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Financial Sector Induced Systemic Instability, 2009

2014 2013 2012 2011 2010 2009 2008

Did the Fed Cause the Recession? – Mark Thoma

Selected Comments


The government intervening in the markets to the extent they have in the last year. We are ruining any chance of fairness and destroying the whole country. Bernnake is an arrogant cluess dipsh$t who cant understand that he doesn't know everything.


Love the post, but choice #3 for reform won’t be implemented. The panic factor re bank runs etc. will be too great if Citi or esp JPM go into bk. My vote is #1.

IMO the Establishment cleverly switched to a fresh face in pushing BO in so that it could easily continue its depradations/looting. There was NEVER going to be real change other than in abortion policy and the peripheral stuff the PTB could care less about.


I’m not too sure the government shouldn’t own the banking system and spend the interest back into the economy as a tax revenue. This wouldn’t stop the private sector from attempting to earn interest on bonds, just keep the system of money itself in the hands of the government. Otherwise clean this up and get rid of the Fed and the FDIC.

The problem with banking is the interest due on the loans is never created. If banking makes itself a growth industry, which government tends to aid and abet it doing because government wants to spend more than it takes in, then banking has to accumulate capital in the form of money. What they actually accumulate is imagined money, in that a portion of the loans are theirs.

The problem is almost from the start the money in existance is less than is owed the banks. The whole matter of debt deflation and rich bankers revolves around the same component. There is nothing else that I would like to see the government own, but the right management of banking and credit money lending by the government could be a very prosperous situation for the economy.

Edward Harrison:

DoctoRx, I’m coming to the same conclusion too. I just posted 3 years worth of Byron Wien’s surprise predictions. And I added this line:

The interesting bit is his confidence in Obama’s political fortunes, which obviously goes back to at least 2006 since he wrote the 2007 list at the beginning of 2007. Someone more plugged in can give me the scoop, but it sounds a lot like Obama had his Wall Street connections up and running pretty early.

Does anyone have a read on this? It seems that BO was dialed into the Street by the beginning of 2007 at a minimum.


Ed, his campaign director was a Pritziker!

 gordon :

This whole post seems to breathe the air of unreality. I am much more inclined to believe Mr A. Doyle, author of the earlier post (also 5 Jan.): ‘Guest Post: Recent Lehman MD Reviews “The Murder of Lehman Brothers”’ who says: ‘…it appears increasingly unlikely as time goes on that any meaningful reform will be instituted to protect the public from what Simon Johnson so aptly refers to as the “rent-seeking behavior of the financial sector”’.

Edward Harrison:

gordon, just because I am labeling the Geithner approach regulation-heavy doesn’t mean I think these regulations will be substantive. They will add a layer of regulation to seem substantive but will be filled with loopholes in order to allow business as usual. An example is the loophole in derivative regulation that allows for off-exchange customized derivatives. Everyone knows that means actors will gravitate to just those products.


That wasn’t clear in your post. I took your post to mean that #2 is an approach that Geithner claims to support. That doesn’t mean the idea is bad, just that a crooked, gutless implementation of it is. But that’s true of any approach.

If OTOH what you meant was that #2 means “do what Geithner says” then of course it’s worthless. Who but an apologist would disagree?


Thanks for the clarification. I must say I’m a bit saddened to learn that you think none of your 3 alternatives could be more than a temporary measure, a band-aid, and not “substantive”. I understand by that word a sort of “final solution” whereby the US (and maybe by extension the world) financial systems could be put on a sensible basis as the supports of the “real economy” and not as its parasites. But maybe I’ve mistaken your meaning of “substantive”.

Frankly I doubt whether a major collapse would lead to major reform. The regulatory frameworks (or moral climates) of poorer countries aren’t notably better than those of richer countries, are they? If anything, I would have thought they’re worse.


I come to the opposite conclusion as Ed Harrison.

  • Commercial banks as utilities model. That worked for a long time, but the growth of the shadow banking system means it’s not enough anymore. As new scams (oops, financial innovations) are invented new regulations have to be put into place. Let’s not forget that the failure of Lehman was the straw that broke the camel’s back, so just regulating and limiting commercial banks wouldn’t be enough anymore.

  • Regulatory and Resolution model. The resolution model is like saying it’s ok to store gasoline next to your fireplace as long as we have a good fire department. Resolution can be expensive (the FDIC often looses money on the banks they take into receivership). Worse TBTF means there’s always an excuse for the government to say they needed to keep a zombie alive. As William K. Black is fond of pointing out, existing federal law not only permits but requires prompt corrective action when a bank becomes insolvent. So why is Citi still alive?

  • Regulation-Heavy model. Only realistic way to go. This model worked from it’s onset in the Great Depression until recently. In fact it didn’t fail at all; it was simply abandoned by a new group of clowns saying “ignore the last 800 years – this time it’s different”. Before that was the longest financial crisis free period in our history. And it corresponded with some of the greatest periods of economic growth in our history, so it was clearly no drag on the economy. Nor does it necessarily mean more regulations – effective regulation often means fewer, simpler rules with fewer loopholes. As for stifling financial innovation, where has financial innovation gotten us lately? A financial sector that doubled in size relative to GDP and grew to 30-40% of corporate profits and then resulted in a meltdown of the world economy. That’s a drag on the economy that we can do without.
  • Edward Harrison:

    In the present system of crony capitalism any reforms will be gutted by lobbyists. It’s unrealistic to expect any substantive reforms from a heavy regulation approach.


    But that’s true of any regulatory change, so 1, 2 and 3 all fare the same. Crony capitalism means any change will be window dressing. Worse, even if by some miracle substantive regulation is put into law, it’s worthless without people actually enforcing it. Puppet/crony regulators are worse than nothing at all, as they give some naive souls an illusion of regulation.

    If you want to take crony capitalism into account, then any proposals are moot until we have real campaign finance reform. I’m not holding my breath on that, but it’s a change that has to take place before any other real reform can.

    Edward Harrison:

    No, that isn’t true of the three proposals – they are very different. The third is not trying to firewall sectors of the economy or regulate away problems. You yourself said crony capitalism means any change is window dressing, so why make huge new agencies?

    And campaign finance reform won’t work either. The only thing that WILL work is a serious depression that reduces crony capitalism. Until then, ’substantive’ reform is only the degree to which we bring the shadow banking system, money markets and insurance companies under one umbrella, regulate derivatives, and set up mechanisms to reduce bank size to where they can all fail with less systemic. But, we would be fooling ourselves that any of these things are going to prevent another crisis.


    “that isn’t true of the three proposals”

    All 3 proposals involve regulatory change and hence are subject to gutting by vested interests. How can you refute that? Which one doesn’t involve any change?

    “And campaign finance reform won’t work either.”

    Why? Bribes (a/k/a campaign contributions) are what gives lobbyists their power. Finance “contributed” $475 million to the 2008 elections (#2 was healthcare at a paltry $167 million). They were the biggest contributors to Obama, and the likes of Schumer and Frank need no mention. The Dems appointed freshmen in vulnerable seats to the House Committee on Financial Services so they could lap up bribes.

    You can argue that we won’t get effective campaign finance reform, but how do you argue that it wouldn’t matter if we did?


    January 6, 2010 at 12:24 am

    I’m throwing my hat in with you, alex.

    As Amatai Etzioni observed in The Moral Dimension:

    “If those whose duty it is to set and to enforce the rules of the game are out to maximize their own profits, a la Public Choice, there is no hope for the system.”

    Unless there is a major change in the moral climate that leads to a considerable reduction in political corruption and a significantly improved environment necessary for a modern economy, ranging in trust in financial institutions to curbing the ability of monopolistic firms to use the state to restrain competition, there is no hope.

    Edward Harrison:

    alex, if what you and DownSouth are saying is that the moral climate and the crony capitalism probably won’t end unless we get an economic collapse or are relegated to former leading power a-la Great Britain, then I would agree. The U.S. has had declining power written all over it for decades. This is what broke Bretton Woods apart.

    If I were Michael Panzner and had thrown in the town already, i would be writing about Financial Armageddon and how to prepare for its inevitability. But, I’m not there yet. i still hold some hope that we can avoid a worst case scenario.

    Yesterday, I wrote a post at CW about Paul Volcker. Charlie Rose asks him about reform and option number one, “Do you think that Congress will see it your way?” His response was “Eventually, yes. They need a little more persuasion.” I have heard him make this remark twice now and it seems to me he’s saying what I am saying: the system is going to collapse eventually. At a minimum, I’ll get the reforms I want then. I hope it doesn’t have to come to that to get substantive change.


    An economic collapse would do it (it worked during the Great Depression) but I’m not saying it’s necessarily necessary. An alternative would be real campaign finance reform, as it’s the biggest source of the problem. You can’t get elected or stay elected in most cases without cultivating copious bribes. I’m not optimistic about the possibilities, as I’ve been going on about this for 30 years. One bright spot is that a number of states, such as Arizona, Maine and Vermont, have publicly funded campaigns for their state offices, in spite of the Supreme Court’s bizarre interpretation that bribery = free speech.

    One thing I am sure of is that absent very strong public opinion for campaign finance reform, it will never happen. That’s why I wish people would see that the bribery is the reason for the lack of finance industry reform and the horrible excuse for health care “reform”. I’m not a nihilist but until people know in their gut and recite as obvious that this is the source of the problem, nothing will change.

    Who knows, maybe a collapse would give us real reform on all fronts. Alternatively we’ll muddle along with half-baked reform and having the taxpayers prop up Wall Street’s curious notion of “free enterprise”. I certainly don’t claim to have a crystal ball.


    I have seen enough of Blacks interviews to know why Citi is still alive. Because the rest of them are broke as well

     #1. Rubin was at Citi and a GS alum and friend of the administration is

     #2. Rubin and Sandy Weill would go to a confined country club is

    #3. The government has no clue how to get the derivatives animal back in the box so they allow these insolvents to make believe everything is okay.

    Government did the same thing when inflation and deposit deregulation broke the S&L industry in 1980. Instead of stepping up and taking the debt off the hands of the S&L’s and giving them some kind of new start, they came up with a scam to let crooks gamble with the money they were allowed to imagine was still there. Unlike a bank, an S&L couldn’t create its own money, but had to attract deposits. Money naturally ends up in banks because people need to write checks so there was a cheap source of deposits S&L’s didn’t have.

    Still the US banking system was pretty much insolvent in the 1980’s. My guess is they hope they can wait this one out as they waited that one out. No dice, as there is not much chance they are going to maintain an upward sloping curve nor are they going to be earning 10% on cheap money as they were in the 1980-1995 period. Plus, the economy needs so much more credit pressure to keep the collateral in force.


    The post Great Depression economic model got mauled by inflation and subsequent soaring interest rates in the 70s. The regulated model isn’t build for that instability.

     alex :

    Even mauled that model looked better than what we have now.

     aet :

    Late seventies inflation? You mean when the bills for the Vietnam war became due?

    What’ll happen when the time for the Iraq/Afpak bills to be paid rolls around? I predict a similar wave of high inflation, and with high interest rates similar to the late seventies/early eighties…co-incidentally, that was just in time for the boomers borrowing to buy their homes.

    But this time around the boomers won’t be enjoying high interest rates on their lifetime savings. Interest rates will stay low until the boomers die off.
    Why not higher interest rates NOW to pay the boomers investment income on their retirement savings? Is there a surplus of capital, that interest rates ought to now be so low?

     kievite :


    This approach “regulation as a Swiss knife” has obvious problem of corruption of regulators. In other words it’s unclear who prevents the capture of regulators. If the appointed Fed chairman does not like part of Fed mandate related to regulation he can simply ignore it as long as he is sure that he will be reappointed. That happened with Greenspan.

    You need to understand that in essence the Fed is a political organization. As such it serves the elite which rules that country, whether you call then financial oligarchy or some other name.

    And the Fed Chairman is one of the most powerful political figure in the USA. May be the second in command. And definitely the most powerful unelected official. If you compare this position with the role of the Chairman of the Politburo in the USSR you’ll might find some interesting similarities.

    In other words it is impossible to prevent appointment of another Greenspan by another Reagan without undermining the power of Financial Oligarchy. And the transition to banana republic that follows such appointment is irreversible even if the next administration waterboards former Fed Chairman to help him to write his memoirs ;-) .

    Entrenched Financial Oligarchy is probably a more serious threat to the country then someone hiding in a cave in Afghanistan or Pakistan.

    You need to reform political system to be able to regulate financial industry.

     Ben :

    Change is going to happen, whether our two-party system likes it or not. If they don’t respond, a social movement will bypass them, and we’ll end up with an ugly outgrowth like the teabaggers – or worse – behind which the powerless majority can rally.

    Whoever successfully harnesses the anger growing in the country’s core will ride the wave to power. Obama was the left’s hope. The right could do worse than Ron Paul, but I fear he doesn’t sufficiently represent the haters.

    The banner won’t be one of hope; it will be one of anger and fear.

     psychohistorian :

    Excuse me! What is this BS about Obama being the Left’s wet dream. What new definition of Left has the continuation of the Bush policies become?

     aet :

    People disappointed with Obama won’t be turning into Reagan Republicans, you know.

    They’ll find people who actually will support their interests, and not simply pay lip service to their ideals on TV while actually running legislative and executive interference, almost a rear-guard action, to prevent those responsible for these crimes from being named, much less punished.


    Having spent some time in the mortgage business and having worked for a guy who spent time as an underwriter for FNMA, I can tell you that nothing happened in this mess that didn’t lead right to the top of FNMA and FHLMC. Both of these companies passed out loot to the politicians and to their politically connected management. They were both called on the carpet in a report by Armando Falcon early in the Bush administration and from what I understand had their wings clipped somewhat.

    The point here is that FNM and FRE called the tune in the mortgage business and basically set the tone for what could be bought and sold in regard to mortgages. Being they were privately owned companies, no matter whether they were backstopped by the government or not, their rules set the tone and if the rules led to losses, then it is clearly on the shoulders of men like Franklin Raines.

    Unlike the 1980’s, there wasn’t an interest rate shock in the 2000’s. When the Fed cut rates in early 2001, the 10 year treasury was in the 5.45% range. The majority of the time the 10 year was above 4%, which indicates that mortgage rates were not below 5% for long at any time. At the peak, they might have made near 7% in 2007, so we aren’t talking about a bubble popping rate. Nor are we talking about a rate induced boom from the Fed, though I think Greenspan was complicit. More than anything, the sudden appearance of rates 2% or so lower than anything seen pushed demand against supply and created a price spiral. In places like California, people have been lying in wait for price spirals for the past 40 years, so it is really hard to say this time should have been different.

    FNM got all the money because it could. There is talk about ARM’s, but FNM held the key to what kind of qualification they could allow on these programs. Clearly they weren’t expecting the rate to go down and if the market was passing on ARM’s at rates in excess of fixed rates, then there were bad decisions made.

    The credit based scoring used in the modern finance market had no basis for existence. There was no real experience to use that kind of underwriting, only bigger bonuses to be paid those working in the business. 28/36, 25/33 and 33/38 ratios and experience with them dated back to the 1980’s. My experience with residential real estate goes back to 1976 and FHA had a 3% downpayment requirement on cheap homes back then and they would finance the closing costs to boot. FHA wasn’t used by a lot of agents just because there was some math above first grade involved in figuring the loan amount and the downpayment and loan amount never added up to the sales price.

    My sister has brokered loans for 20 years and when she described the socalled science involved with the credit score nonsense, I had to laugh. I already knew the mortgage business was headed for collapse. Doug Noland had drummed FNMA since before I started reading his articles in 2001.

    I lived through the late 1980’s collapse in the DFW housing market. So much of the bad debt in housing is covered up by rising prices and they overbuilt Dallas and created a glut at exactly the wrong time. During the early years of the 1980’s when interest rates were in the teens, buydown financing became a literal necessity. They had to do it or the market would have collapsed. It worked short term because of the inflation that was going on at that time, but if something occurred to stop prices from going up, the market was suddenly glutted. People had to have an increase to sell a house and once the rates moderated to around 10% to 11%, the buydown financing was no longer necessary. They also came out with structured negative amortization loans, so there wasn’t much cushion. The market soured and more than 100,000 homes were forclosed in what remained one of the faster growing cities in the country.

    Michael Lewis did an article in Vanity Fair in late 2008 and the main character was a guy named Steve Eisner. Eisner found out that the real estate bubble only needed for prices to quit going up. I recall in 2006 there were monthly foreclosure filings here of around 4000 and there were about the same number of new homes being built, so the new market was pretty much being put right back out there. There wasn’t much suburban appreciation in the DFW area so there was no bailout and if there were speculators, they were stuck.

    The point of all of this is that FNM took a bath in some areas in the 1980’s and then went out and made even worse mistakes. I know some of this was because they could get reinsurance, but most of it was just because they could that they did it. I don’t know that they intended to run the business off the cliff, but something tells me the business has been hanging for a longer time than imagined. It is only the size of the bubble that made it this big, as they had to do something to keep the game going. That is the way credit bubbles are. Things haven’t changed and the massive credit and debt overhang on the economy hasn’t gone away. Recovery and prosperity are a long ways off. The whole matter may have been totally inevitible.

     aet :

    Oh the US mortgage business has contrary to what people may think, always been a public-sector thing: so the bail-outs of non-deposit taking investment houses is a-ok…because this crisis is actually all the Government’s fault, and those lazy lying shiftless poor people getting a free ride…

     Dave Raithel :

    “I certainly see the boom-bust cycle as endogenous to the capitalist system in a way that is unrelated to the Federal Reserve. Remember we had the panics of 1837, 1857, 1873, 1893 and 1907 before the Fed even existed.” Yep. We just need ourselves an experiment to separate out all other variables but the Fed and the monetary scheme afore it ….

     Doc Holiday :

    One of the main problems with the current systemic failure, is that no one is accountable for anything, including the co-pirates Paulson and Geithner.

    The inability of society to view these type of people as predatory instigators of collusion and treason-like activities is a massive problem, because people like these and a very long list of wall street mafia-crooks are responsible for economic genocide — these wall street bastards are financial terrorists and they are hidden behind the corrupted shields of homeland security, the SEC, FTC, Treasury, DOJ and all the corruption that is beneath the umbrella of the American government at this point. If that seems a bit harsh, then why the fuck are there not investigations going on — to place people in jail from Fannie, freddie, AIG, Citi, Lehman, JPM and the vast majority of crooked bastards that were bailed out by TARP collusion? No one cares I assume …. so, let’s let them take more and more … barf!

