder dividends." Actually, it is not true that any business "must" organize as a separate entity. Certain very large businesses choose to incorporate because they find that the benefits that the government gives them by granting corporate status are so great as to make it worthwhile to pay the corporate income tax.

Market regulation is not inherently antithetical to freedom, as long as the same rules apply equally to everybody, and no special favous are provided. The rules of the markets should be arranged so that there is a price to be paid for all actions that have adverse effects on others. Incorporation is itself an act by the government, extracting a cost from other market participants in the form of reduced competition.

But markets are ultimately made of people. Markets do not have a soul of their own, even if it sometimes seems like that. And people can not be truly free without a fair set of rules to protect their freedom. The modern “free market” fundamentalists are actually nothing but market anarchists.