I posted Gideon Rachman's FT column  on oD's The World link-watch page on diigo earlier today. Gideon writes:

Investment bankers, the shock- troops of the Reagan-Thatcher revolution, were allowed to bet their banks on this new market, because regulators and politicians believed so firmly in the magical and self- regulating qualities of the market.

The same process of intellectual overshoot happened with other signature ideas of the Reagan- Thatcher era: privatisation, scepticism about environmentalism and democracy promotion.

Well ... I think there is a kind of "democracy promotion" --- the kind openDemocracy stands for --- that is not neo-liberal and is in the wings, waiting for its open moment, as it were.

That apart, Gideon's judgement of ``overshoot'' is very welcome. I wrote asking him about the idea of "progress"  -- did he think that was oversold too? The pessimistic conclusion to his column, in which he saw just a batting back and forth between over-regulation and over-deregulation, suggested that he might be shorting progress too. Can we socially  learn from these crises?

 

 

 

The essence of the de-leveraging crisis

Paul Krugman has a simple model of the crisis that is a pretty useful tool to think about what is happening and what should be done immediately. It is not a model of why we got here, but a diagnostic tool for short term action.

First, Krugman's conclusions from the model are a) that taxpayers becoming shareholders in banks is a good next move and b) that international coordination of rescue plans is particularly important. Quoting him directly:

 

 

First, it suggests that the core problem is capital, not liquidity - or at least that you can explain much of what's going on without appealing to a breakdown of buying and selling per se. To the extent that this is true, rescue plans centered on making troubled assets liquid, like the Paulson plan passed last week, won't do the trick. Instead, what's needed is an injection of capital, which can't reverse the original shock, but can undo the financial multiplier effect of that shock.

 

Second, the international implications: to the extent that we regard falling asset prices and their consequences as a bad thing, which we obviously do right now, this analysis suggests that there are large cross-border externalities in financial rescues. Macroeconomic policy coordination never got much traction, largely because economists never could make the case that it was terribly important. Financial policy coordination, however, looks on the face of it much more important. Capital injections by U.S. fiscal authorities would help alleviate the European financial crisis, capital injections by European fiscal authorities help alleviate the U.S. financial crisis. Multilateral Man, come home - we need you!

 

On the specifics of how to re-capitalise the banks, I have to agree 100% with the basic framework proposed by Willem Buiter.

The model makes it clear why we might want to re-capitalise the banks rather than allow the de-leveraging to run its course. Ordinary savers are quite right to be wanting to reduce their holdings of risky assets--they have understood that the investments they held were much less good quality than they previously thought. The price of houses, art works and all the bubble assets must still fall a great deal. But this adjustment, which is just a welcome return to reality, is creating massive knock-on effects as the ``Highly Leveraged Institutions'' of the financial sector have to reduce their lending because the price of the assets they were using as security for the lending is (rightly) falling. This forces the financial institutions to sell assets, making the problem worse. As Krugman points out, this is exactly the way that contagion spread from the Russian to the Asia to the Brazilian crisis in 1998.

Worryingly, the model leaves open the possibility of instability. In particular, if we --- we the ordinary savers --- become extremely unwilling to hold assets with any risk at all, then the model predicts that we spiral into a very nasty loop indeed. I do not think we are there yet, but the model underlines the importance of investor psychology at this point.

A financial system based on such highly leveraged institutions is not right. But we need to wean the system from that leverage slowly, giving the real economy time to adjust, while the logic of Krugman's de-leverage model is that this is being forced on banks at lightning speed. Re-capitalising the banks is a way of breaking the cycle of de-leveraging. Krugman's international conclusion comes form the fact that the banks all hold assets from all countries, so that asset price shocks ripple through the leverage multiplier much faster than would be suggested by the extent of movements of goods and services around the world. Krugman illustrates this with a nice graph.

So the way forward is becoming clear. Put capital into the banks following the Special Resolution Regime proposal of Buiter's to stabilise the system. Once the real economy has access to the credit it needs to operate, nationalise or hyper-regulate the banks and let the real economy slowly - over five years - reduce its dependence on bank credit.

The chart shows rest-of-world assets in the United States (red) and US assets abroad (blue) as a percentage of non-US GDP. What this shows is that when US asset prices fall, foreign financial firms feel the de-leveraging squeeze; and when foreign asset prices fall, so will US financial firms.