     Ishmael :

    Mr. Harrison:

    I agree with your selection of Number 1, but I believe there needs to be some accountability system to go along with this.

    This means accountability for honesty. We let too many white collar criminals walk and this is at all levels.

    If you unknowingly buy stolen property or accept counterfeit money you lose. Accordingly, I do not want to get into the details of how a transaction takes place or who was the fraudulent party be it the mortgage banker, the rating agency the IB who packaged it. This was basically securities fraud and you profited from the scheme so give the money back. All of these people should be made to give the money back net of taxes paid. Don’t have the money, get it or other measures are implemented ie jail, garnishment etc. Of course if large somes are given to related parties or charities there should be claw backs.

    Keep it simple. This is easy to implement and not a hard concept to understand. No one should profit from a crime either knowingly or unknowingly. Exactly defining the crime might be difficult and this should not be handled by a jury but maybe by a three judge panel or similar. Nothing but the fear of god is going to change this.

    Of course such action would never be implemented with the current crony government.

    That takes care of such things as the Dot.con and the recent housing securitization problems but there are a large number of areas where accountability need to be implemented and that is especially true through out the government.

     moslof :

    Ah yes a long term trend towards solvency is now well established. However just like the deregulation phase of bubble blowing we cannot just let it run its course. We must add fuel to the fire and accelerate the trend towards solvency by zeroing in on the guilty ones among the insolvent and “punishing/regulating” to prevent a future trend toward insolvency.

     Guest :

    Both Thoma and Tabby are card carrying dems. This is now Obama’s economy (and Summers’ and Rubin’s and Barney’s) and it is not going well. What better defense than the argument of original sin (i.e. we are all guilty and so assigning accountability is futile).

     john :

    Ross Perot was right. Ralph Nader was right. Hell, John Anderson was right, right?


    No, I’ll side with Matt Taibbi. He speaks his mind without attempting to hedge.
    In fact, I’ve noticed this articles writer (Edward Harrison)
    straddling the fence much of the time.

    Time to stop that and choose sides.
    Either you’re on the payroll of the 0.1% that own 1/3 the wealth in the U.S. OR, you’re on our side.

    There’s no doubt in my mind that Bernake, Obama, Geithner are merely order takers for the ultimate owners of the Fed & Goldman.

    There’s a war starting. Choose your side.

    Edward Harrison :

    Where am I straddling the fence when i call it crony capitalism or kleptocracy. None of these reforms are going to happen until we get a Great Depression style collapse. Its in No one’s interest in Washington or on Wall Street to reform the system. It works just fine for them.

    Do I have to spell it out Taibbi-style? C’mon, get serious for a second. If you can’t read an article and come to your own conclusion based on the facts, then you’re lost.


    Great article!

    I also have a preference for setting up robust failure modes rather than trying to prevent all failures.

     Jon :

    Wrong, Edward. It’s all Barney Franks fault. Charles Calomiris says so and so does Peter Wallison, and probably Larry Kudlow too. You can’t possibly disagree with them, can you?

    Edward Harrison:

    One more thing on the now deleted ‘limp dick’ comment. Election boycotts are pointless. None of this is going to change because you withheld your vote. Don’t kid yourself that makes a difference. Both parties are in bed with the same corrupt system of special interests. None of this is going to change until people get up off the couch, turn of the Bachelor, wake up and realize they are being robbed. Then maybe they will take civil action.

    Deception is the strongest political force on the planet.

    DownSouth :

    That’s the spirit!

    As Peter Skerry wrote in Mexican Americans: The Ambivalent Minority, our elite-network approach to politics in the US “is profoundly antipolitical. It teaches those without political power that it can and should be bestowed on them by elite benefactors.”

    The famous WWII fighting ace “Boots” Blesse put it this way:

    No guts, no glory. If you are going to shoot him down, you have to get in there and mix it up with him.

    We shouldn’t dread the conflict. We should relish it.


    January 6, 2010 at 2:06 am

    Do you really think demonstrations and protests matter? I think we’ve reached the point where the powers to be just don’t care unless there is violent revolt, and that’s just not going to happen.

    Besides, the only people who actually took your advice and protested are the tea party people, and it seems that apparently the blogosphere doesn’t want to be associated with the kind of people who actually go into the streets.


    A link to Mr Taibbi’s article might be nice.

    I’m not sure if it is a peculiarly American trait to want to identify so closely with another group, or if it’s just because it’s the only culture we in the rest of the `west’ are exposed to any more. But within the American culture there does seem to be a strong bent toward wanting to label each other a particular way, as a member of given political party, a particular ’school of thought’, or even associated with a given popular figure.

    Labels are ok and it helps start a discussion, but then to use it as a *badge of ignorance* to all those with a different label is juvenile. `My gang is better than yours! So nyer!’. Perhaps it is tied to the extreme competitiveness which also seems to pervade your culture – everyone wants to be on the ‘winning’ team (TBH that seems pretty juvenile too).

    So from this framework, what can any ’side’ do but blame the other? And you MUST belong to some ’side’ to even enter the debate of course – see any talking heads interview, the interviewer will ensure everyone takes sides even if they don’t want to.

    Is anyone important ever likely to admit that the system itself is simply unstable and fundamentally flawed? e.g.

    Could the media ever admit it has failed in it’s role to keep the powerful honest? That’s why you have ‘freedom of speech’ in the constitution, and journalists are extended the *privilege* of protecting their sources, after all.

    Or even perhaps more seriously, democracy itself has failed? (Which is pretty obvious given the whole ‘change’ thing you ALL VOTED FOR – not that the silly geriatric and gun-tot’n barbie were really valid alternatives – that they were even considered is only a further indictment). But such a proposition is simply unthinkable for the generation that `triumphed’ over the `evil empire’.

    No, it’s easier just to blame someone else. Bonus points if you pick on an ethnic minority whilst you’re at it.

    So along with the generation of `greed is good’, `might is right’, and `we’re the good empire’, and just like many ideas in science – it will probably take a generational change before any real attempt will be made at addressing these real problems. If it lasts that long.

    Doc Holiday:

    Re: “the now deleted ‘limp dick’ comment”

    > Did I miss something? Is there a rewind or replay?? I can’t be here all the time — and now I feel cheated to have apparently missed a nakedcapitalism moment which might have possessed within itself a fleeting moment of sincere passion, which is now apparently deleted and now only a reference which will be lost upon the winds of shitty pixel dust — blowing like snowflakes in a forest of financial darkness, inhabited by no one and dreamed of by no one … just silence and emptiness mixed into forlorn despair. My desire ceases to be, I am so sad for the lost comment!

    Also see:

    Wake up, wake up dead man
    Wake up, wake up dead man.

    Jesus, were you just around the corner?
    Did you think to try and warn her?
    Were you working on something new?
    If there’s an order in all of this disorder
    Is it like a tape recorder?
    Can we rewind it just once more?


    Our financial and political elites can live with the idea of democracy but not the practice of it.

    In the American agrarian populist movement on the late 19th century the farmers from the South and the West built marketing and purchasing cooperatives in the teeth of opposition from railroads, banks, and supply houses. As a consequence of such activity populist became more and more aware of the ability of concentrated economic and political power to shape not only the economy and the political process but culture itself. Later these alternative instituional structures and people’s experices in creating and running them gave activists the self-confidence to form a third party which contained in its platform a sophistcated analysis of the way the American economy functioned at that time and suggestions for how it could be changed.

    What are the ideas for new institutions of recruitment for a social movement in 2010? Does Steve Keen’s cutting edge work on credit flows indicate that we should consider creating a new type of local banking institution independent of Wall Street and the Federal Reserve?


    “Does Steve Keen’s cutting edge work on credit flows indicate that we should consider creating a new type of local banking institution independent of Wall Street and the Federal Reserve?”

    No, his work is neutral on that point. His real insight builds on Minsky, that excessive debt levels are inherently unstable. Keen and others have developed models that show why this is so.


    I have often thought the same way – where are the positive alternative proposals? The despairing comments on this thread have a depressingly late-Weimar feel about them; “we need a depression”, “you can’t trust any politicians” and “democracy has failed” etc. We know that sort of despair can be a short road to a very ugly regime indeed.

    I really can’t believe that the entire US population is so morally decrepit that there is no hope of positive action before that stage is reached, but I am very worried about the apparent absence of positive programmes.

    Maybe the way Barack Obama’s campaign raised hopes that were later dashed has had an even worse influence than I thought.

    Joe Renter:

    One thing to keep in mind is that this is a world wide problem that effect billions. The whole system will collapse soon and when it does there will be a system put forth that will not be based on corruption. It will take some time and we will all need to scale back (those in the west) on what we think we need for our material well being.
    “The American dream (myth)” is not sustainable scenario. An economical model made up of one third capitalism to two thirds socialism, a highly complex bartering system will be implemented. It will not be easy for those who think that having the most toys and status are the winners and those below are the losers. It will be a challenge, to be sure, but without drastic changes in the economic, political, and environmental fronts they will be no future for mankind. Share International’s web site has more information on this subject.

    There is hope.


    Mr. Harrison -

    Do you really believe people don’t understand that they’re being robbed? The fury and resentment are almost palpable. People just don’t know what to do with their anger, yet. Voting out one lying, thieving administration just to see the next one act the same way has increased, not diminished the fury. I think the recent flurry of announcements by democratic governors, representatives and senators that they will not run for re-election is an acknowledgment of that growing ire.

    You probably don’t need to go any further than Hollywood to see a reflection of the growth of the public’s resentment and suspicion. Compare the portrayals of corporate and government employers in “The Man in the Gray Flannel Suit,” “I Dream of Jeannie,” “Bewitched,” “The Constant Gardener,” and “Avatar.”

    Those portrayals moved from benign and wise to benign and befuddled to evil incarnate in two generations.

    Hugh :

    I have never understood the idea that bubbles can’t be stopped. A bubble that is big enough to create a major shock to the system or even put it at risk can be seen literally years away. It’s not rocket science. The math doesn’t add up in an obvious way. The real reason they aren’t stopped is that politicians won’t brake the upside which makes them look good. And they are receiving strong pressure from those making a buck on the upswing to keep the game going. There is nothing mystical about bubbles that makes them hard to see. There is no political will to prevent them, especially in a kleptocratic state such as we have now.

    Even after your added note, I still don’t understand the association of Geithner with regulation. He is a financial industry sockpuppet.

    You also seem to think like Summers, Obama, Geithner, Bernanke, etc. that the current system can be maintained and no increase in rules? It makes me wonder where you have been the last two years. Our financial system is set up now as a casino. It is filled with players whose only function is geared to gaming the hell out of it. This is not a salvageable entity. It needs deep thoroughgoing reforms. It needs to be a lot smaller. The paper economy has to be dismantled in toto. Finance must be simplified and price must be tied to real, sustainable profitability.

    As it is now, the markets serve no positive societal function. They aren’t efficient. They misallocate. They incentivize systemic risk and moral hazard. They are ultimately wealth destroying and threaten both our own and the world’s stability. I have no sympathy for those who would perpetuate any part of the current system. Markets don’t need just to be reined in. They need to be completely reformulated and reset.

    Not going to happen I know, but that’s why I think the chances of depression are so high.

    Toby :

    Yes indeed Hugh, and with bells on too.

    Wealth itself needs to be reassessed, re-understood culturally, so as to be based on the health of the ecosystem and the health of society, to the extent these things are measurable (we getting better at measuring both it seems). Money, at least initially, needs to be redesigned to function purely as a medium of exchange, NOT as a store of value (it’s actually an abstraction of value but that’s beside the point), not as a commodity in and of itself. That way we would have a systemic chance of perceiving wealth and profit in non-monetary things. Charles Eisenstein and Bernard Lietaer favour a money with demurrage (a monthly fee which would steadily diminish its value), which by design would disincentivize hoarding. I find the idea very promising. While money only comes into existence as interest bearing debt (money IS debt), we ensure society is addicted to “growth” as a junky to his drug, and also ensure money’s steady accumulation to the rich, which dangerously over-calcifies the status quo. Growth and decline are natural processes, healthy both. Economics needs to get up to speed on this, and not cling like Scrooge to the glitterning profit/greed paradigm, which is strip-mining existence, strip-mining our future in the interests of nothing but monetary accumulation. The process is frightening and absurd.

    The other problem we need to take seriously is technological unemlpoyment. I know orthodox economics dismisses the idea as a lump of labour fallacy, but the data suggests otherwise; it is real and becoming more serious by the decade. Factories and farms are close to 100% automated, and now soft skills are under profound attack too. Google “The Eureka Machine” and new software performing journalistic tasks for Bloomberg. Technological development is a serious challenge to the current model, is rendering it harmful, and certainly not something to be brushed aside with a theory not sufficiently supported by the data. For example, the US experienced a 60% increase in productivity in the last decade, but wages were either stagnant or fell.

    Only radical change can re-ignite progress. The current model is totally defunct and juiceless, nurturing nothing but its own decay. Defending it merely worsens the coming collapse. Excuse the cliche, but it really is time to wake up.

     aet :

    Re Tech change.
    Solution: guaranteed annual incomes sufficient to buy food & shelter for all citizens.

    Automation is no joke: that its benefits are too concentrated is the unfunny part.

    Intelligent and sensitive tax policy, as a means to the redistribution of income, is the only way to deal with this one over time. Otherwise, lots of starvation and other privation – even though there’s never been so much food and other goods grown and produced by so few.

    Or so much leisure time in society as a whole, for that matter.

    Toby :

    The GAI interests me, but until we get money’s design right, we’re just tinkering at the edges with such ideas. The other thing to try is reduction of the working week. Technological development should be embraced as a potential emancipation declaration, where we free people everywhere from drudgery and exploitation, thereby spreading the benefits of human ingenuity as broadly as we are able. The current system overrewards the rich and overpunishes the poor, WHILE raping the ecosystem. We have to change it.


    OK lets talk about what really went wrong with Fannie and Freddie and where the blame lies. We can look at the original regulator HUD which decided it was a good idea under government persuasion for them to buy sub prime loans. We can look at the accounting scandals in 2003 through to 2005 and how the regulator OFHEO was left with egg on its face for not doing a proper job.Next we ought to look at how many times proposals for new regulation and reform were put forward before congress and which were all rejected bar one and that was a watered down version. It was actually the Federal reserve through both Alan and Ben who were most vociferous in pushing for limits and new regulation on Fannie and Freddie. To blame lack of regulation is the easy answer and the real reason things went wrong may be subtly different. The real reason Fannie and Freddie went head long into sub prime during 2006 – 2008 was to gain political favour having lost much of it during the scandals leading up to 2005. The answer is probably that Barney Frank had brokered a deal were by GSE congresssional benefits were linked to affordable housing and in an effort to gain political favour the GSE’s went overboard.

    The solution was not necesaarily more regulation, because the regulations that were there were not enforced. The solution is for congress to stop interferring in the markets for political motives, get regulators to actually do their job, introduce a proper financial consumer protection agency and to really clamp down on capital requirements where leverage and risk is used. If I have sugegsted the FED was innocent then that is not true they should have been given a better mandate to look at both inflation and asset appreciation. While we are at it the government statistics departments ought to be divorced from government so that deliberate tampering for political means is clamped down on.

     aet :

    The US public ought to stop giving taxpayer support to right-wing political lobby & dis-information groups like the AEI: which supports every increase in military spending and every mandatory imprisonment proposal for low-level street crime, but which thinks big-business ought to always and everywhere be exempt from any and all social control.

    “American Enterprise institute”: the St. Ronald Reagan Society.

     Glen :

    Bubbles are not a FLAW of our current system, they are a feature. Bubbles are BIG MONEY for Wall St without having to actually do any real GDP growth. It’s all sizzle and no steak.

    I agree with Paul Volcker – the only real financial innovation in the last thirty years was the ATM.

    We need to turn banking back into the means to finance the creators of new technology, new industry, and real growth rather than a way to disguise the collapse of the middle class and the implosion of America’s technological and manufacturing core.

    This has to work both ends of the problem – failed companies have to FAIL. Regulatory laws to enforce a fair and level marketplace have to be fixed and enforced after a thirty year delusion that we can run our financial system without having to worry about crooks.

     sean :

    Edward Harrison states:

    ”….This is kleptocracy, of course. Crony capitalism. And by that I mean the system Taibbi lucidly breaks down for us is one of privatized gains and socialized losses..”.

    Perhaps the case is the political and business structure is now more redolent of a form of soft fascism .
    The GSE’s ,Democratic and Republican parties, the military industrial complex as described by Eisenhower ( Defence contractors place constituent parts of their business in as many States as possible and align State senators and Reps with their needs as opposed to Defence needs) Corporate business , Wall street and the Banks all have manged to align the power of the Federal government to their objectives.

    Lobbying as you describe ensures this trumps the Constitutional rights of US citizens. Indeed somehow the survival of the United States is linked to the survival of Wall street and the banks rather then the other way round. Consider the banks who were bailed out with taxpayers money and an ordinary US citizen whose property is foreclosed. In ordinary language it appears that Corporate entities have Constitutional rights as entities superior to those of US citizens.

    This scenario is not unique to the USA. Here in Ireland a very similar situation has developed.

    What I have noticed ities as one integrated oppressive instrument.

    The philosophy behind the US constitution was to limit the power of the state and the Bill of Rights was to ensure its citizenry’ rights were paramount.
    The power of the state and crony capitalism are expanding whilst the rights of the citizenry are declining alsong with their capacity to a decent life.


    The problem is so insidious, it permeates every fibre of the American social fabric.

    Everyone seems to agree that there is a lack of morality, ethic, fairness and justice whatever you want to call it.

    This seems to bring many Americans back to the initial Constitution written at a time when there was vast amount of land still there for the taking.

    Fast forward a couple hundred years when all land has been claimed but the ownership society is still idealized.

    Let’s face it, the basic tenets of fairness vanished a long time ago. For example, how can someone who bought waterfront property 50-60 years ago often on a teacher’s income be worth millions while the typical young professional couple starting out can’t even dream of owning such a property in their lifetime.

    The game lasted while everyone thought they could get a piece of the pie. Slowly, everyone is going to understand that there is “royalty” in the US, just like what happened in Europe a long time ago.

    Everyone can blame everybody else but in my mind, the system evolved to what it is today because of prevalent ideologies. Ideologies which made sense when America was empty but don’t make sense today with 300 million people vying for the big life and being told they can get it if they work hard enough and just stay optimistic ALL the time.

    You can be disgusted at the biggest cheats but ALL North Americans are cheats. We are all taking more than our share on this planet. And human nature dicates that we never have enough. Going against the phenomenon of getting more was like standing in front of a moving train.

