July 13, 2009

Financial Engineering, Gambling and Deflation

TomDispatch.com has a nice summary of the gambling associated with structured finance, written by Barbara Garson. She has been searching for unemployed people that were handling those structured financial products, especially credit default swaps, that seemingly brought the whole world down. She was absolutely unable to find such people, even from Lehman Brothers or AIG. (Note to Garson: These people like to call themselves financial engineers.)

At the last paragraph Ms. Garson reviews the situation from the point of view of the real economy, where productive people are kicked out of jobs, while financial engineers keep on pushing their wares.
In other words, people are speculating on derivatives and derivatives of derivatives because there's no action in the real world. You can't invest in new real businesses or lend money to old real businesses for expansion unless people can afford to buy the products they'll produce. That brings me back to where I started: our real world. You know, the one where just about everyone's unemployed except those swap guys.
In a deflationary environment, real assets, like factories, start to look like huge risks. To keep investors from withdrawing from the real economy, financial assests need to be equally scary to investors. Governmental bailouts of financial assets simply encourage people to withdraw their capital from the real economy to plunk it into government-guaranteed gambling.

Safe financial assets, like cash and government securities, that have no backing in the real world, need to be scary as well. To achieve this, some inflation expectations are required. The Federal Reserve has been quite aggressive on this front, and clearly quite successful. Unfortunately, the European Central Bank does not seem to take this thankless task quite seriously.

Even if holding cash could be turned into a scary proposition, there are ways to store value that, even though physical, are equally as useless to the real economy. With this I naturally mean precious metals. Naturally some of the "real" economic activity has not much value either. Activity with negative value is quite possible. (Let's call it the salad shooter economy, in honor of James Howard Kunstler.)

All this trouble was brought to us by a financial market that grew to be bigger than the real economy. The solution to our problems should not necessarily proceed by making the real economy even smaller. That route will only result in a self-reinforcing deflationary spiral. Instead, the real economy should be functioning, while the financial economy should deleverage and shrink. A complete government bailout of the speculative financial system will achieve the exact opposite.

Let gamblers take their losses. That alone will give a boost to the attractiveness of the real economy. There's a problem with that proposition: all of us with savings at financial institutions are part of the gamblers through our funding of it. But as we have all gambled, we must all bear the losses.

Even though deflation is the immediate issue, as credit is collapsing, ultimately existing savings that are invested in credit will lose some value, because of the eroding base of credit worthy debtors on which its value was based. This loss of value can happen through a process of default, through being diluted by new savings, or through a devastation of the real economy.

The third option initially involves massive deflation, which might make it attractive to those that hold cash assets. However, it will ultimately result in people with cash assets facing empty store-shelves, at which point the deflation will suddenly turn into massive inflation, quite similar to the receding shoreline before a tsunami.

We have to remember that inflation has both a numerator and a denominator. In this situation, increasing the numerator (in the dilution scenario) is much preferable to a collapse of the denominator. Unfortunately, this might already be somewhat too late. If the collapse advances from industrial production to food production, there will be real trouble.

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