 

Sounds like a firm of City lawyers -- Krugman, Blinder & Co. In fact, it is half the panel line-up on this excellent film of the Princeton Economics Department panel on the subprime crisis.(YouTube embedded below - the whole thing is about 1 hr, with the first 1/2 hour most informative, IMO).

Unfortunately, Blinder is mostly cut. Brunnermeier is fascinating on really detailed stuff---economists will never be short of clever fixes to regulation problems; Hong is really  interesting --- I want to post on his point about the psychology and sociology of systems prone to bubbles; Krugman --- well, if you've followed him in the NYT, you won't find any surprises here. 

My note to Willem Buiter on his praise of the Fortis "nationalisation":

Dear Professor Buiter, I agree that Fortis shows that the worry - expressed just today by Munchau in the FT - that Eu cannot respond in a crisis is wrong. But the outcome of the capital injection seems favourable compared to what would come out of TARP, no?

51% of old shareholdings preserved --- doesn't this show that a little more transparency to voters in the Benelux might have got them a better deal?

Taxpayers are unwilling risk capitalists here, and that should make our representatives negotiate harder for our upside, not less hard. Best wishes, Tony

My note to the FT's Martin Wolf this morning, on reading his column, which argues (quoting Churchill Winston “The United States invariably does the right thing, after having exhausted every other alternative.”) that the time for a bail-out is now.

Dear Martin,

I enjoyed, as ever, your column on avoiding depression. I do wonder how much time we have (our political systems have) to negotiate the deal ... Paulson tried to tell us it needed to be done over 1 week-end; 10 days later it was not passed and the consequences are still mostly confined to the financial sector. What sets the ticking clock here? Presumably, the real economy's borrowing that comes up for renewal is the biggest deadline. And is that not temporarily extendable by central banks? Indeed, the various central bank facilities are presumably doing exactly that.

Given that decisions made in crisis are highly determinant of the shape of the eventual settlement, should we not be thinking about how to extend the window for negotiation rather than implementing a solution to the crisis?

Best wishes,


Tony

Here is the first draft of the bailout bill. Just 20 pages into it, but it looks as if the right terms have been put into it. Breath-holding over. The American system appears to have delivered.

There's a huge amount of excellent and important commentary on the financial crisis. I have collected together the RSS feeds I'm using in 4 netvibes tabs that I am skimming through to keep abreast. You'll find feeds from Krugman, Roubini, Setser, DeLong, Thoma and many others who are commenting regularly on the crisis.

If you're not a netvibes user, go to the link here. You will see tabs across the top of the screen with Economics 1 to 4 - click those for the feeds. Click on a feed to have a quick read of what it contains, or do "shift+click" on a title to open the originating article.

The professional economics blogosphere, mainly under the influence of american academics, offers a pretty complete substitute for the analysis pages of the main newspapers. There are just a few exceptions - like the FT's own economics blogs (and especially Buiter's Mavrecon). An excellent European voice comes from VoxEU, a group blog of Euroconomists.

I hope you find these feeds useful, and drop me a line (tony dot curzonprice at opendemocracy dot net) if you've got some RSS feeds or sites that you think should be added to this list for crisis-watching.

 

The price of mistrust

Gamekeeper Hank Paulson has asked taxpayers to put up $700bn of risk capital to spend on his erstwhile and future colleagues on Wall Street. He has given permission to his previous employer, Goldman Sachs, to become a deposit-taking institution. (I am no financial adviser, but I would caution anyone to think twice before transferring their balances to Goldman Sachs today). Are the Democrats right to be resisting the blank cheque, or are they playing loose with the world economy?

The dilemma is clear: crises require flexibility, rapid action and leadership; but the power of flexibility can be abused. Paulson, who rose to the top in the macho culture of ``take no prisoners'' Wall Street is not the man the taxpayer should trust. Worse, the Bush administration's systematic capture by energy, military and religious interests does not suggest a culture that can be trusted with huge power.

Here, concretely , is the worry. The US taxpayer gives Paulson the risk capital. He spends it on buying up the assets that banks do not value--he buys them at a price that the banks find attractive. Once the bad assets out of the way, the banks no longer have to worry that their colleagues and counter-parties will go suddenly out of business and they can start to lend again. It is back to the good old days, except the taxpayer holds all the junk. Paulson has bailed his buddies; the Bush administration has rewarded its friends; bankers and lawyers learn to subvert the new regulation as they subverted the old. Wall Street--indeed world finance--can return to being a cosy club dedicated to personal enrichment.