    Many American ideologies are still rooted in the past but times have changed. Something tell me that Americans won’t willingly change because it is the right thing to do.

    Circumstance will force them to.

    [Dec 28, 2009] Too late to learn? by Julian Delasantellis

    Review of the book The Cost of Capitalism: Understanding Market Mayhem and Stabilizing our Economic Future, by Robert Barbera
    Dec 23, 2009 | Asia Times

    A few weeks ago, I wrote about the competition between the followers of John Maynard Keynes and Milton Friedman for the title of the most influential economist of the twentieth century, (see Off with their blinkered heads, Asia Times Online, October 1, 2009). I noted how, even with the followers of the two 20th century greats locked in a death struggle among dead ideologies, there is no question of who the 21st century's most influential economist is, even with the century barely 10% done.

    "His name is Hyman Minsky."

    Even among the economic literati the name of Hyman Minsky is not well known, and that is unfortunate. Born in 1919 and raised in the time of Keynes, he was never a doctrinaire Keynesian; by late in his life, economic fashion had flipped to be the time of Friedman; yet, once again more in tune to history's different drummer, nor was Minsky a Friedmanite monetarist. Out of place in the 20th century, he would have found himself at the central fulcrum of economic ideology in the 21st, had he not died in 1996.

    Keynes' burden to bear was the unemployment spurred by the Great Depression in the middle of the last century, and the great inflation that followed the over application of Keynes at the end of the century. The situation that faced Minsky was none, or perhaps all, of both wrapped together - the problem of the financial market bubble.

    The rescue of the Great Depression economy by Keynes was, by the 1960s, so comprehensive and thorough that one of the depression's acknowledged causes, destructive financial market bubbles whose dolorous impact spreads out of finance to negatively impact the general economy, was something only remembered by old timers.

    The world economy essentially went more than 50 years, from the Wall Street crash of 1929 to at least the gold/silver bubble of 1980, before experiencing another such bubble. With the 1970s' threat of inflation then controlled by monetarism and its strict control of the money supply, interest in studying or even considering financial market bubbles began to be seen as the quick way for young economists to kill their careers.

    Economists found tools to smooth out the shooting ascents and crashing descents of the previous decades; the fact that they could, with inflation falling towards zero and recessions becoming few and mild, only confirmed the name of the period given to the era right up until the recent crashes as "the Great Moderation".

    The reign of former US Federal Reserve Board chairman, Alan Greenspan, of more than 20 years of mostly prosperity was monetarism seizing the king's throne; during his tenure he was famed and feted for his obsession with drawing meaning from the most obscure economic statistics; from truck tire retreadings to rat turds left on freight rail cars, Greenspan was known for his interpretive artistry with the arcana of everyday economic life.

    As for his studying gyrations in the financial markets, and their effect on the everyday, outside, real economy, Greenspan cared little. Sometimes financial markets would be going up, sometimes down, but, as long as government did not intervene, it all would work itself out in the end.

    Exactly the opposite to what Hyman Minsky believed.

    Like a plant dormant for 20 years instead of for just one season, an explosion of interest in Hyman Minsky emerged last spring. He was favorably mentioned by all the right economic commentators in the New York Times and Financial Times; Paul Krugman titled a blog post "The night they re-read Minsky", after the bawdy 1968 musical comedy, The Night They Raided Minsky's. Much of Minsky's core canon is being republished, including his 1975 biography of Keynes, and his Stabilizing an Unstable Economy, from 1986. Demonstrating the cojones that have allowed them to rise to the summit of the greasy pole of world retail, is even charging US$5 for a download of a boilerplate academic article written about Minsky in 2005, something available for free to anybody with access to academic databases.

    But all these are chock-full of the obtuse jargon of academic economics, and were written before one could see how the current economic crisis was in many ways foretold by Minsky. For this we must look at Wall Street economist Robert Barbera's The Cost of Capitalism: Understanding Market Mayhem and Stabilizing our Economic Future . If you're still looking for a holiday gift for that always difficult to please neo-Schumpeterian, I'd look no further than here.

    The springtime fascination with Minsky was short-lived and superficial, and it's now mostly passed. Neither of the two, recent forest-leveling bruisers meant to be the sources of record for the entire crisis, Andrew Ross Sorkin's Too Big To Fail, and Charles Gasparino's The Sellout, carried any mention of Minsky. That leaves it to Barbera as one of the few commentators actually saying something interesting and innovative about the crisis.

    In the church of Friedman, inflation was the ol' devil tempting the good folk; the 1980s seemed to prove that, let loose, it would cause untold havoc on the populace. But, as Barbera notes:

    The last five major global cyclical events were the early 1990s recession - largely occasioned by the US Savings & Loan crisis, the collapse of Japan Inc after the stock market crash of 1990, the Asian crisis of the mid-1990s, the fabulous technology boom/bust cycle at the turn of the millennium, and the unprecedented rise and then collapse for US residential real estate in 2007-2008. All five episodes delivered recessions, either global or regional. In no case was there a significant prior acceleration of wages and general prices. In each case, an investment boom and an associated asset market ran to improbable heights and then collapsed. From 1945 to 1985, there was no recession caused by the instability of investment prompted by financial speculation - and since 1985 there has been no recession that has not been caused by these factors.
    Thus, meet the devil in Minsky's paradise - "an investment boom and an associated asset market [that] ran to improbable heights and then collapsed".

    According the Barbera, "Minsky's financial instability hypothesis depends critically on what amounts to a sociological insight. People change their minds about taking risks. They don't make a one-time rational judgment about debt use and stock market exposure and stick to it. Instead, they change their minds over time. And history is quite clear about how they change their minds. The longer the good times endure, the more people begin to see wisdom in risky strategies."

    In 1985, the rock band Starship, a rump group of leftovers from the 1960s' Jefferson Aiplane and the 1980s Jefferson Starship, released the video for their single We Built This City; in it, a sleepy rural settlement is transformed into modern San Francisco just by the power of rock and roll music. In Hyman Minsky's world, modern metropolises are built not with rock, but with investment capital.

    In the early, first stages of an investment boom, things can be pretty well signified by Starship's sleepy rural outpost.

    Something bad happened within the memory of the participants in the capital markets of this place, namely, the blow-off, destructive phase of the previous boom cycle. Therefore, economic and investment decisions now tend towards the conservative side. The investments are usually made with old-fashioned, fixed-rate financings, and, most importantly, the savings cushion of the borrowers is always enough to be able to cover the payback of both principal and interest of any loans should they come due and have not produced a sufficient revenue stream yet.

    This is a very safe investment environment, also, a very boring one. Therefore, like in any evolutionary process, somebody decides to push the envelope in what is then generally accepted as "progress".

    Investors start to borrow more, to ramp up both leverage and risk. Borrowing expands, and is no longer solely financed by predictable fixed long-term rates but by much more volatile short-term flexible rates. Most important, it is no longer considered all that necessary to carry as savings sufficient principal and interest needed to pay back the loans. The income-producing investments are up and running; they're producing a cash flow; and, as long as that continues to be reliable, there should be enough to fund the loans. 

    It is in the final stage of a Minsky expansion where all the greed and glory, the delight and the destruction of unregulated finance capitalism, can be found. All rational and practical limits against the assumption of risk and leverage are abandoned; nobody has two quarters they can rub together in their bank accounts or any other readily accessible sources of emergency cash. With debt obligations far in excess of investment cash flows, more and more borrowing is being used to fund almost all the daily needs of life. This creates a boom in asset prices, which spurs more lending; indeed, the only way people can pay back their old loans is with new, even bigger, very short-term loans .

    But what if the collateral to finance the new loans falls in value? At that point, just like in the condominium markets in South Florida and San Diego in mid-2006, the borrowing stops; so does the price appreciation that was addicted to the ever-continually rising borrowing. The entire wealth-creation machine goes into reverse, and assets and wealth are destroyed at a maddening pace. In the current lingo, this asset price turnaround that opens the gates of economic hell is now being called a "Minsky moment".

    At Harvard, Minsky had studied under the king of the Austrian School of economics, Joseph Schumpeter, and many see echoes of Schumpeter's famed "creative destruction" in Minsky's theory of financial cycles. Minsky would not have been one of these. Whereas Schumpeter believed that each successive boom and bust cycle led to a more advanced and productive economy, Minsky believed just the opposite, seeing in the successive financial crises that ended with the Great Depression ever greater and greater danger, through the growing amounts involved, to the financial markets and the economy in general.

    As I noted here many times, Barbera observes that one common factor driving the blowoff stages of bubbles is "TTID" - this time it's different - the belief that what is on display amongst the irrational exuberance of rapidly rising prices is not the fundamental human characteristic of greed in unholy union with the dynamics of mob psychology, but an existential change in the human dynamic forcing a basic re-allocation of capital from the old paradigm to the new. As Barbera noted about his experiences at a 2000 White House Conference on the New Economy, just a few weeks after the actual dot-com top:

    I had the misfortune to experience this sentiment firsthand, at the White House Conference on the New Economy, in April 2000. As I noted earlier, Alan Greenspan was the rock star at the conference, peopled almost entirely by true believers. Somewhat inexplicably, I was also in attendance. After the main session was held, all participants were assigned to breakout groups. I joined about a dozen others. Our collective task was to answer the question: "What could go wrong?" Not being the shy type, I volunteered within the first five minutes of our round table that the obvious issue we had to grapple with was the potential for a bursting of the large technology share price bubble.

    Our moderator, a White House insider whose name, thankfully, I do not remember, pounced. "This is not a bubble!" ... In the end, the group decided that the big risk going forward, in this brave new world, was the technology gap that was sure to worsen between the United States and poor African and Latin American nations. Bubble? The word was never uttered again.

    The year 2000 saw US president Bill Clinton's head, swollen huge from the victories over the baying hounds of impeachment and the vengeful furies of Hillary, grow so massive as to threaten the asphyxiation of the planet. So it's not all that surprising that out of the fertile ground of national hubris and delusion the dot-com tech bubble grew - 2004-06 proved that it was just as easy or easier to grow an even bigger bubble with a dolt as president.

    As this is a book targeted not for academics but for finance professionals, I did not expect to see many encouraging words for Minsky's core policy prescription for smoothing out the boom/bust cycles of finance capitalism - a much bigger government role in the economy, up to and including some measure of government control over the private market's investment decisions.

    For Minsky, putting investment control in the hands of enlightened bureaucrats whose pay packets were mostly unrelated to the gyrations of the boom/bust cycle prevented lots of unnecessary investment during the boom, and supported it from withering into non-existence during the bust. Barbera, echoing much of current American political discourse, can't see much further than government's inevitable waste:

    Government projects, once they begin to spend, face no such [spending] discipline. Benefits, as it turns out, are in the eyes of the bureaucrat, they can be refined again and again so as to perpetually justify investment projects. Indeed, at the worse, we may find ourselves authorizing bridges to nowhere!
    Bridges that, when reversed, lead directly from Sarah Palin's house to the White House.

    During the long, beneficent salad days of Greenspan's reign, the populace regarded him almost as a sort of Olympian god of money, greeting him on his trips to be among the mortals in the provinces with extended hand, Roman-type salutes of adoration. These days, the salutes are the same, but they are missing four of the previously present five fingers.

    In his defense, the old fox has two refuges. One, that there was no evidence of a real-estate bubble in the period up to 2006; two, that even if there was, the pain of pricking it would have been worse than letting it burst from natural over-inflation.

    Minsky proves both these points wrong. First, it was his contention that bubbles were not rare, unpredictable events, but natural, to-be-expected features of modern finance capitalism. The rampant new borrowing required to make the payments on the old borrowing, Minsky's key cenotaph of an economy in bubble, blowoff phase, was self-evidently rampant in that long-passed period of just three years ago.

    As to Greenspan's defense that the bursting of the bubble would have been worse than letting it explode naturally, well, currently, the US Department of Labor's broadest measure of unemployment, its so called "U-6" index, is now showing more than one in six American workers now either unemployed, underemployed/working part time, or having given up looking for work altogether. Doing things naturally is good, I suppose, unless its like natural childbirth or speculative bubble bursting, where you can die from it.

    To me, the most important insight gained from Barbera's valuable introduction to Minsky is just how much it validates what all Americans witnessed with their own eyes just a few years ago.

    Then, the bubble madness was all around, symbolized by such cultural phenomena as the mad rush to have the forests plowed under for another new cookie-cutter housing development, the monomaniacal obsession with rising real-estate prices at all social occasions, the children dropping out of college, or even high school, to try to make their first million before their first shave, and my favorite, a strange new agricultural sprout that seemingly burst overnight from the ground like a tempting but ultimately poisonous kudzu on a small piece of wood nailed to a stake, a hand scribbled magic marker written entreaty to "quit your job to make $100,000 in real estate by next month".

    In The Graduate, Ben eschews the advice regarding plastics, to first bed his father's partner's wife, then to romance her daughter. The mother, the inimitable Mrs Robinson, is none too pleased with this situation; she beats her daughter in protest, crying "It's too late!"

    "Not for me!" the daughter responds.

    But, if as the cultural zeitgeist seems to demand, and in contrast to all we've learned from Minsky, another bubble is so soon spun in another ill-considered attempt to bring back the prosperity of the previous burst bubbles, it will be too late to maintain the world capitalist economy in any now recognizable form.

    The Cost of Capitalism: Understanding Market Mayhem and Stabilizing our Economic Future, by Robert Barbera, McGraw-Hill. ISBN-10: 0071628444. Price US$27.95, 240 pages.

    “Wake Up, Gentlemen”

    The Baseline Scenario


    I’ll add (I mean ADD), a (long) quote from another President:

    “The prime need today is to face the fact that we are now in the midst of a great economic evolution. There is urgent necessity of applying both common sense and the highest ethical standard to this movement for better economic conditions among the mass of our people if we are to make it one of healthy evolution and not one of revolution. It is, from the standpoint of our country, wicked as well as foolish longer to refuse to face the real issues of the day. Only by so facing them can we go forward; and to do this we must break up the old party organizations and obliterate the old cleavage lines on the dead issues inherited from fifty years ago. Our fight is a fundamental fight against both of the old corrupt party machines, for both are under the dominion of the plunder league of the professional politicians who are controlled and sustained by the great beneficiaries of privilege and reaction. How close is the alliance between the two machines is shown by the attitude of that portion of those Northeastern newspapers, including the majority of the great dailies in all the Northeastern cities–Boston, Buffalo, Springfield, Hartford, Philadelphia, and, above all, New York–which are controlled by or representative of the interests which, in popular phrase, are conveniently grouped together as the Wall Street interests.”

    … …

    “The present conditions of business cannot be accepted as satisfactory. There are too many who do not prosper enough, and of the few who prosper greatly there are certainly some whose prosperity does not mean well for the country. Rational Progressives, no matter how radical, are well aware that nothing the Government can do will make some men prosper, and we heartily approve the prosperity, no matter how great, of any man, if it comes as an incident to rendering service to the community; but we wish to shape conditions so that a greater number of the small men who are decent, industrious and energetic shall be able to succeed, and so that the big man who is dishonest shall not be allowed to succeed at all.”…

    …”Unfortunately, those dealing with the subject have tended to divide into two camps, each as unwise as the other. One camp has fixed its eyes only on the need of prosperity, loudly announcing that our attention must be confined to securing it in bulk, and that the division must be left to take care of itself. This is merely the plan, already tested and found wanting, of giving prosperity to the big men on top, and trusting to their mercy to let something leak through to the mass of their countrymen below–which, in effect, means that there shall be no attempt to regulate the ferocious scramble in which greed and cunning reap the largest rewards. The other set has fixed its eyes purely on the injustices of distribution, omitting all consideration of the need of having something to distribute, and advocates action which, it is true, would abolish most of the inequalities of the distribution of prosperity, but only by the unfortunately simple process of abolishing the prosperity itself. This means merely that conditions are to be evened, not up, but down, so that all shall stand on a common level, where nobody has any prosperity at all. The task of the wise radical must be to refuse to be misled by either set of false advisers; he must both favor and promote the agencies that make for prosperity, and at the same time see to it that these agencies are so used as to be primarily of service to the average man.”

    Theodore Roosevelt, Address to the Progressive Convention, August 1912

    History Rhymes…

    James Gornick

    Far-fetched, Wall Street and Washington Still Sending Toxic Messages…

    This concern was voiced by Joseph Stiglitz back in July of 2009 in an article that appeared in the Vanityfair. In this article, it holds the Far-fetched theme for challenge placed against all who have lost touch of the pure math of how the theorems are becoming weighted to question the current crisis. Stiglitz stated, “The reputation of American-style capitalism will have taken a beating—not least because of the gap between what Washington practices and what it preaches. Disillusioned developing nations may turn their backs on the free market, posing new threats to global stability and U.S. security” (Stiglitz).

    The article pointed out that “nowhere is the battle raging more hotly than the Third World, among the 80 percent of the world’s population that lives in Asia, Latin America, and Africa, 1.4 billion of whom subsist on less than $1.25 a day” (Stiglitz).

    Stiglitz went on further; with his thoughts on the economic debates taking place by the many economists and pundits from around the world. He stated, “These economic debates take on particular potency in the developing worlds. Although we in the West tend to forget, 190 years ago one-third of the world’s gross domestic product was in China. Nevertheless, then–rather suddenly, colonial exploitation and unfair trade agreements, combined with a technological revolution in Europe and America, left the developing countries far behind, to the point where, by 1950, China’s economy constituted less than 5 percent of the world’s G.D.P. In the mid–19th century, the United Kingdom and France actually waged a war to open China to global trade. This was the Second Opium War, so named because the West had little of value to sell to China other than drugs, which it had been dumping into Chinese markets, with the collateral effect of causing widespread addiction. It was an early attempt by the West to correct a balance-of-payments problem” (Stiglitz).

    Why bring this economist and others in this article post are critical to drive home the nature of tides showing cracking at the seams of the fault lines of sustainable recoveries. The academia should join in the support or the refuting of the message this is going to deliver.

    The simple for these assumptions are base for all to sharpen their pencils and get out their calculators is based on bringing two theorems of Welfare and the Traditional neoclassical economics.

    The theory of neoclassical economics literature assumes that markets are always efficient except for some limited and well-defined market failures. There are more studies being produced by the likes of Stiglitz and others. These studies bring supports for reversing their presumption too: It is only under exceptional circumstances that markets are efficient by the high degree of transparency of the financial markets, as regulated through governments and their abilities of their countries through the intervention and policies of their central banks in creating an engineered efficient market from failure. This presumption theory is based upon the measurable tolerances of two theorems. One is that of the “Welfare stress formula” as the recent departed Paul Samuelson along with Bergson was recognized contributors to this fundamentally accepted theorems and the other is the “Information Economics” developed by Stiglitz.

