May 23, 2009

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.

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