This is why the Democrats now resist nodding through Paulson's plan. Paul Krugman summarises the problem on his New York Times Blog. The presidential politics make this particularly hard. It is a crisis and your leader asks for urgent help. As you start to raise objections, you can easily be turned into the cause of problems. Every time Nancy Pelosi says ''no'', markets will fall. There is a basic political Pavlovianism that will make the Democrats seem anti-economy. Obama's response to the plan--''it seems very big, but this is an emergency and I will not get in the way''--clearly recognises the danger. McCain's response--''Fine, but No New Taxes''--is clever: McCain protects the taxpayer, and no one thinks he would fail to support Wall Street.

The solution? The Democracts must put flexibility into the rescue package so that the next administration is not tied down to supporting a bad bail-out. Taxpayers should agree to put new money into banks in exchange not only for the toxic assets, but also for various options. Firstly, the option to turn those toxic assets into shares in the banks at the price before last Friday's announcement of a bail-out. This means that if world finance does recover past profitability, taxpayers will not have been the ultimate suckers, the ones who will always patiently take on the losses while others take on the gains. Second, taxpayers should require the option to monitor and cap all pay deals in the rescued institutions. As the Lehman case shows, profitability can go down while individuals still command astonishing rewards--not the rewards that an effectively nationalised industry should tolerate. Third, taxpayers should insist that the risk be borne by those who profited most from the leverage-bubble. Mark Thoma is very convincing that this should be done through a strong dose of progressive income tax.

The basic rule of finance is ''Who has the gold makes the rules''. When the banks have no capital, and the taxpayers are asked for gold, they need to remember that they make the rules. This is the moment to set the rules, not tomorrow, after a recapitalisation. There is a critical difference of a few months between today's crisis and the 1932 banking crisis that brought in the New Deal. Banks started failing in November '32, after the election. Roosevelt's plan was the important one. Today, unfortunately, three months make all the difference. It will be Paulson's rescue. The Democracts must avoid being cast as the destroyers of the economy, while standing firm as the rule-makers of last resort on behalf of that unlikely risk-capitalist, the taxpayer. Nouriel Roubini, long the Casandra of the this crisis, warns in his FT commentary that the crisis will spread to the real economy and to Europe's as well as the US's.

It is going to be hard, so now is not the moment to waste the hardship on a crony's solution.

 

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tony curzon price 2008-09-22

I wrote the other day that we -- the collective, global, democratic "we" -- desparately need to take responsibility for financial regulation. I mainly had in mind our own shareholder, pension-holder, saver activism. But our friends at Avvaz.org have a very sensible, complementary approach that tries to put pressure on our governments to take the issue of regulation seriously. Their new campaign around the issue is here: looks to me like a good one to sign up to.

The de-leveraging crisis--or the sub-prime crisis or the debtonation crisis--came about through the interaction of wicked plutophiles, genuinely useful financial innovations and lax, cowardly and confused regulators. It is important to untangle these in order to destroy what was genuinely bad in our financial arrangements. The spread of cheap computing, the theoretical understanding of how to price flexibility--option pricing--and the globalisation of supply and demand for capital set the stage for the growth of the financial sector from the 1980s for the next 25 years. In a world of benevolent, professional bankers, these changes would have been welcomed. However, the world of finance became the global magnet for hordes of semi-quantitative plutomaniacs against whom the partially sighted, ideology-bound regulators had no chance of success.

Globalisation, financial innovation and computing have brought benefits that now, when blame is spread generously, should be remembered. The heart of every financial transaction is an exchange of financial risks. When you sell a house, you want an amount of cash in exchange with a known, certain value. When a bank offers a mortgage, it swaps a known value for the likelihood of a stream of payments. The seller of the house has become financially more secure; the seller of the mortgage has taken on the corresponding risk. Moving risk around has real social value. A manufacturing company in Senzhen with good commercial contacts to corporate America can borrow to expand; it wants to take on risk. A fifty year-old office worker in California, at the height of her earning powers and saving for retirement, may find that an investment in a Senzhen factory is attractive. Globalisation of capital markets--whatever abuse it also permitted--expanded the opportunities for these sorts of re-allocations of risk. There is real social value in doing this--as long as you do it right.