    These conditions can measure the accuracy of a failing recovery and/or the pressures to cause the signal of a double dip recessions or that of a larger balloon-busts of debt to liquidity imbalances as failures to repay debt issues keep rising.

    The amazing accuracy coming within the future as these calculations can forecast the current environments as has been used to reveal the eventual looming debt collapses looming on the not too distant future of this recent recession and to be suspect if we have entered true recovery that does not invite the larger debt collapse factors.

    This central theme of convergence too divergences in showing what pressures are coming out to support the metric used to determine recovery of economical sustainability. A further debt of looming collapses are seen mounting by the verifiable supplies of bailout welfare stressors as recently provided to Dubai World from Abu Dhabi.

    Even the fact that the warning of Abu Dhabi to demand control over the emirates of Dhabi World and other holders of large debts coming up for defaults was well published in an article out of Bloomberg news.

    These mounting concerns are spreading throughout the Asian rim and other countries struggling with the real fundamentals of how to dry up liquidity induced into the market place. This use of free flow stimulus and the push of the falling dollar have brought to the brink of the abyss, the near hoarding of cash as seen by many banks that have driven treasurers to record Bond-Market sales. This has caused the inverse for stocks to lose yield advantages as Share Buybacks dwindle and the issuance of diluted shareholder values has become the common place by the financial banking and investment firms clearing themselves from TARP.

    This does not mean they have not stopped their high-risk bets of forging the “Carry-Trade” to bring back the eventual “Too-Big to fail” (TBTF).

    These conditions are further aggravated by the recent announcements of Federal Reserve, The Treasury Secretary, and the President of the United States for further developments of welfare stressors in America.

    These stressors are through excessive problems seen through drying up of liquidity and the continued arrogance of the free market running amuck with the “Carry-trade” at play. Further stress is seen worldwide with the theme of a severe Jobless recovery metric playing out with increasing the profound effect of the Welfare economics theory and its critical importance.

    All these concerns of liquidity infusions still not under a cohesive and verifiable control of stringent regulations adopted around the world over the financial banking and investment sectors. Even the recurrent calls made by Paul Volker still seem to be ignored, but the warning siren is sounding louder now than ever before. Volker pleas to Fix Too-Big Banks Ignored as read in an exclusive article out of Bloomberg today.

    Stiglitz has shown (together with Bruce Greenwald) that “whenever markets are incomplete and /or information is imperfect (which are true in virtually all economies), even competitive market allocation is not constrained Pareto efficient”. In other words, there usually exist schemes of government intervention that can induce Pareto superior outcomes, thus making everyone better off. Although these conclusions and the pervasiveness of market failures do not necessarily warrant the state intervening broadly in the economy, it makes clear that the “optimal” range of government recommendable interventions is definitely much larger than the traditional “market failure” school recognizes For Stiglitz there is no such thing as an “invisible hand”.

    The hope from this article post brings all to take the journey and review the late professor and Doctor of Economic, Paul Samuelson. There are many others still kicking the tires of new accepted theorems of economic tools for all to use. Like Stiglitz that continue to develop the framework of mathematics and sound theories derived from these math formulas to assist in the sustained balancing of the ever changes ongoing with the polarized Globalization that is now more than ever interdependent of the success and not failure of one another.

    This still is not being seen, as the sure greed of the advanced “Carry-trade” needs to come to an end and the supports of an increase support of the Greenback along with the strength of the Asian rim to measure the YUAN to keep in step not to sink their surrounding emerging growth partners.

    Until real true regulatory measures are past, and not the water down version that is emerging out of the House of Representatives as filed last week. Paul Volker and others still need to be taken for what they are conveying not only to the United States but also to the World now…

    Far-fetched continued Theme

     Scot Griffin

    The explanation for the perceived “flaw” is the recognition of the existence of regulatory capture. That is, the regulators were captured by the very businesses they were required to regulate. The regulators were puppets on a string dancing to the tune of the financial innovators. There was no separate regulatory innovation. It was lock-step by design.

    Now, let’s assume there was no regulatory capture. What was the motivation for “regulatory innovation?” The answer is GDP growth.

    There’s an argument that “It’s the economy, stupid!” the meme spawned by the first Clinton campaign, has had adverse consequences on the long term health of the economy by focusing government officials and regulators on an arbitrarily short cycle (e.g., 2 to 4 years) just as public corporations are. Again, extending the analogy (started above) of U.S. government as corporation, the voters are shareholders and they vote based on earnings growth. If you recognize that a lot of members of government have been involved in managing public corporations, it is easy to see how they can get caught up in this mentality.

    Of course, one might argue correctly that this short-term focus existed long before Clinton.


    Federal Reserve officials would say that regulation should be viewed though the lens of promoting economic growth.

    Policy-makers “kick the can down the road”, adopt increasingly risky strategies, and hope for the best.

    Desperate For Economic Growth: The More Things Change, The More They Stay The Same

    Obama on the economy:

    “We’ve got a long-term structural deficit that is primarily being driven by health care costs, and our long-term entitlement programs. All right? So that’s the baseline. Now, if we can’t grow our economy, then it is going to be that much harder for us to reduce the deficit. The single most important thing we could do right now for deficit reduction is to spark strong economic growth, which means that people who’ve got jobs are paying taxes and businesses that are making profits have taxes – are paying taxes. That’s the most important thing we can do.”

    [Dec 16, 2009] Former Barclays Chief Points Out Bonuses Were Paid Fraudulently

    Well, because he is a man of probity and is writing in the UK, where the standards for libel are much lower than in the US, former Barclays CEO Martin Taylor does not use the F (fraud) word, but that is precisely the behavior he describes.

    I know it is fashionable to depict the investment banking industry as ever and always dishonest (as former SEC chairman Arthur Levitt pretty much does today in the New York Times, indirectly), but differences in degree are differences in kind. It is one thing to nick your clients occasionally, when they might not notice, or when they are making so much money they wouldn’t mind all that much if they did figure out the bankster had arranged for a bigger cut than usual. It is quite another to take every one every way you can at every available instance. While neither is honest, one is petty cheating and pilferage, the other is rape and looting.

    This is the essence of  Martin Taylor’s, the former chief executive of Barclays article - Comment - Opinion - Innumerate bankers were ripe for a reckoning in the Financial Times (Dec 15, 2009), which is worth reading in its entirety:

    City people have always been paid well relative to others, but megabonuses are quite new. From my own experience, in the mid-1990s no more than four or five employees of Barclays’ then investment bank were paid more than £1m, and no one got near £2m. Around the turn of the millennium across the market things began to take off, and accelerated rapidly – after a pause in 2001-03 – so that exceptionally high remuneration, not just individually, but in total, was paid out between 2004 and 2007.

    Observers of financial services saw unbelievable prosperity and apparently immense value added. Yet two years later the whole industry was bankrupt. A simple reason underlies this: any industry that pays out in cash colossal accounting profits that are largely imaginary will go bust quickly. Not only has the industry – and by extension societies that depend on it – been spending money that is no longer there, it has been giving away money that it only imagined it had in the first place. Worse, it seems to want to do it all again.

    What were the sources of this imaginary wealth?

    In the last two of these the bank was not receiving any income, merely “booking revenues”. How could they pay this non-existent wealth out in cash to their employees? Because they had no measure of cash flow to tell them they were idiots, and because everyone else was doing it. Paying out 50 per cent of revenues to staff had become the rule, even when the “revenues” did not actually consist of money.

    Now the real question is: why is anyone indulging this “talent” myth, the idea that the banksters ever deserved their outsized pay? And worse, they insist on their fraudlenty level of compensation as a new normal that must continue. Now I know some like the Epicurean Dealmaker get angry, and insist that Some Were Honorable, but let us face it: a credit tsumani lifted ALL boats, and people in fee businesses like M&A would have gotten far fewer deals done, and at far lower prices, were it not for the mania on the funding side.

    We all need to start using the F word a lot more, because a great deal of what went on was criminal and needs to be described in those terms.

    Doc Holiday:

    Great stuff there Ms Smith!

    It is curious why IRS and FASB (DOJ, FBI, SEC, FTC, etc) and especially Homeland Security were so slow in becoming involved in any sort of investigations related to the “F’ word. There was never a hint of curiosity associated with regulations or impropriety related to the “F’ word within any American agency during the Bush Reign — and now in the Obama Era, the “F” word has been relegated to the point of being a meaningless acronym.

    As to the reason why this corruption was global and the reason behind the lack of financial regulation anywhere simply suggests that we live in a time of chaos. To think otherwise, would be to miss the reality of the impacts related to Trillions of bucks evaporating — however, history does provide many examples of the shit that happens when Fascism takes root in a country …. ash the folks in Japan, Italy and Germany how that all worked out for them and then ask yourself if that’s the kind of change your looking for!

    Tao Jonesing:


    You ask why anybody is indulging the “talent” myth. The preliminary question is who is buying the myth? My bet is that this is a U.S.-based phenomenon.

    If I’m correct, that changes the answer to your why question.

    The U.S. is a dying empire. It doesn’t have to be, but it is, and the reason why is that we have a set of managers trying to pretend that a mature industry remains a growth industry. As a result, the managers demand growth to justify their continued tenure as managers.

    The banksters have been able to sell the “talent” myth to justify their outsized pay because they are the only ones able to deliver the type of GDP growth the U.S. economy needs in the short term, even if that kills the U.S. economy in the long term. You’ll be gone, I’ll be gone.

    We need a set of managers who accept the fact that the U.S. economy is a mature economy and treat it accordingly. Sustainable growth is the key because explosive growth is no longer attainable.

    Independent Accountant:

    I have said similar things for years. Banks cost of capital (COC) calculations are wrong. Their cost accounting stinks. They are frauds which exist to pay their senior executives big salaries, not make money for shareholders. Banks “guarantee” accounting stinks. Without FDIC insurance, their COCs would soar and their net “capital destruction” might be exposed. I could go on and on. Taylor, welcome aboard.


    What’s the point of laboriously adding value through a long career of work, thrift and self-denial if you can just plunder and get rich immediately? Wouldn’t you be a fool? Isn’t it better to be Ghengiz Khan than some hard-working farmer, builder or trader in mediaeval Samarkand? Ghengiz looted and wrecked the place, than moved on to the next. He and his Mongols took everything and created nothing, and they did very well for themselves. And they knew how to party!

    More directly, what is the reason for having a job, skill or profession, or going into business? To have a respectable career, raise a nice family, pay your taxes and eventually retire in comfort? Or is it simply to get rich? If the latter, why play games? Fraud, drugs, intimidation, political fixing, gun-running, all are likely to make you richer faster than anything honest will do, and many of them are either legal or unchallengeable if you know the right people. Our modern Mongols don’t follow the yak-tail standards into battle, instead they follow the example of people like Al Capone.

    Maybe instead of agonising over the state of macroeconomics it would be more worthwhile to look in detail at Al Capone’s Chicago, and try to draw some conclusions about what holds societies together and how they can collapse socially, not only environmentally.

    DownSouth :


    Your question–“Isn’t it better to be Ghengiz Khan than some hard-working farmer, builder or trader in mediaeval Samarkand?”—recalls another historical example:

    But Columbus himself did not belong to the tradition of Reconquista. As a Genoese, settled in Portugal and then in southern Spain, he was a representative of the Mediterranean commercial tradition, which had begun to attract Castilians during the later, Middle Ages. His purpose was to discover and exploit the riches of the East in association with a State which had conferred its protection upon him. For this enterprise he could draw upon the experience acquired by Castile in its commercial ventures and its colonization of the Canaries. But unfortunately for Columbus, Castile’s mercantile tradition was not yet sufficiently well established to challenge its military tradition with any hope of success. While he saw his task essentially in terms of the establishment of trading bases and commercial outposts, most Castilians were accustomed to ideas of a continuing military advance, the sharing-out of new lands, the distribution of booty and the conversion of infidels. Inevitably the two opposing traditions—that of the merchant and that of the warrior—came into violent conflict, and in that conflict Columbus himself was defeated and broken. It proved impossible for him to compete with the deeply ingrained habits of a crusading society…

    J.H. Elliott–Imperial Spain: 1469-1716


    By any reasonable measure of private value added without government intervention, investment banking has had (has) enormously negative productivity. The “talent” was (is) negative. Ordinary bankruptcy would have fully revealed this. And, the purely private consequences from such bankruptcies would have unleashed a raft of lawsuits exposing “F” behavior. Bail-outs substituted yet more bonuses and moral hazard in the stead of private retribution. As a nation, unfortunately, we agreed to that Faustian bargain in return for safety from manufactured economic bugbears in October of 2008.

    Vinny G:

    The other day I saw Shakespeare’s Merchant of Venice again. Somehow, the main character, Shylock the ruthless Jewish moneylander, reminds me of our average bankster in this country.

    I am not anti-semitic and I have many Jewish friends in medicine (but none in finance), but if I were Jewish, and working in banking this would be the time I would read the Merchant of Venice carefully. Your Jewish lobby has skewed America’s policy to serve only the interests of your genocidal nation of Israel, your Jewish-controlled banking system has destroyed the lives of tens of millions in this country alone, and your Jewish-controlled media has turned this entire country into a nation of immoral chumps.

    But don’t be so sure about your grip on power now. As the Bible’s writings of Solomon state, “Pride cometh before fall”. You’ve just about maxed out on pride, arrogance, greed, violence, and torment of other human beings, as you have throughout your history, in fact. Read the Merchant of Venice after you finish counting your money.



    I too have a number of Jewish acquaintances. But unlike yourself, I find some of them to be the salt of the Earth, and others to be unrepentant scumbags.

    What you are spouting is pure, unadulterated bigotry.

    Take the following assertion, for instance:

    You’ve just about maxed out on pride, arrogance, greed, violence, and torment of other human beings, as you have throughout your history, in fact.

    “In fact”? In fact there is no historical basis whatsoever to justify making such a sweeping, blanket condemnation of the Jewish people.

    PBS Frontline yesterday aired an absolutely outstanding program, “From Jesus to Christ: The First Christians,” that tells the epic story of the rise of Christianity:

    Christianity, in its inception, was an entirely intra-Jewish phenomenon, a sect that existed completely within but on the fringe of mainstream Jewry. Jews lived under the brutal regime of Roman imperialism. Granted, Christ was very much in the vanguard in the fight against Roman oppression. But Jesus’ teachings were not that distant from those of mainstream Jewry, especially in regards to revolting against grievous Roman rule.

    The schism between Christianity and Jewry grew over time, but the complete split between the two took centuries. And granted, one of the Christians’ complaints was that those higher up in the Jewish hierarchy acted as mere handmaidens for the Roman rulers (can anybody say Barak Obama?). But remember, this was Jew on Jew criticism.

    By the turn of the fourth century, Christianity had grown to become the dominant religion of the Roman Empire and was officially recognized as so under the emperor Constantine. The growing drumbeat of Jewish demonization was an exigency of 1) the final split of the Christians with the Jews and 2) the adoption of Christianity as the official, mainstream religion of Rome.

    One interesting question the program raises is what factors led to Christianity’s rise. Early Christian doctrine not only advocated liberation and social justice, but with its doctrine of “good works” also strived to provide a social safety net for those who fell on hard times. By offering a hand in the hour of need, this gained Christianity many loyal converts. But as Frontline pointed out, all this was part and parcel of the Jewish tradition and the Jewish experience, and not the Roman-Pagan tradition.

    Of course when Christianity became the official religion of the Romans, it had to change its spots and stop promoting liberation and revolution. Instead of attacking Roman rule, it had to legitimize it. And thus the Christian tradition that comes down to us today is a very mixed one, as, I might add, is the Jewish one.


    Oh C’mon Vin. There were lots of nice Protestant boys in on the fun, and lots of girls too with daggers for souls, and Americans from Chinese, Korean, Irish, German and Lithuanian ancestry. And the Brits, look at what they did. And look at the 1920s, mostly Waspy types. And then there’s Iceland, those Jews, ha hah. The J word is only a distraction from the F word. Total FAILURE of regulators, politicians, academics, executives, traders and speculating three-card Monte two-house-and-a-condo-on-your-credit-card-mortgage borrowers. It’s like in Oedipus Rex when the guy realizes he screwed his Mom and whacked his Dad.

    And Oedipus is still King somehow, even today, and he’s still Blind to real sight. It’s all a failure of the human condition. And throwing around the J word is just one more failure. I’m not Jewish, I’m a Magonian Disciple from the Church of the Holy Logos, but I had a Jewish girlfriend once and she was hot stuff, believe me. LOL.

    Robert McGarvey:

    Let me see….unrealised mark-to-market profits on the trading book, especially in illiquid instruments; ….profits conjured up by taking the net present value of streams of income stretching into the future…not receiving any income, merely “booking revenues” I seem to remember another case like this about 10 years ago. It was ENRON, it was fraud and now Jeff Skilling is sitting in jail for 25 years. Something for bankers to think about.

    Doug Terpstra:

    What a concept, crime and punishment. I retract my ‘blanket amnesty’ note. Let’s furlough the cannabis farmers to make room for the fraudsters, the malefactors with true victims.

    We must have real penalties and enforcement to have any deterrent in the future. Obama has (apparently) forgotten this, in violation of his constitutional vows.

    What a conundrum, fraud so systemic and widespread it has become “that which must not be named”. To call it fraud, to call torture and targeting of innocents a “war crime”, is to threaten the very edifice of “civilization”.

    When it all collapses, as it must, a ‘truth and reconciliation’ commission with blanket amnesty for all the perps may be the only practical solution. But going forward, I think we must then burn the current 6,0000-plus page loophole code and insist on a truly progressive tax structure (pre-JFK) that taxes not work but speculation, concentrated and inherited wealth, and capital gains.


    No individual or community can face squarely the fact that they do make themselves the center of their universe; this idolatry is too devastating for any of us freely to admit. Hence, says Niebuhr, we deceive ourselves that what we do is right, in fact our moral or religious obligation. Anxiety is the engine of deception and self-interest. Nations and peoples go to war mainly for self-interest; and though that be the fundamental ground, they will argue that they are really defending God, their sacred tradition, or, in our secular day, peace, order and democracy. This claim, that what they do for themselves they really do for “values,” makes it very difficult both for individuals and their communities to admit their driving self-interest. If they do, they seem to be denying all that is of value in the community, tradition, or religion.

    –Langdon B. Gilkey

    Anonymous Jones:

    Another absolutely fantastic quote, not just about self-deception but about war. Most people still believe the U.S Civil War was about abolishing the cruelty of slavery! People astonish me. Conflicts may be about values, but war is about money. Wars have to be financed, and the people who finance wars expect to have a positive ROI. If there weren’t any money in it, the financing would quickly dry up and with it, the war.

    By the way, the quote from Niebuhr about hypocrisy yesterday was also great. I wish I had time to read more from the original sources you cite. Amazing insight and great writing.


    Unfortunately, many countries go broke pursuing war, if not financially, then morally (are the two different? – this post suggests otherwise).

    I occurs to me that the U.S. is also in that flock; interventions justified by grand cause built on fallacy, the alpha and omega of failure. Is the financial aparatchik (or Nomenklatura, a term I like which, as many from the Soviet era, succinctly describes aspects of our situation today) fated also to the trash heap, despite the best efforts of the Man of the hour, Ben Bernanke?

    Stay tune to this channel.

    Vinny G.:

    I think America will fall so hard, and on such a permanent basis, a ‘truth and reconciliation’ commission may take the shape of a Nuremberg trial. I expect the place will look like a bad version of Max Max.

    To me, America has been resembling a malignant tumor for at least 30 years now, sapping this planet of resources and giving nothing good in return (except Coca-Cola and Big Macs, of course). I tend to view the planet as a living organism, and like any organism it seems to have built-in immunological systems to deal with malignant tumors… even those tumors that from afar may appear TBTF.

    As Eliza Doolittle would put it, “America: we can all muddle through without you; Somehow we’ll do bloody well without you!”

    [Dec 15 2009]  Innumerate bankers were ripe for a reckoning By Martin Taylor

    " the system was brought down because risk management was deficient, because greed was rampant, and because bankers could not count."
    December 15 2009 |

    The late Eddie George was very fond of a little joke that went as follows. “There are three types of bankers: those that can count, and those that can’t.”

    Sometimes jokes capture profound truths. In all the fuss about bank bonuses, we have heard about labour market “realities” (from the bankers), and moral and political philosophy (from everybody else). We need to think more about simple arithmetic.

    All business people know that you can carry on for a while if you make no profits, but that if you run out of cash you are toast. Bankers, as providers of cash to others, understand this well. They just do not believe it applies to their own business.

    In general, banks have no measures of cash flow that work for banking. They do think about liquidity – can you borrow from other market participants, can you get money from the central bank? Being turned down in the market means curtains – it happened to Northern Rock in 2007 and Midland Bank a quarter of a century before, and forced its sale to HSBC.

    That means they are not conscious of making cash decisions, of the sort that other businesses face daily. Even a dividend cut – one of the ultimate cash choices – will usually be discussed in terms of capital preservation and ratio management. But of course they frequently make decisions with cash consequences, and about five years ago they began to spray cash around like drunken sailors. The recipients were employees, in the form of bonuses, and to a lesser but still significant extent shareholders, in the form of dividends.

    The existence of bonuses reflected the nature of financial businesses, where labour always represented a major cost, while revenues were volatile. It therefore became essential to make labour costs variable, and bonuses were the mechanism used to do this. In a year like 1974 partners in London stockbroking firms got no money, and something similar happened in 1994 to senior investment bankers in fixed income businesses.

    City people have always been paid well relative to others, but megabonuses are quite new. From my own experience, in the mid-1990s no more than four or five employees of Barclays’ then investment bank were paid more than £1m, and no one got near £2m. Around the turn of the millennium across the market things began to take off, and accelerated rapidly – after a pause in 2001-03 – so that exceptionally high remuneration, not just individually, but in total, was paid out between 2004 and 2007.

    Observers of financial services saw unbelievable prosperity and apparently immense value added. Yet two years later the whole industry was bankrupt. A simple reason underlies this: any industry that pays out in cash colossal accounting profits that are largely imaginary will go bust quickly. Not only has the industry – and by extension societies that depend on it – been spending money that is no longer there, it has been giving away money that it only imagined it had in the first place. Worse, it seems to want to do it all again.

    What were the sources of this imaginary wealth? First, spreads on credit that took no account of default probabilities (bankers have been doing this for centuries, but not on this scale). Second, unrealised mark-to-market profits on the trading book, especially in illiquid instruments. Third, profits conjured up by taking the net present value of streams of income stretching into the future, on derivative issuance for example. In the last two of these the bank was not receiving any income, merely “booking revenues”. How could they pay this non-existent wealth out in cash to their employees? Because they had no measure of cash flow to tell them they were idiots, and because everyone else was doing it. Paying out 50 per cent of revenues to staff had become the rule, even when the “revenues” did not actually consist of money.

    How did the shareholders let them get away with this? They were sitting on the gravy train too, enjoying the views from the observation car. How did the directors let it happen? Innumeracy, and inability to understand accounts that have become misleading to the point of treachery. How depressing the shame and folly of it all is, when one considers that the system was brought down not because risk management was deficient (though it was), nor because greed was rampant (though it was), but because bankers could not count. Merry Christmas.

    The writer is chairman in Syngenta and former chief executive of Barclays

    1. GC, I think the article is referring to something known as a ''negative basis trade'' involving CDS and special derivative accounting regulations. Try FAS 133 and the old FIN 46 R. My understanding is that this also involved the participation of an insurer using an off balance sheet structure for the CDS risk, as, in the US anyway, insurers are prevented from trading in derivatives under NAIC. Under GAAP, available for sale securities are usually held in the trading book and are direct to equity. Someone please correct me if this is wrong...I am just an ignoble MBA, not an accountant, and all I know of IFRS is to be very afraid of it, so I hope I am interpretting Mr. Taylor's remarks correctly. ;- )

      Writing down associated losses tied to these trades is also linked to the problem of restating this income for potentially several years, and the impact that will have on capital. Would enjoy hearing others thoughts on this.

      Mr Taylor, if you're out there, was it really "no account of default probabilities" - or rather, equating probability of default with rate of default?


    2. Barley, London

      Short, profound and lucid. Excellent dissection of the financial crises from an insider, maybe with part-blooded hands. John Allen Paulos, author of Innumeracy, would be proud. All of us in general are at the mercy of poor arithmetic and blindness to probability and risk. Maybe we thought a whole industry of bright men backed by quants and computation had conquered this, Taylor's broadside is a sharp corrective. My only suggested edition would be to re-write the final sentence - minus provisos and caveats as - " the system was brought down because risk management was deficient, because greed was rampant, and because bankers could not count." The simian mind had concocted a money-making machine, milked it, quickly seen its flaws, and the key alphas got out quickly. We will be there again, and soon...


    3. John Staub | December 16 7:20pm 

      "Because they had no measure of cash flow to tell them they were idiots, and because everyone else was doing it."

      In front of their jury, all 'thieves' hope to be found 'idiots'.


    4. John Rhys | December 16 6:41pm 

      Excellent summary of what many of us may have thought we had worked out, but were unable to put together in such a brief and compelling analysis. And of course it obviouslycomes from someone who was cose to what was going on.

    5. Nick Kaufmann | December 16 5:21pm 

      The bankers could count perfectly well: cash bonuses from illusory accounting profits are just that - cash in hand. It's the stakeholders who let them get away with it who cannot count and are now paying the reckoning. So the taxpayer bails out the banks, shareholders lose (fair enough - they allowed it to happen) and bankers resume their merry dance cosseted by the benign conditions caused by the public bailout. More fool us...

    6. R.McGeddon | December 16 4:17pm 

      I read this article and smiled as two thoughts crossed my mind:-

      1) 'I believe that banking institutions are more dangerous to our liberties than standing armies' Thomas Jefferson, third President United States of America 1801-1809

      2) 'Quis custodiet ipsos custodes ?' Juvenal
      Wasn't Mr. Taylor in charge of Barclays BZW in the 1990's ??


    7. GC | December 16 2:55pm 

      @'rolo' and 'gotit!' Yr both reading into this what you want to. I dont know where this fallacy comes from - that all banking profits are 'made up'?
      If you want to believe that then continue living in your delusional world. Investment banks are cyclical businesses, sometimes they make huge profits sometimes they dont, if you arent prepared to take the risk dont buy the shares its quite simple.


    8. rolo | December 16 2:06pm 

      Everything in banking is absurd. There is nothing new in this. From the very beginning of its invention until right now, absolutely EVERYTHING in banking is a fallacy, as it is in accounting -and I mean everything, even curriculums for chartered financial analysts courses for example-, meaning it also will be in the coming future. It is absolutely ********. Banking is only good for bankers, regardless of their surname being Madoff, Morgan, Goldman, Sachs, Merryll, Lynch, Green or simply Greed.


    9. got it! | December 16 2:00pm 

      Excellent article. Now I fully understood why there are so much objection to big bonuses paid to bankers. What the banks earned are mostly unrealised income, but bonuses are actual cash paid out. Sarkozy's disdain for anglo saxon capitalism is fully supported. Thank you FT.


    10. GC | December 16 1:18pm 

      But investment banks have made a lot of money, - not imagined - signed off audited huge profits during this decade.
      Granted huge writedowns on toxic assets caused large losses in 2008, however, many investment banks have started to enjoy decent revenue generation again in 2009. Shareholders in GS for example have seen a 5-fold return in the share price from the beginning of the decade to the highs in 2007. Granted its now much lower than those highs but thats the nature of investing in a cyclical business.

      I note that one investment bank that never made any money and was value destructive to shareholders was BZW - Barclays pre cursor to Barcap which was eventually sold to Credit Suisse for a song. The reason for that investments banks failure? Bad Management.


    11. Geoffrey Nicholson | December 16 12:43pm 

      The link in my previous post did not post correctly--here it is http://www.nichols...m/commentaries.htm


    12. Geoffrey Nicholson | December 16 12:37pm 


      I think Mr Taylor makes a number of very good points, but that numeracy is not really the issue. it is more that most bankers do not focus on cash as a metric. Until banks introduce cash measures and manage cash as an objective, banks will not generate cash. That was fine in the last two decades when investors looked to banks for earnings, but now that the growth outlook is severely cut, investors need to demand cash returns. I wrote a piece last month on my website on how banks should do this any it is important: This is a big culture and management shift that some banks will not manage to execute
    13. Caroline Bradley | December 16 12:36pm 

      Martin Taylor hits the nail squarely on the head but what is worse is that none of the education (up to MSc level) available to people working in this field has any focus on cash flow. Everything is based on market value which, as we have seen, is not only unreliable but extremely volatile. We are now storing up problems for the next bank bust a few years down the road. Taxpayers should prepare for the next bailout!


    14. John Moore | December 16 11:47am 

      Although not relevant to the point of his article, Martin Taylor omits an important source of profit for banks, which increased exponentially from the mid 1990s and really started taking off in 2002-3. The merging of investment banks with retail banks boosted their profits by the giving proprietary traders access to the much cheaper (about 0.375% pa cheaper) and much more plentiful funding for their proprietary books, thanks to the implied but real government guarantee enjoyed by retail banks. The Economist's suggestion that merged banks should pay an annual guarantee fee for this has merit: it would make proprietary trading more expensive and would automatically shrink traders' bonuses to more reasonable levels, without any need to regulate them.

    15. nikkit | December 16 11:36am 

      Worse than their lack of ability to count is the bankers very capable ability to blatantly lie. From personal experience I would say that from 2003 onwards, black has been white in the banking world and anyone challenging that has been heavily penalised, Sadly, no one in authority has seen fit to address this very serious problem. Consequently, bankers are continuing to lie left right and centre and the best example of this has to be how Lloyds Banking Group told its investors in Jan 09 that the merger with HBOS was "an enormously good deal" - and now we know, via Archie Kane, that Lloyds knew full well that HBOS was a toxic disaster. And yet, no one is being taken to task for this deliberate deceit.

    16. Richard Jenkins | December 16 11:21am 

      Not that it is any excuse for bank directors, not to mention the FSA, but we should remember that the entire business and financial world thought that Enron was a work of genius, until one solitary journalist had the temerity to ask: "where's the cash?". Come to think of it, the existence of the Enron example, and the role of mark-to-market in that debacle just adds grounds for condemnation of directors and regulators alike.


    17. Catty-Cornered | December 16 9:03am 

      Banks are a just a method of being able to transfer certain financial risks from one party to another, and in the process generate return. The largest of those risks being credit risk and liquidity risk. This is a very useful tool for society, and should not be underestimated.

      However, in investment banking, I agree that paying bankers by expected return at the time that the deal is structured is only likely to lead to excessive risk taking. Estimating the potential risk and potential returns generated many years into the future is naive. Deal structurers should be paid on the basis of how a deal actually performs.

    18. Tiredofallthisnonsense | December 16 8:40am 

      Governments and central bankers provided the environment for all this and have cleverly shifted the blame to anyone but themselves. And spare a scapegoat thought for the academics behind the risk models which propagated the three letter acronyms which allowed borrowing by those who shouldn't. And for the system overall which demands high ROEs from bank and other corporate managements. And save a little blame for yourself - each and every one of us who has enjoyed the fruits of the system for the past 20 years (at least) of reckless over-borrowing.


    19. Report Rhema | December 16 8:25am 

      What an excellent article! As the saying goes 'Cash is king and everything is a matter of opinion' - so if you withdraw cash from a balance sheet that is a matter of opinion - hardly surprising you go bust! Common sense ought to be taught on MBA courses!!

      The problem we have in the UK of course is partly due to the fact that we are mesmerised by anything American. The American bankers came and told us 'how things are done' in terms of bonuses and we swallowed it 'hook, line and sinker' - a bit like the American GI in that old film - Chicken Run. Now they will probably come out of the recession much quicker than us...all because we were trying to play the big boys game!

    20. Report keith | December 15 11:14pm 

      They could count their bonuses very well and count on receiving one very well. Banks are a clear case of market failure and their employees at the senior level have basically become the biggest bank robbers of all time. As for basing pay on current revenues and not profits over extended periods of time, then that is a clear case of market failure --


    21. Report Arjun Sundar | December 15 11:12pm 

      Being an accounting student and a job-seeker in investment banking, with knowledge of the, I must first appreciate the fact that you have spotted something obvious that people were blind to. The conversion of 'unrealised profits' is so true and brings back shades of the 'future profit realisation' that Enron had brought in.

      But, the bigger picture is that, a bulk of the banking business runs on credit lines, even to finance themselves. Assuming themselves as a perpetual business, they tend to take it for granted that the market would not crash and people would extend credit to them in normal times.

      The problem here was, nobody foresaw a market crash and further hyped an already hyped market. Ofcos, when reality struck, people were reluctant t extend credit (and hence the credit crunch) and banks were helpless.

      The solution though is not just curbing bonuses. Though that is a key incetive, what if an employee/ senior level exec is still keen to take risks. The more relevant solution would be to introduce a ruling that would regulate that limits the speculation on floating values or book values. Even if an employee wants to baselessrisk, he should not be able to take them over and above an extent as per regulations. Then, immaterial of bonuses, they cant circumvent the aim.


    [Oct 21, 2009] Guest Post: Congressmen Grayson, Clay and Miller Introduce CFPA Amendment to Help Reduce Looting By George Washington of Washington’s Blog.

    Congressmen Grayson, Clay and Miller are introducing an amendment to the Consumer Financial Protection Agency bill:

    Today we will offer the “Financial Autopsy” amendment. The Grayson/Clay/Miller amendment is essential to attacking the root problem of consumer bankruptcy and foreclosure because it requires the CFPA to do a financial audit of products that have caused the highest rates of bankruptcy and foreclosure annually. Not later than March 31st of each calendar year, the CFPA will list these anti-consumer products, submit their conclusions on why these products “fail” consumers, the companies and employees that underwrote these products, and authorizes the CFPA to take action to restrict these products.

    Financial Autopsy Amendment:

    - Requires the CFPA conduct a “Financial Autopsy” of each state’s bankruptcies and foreclosures (a scientific sampling), and identify financial products that systematically led to a large number of bankruptcies and foreclosures.

    - Requires the CFPA report to Congress annually on the top financial products (the companies and individuals that originated the products) that caused consumer bankruptcies and foreclosures.

    - Requires the CFPA take corrective action to eliminate or restrict those deceptive products to prevent future bankruptcies and corrections

    - The bottom line is to highlight destructive products based on if they are making people “broke”. Thank you for your consideration, we hope you will join us in supporting this amendment.

    Alan Grayson Wm. Lacy Clay Brad Miller

    Is this a good amendment or a bad amendment?

    It is a great amendment.


    Instead of trying to pass a one-size-fits-all bill prohibiting certain specified conduct, it will force an annual analysis of what financial products are sticking it to the consumer.

    Remember, credit default swaps didn’t bring down the economy because they are toxic while all other financial vehicles are pure as the driven snow. CDS brought down the economy because they were the choice du jour of the looters.

    If we outlaw CDS (which I have argued for in the past), then the looters would create some other instrument for looting.

    The Grayson/Clay/Miller amendment would help to force an annual review of the tool-of-trade of the rip-off artists.

    Note: Given the huge incentives for financial “innovation”, the armies of lawyers, mathematicians and other footsoldiers employed by the financial giants, the pressure that the “too big to fails” to earn their way out of the hole, and the rapidity with which imbalances in the modern financial system can build up when alot of people are making the same kind of trade, an annual review is probably not enough.

    So my only suggestion for Congressmen Grayson, Clay and Miller is that the amendment require:

    (1) Annual reviews generating formal written reports

    Plus …

    (2) Monthly informal reviews. If a review reveals a large number of bankruptcies or foreclosures caused by a specific type of financial product, this would trigger a formal report

    Trust me . . . the boys can still cause the economy to thoroughly crash if their actions are not examined for a year at a time.

    Call your congressional representatives and demand that they support the Grayson/Clay/ Miller amendment.

    Update: Karl Denninger has some additional suggestions here.

    The Next Financial Crisis The New Republic

    The idea that banks should carry an “equity cushion” (to absorb losses before anyone has to turn to the government) worth around only 6 or 8 percent of their assets is a quite modern idea. (As recently as the mid-nineteenth century, banks financed significantly more of their assets with equity.) Perhaps a low equity cushion made sense when banks were tightly regulated and limited in the risks they could take, say from 1935 to around 1980. But leading students of central banking today, such as Charles Goodhart, argue strongly that, with the collapse of effective regulation over the past two decades, thin equity layers at many leading banks (in combination with limited liability of shareholders) are completely inappropriate for maintaining a stable financial system.