Financial intermediaries can often provide more attractive risk re-allocations than would be possible with direct contracting between lenders and borrowers because they can enjoy the statistical effects of pooling risks. This is the basis of insurance: because things tend not to all go wrong at the same time--because ``sod's law'' is not a law--two mortgages are less risky than one mortgage. Information technology expanded the scope for the discovery of offsetting risk of this sort, and so found ways to ``cancel-out'' uncertainty. There is real social value in doing this, as long as you really do it. Only inveterate gamblers prefer material uncertainty to stability, and they can always be served at the casino. The more material uncertainty can be destroyed through social aggregation of risk, the easier we ought to be able to sleep at night ...as long as we are really doing this. Computers trawling great databases of prices could identify opportunities for cancelling risk on an unprecedented scale.

The development of portfolio theory and option pricing theory by financial economists has opened the way for a greatly increased scope for pooling risks. Even once you have identified uncertainty that can be ``cancelled out'', you need to turn that aggregate into a product that those affected by the uncertainty can buy; and as long as you can assess the price of risk, these become products that those with a collective appetite for risk can supply. So, a retiree might want to swap her accumulated pension fund in exchange for a promise to have her medical care covered, her subsistence needs covered, and a small amount left over for her children. Financial theory now allows such products to be priced and supplied.

In the midst of all this potential to do good came the plutomaniacs and bad regulators. The three forces of good change in finance of the last 25 years--increased opportunities to trade, increased data-processing and increased understanding--could all in themselves justify some degree of increase in the level of leverage. For every pound, euro or dollar of certain value that a financial firm could count on, it could now transform those into more uncertain pounds, euros or dollars of value than in the past. The banking multiplier could increase. Its increase from a traditional value of about 6 to the current value of about 25 is the story of ``debtonation'' that Ann Pettifor has told so well. Even if the forces of good change could justify--an extreme suggestion--a doubling of the rate of leverage, the five-fold increase we have lived through in 20 years can only be explained by the monumental failure to properly guide an invisible hand made weak by the mendacity of many in the financial industries.

As globalisation allowed banks to run rings around national regulators, the Bank for International Settlements transformed itself in the 1980s into a world-wide regulator. All banking institutions need to show consolidated accounts and prove that taking all their operations together, they have sufficient capital to cover ordinary and even extraordinary risks. Banks are required to limit their lending to 8 times their capital, where the value of the capital base is cleverly adjusted for its riskiness. In a world of benevolent bankers, all of them following the rules, these constraints should have worked. The banking money multiplier would have stayed at 8X, a number apparently entirely justified by the good forces for change in finance.

But we know the reality ...Banking ``innovation'' became more concerned with hiding the lending that banks were extending in order to continue to lend a long way beyond the 8 times capital limit. The ``special investment vehicles'' like Granite--the Jersey-based company that Northern Rock set up--existed only to be the repositories of lending that would not be counted against capital by the Bank for International Settlements regulation. Bankers, bonuses based on the volumes of the transactions they performed, had found a way around the spirit of regulation to unconstrained personal gain. Asset price bubbles followed, as the money created by banks chased limited investments. Emerging markets, technology stocks, housing, stock markets, gold, commodities, contemporary art ...anything in vaguely fixed supply--or at least supply slightly more fixed than the unconstrained creation of money by the financial sector--rose in price to absorb the money being created in the cracks of international regulation by the plutomaniacs. We can tell that the crisis still has a way to run from the stellar results of Hirst's last auction.

The crisis we are now going through comes from the fact that the money-creation went into a largely virtual economy. This was not about factories in Senzhen or retirement packages ...most of the growth in money was going to casino chips on which rich-world middle classes became hooked; their appreciating housing assets gave them a sense of righteous enrichment, a reward for who knows what hidden moral virtue they could conjure. The retrenchment today will require de-leveraging from today's absurd 25X to a normal 8X. Two thirds of the debt in the system needs to be eased out.

The dilemma now is this: how do we de-leverage in such a way that the virtual economy is hit, not the real? and how do we protect the real forces for good while cutting off the most destructive tendencies of the plutomaniacs? Regulatory pragmatism is aimed at the first problem now. AIG is too close--or thought to be too close--to the real economy to be allowed to default, while Lehman is sufficiently virtual to need to go. HBOS has strong links to reality--its mortgage business in the UK is tightly related to household savings, and so to the UK economy as a whole--to get nod-through approval to join the stronger balance sheet of Lloyds-TSB. As banker to the real economy and bankrupter of the virtual economy, this regulatory pragmatism is the right approach to the immediate mess.