    Second, the managers and boards of directors of financial institutions should be personally liable up to a reasonable sum when their companies fail. They should lose a portion of past salaries and bonuses, while also seeing their bank-provided pensions reduced substantially. Richard Parsons, the chair of Citigroup since February 2009, is estimated to be worth more than $100 million. Yet he reports that he owns only around $750,000 of Citi stock. Such negligible personal downside risk for the board of directors is the norm in high finance today. We should let bank executives be paid well when they are successful--but they should truly lose if they take risks that lead to taxpayer bailouts. It can take up to a decade before the success or failure of past business decisions really becomes evident in banking, so reductions in pensions, and clawback of bonuses, should take this into account.

    Third, we need to set rules so that our regulators and public servants, who have the role of protecting taxpayers, are not financially conflicted. Today, the revolving door from government leads directly into the lobbies of our major banks. We need a rule that all employees of the Fed, the U.S. Treasury, and other regulatory bodies are not permitted to work in finance for at least five years after they leave office. If government employees have joined a regulatory authority from the financial sector, they should have a “cooling off” period within which they are prohibited from any official role in the design or implementation of regulation or bailouts.

    Finally, we need more assertive leadership at the Fed regarding broader system issues. The Fed, of course, will protest, “This is not our job.” It will say that Treasury is responsible for the administration’s approach and that authority ultimately rests with Congress.

    This is true, strictly speaking. The Fed did not create our current atmosphere of deregulated risk-taking. But neither is the Fed blameless. The Fed is partly a prisoner of the current system--but it is also partly a jailer. In the moments when the Fed is presented with a rescue-the-banks-or-the-economy-will-collapse scenario, it is a prisoner. But the Fed, and especially the chairman of the Fed’s board, has plenty of power to shape the environment that produces this choice. And it has taken on the challenge of shaping the financial climate before.

    During the 1930s, Fed chair Marriner Eccles was an advocate for change across the financial system. Now, Bernanke needs to play the same role. He needs to advocate for rules and regulations that ensure financial leaders will bear serious costs when there is a future failure due to excessive risk-taking. Otherwise, the Fed will continue to be a handmaiden to repeated bailouts. And, with each bailout laying the groundwork for the next one, the peril facing our financial system will only grow worse.

    Peter Boone is chairman of Effective Intervention, a Britain-based charity, and a research associate at the London School of Economics’s Centre for Economic Performance. Simon Johnson is a professor at MIT’s Sloan School of Management and a senior fellow at the Peterson Institute for International Economics. They write for The Baseline Scenario, a blog on economics.


    Safe Haven Another Finger of Instability

    "To trace something unknown back to something known is alleviating, soothing, gratifying and gives moreover a feeling of power. Danger, disquiet, anxiety attend the unknown - the first instinct is to eliminate these distressing states. First principle: any explanation is better than none... The cause-creating drive is thus conditioned and excited by the feeling of fear ..." Friedrich Nietzsche

    This weekend I turn 60 and have been a little more introspective than usual. I am often told that the letter I wrote well over three years ago on ubiquity and complexity theory and the future of the economy was the best letter I have ever done. I went back to read it, and it has aged well. I basically outlined how a financial crisis would unfold, and now it has.

    On reflection, I think that there are perhaps other, even larger, events in our future than the recent credit crisis and recession; yet, just as in 2006, there is a great deal of complacency. But as we will see, there are fingers of instability building up that have the potential to create large disruptions, both positive and negative, in our future. And for the political junkies in the room, I offer a brief insight into what may be one of the more intriguing behind-the-scenes developments in recent years. Now, to the letter.

    "Any explanation is better than none." - Nietzsche

    And the simpler the explanation, it seems in the investment game, the better. "The markets went up because oil went down," we are told (except that when oil went up, then there was another reason for the movement of the markets). But we all intuitively know that things are far more complicated than that. However, as Nietzsche noted, dealing with the unknown can be disturbing, so we look for the simple explanation.

    "Ah," we tell ourselves, "I know why that happened." With an explanation firmly in hand, we now feel we know something. And the behavioral psychologists note that this state actually releases chemicals in our brain that make us feel good. We become literally addicted to the simple explanation. The fact that what we "know" (the explanation for the unknowable) is irrelevant or even wrong is not important in achieving the chemical release. And thus we look for reasons.

    The credit crisis happened because of Greenspan's monetary policy. Or maybe it was a collective mania. Or any number of things. Just as the proverbial butterfly flapping its wings in the Amazon triggers a storm in Europe, maybe an investor in St. Louis triggered the credit crisis. Crazy? Maybe not. Today we will look at what complexity theory tells us about the reasons for earthquakes, tornados, and the movement of markets. Then we look at how the world and that investor in St. Louis are all tied together in a critical state. Of course, what state and how critical are the issues.

    Ubiquity, Complexity Theory, and Sandpiles

    We are going to start our explorations with excerpts from a very important book by Mark Buchanan, called Ubiquity: Why Catastrophes Happen. I HIGHLY recommend it to those of you who, like me, are trying to understand the complexity of the markets. Not directly about investing, although he touches on it, it is about chaos theory, complexity theory, and critical states. It is written in a manner any layman can understand. There are no equations, just easy-to-grasp, well-written stories and analogies.

    As kids, we all had the fun of going to the beach and playing in the sand. Remember taking your plastic buckets and making sandpiles? Slowly pouring the sand into an ever bigger pile, until one side of the pile started an avalanche?

    Imagine, Buchanan says, dropping one grain of sand after another onto a table. A pile soon develops. Eventually, just one grain starts an avalanche. Most of the time it is a small one, but sometimes it builds on itself and it seems like one whole side of the pile slides down to the bottom.

    Well, in 1987 three physicists, named Per Bak, Chao Tang, and Kurt Weisenfeld, began to play the sandpile game in their lab at Brookhaven National Laboratory in New York. Now, actually piling up one grain of sand at a time is a slow process, so they wrote a computer program to do it. Not as much fun, but a whole lot faster. Not that they really cared about sandpiles. They were more interested in what are called nonequilibrium systems.

    They learned some interesting things. What is the typical size of an avalanche? After a huge number of tests with millions of grains of sand, they found that there is no typical number. "Some involved a single grain; others, ten, a hundred or a thousand. Still others were pile-wide cataclysms involving millions that brought nearly the whole mountain down. At any time, literally anything, it seemed, might be just about to occur."

    The piles were indeed completely chaotic in their unpredictability. Now, let's read this next paragraph from Buchanan slowly. It is important, as it creates a mental image that helps me understand the organization of the financial markets and the world economy. (emphasis mine)

    "To find out why [such unpredictability] should show up in their sandpile game, Bak and colleagues next played a trick with their computer. Imagine peering down on the pile from above, and coloring it in according to its steepness. Where it is relatively flat and stable, color it green; where steep and, in avalanche terms, 'ready to go,' color it red. What do you see? They found that at the outset the pile looked mostly green, but that, as the pile grew, the green became infiltrated with ever more red. With more grains, the scattering of red danger spots grew until a dense skeleton of instability ran through the pile. Here then was a clue to its peculiar behavior: a grain falling on a red spot can, by domino-like action, cause sliding at other nearby red spots. If the red network was sparse, and all trouble spots were well isolated one from the other, then a single grain could have only limited repercussions. But when the red spots come to riddle the pile, the consequences of the next grain become fiendishly unpredictable. It might trigger only a few tumblings, or it might instead set off a cataclysmic chain reaction involving millions. The sandpile seemed to have configured itself into a hypersensitive and peculiarly unstable condition in which the next falling grain could trigger a response of any size whatsoever."

    Something only a math nerd could love? Scientists refer to this as a critical state. The term critical state can mean the point at which water would go to ice or steam, or the moment that critical mass induces a nuclear reaction, etc. It is the point at which something triggers a change in the basic nature or character of the object or group. Thus, (and very casually for all you physicists) we refer to something being in a critical state (or use the term critical mass) when there is the opportunity for significant change.

    "But to physicists, [the critical state] has always been seen as a kind of theoretical freak and sideshow, a devilishly unstable and unusual condition that arises only under the most exceptional circumstances [in highly controlled experiments]... In the sandpile game, however, a critical state seemed to arise naturally through the mindless sprinkling of grains."

    Thus, they asked themselves, could this phenomenon show up elsewhere? In the earth's crust, triggering earthquakes, or as wholesale changes in an ecosystem - or as a stock market crash? "Could the special organization of the critical state explain why the world at large seems so susceptible to unpredictable upheavals?" Could it help us understand not just earthquakes, but why cartoons in a third-rate paper in Denmark could cause worldwide riots?

    Buchanan concludes in his opening chapter, "There are many subtleties and twists in the story ... but the basic message, roughly speaking, is simple: The peculiar and exceptionally unstable organization of the critical state does indeed seem to be ubiquitous in our world. Researchers in the past few years have found its mathematical fingerprints in the workings of all the upheavals I've mentioned so far [earthquakes, eco-disasters, market crashes], as well as in the spreading of epidemics, the flaring of traffic jams, the patterns by which instructions trickle down from managers to workers in the office, and in many other things. At the heart of our story, then, lies the discovery that networks of things of all kinds - atoms, molecules, species, people, and even ideas - have a marked tendency to organize themselves along similar lines. On the basis of this insight, scientists are finally beginning to fathom what lies behind tumultuous events of all sorts, and to see patterns at work where they have never seen them before."

    Now, let's think about this for a moment. Going back to the sandpile game, you find that as you double the number of grains of sand involved in an avalanche, the likelihood of an avalanche becomes 2.14 times more likely. We find something similar with earthquakes. In terms of energy, the data indicate that earthquakes become four times less likely each time you double the energy they release. Mathematicians refer to this as a "power law," a special mathematical pattern that stands out in contrast to the overall complexity of the earthquake process.

    Fingers of Instability

    So what happens in our game? "... after the pile evolves into a critical state, many grains rest just on the verge of tumbling, and these grains link up into 'fingers of instability' of all possible lengths. While many are short, others slice through the pile from one end to the other. So the chain reaction triggered by a single grain might lead to an avalanche of any size whatsoever, depending on whether that grain fell on a short, intermediate or long finger of instability."

    Now, we come to a critical point in our discussion of the critical state. Again, read this with the markets in mind (again, emphasis mine):

    "In this simplified setting of the sandpile, the power law also points to something else: the surprising conclusion that even the greatest of events have no special or exceptional causes. After all, every avalanche large or small starts out the same way, when a single grain falls and makes the pile just slightly too steep at one point. What makes one avalanche much larger than another has nothing to do with its original cause, and nothing to do with some special situation in the pile just before it starts. Rather, it has to do with the perpetually unstable organization of the critical state, which makes it always possible for the next grain to trigger an avalanche of any size."

    Now, let's couple this idea with a few other concepts. First, Nobel laureate Hyman Minsky points out that stability leads to instability. The more comfortable we get with a given condition or trend, the longer it will persist and then, when the trend fails, the more dramatic the correction. The problem with long-term macroeconomic stability is that it tends to produce unstable financial arrangements. If we believe that tomorrow and next year will be the same as last week and last year, we are more willing to add debt or postpone savings in favor of current consumption. Thus, says Minsky, the longer the period of stability, the higher the potential risk for even greater instability when market participants must change their behavior. (And, three years later, we can now all see that truth. But it was not as obvious to a lot of people in 2006.)

    Relating this to our sandpile, the longer that a critical state builds up in an economy, or in other words, the more "fingers of instability" that are allowed to develop a connection to other fingers of instability, the greater the potential for a serious "avalanche."

    Or, maybe a series of smaller shocks lessens the long reach of the fingers of instability, giving a paradoxical rise to even more apparent stability. As the late Hunt Taylor wrote, in 2006:

    "Let us start with what we know. First, these markets look nothing like anything I've ever encountered before. Their stunning complexity, the staggering number of tradable instruments and their interconnectedness, the light-speed at which information moves, the degree to which the movement of one instrument triggers nonlinear reactions along chains of related derivatives, and the requisite level of mathematics necessary to price them speak to the reality that we are now sailing in uncharted waters.

    "... I've had 30-plus years of learning experiences in markets, all of which tell me that technology and telecommunications will not do away with human greed and ignorance. I think we will drive the car faster and faster until something bad happens. And I think it will come, like a comet, from that part of the night sky where we least expect it."

    A second related concept is from game theory. The Nash equilibrium (named after John Nash) is a kind of optimal strategy for games involving two or more players, whereby the players reach an outcome to mutual advantage. If there is a set of strategies for a game with the property that no player can benefit by changing his strategy while (if) the other players keep their strategies unchanged, then that set of strategies and the corresponding payoffs constitute a Nash equilibrium.

    A Stable Disequilibrium

    So we ended up in a critical state of what Paul McCulley called a "stable disequilibrium." We have players of this game from all over the world tied inextricably together in a vast dance through investment, debt, derivatives, trade, globalization, international business, and finance. Each player works hard to maximize their own personal outcome and to reduce their exposure to "fingers of instability."

    But the longer we go on, asserts Minsky, the more likely and violent an "avalanche" is. The more the fingers of instability can build. The more that state of stable disequilibrium can go critical on us.

    Go back to 1997. Thailand began to experience trouble. The debt explosion in Asia began to unravel. Russia was defaulting on its bonds. Things on the periphery, small fingers of instability, began to impinge on fault lines in the major world economies. Something that had not been seen before happened: the historically sound and logical relationship between 29- and 30-year bonds broke down. Then country after country suddenly and inexplicably saw that relationship in their bonds begin to correlate, an unheard-of event. A diversified pool of debt was suddenly no longer diversified.

    The fingers of instability reached into Long Term Capital Management and nearly brought the financial world to its knees.

    So, where are the fingers of instability today? Where are the fault lines that could trigger another crisis? Are there any early warning signs? I see two possibilities, one positive and one negative.

    Chad Starliper sent me the following graph. It shows the debt-to-GDP ratio for the US, adding in various levels of debt. For instance, the ratio of debt to GDP for all levels of government debt is 87%. But if you add household and business debt along with the GSE (government-sponsored enterprises) like Fannie and Freddie, the ratio rises to 331%. If you add in future benefits of Social Security and Medicare, the number becomes more like 1,000%.

    The Obama administration tells us that the government deficit is going to be well over $1 trillion a year for at least ten years. And that does not take into account the outlier years in the 2020s when the really heavy lifting of Social Security and Medicare kicks in.

    There is a truism that goes a little like, "If something can't happen, then it won't." Let me make a prediction. We won't have a trillion-dollar deficit in ten years. Why? Because it can't happen. The market will simply not allow it.

    As I have written, we can run large deficits almost forever, as long as the deficits are less than nominal GDP. While it may not be the wise thing to do, it does not bring down the system.

    But when you start adding to the deficit in amounts significantly larger than nominal GDP, there is a limit. Each dollar, like the grains of sand, adds to the potential instability of the system. Is it $2 trillion more? $3 trillion? No one can know, but the longer it goes, the worse the ensuing financial earthquake will be.

    The current political class and their intentions are dangerously close to killing the golden goose. It is one thing to steal the eggs; it is an altogether different thing to kill the goose through ignorance of the consequences. And the size of the deficit, for as long as they plan to have it, will most assuredly kill the goose.

    Just as I was writing in 2006 about the potential for a crisis, and yet the party went on for quite some time, I think the party can limp along now. But there will come a point when the party is over. Interest rates on the long end will rise precipitously, forcing mortgages up and making the deficit even worse. It will be an even worse crisis than the one we have just gone through. And there will be fewer options for policy makers, and none of them will be good or pleasant. And it will take most people unawares. They will see the current trend and project it into the future. And they will be hit hard.

    Can we avoid this calamity? Yes, we can wrestle the US budget deficit back under some kind of control, close to nominal GDP or on a clear trajectory to get there within a reasonable time (say, a few years). As noted above, we can run deficits close to nominal GDP almost forever. But there is no political willpower to do that now. And so, the market will at some point force the hand of the political class. That investor in St. Louis, or China or (????) will decide not to buy government debt at such low rates. The avalanche will start. And everyone will be surprised at the ferocity of the crisis. Except you, gentle reader. You have been warned.

    Let me re-emphasize that point. If we do not get our act together, the results could be truly serious. And it is not just the US. Japan, as I have written, unless it changes, will hit the wall in the next few years. There are some really sick actors in Europe. You are going to have to be far more nimble and prepared for this next crisis, should it arise, than you were for the last one. Over the next few months, I will be devoting some space to helping us think through how we do that.

    3 Billion and Counting

    And now for something a little more positive. From the beginning of the wireless revolution and the development of the internet, it was not until 2001 that we finally had one billion people connected. It only took another six years to add another billion. And sometime in 2011, somewhere in the world, we will add yet another billion. We are adding some 70,000 people a day, with smarter and cheaper computers, phones, and netbooks. By some estimates, there will be five billion connected to the network by 2015.

    A study done in 2005 of 21 developing countries by Leonard Waverman of the London Business School "... showed that an extra 10 mobile phones per 100 people in a typical developing country leads to an additional 0.59% of growth in GDP per person." (Jump Point)

    Think of each one of those additional connected people as a grain of sand. We have already seen a large surge in productivity from the internet and mobile phones. Farmers in India now know what the prices are for their products and don't have to take lowball offers from middlemen. Fishermen in Indonesia can call around and find where they can get the best price for their day's catch.

    Tom Hayes argues in his book Jump Point that, because of the growing connectivity, rather large changes are coming to the way we organize our lives. It is a very interesting book and one that I will review in depth at some point.

    But what Hayes calls the Jump Point is what I referred to as critical mass. "In mathematics it is called a 'jump discontinuity.' In engineering, this is known as a 'step phase change.' In climatology, it is called an 'abrupt delta.' I call it a Jump Point - a change in the environment, in this case the business environment, so startling that we have no choice but to regroup and rethink the future." (from the introduction)

    Not all of the changes are benign. The potential for business and marketing models to be turned on their head is rather striking. I recommend the book to those who are thinking about the future. It is easy to read, provocative, and well written. You can get it at

    I wrote this three years ago: "Today more than ever your portfolio should be targeting absolute return strategies. In a world with fingers of instability that may be connected in ways we have not seen in the past, caution is the order of the day. If we do see a slowing US economy later this year, the average complacent investor is not going to be happy as his diversified portfolio all seems to be going south at the same time."

    That is still true today. To talk with my recommended managers around the world you can go to if your net worth is $1.5 million or more. If you are in the US and are still on your way to becoming an accredited investor, you can sign up at

    The Texas Senate Race - A Game Changer

    Indulge me for a moment while I delve into a little inside politics. I used to be very involved in Texas politics, but when I sold my business in 1999 and had to go back to work for a living, I mostly left out political commitments, although I do keep up and have a lot of friends. There is something happening in Texas that has the potential to shake things up, and I thought I would give my readers a heads up.

    Long-time Texas Senator Kay Bailey Hutchison has let everyone know that she intends to come back to Texas and run for governor next year against current governor Rick Perry, who is going to run for his third term. Hutchison has indicated that she will resign sometime this fall, which will give Perry the right to appoint a Senator to fill the seat. He has told associates that if he does, the appointment will be a game changer. Who in the Texas political landscape could be termed a game changer? Not one of the half dozen middle-aged white guys who would love the appointment. Not that some of them would be bad choices, just not a game changer. Another woman? There is not one who has run a statewide race and has the necessary experience.

    Then there is my long-time good friend Michael Williams. Michael has run statewide three times as the chairman of the Texas Rail Road Commission which, despite the name, is responsible for energy as well as railroads. It is a very powerful post in Texas. He is wildly popular with the grass roots and conservatives in the state. He is one of the best speakers on the stump in the country. He has a powerful command of the energy problem we face. He is totally electable as a Senator. And he is black.

    Now that is the definition of a game changer. He will burst on the national scene with a presence. If Governor Perry truly wants to do something that will change the game not just for Texas but for the country, he will appoint Michael at his first opportunity and allow him to run in the primary as a sitting Senator. Michael will be at my birthday party Saturday night, along with his beautiful and extremely smart wife, Donna. Next week on the 12th of October I will be hosting a small private fundraiser at my home for those interested in meeting Michael. You can click here to respond.

    And for the locals wanting to help in the campaign, Michael's web site is

    60 Years and Counting

    I turn 60 on Sunday, although we will be celebrating with parties on Friday and Saturday. For whatever reason, when I turned 50 I was apprehensive. I can quite honestly say that I am excited about this birthday, and the future. For all the problems we are facing as a country and as a world linked together, I think this is the most exciting time to be alive in the history of the world. And the next 30 years are going to be much better than the last 60!

    And you, gentle reader, are part of my reason to be so optimistic about the future. I continue to be amazed that so many people find the writings of this humble analyst to be worth their time. In truth, we are all constantly bombarded with more and more emails, advertisements, phone calls, letters, books, papers, and information, and it is getting harder and harder to focus on what is really critical. You give me the most important gift that anyone can receive in the Information Age, and that is the gift of your attention. You have hundreds of opportunities to divert it elsewhere, and yet you give me some of your precious time. I am grateful, and will always strive to make this letter worthy of your interest.

    Finally, my good friend Sir Ed Artis of Knightsbridge fame, who is now in the Philippines, writes that he urgently needs funds to ship needed medical and relief supplies that have been already donated and are waiting on the docks. The disaster in the Philippines is quite tragic and calls out to those of us around the world who can help. You can go to to learn more and to donate.

    My daughter Tiffani points out that I have guests arriving for my party and I need to hit the send button, so have a great week. I am going to run and enjoy my friends and some great Texas barbeque.

    Guest Post: Why Concentration in the Banking Industry Threatens Our Economy By George Washington

    As everyone knows, the big banks have gotten bigger and bigger. Noted economist Mark Zandi says we have an oligopoly of banks, and that “the oligopoly has tightened”.

    The TARP Inspector – Neil Barofsky – told Huffington Post yesterday that, because of the consolidation in the banking industry:

    I think we may be in a far more dangerous place today than we were a year ago.


    Economists and other financial experts could provide many reasons why concentration is dangerous. Certainly, their very size distorts the markets. and the economy cannot fundamentally recover while the giants continue to drag our economy down the drain.

    But I would like to use an analogy from science to discuss why our current, highly-concentrated banking lineup presents a huge threat to our economy  (analogies can sometimes be useful; e.g. Taleb talks about black swans).

    It has been accepted science for decades that when all the farmers in a certain region grow the same crop – called “monoculture” – the crops become much more susceptible.


    Because any bug (insect or germ) which happens to like that kind of crop could take out the whole crop on pretty much all of the region’s farms.

    For example, one type of grasshopper – called “differential grasshoppers” -  love corn.  If everyone grows corn in a town in the midwest, and differential grasshoppers are anywhere nearby, they may come wipe out the entire town’s crops (that’s why monoculture crops require much more pesticides).

    On the other hand, if farmers grow a lot of different types of crops (”polyculture”) , then a pest might get some crops, but the rest will survive.

    I believe that the same principle applies to our financial system.

    If power and deposits are concentrated in a handful of mega-banks, problems with those banks could bring down the whole system.  As Zandi noted, there is an oligopoly in the banking industry (and “the oligopoly has tightened”).

    Moreover, the mega-banks are huge holders of derivatives, including credit default swaps. JP Morgan Chase, Bank of America, Goldman Sachs, Citigroup, and Morgan Stanley together hold 80% of the country’s derivatives risk, and 96% of the exposure to credit derivatives.

    Even though JP, B of A, Goldman and Citi are separate corporations, they are so interlinked and intertwined through their derivatives holdings that an attack by a “pest” which swarmed in on their derivatives could take down this “monoculture” of overly-leveraged, securitized, derivatives-heavy banking.

    Indeed, taking just one example – JP Morgan – independent analyst Reggie Middleton notes:

    As of June 30, 2009, JPM had exposure of $85 billion (or 108% of its tangible equity) towards off balance sheet lending commitments and guarantees…

    As of June 30, 2009, the total notional amount of derivative contracts outstanding as of June 30, 2009 was about $80 trillion (or 101,846% of its tangible equity)…

    Gross fair value (before FIN 39) of the derivative receivables and derivative payables was $1,798 billion (or 2,276% of its tangible equity) and $1,749 billion (or 2,214% of its tangible equity), respectively. The, fair value of JPM’s derivative receivables (after FIN 39) was $84 billion (or 106% of its tangible equity) while the fair value of JPM’s derivative payables (after FIN 39) was $58 billion (or 73% of its tangible equity). FIN 39 allows netting of derivative receivables and derivative payables and the related cash collateral received and paid when a legally enforceable master netting agreement exists between JPM and a derivative counterparty…

    About 23% of the derivative receivables (in terms of fair value after FIN 39) were below investment grade (less than BBB or equivalent) while 12% were rated BBB or equivalent…

    Within the dealer/client business, JPM utilizes credit derivatives by buying and selling credit protection, predominantly on corporate debt obligations, in response to client demand for credit risk protection on the underlying reference instruments. Protection may be bought or sold by the Firm on single reference debt instruments (”single-name” credit derivatives), portfolios of referenced instruments (”portfolio” credit derivatives) or quoted indices (”indexed” credit derivatives). The risk positions are largely matched as the Firm’s exposure to a given reference entity under a contract to sell protection to a counterparty may be offset partially, or entirely, with a contract to purchase protection from another counterparty on the same underlying instrument. Any residual default exposure and spread risk is actively managed by the Firm’s various trading desks. After netting the notional amount of purchased credit derivatives where the underlying reference instrument is identical to the reference instrument on which the Firm has sold credit protection, JPM has net protection purchased of $82 billion along with other protection purchased of $77 billion.

    So that’s it. They are square, then. Of course unless the sellers of their protection default. If they do, then it may very well cause a daisy chain reaction that could get very ugly … If you thought Lehman caused problems, compare Lehman’s counterparty exposure to JPM’s.

    The bottom line is that our current banking monoculture threatens not only the biggest banks, but the entire financial system. Pesticides become less effective as pests develop resistance – and, as a byproduct, we poison friendly critters.  Likewise, the giants “creatively” work their way around regulations so that the regulations are no longer effective (or at least not enforced, and regulatory capture is widespread.  And too much regulation stifles productivity, as an unintended byproduct.

    Having power and deposits spread out among more, smaller banks would greatly increase the stability of the financial system. And having more power and deposits in banks using a wider variety of business models (e.g. among banks that aren’t heavily invested in derivatives and securitized assets) will create a banking “polyculture” which will lead to a much more stable financial system.

    In other words, if we decentralize power and deposits and increase the variety of banking models, we will have a healthier financial system, we won’t have such an urgent need to try to micromanage every aspect of the banking system through regulation, and the regulations we do have will be more effective.

    By the way, I would argue that that is one of the reasons why Glass-Steagall was so important: it enforced diversity – depository institutions on the one hand, and investment banks on the other.   When Glass-Steagall was revoked and the giants started doing both types of banking, it was like a single crop cannibalizing another crop and becoming a new super-organism.  Instead of having diversity, you’ve now got a monoculture of the new super-crop, suscectible to being wiped out by a pest.

    The kinds of things which threaten depository institutions are not necessarily the same type of things which threaten investment banks, hedge funds, etc.

    The above is yet another reason we should break up the giant banks using antitrust or other laws.

    Note: Wells Fargo’s derivatives holdings are substantial, but much less than the other big boys. But rumors are that Wells might be in real trouble as well due to its commercial real estate and other portfolios.

    [Oct 14, 2009] “Does Banking Contribute to the Good of Society?”

    Quelle horreur, some smart people are starting to question whether banking serves a redeeming social function.

    Of course, in the abstract, it does. Banking (or more accurately, extending credit) is essential for commerce. But any essential support function, if it overpriced in relationship to its true value, becomes a drag on the productive economy. And our modern system is extracting a very large toll relative to its actual worth.

    One argument against banking comes from Roger Bootle at the Telegraph (hat tip Swedish Lex); the other from Bill Black. Bootie makes a broader, philosophical argument, starting by distinguishing activities as creative (making something out of nothing and increasing net enjoyment) versus distributive (something that merely shifts benefits from one party or group to another). Activities fall along a spectrum, and Bootle asserts:

    Successful societies maximise the creative and minimise the distributive. Societies where everyone can only achieve gains at the expense of others are by definition impoverished. They are also usually intensely violent.

    He assesses modern finance against this standard and not surprisingly, finds it sorely wanting:

    A leading British journalist recently decried the widespread condemnation of bankers’ and hedge fund executives’ high remuneration on the grounds that these people, it said, were “the wealth creators”…This completely misses the point….the question is, what has the process that generated this money contributed to the common weal?

    Much of what goes on in financial markets belongs right at the purely distributive end. The gains to one party reflect the losses to another, and the vast fees and charges racked up in the process end up being paid by Joe Public…

    Even what the great investors do belongs at the distributive end of the spectrum. The genius of the great speculative investors is to see what others do not, or to see it earlier. That’s all. This is a skill…I am not convinced, though, of the social worth of such a skill, still less of the wisdom of encouraging society’s brightest and the best to try to perfect it.

    This distinction between creative and distributive goes some way to explaining why the financial sector has become so large in relation to GDP – and why those working in it get paid so much. Even when a certain sort of financial activity is purely distributive, the returns to the winning parties are so enormous that the activity is immensely seductive – and the professionals who appear to be responsible for securing these gains are highly sought after and highly rewarded….

    And we need to consider the identity of the investors who are making a lower return to make it possible for hedge funds and their like to make a higher return. They are the investors in slow-moving and restricted institutions such as pension funds and insurance companies, or central banks whose market activities are dictated by some objective of public policy, rather than private gain.

    Yet there are reasons why we should want such institutions to be this way. Pensioners do not want their pension funds to be run like hedge funds – or their insurance companies, or their central banks. So we have allowed, and even encouraged, a system to develop in which clever people make huge amounts of money out of institutions that, for reasons of public policy, we constrain in a way that allows scope for such profits to be made. Is that clever or what?

    Perhaps the greatest problems are caused by the interaction between financial markets and the real economy. There, time horizons are longer, price adjustments are more sluggish, and motivations less single-mindedly selfish. And so much the better – for them and for us. But how are they able to withstand the onrush of supercharged greed that floods out at them from the financial markets? If we think that it is right and proper – and economically advantageous – that some parts of the economic system should not be organised like investment banks, then we should make sure that they are protected from those parts of the system that are organised like investment banks.

    Bill Black, in “How the Servant Became a Predator: Finance’s Five Fatal Flaws,” at New Deal 2.0 is far more casutic. He starts by taking a position near and dear to the Japanese, that financial firms should not be very profitable, because high profits mean they were operating at the expense of the “real” economy (of course, the Japanese bank managed to wreck the economy anyhow, but that was partly if not largely the result of rapidly deregulating a very primitive banking sector. And I am not exaggerating in my characterization; recall I consulted to them in the mid-1980s. They had NO concept of cash flow based lending, for instance).

    Black’s key arguments:

    ….the finance sector is worse than parasitic. In the title of his recent book, The Predator State, James Galbraith aptly names the problem. The financial sector functions as the sharp canines that the predator state uses to rend the nation. In addition to siphoning off capital for its own benefit, the finance sector misallocates the remaining capital in ways that harm the real economy…:

    Corporate stock repurchases and grants of stock to officers have exceeded new capital raised by the U.S. capital markets this decade. That means that the capital markets decapitalize the real economy….

    • The U.S. real economy suffers from critical shortages of employees with strong mathematical, engineering, and scientific backgrounds. Graduates in these three fields all too frequently choose careers in finance rather than the real economy because the financial sector provides far greater executive compensation….

    • The financial sector’s fixation on accounting earnings leads it to pressure U.S manufacturing and service firms to export jobs abroad, to deny capital to firms that are unionized, and to encourage firms to use foreign tax havens to evade paying U.S. taxes.

    • It misallocates capital by creating recurrent financial bubbles. Instead of flowing to the places where it will be most useful to the real economy, capital gets directed to the investments that create the greatest fraudulent accounting gains…. Unless there is effective regulation and prosecution, this misallocation creates an epidemic of accounting control fraud that hyper-inflates financial bubbles….

    • Because the financial sector cares almost exclusively about high accounting yields and “profits”, it misallocates capital away from firms and entrepreneurs that could best improve the real economy (e.g., by reducing short-term profits through funding the expensive research & development that can produce innovative goods and superior sustainability) and could best reduce poverty and inequality (e.g., through microcredit finance that would put the “Payday lenders” and predatory mortgage lenders out of business).

    • It misallocates capital by securing enormous governmental subsidies for financial firms, particularly those that have the greatest political power and would otherwise fail due to incompetence and fraud.

    The remarkable thing is that despite the ample evidence of the damage wrought by the financial sector, it has managed to secure even greater rewards for its predation and incompetence. But that is largely a function of media coverage, which has presented a picture flattering to the Obama Administration and and the perps. A Pew Research Center study on the coverage of the crisis concluded:

    The gravest economic crisis since the Great Depression has been covered in the media largely from the top down, told primarily from the perspective of the Obama Administration and big business, and reflected the voices and ideas of people in institutions more than those of everyday Americans…

    Citizens may be the primary victims of the downturn, but they have not been not the primary actors in the media depiction of it.

    A PEJ content analysis of media coverage of the economy during the first half of 2009 also found that the mainstream press focused on a relatively small number of major story lines, mostly generating from two cities, the country’s political and financial capitals.

    A companion analysis of a broader array of media using new “meme tracker” technology developed at Cornell University finds that phrases and ideas that reverberated most in the coverage came early on, mostly from government, particularly from the president and the chairman of the Federal Reserve, and that few Republicans in Congress articulated any memes that got much traction.

    As the story moved away from Washington—and the news about the economy seemed to improve—the amount of coverage of the economy also dropped off substantially.

    So with vested interests firmly in control of spin, is it any wonder that most people have been lulled into complacency, or at worst, sullen resignation?

    fresno dan:

    I think the arguements are unnecessarily rococo and complex. People who are paid to gamble with a renumeration plan of heads they win, tails I (taxpayers) lose, will always end up in this situation.
    Look at the salaries, bonuses, and manipulated stock options of the CEO’s – other than Greenberg of AIG, has even one lost any money, despite the incredible losses to shareholders and the economy?
    Banks don’t exist in a vacuum – Fed rates, the regulatory scheme, accounting rules – all believed that “credit is the lifeblood” of the economy. Credit is a tool, and is no more helpful to an economy than a hammer is to buidling the space shuttle (i.e., helpful, but not the be all and end all)


    • reason:

    There is something CRUCIAL missing from this analysis. The importance of LEVERAGE and LIMITED LIABILITY being combined, particularly in hedge funds. That is the real rort, and it is hidden away from view. Hedge funds enable huge gambles to be made, with a limited downside. And of course all those bets become self-fulfilling as credit expands.


    • reason:

    I think we need to get someone to trace this all through in detail, so we have some facts to lay on the table and not just speculation and rhetoric. I don’t really understand how FIRE garnered such a big share of national income.

    I think there has been slow stealing from the middle-class based on consistant irrational biases on the part of the middle-class. It has to do with exploiting positional goods, to ratchet up debt levels.

    Largely, people have been sold the illusion of land ownership, whereas really the bank owns it all and the people only own the liabilities of land ownership, and pay rent to the banks. This is not true of every individual, but it is reality for very many. And the bank can do this. By steadily reducing lending standards, they can bid up the price of land. And because land is a positional good, it is a zero sum game – there is no net gain to anyone apart from the bank and land developers to land price inflation. Stricter technical building codes would at least channel some of the spending into better quality housing, but from what I hear thats not the case.


    • carol:

    ¨some smart people are starting to question whether banking serves a redeeming social function.¨

    Well William Black and many others, you included, have asked that question for a long time. And many have already answered it, a long time ago. Are we running circles: have we lost the debate?

    Just an example: while with an abundance of valid arguments the TBTE (too big to exist) should have been split up and partly shut down, the big ones have become even bigger. Recently, Simon Johnson had a discussion with a senior advisor on the White House economic team and guess what she said: ¨We have created them [our biggest banks], and we’re sort of past that point, and I think that in some sense, the genie’s out of the bottle and what we need to do is to manage them and to oversee them, as opposed to hark back to a time that we’re unlikely to ever come back to or want to come back to.”
    So, the White House has given in, and accepted that too big to fail has become even bigger to fail.

    Re Japan: … ¨a very primitive banking sector. And I am not exaggerating in my characterization; recall I consulted to them in the mid-1980s. They had NO concept of cash flow based lending, for instance¨

    Yves, you made my day

    Over the last decade, many US and EU banks and IB´s also had NO concept of cash flow based lending: they only looked at the inflated balance sheet, and applauded the high numbers, not thinking for a second about the cash flow (non-Wall Street workers income) needed to service the interest on all those loans. In the end, overly complex just morphs into primitive.

    ¨…But that is largely a function of media coverage,..¨

    Many have observed that not a single Pulitzer prize this year went to a financial crisis article.