But what of the longer term problem of good regulation? Can we have our good financial cake without it being forced down our throats like geese prepared for their liver? A solution to a problem usually comes from choosing the right constraints: what is fixed? what can be assumed to be in our choice? It is important to assume that the plutomaniacs will always be with us: financial regulation must assume that the great magnet of money will always disproportionately attract the iron-like sharks. What was true of politics when David Hume recommended that we design constitutions on the assumption that every man be a knave should now, in a world where the market has become mightier than the sword, be applied to financial regulation. 75 years after Hume's advice, Benjamin Constant, in his essay on the Freedom of the Moderns as Compared to that of the Ancients, reminded us that we ought to continue, all of us, to stay involved in politics in order to prevent the return of tyranny:

we should [...never...] surrender our right to share in political power too easily. The holders of authority are only too anxious to encourage us to do so. They are so ready to spare us all sort of troubles, except those of obeying and paying!

Today, this advice holds for control over finance. This is where the holders of authority lie in wait for us. Politics today needs to be in the shareholder assembly, as activist investors, as savers and borrowers. We must take control of regulation from the demoralised public servant and help ourselves. Where is your pension invested? Who manages the money? How culpable am I for the use that my savings have been put to? In our pre-occupation for the freedom of the moderns, for our cherished ability to get along with our private concerns, we have left a gaping opportunity for plutomania to operate and create havoc. Regulation is too important to be left to the conflicted civill servants.

We need all to become our own regular regulators.

 

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tony curzon price 2008-09-19

Tim Duy has a great analysis of what the week-end teaches us about where we are with Lehman, Merrill, AIG etc. I think he is right that this is a signal from the US authorities that the socialisation of losses is over; that any taking-over of dud assets by the public will now go through Congress, and not through a technocratic nod-and-wink. The danger, as it has been for a year, is contagion to the real economy---when do firms providing real value find that either a) demand has fallen such that they have to cut back operations or b) that their own credit lines for working capital and investment programs are closed, and so have to cut back?

That danger still exists. Certainly, as banks find it harder and harder to satisfy regulators that they have enough capital to guarantee the loans they have made, they will cut back their lending. So far, the Fed has become banker-of-last-resort by allowing bonds and now even shares to be put up as guarantees for cash loans.

In any case, the week-end moves by the Fed mean that the music of time is picking up again. After 1 year of waiting, time-haltingly hoping, that the crisis would resolve itself, the regulator has called time-up. There may yet need to be large-scale public cash injections into the corporate sector to avoid deep depression. But this week-end shows the regulator has, at last, given up on hopes of self-repair. So adopt the pose of the surfer caught between breaking waves: take a deep breath and hope the turbulence of the breaking behemoth does not keep our economies trapped under for too long.

When we re-emerge, expect to see JP Morgan and Goldman Sachs still standing, but not much else in the financial firmament. Expect a divided world of finance---hyper-regulated standard products on one side, and a pool of crazy, gambling sharks on the other. Think twice about risk-reward before surfing in the sharky waters again.

 

George Hewitt doesn't like the way:

"the torrent of media commentary on the Georgia-Russia war has been characterised by near-obsessive geopolitical calculation, which [...] tends by default to view Georgia's "lost" territories (if they are viewed at all) as nothing more than inconsiderate and irritating pawns on a global chessboard."

Georgia has its own "near abroad", that happen to be within its UN-defined borders; Russia has Georgia in its "near abroad" ... Remember Mandelbrot's ginerbread man: whatever the scale you examined it at, you'd get those repeating patterns. Fractals of nationalism. And what about the non-Ossetian minorities in South Ossetia? Where will they go, as one of our commenters asked.

Surely there is a pattern here that we can see should be avoided: to treat the other, be it ethny, nation, or however you care to define the outsider, as a means to your political end? Shouldn't alarm bells from the Balkans be ringing in NATO's ears?

George Hewitt provides the historical background and the detail that we need to read to understand---to really sympathetically understand--- that when we take the short-cut of geopolitics, we allow ourselves to think of South Ossetia and Abkhazia as mere pawns in a new cold war, then we have already ruled out the possibility of a humane solution.