    And what about this snippet in the Bloomberg article linked above (Geithner aides reaping millions working for banks): ¨Sperling also drew a $137,500 salary from Bloomberg News for writing a monthly column and appearing on television¨ 12 columns and some tv appearances, probably just talking his books, got him $ 137,500 ?!

    Often it appears as if Wall Street is paying the press, for copying their talking points; some apparently get paid, generously.


    • DownSouth:

    carol said:

    ¨some smart people are starting to question whether banking serves a redeeming social function.¨
    Well William Black and many others, you included, have asked that question for a long time. And many have already answered it, a long time ago. Are we running circles: have we lost the debate?

    It’s one of the great, perennial debates of all times:

    And when through an ancient and still powerful state there spreads a mood of deep discouragement, when the reaction against recurring ills grows feebler…when learning languishes, enterprise slackens, and vigour ebbs away, then…there is present some process of social degeneration, which we must perforce recognize, and which, pending a satisfactory analysis may conveniently be distinguished by the name of “decadence.”
    –Arthur J. Balfour, Lecture on “Decadence” at Newnham College, January 1908

    Historians who live in democratic ages are not only prone to attribute each happening to a great cause but also are led to link facts together to make a system… As it becomes extremely difficult to discern and analyze the reasons which, acting separately on the will of each citizen, concur in the end to produce movement in the whole mass, one is tempted to believe that this movement is not voluntary and that societies unconsciously obey some superior dominating force… Thus historians who live in democratic times do not only refuse to admit that some citizens may influence the destiny of a people, but also take away from the peoples themselves the faculty of modifying their own lot.
    –Tocqueville, Democracy in America

    The economists and financiers always get it wrong, self-servingly so because, after all, who doesn’t want to shroud themselves in a bloated sense of self-importance and undeserved remuneration? So problems that are cultural and political in nature get classified as economic, which means economic solutions are sought for cultural and political problems. And of course no solutions are ever found, because they’re looking in the wrong place.


    • DownSouth:

    Ah, the unmistakable death throes of a once-great empire in its final hours.

    The Castile of Gonzalez de Cellorigo was thus a society in which both money and labour were misapplied: an unbalanced, top-heavy society, in which, according to Gonzalez, there were thirty parasites for every one man who did an honest day’s work: a society with a false sense of values, which mistook the shadow for substance, and substance for the shadow…

    “Money is not true wealth,” he wrote, and his concern was to increase the national wealth by increasing the nation’s productive capacity rather than its stock of precious metals. This could only be achieved by investing more money in agricultural and industrial development. At present, surplus wealth was being unproductively invested—“dissipated on thin air—on papers, contracts, censos, and letters of exchange, on cash, and silver, and gold—instead of being expended on things that yield profits and attract riches from outside to augment riches within.”

    –J.H. Elliott, Imperial Spain: 1469-1716

    This lack of initiative and enterprise in so many Dutch industries, and to some extent in Dutch agriculture, afforded a striking contrast to the state of affairs a hundred years previously, when Dutch entrepreneurs, industrialists and technicians were in the van of commercial and technical progress in the Western World…[A]s a contributor to De Koopman ruefully acknowledged in 1776: “We are no longer innate inventors and originality is becoming increasingly rare with us here. Nowadays we only make copies, whereas formerly we only made originals…”

    The contemporaries who bemoaned the economic decay of the Dutch Republic in the last half—more especially in the last quarter—of the 18th century were inclined to place the principal blame on the allegedly self-satisfied and short-sighted rentiers and capitalists, who preferred to invest their money abroad rather than in fostering industry and shipping at home and thus relieving unemployment.
    –C.R. Boxer, >i>The Dutch Seaborne Empire: 1600-1800

    [W]hereas at one time England was the greatest manufacturing country, now its people are more and more employed in finance, in distribution, in domestic service…I think it is worthwhile to consider—whatever its immediate effects may be—whether that state of things will not be the destruction ultimately of all that is best in England, all that has made us what were are, all that has given us prestige and power in the world…

    Granted that you are the clearing-house of the world, but are you entirely beyond anxiety as to the permanence of your great position?…Banking is not the creator of our prosperity, but is the creation of it. It is not the cause of our wealth, but it is the consequence of our wealth; and the industrial energy and development which has been going on for so many years in this country were to be hindered or relaxed, then finance, and all that finance means, will follow trade to the countries which are more successful than ourselves.

    –Joseph Chamberlain
    Quotes taken from Aaron L. Friedberg, The Weary Titan: Britain and the Experience of Relative Decline, 1895-1905


    • Toby:

    I think fundamental questions need to be addressed regarding money and banking:

    1. Is money’s logical bond with scarcity an insoluble (almost congenital) problem in that it inescapably, though fitfully and slowly, leads to increasingly entrenched societal divisions via hoarding and protecting self (or group/class) against the horrors of poverty?

    2. Can a money be designed that does not assume, over time and because of money’s bond with scarcity described in 1., too powerful a role in society; that is, a money that does not stimulate hoarding and fear of want?

    3. Can high culture operate and sustain itself without a medium of exchange?

    I believe money inherently encourages corruption, not in everyone, but in a sufficient proportion of people for it too slowly become a systemic problem, particularly cyclically. DownSouth’s fascinating post shows over what sort of a period this rhythm has bedevilled humanity.

    Where there is money, there must (it seems to me) be banking, unless a totally automated, non-commodity, zero-cost money could be invented. Money is, by design, an encourager of parasitic economic activity, a motivator of those understandable impulses to achieve “the good life” of idle leisure, the accomplashing of which is sadly interpreted as a sign of ultimate success. Living off interest (or similar) should not be seen as a sign of success.

    So, my lunatic-fringe suggestion is addressing these questions openly and honestly by testing the idea of a resource-based economy, the successful operation of which we are, technically at least, now capable.


    • Michael Fiorillo:

    An important post about what is probably the most critical questions facing the Republic: will an ever-narrowing slice of the population (FIRE, in shorthand) be able to skim off the fruits of what’s left of the productive economy, to the detriment of the majority and body politic, and what repressive measures will put in place to protect those ill-gotten gains from the frustrations of the “losers?”

    Brand Obama (his people’s term, not mine) has been successfully test-marketed to put in place a de facto form of the structural readjustment that afflicted developing nations in the 80’s and 90’s: currency devaluations, declining wages, privatization (occurring at a rapid pace with the public schools, coming soon to Social Security), etc. The robocop response to the G-20 demonstrations in Pittsburgh is a taste of things to come, should people in the US be so rude as to question their overlords.

    Behavior is the most honest form of communication, and that leads to the conclusion that the 2008 election was a phenomenal bait-and-switch job: voting for “hope” and “change” has lead to withering public services, deeper entrenchment of oligarchic control and intensifying repression in order to maintain imperial delusions.


    • Dan Bednarz:

    “Too big to fail” banking and finance are functioning in parasitic instead of symbiotic fashion. This is because they are ensconced in an economic system that requires constant expansion of what looks like wealth but is really symbolic (money), which you cannot eat or put in your gas tank. This expansion impulse is now in conflict with what geologist King Hubbert called the energy and matter supply of the earth -- the distal foundation of human economies. In short, we’ve reached the limits to growth but institutions based on growth are trapped in a scientific paradigm -- which creates a cultural mythology -- that can only strive to grow (by whatever means necessary), even if means creating mounds of debt that can never be paid off because we do not have the energy and matter (resources) to cover these debts.

    Finally, the financiers still maintain a legal claim on resources through the money they continue to accumulate, so it’s not as if “money” is irrelevant.


    • jake chase:

    You don’t seem to understand what ‘banking’ has become. We now live in a world of limitless electronic money in which economic ‘actors’ scramble for ‘returns’ through trading. Of course, there is a productive sector which makes and trades in goods, but an increasing part of its financial activity is dodging risk associated with interest rate and currency movements through activities which can only be characterized as trading. Banks enable this and they are set up to grab a profit on every trade while (hopefully) laying off their bets. Of course, this is pretty much impossible, particularly when the effort is focused on slavish devotion to mathematical expressions of historical price series. During periods of financial stress markets disappear and counterparties blow up. The bank’s history of little profits is overwhelmed by a giant loss tsunami.

    Of course, bank traders understand this, but their bonuses accrue faster than their risk bombs detonate. The financial sector owns the political sector and the blowups are zero cost to it. There is no way in which this trading activity serves any public interest, except very temporarily. In this case it presently enables the US Treasury to borrow at real interest rates approaching zero. How long this will continue is anyone’s guess.


    • rd:

    Banks are necessary to provide an orderly way of redistributing capital through society to enable it to reach its most productive users. Unfortunately, that is only about half of our financial system today. The other half exists to enrich itself at the expense of the people who would normally be some of the productive users of capital.

    Today, they could be moving back towards their beneficial role in society if they were using their profits to become solvent again so that we could release the government expenditure and promises on bank guarantees so that taxpayer money could be used for more productive purposes than guaranteeing bonuses for bank executives. By now the banks balance sheets should be showing a rapid implosion of their leverage that was grossly overextended a year ago. They should all be looking much more like Canadian banks now. Instead, I fear that we are in the middle of a massive transfer of wealth from the main in the street to the bank executives.

    The same arguments can also be made about the legal system today. The law is critical to a stable society. However, the legal system has slowed to a point that tortoises look like Olympic sprinters. Entering into litigation today is like watching a football game where the coaches have unlimited challenges and have the right to appeal each decision even after replay is reviewed. As a result, lawyers get alot of money without accomplishing much in achieving an orderly society. I believe that this is one of the reasons why we are continuing to see the level of malfeasance with little punishment even though there are now bookshelves of laws and regulations that are supposed to prevent the malfeasance. The vast majority of these laws and regulations could not even be conceived of in the 1920s and yet we are seeing the same level of fraud and corporate misdealing as we saw then.


    • donna:

    This has been my point all along. They are no longer providing a productive service but merely extracting profit from the system to pay themselves. So the reform is needed to ensure that money once again funds productive development and not obscene bonuses. As is, the system is simply broken. Like CEO pay that is obscene compared to worker’s salaries since workers then can no longer afford to buy anything. Once the banks extract too high a profit, they are no longer funding productive investment. Why this is even a controversial issue at lal is beyond me.


    • Hugh:

    Bravo for Bill Black and Yves. This is exactly right. Whether you call it the paper economy or the financial sector, it is an entity which is not only unproductive but massively destroying of wealth. The trillions pumped into it have done no good to the vast majority of Americans and could have been redeployed to shore up the real economy and stabilize the finances of most Americans. The argument that we need to save the financial sector as it is currently constituted is one which is advanced by those who are mostly closely associated with it and who benefit disproportionately from it. But the choice was never keep the current system or do nothing and accept a collapse. We need to get rid of the current system and replace it with something better and more durable which answers to the needs of the country and its citizens and not a few self-serving elites.


    • jake chase:

    Thirty odd years of globalization under floating currencies have produced the following results in America: disappearance of manufacturing, reduced real wages, repeated financial bubbles, debauch of the dollar as a store of value, increasing returns to transactional paper shuffling (finance, law, insurance), chronic underemplyment and inflation of necessities (most of which is disguised by statistical slight of hand). These consequences are an inevitable result of free trade and unrestricted capital mobility.

    The dollar’s reserve currency status still allows America to borrow cheaply. We have a limited window to rebuild infrastructure and create real energy independence. Unfortunately, it is difficult to monopolize these activities, politicians have no idea how to establish them and cannot be trusted to see them through. Thus, our payoff from globalization is the $&*^ clogging the isles at every retail store. Although the workers cannot really afford to buy this stuff without credit, the banks will lend anyone all he wants at 27-30%, until the day his job disappears.

    Our middle class bought the fantasy that lower wages for workers would translate into stock market gains for their IRA plans. It worked okay for a while, didn’t it? Unfortunately, the executives learned how to game the market to enrich themselves. The banksters learned they could frighten the corporations over interest rate and currency risk and enrich themselves. The politicians understand that since we only have a choice of two candidates (and one is usually a moron), anybody who can manage to sound intelligent and sympathetic can grab power and then do exactly as he wants for the benefit of those backing his candidacy.

    So long as a vast majority remains ignorant of economic reality, we are hostage to a succession of opportunistic charlatans more or less guaranteed to appear one after another. Banking as currently practiced is merely one symptom of the free market globalization disease.


    • LeeAnne:

    Bootie’s statement: “The genius of the great speculative investors is to see what others do not, or to see it earlier. That’s all. This is a skill…I am not convinced, though, of the social worth of such a skill, still less of the wisdom of encouraging society’s brightest and the best to try to perfect it.” misses the worth of the skill of the speculative investor.

    For heaven’s sake anything in extreme is unhealthy. Consolidation of capital gave too much power to too few that enabled the ‘managers’ of capital to dismantle oversight of themselves and the rule of law in secrecy while corrupting representative government. As consolidation of capital increased, so did the political power of finance and corporations, particularly the power to corrupt representative government who had the responsibility for protecting the public who are the legitimate producers of wealth.

    Investors serve as knowledge processors, a useful tool for distributing capital. When transactions are published in a timely manner, accurately and lawfully regulated open publishing systems make transactions available to be analyzed and used for any purpose whatsoever including ’social worth.’

    That does not however make a speculator a ‘wealth producer.’ There is no justification for legally permitting leveraged gambling of capitol produced by any profession other than investment bankers themselves heavily regulated; bankers are supposed to be acting as agents with fiduciary responsibility ot those who are busy producing capital hwo need protection for their savings and the preservation of the value of their currency. That has been destroyed and the destruction continues to be perpetrated against the American people.

    Gambling is a zero-sum game when the players are playing with their own money; they can win or lose only the money they have collectively put into the pot; therefore investment banking partnerships worked. Its when the gamblers in the casino decide to play with the money of the workers’ wages and savings, those designing the casinos, waiting on the tables, changing the beds in the hotel, and cooking in the kitchen that gambling is quite another story; or when the gamblers are cheating at the table raises the ante on the other layers secretly. It is then criminal and predatory. Subjecting the bystanders/taxpayers to the debts incurred by bankers is worse still and being covered up by market manipulations that have been going on for many years if not decades -and continues under the present administration.

    The failure of government to regulate; that is, government corruption, has brought about this collapse and produced, if not a giant squid, a literal blood-sucking tax on the American people by finance and related FIRE corporations. Taxes that go to government are at least presumably used for public benefit while the private sector CEOs, fighting against basic human health care for participants in the real economy, fly around in Hermes covered pillows on $30M jets, build $30 million vacation homes and import millions of illegals to wait on them -for cheap -jeez, never in the history of the world!

    And to think the creeps, lead by the FED have the power to hock the American people to pay for this crap for the next indefinite number of years; it will produce the largest number of professional criminals since the USSR if it hasn’t already. What incentive does anyone have to obey laws under such a system other than the risk of getting caught?


    • craazyman:

    Why Banking is Great!

    In the scope of economic history — from primitive tribal barter cultures to the modern post-industrial society — it seems clear that money and banking have performed useful functions over the long-term, although with tremendous “moral volatility”.

    They broke down the tyrrany of the priest-kings, emperors, Popes and Princes. Money lubricated barter and trade. It created private property and made commoners out of peasants and citizens out of commoners and men and women out of them all — living in Levittown and drinking beer instead of pulling turnips in the Prince’s back 40. That inflatable pool says it all. No essay is required.

    That and Jesus and the Saints and Greek thought and Roman Law — all coming from the dark of the weird mind cage, like Caravaggio’s light on Matthew counting coins in the dark.

    Money was less relevant to a small tribal society — where your Karma is in your face — than a larger civilzation, where your karma shoots out anonymously and you can only feel it but not see it.

    Money and property — the particle/wave duality of spirit incarnate — became a metaphor for an extension of the boundaries of the person and a force of protection. Money was the great leveler, the Colt 45 of history. It seems far more than a medium of exchange, a method of payment and a store of value.

    It also has almost a mystical quality. It’s a measure of the Life Force, the force that drives flowers and insects and the imagination. And in that regard it has an unconscious sacred element, one that naturally belongs to all life and all people everywhere, the property of the Holy Spirit. It is, therefore, also a public good in the strictest sense.

    It’s profoundly immoral for a society to be structured in a way that deprives a large subset of its population of money. We consider this an evil. It cheats humanity of its metaphorical right to life and spirit.

    And so the broadening of credit, even through banks and bankers, is a metaphor for distributing the life force throughout society and enlarging the spiritual energies of a people.

    That force powers inspiration, imagination, innovation, invention. It can accumulate itself into a pool to drive extraordinary achievements and feats of group creativity. It can also subdivide itself to power the creative drive of a single person. Money is an electricity of the imagination.

    It’s ironic that a profession as stodgy and narrow as bankers would stand as the gatekeepers of the Great Life Force and hand it out — or not. They commit two sins. Giving too much of it out to the wrong people. Or not enough to the right people. It’s usually clear when they are sinning. But it’s harder to know how to keep them chaste.

    So we have rules and regulators, in theory.

    But when bankers “make” their own money by lending it negligently and even knowingly out to the wrong people and falsifying profits therefrom and putting cuts of it in their own pockets, they are counterfeiters and no longer bankers.

    It’s a fuzzy boundary. As counterfeiters they fake the life force and steal the life from society. Just as they do as hoarders. So yes, banking does contribute to society as a institution that channels the public good aspect of money, but it also can corrupt the public good aspect of money — the great duality of all things seen in this particular.

    It’s sort of a “guns don’t kill, but people do” argument.

    Beam me up, Scotty.


    • Tradermark:

    If you are not familiar with William Black he was on Tech Ticker in May

    This is the type of person who should be in the US Treasury if this was a representative republic

    Not a corporate representative republic

    [Oct 7, 2009] Guest Post- “Martin Wolf, the FT’s rebel with a cause, and the future of finance

    September 30, 2009 |

    By Swedish Lex, an expert and advisor on EU regulatory and political affairs:

    If you belong to those who believe that the debate on how to fix finance is mightily underwhelming when compared to the latter’s monumental failure, then I suggest reading Martin Wolf’s latest column in the Financial Times.

    Wolf essentially trashes the financial system and the remedial actions taken thus far, Michael Moore-style:

    What entered the crisis was, we now know, an ill-managed, irresponsible, highly concentrated and undercapitalised financial sector, riddled with conflicts of interest and benefiting from implicit state guarantees. What is emerging is a slightly better capitalised financial sector, but one even more concentrated and benefiting from explicit state guarantees. This is not progress: it has to mean still more and bigger crises in the years ahead.

    In Wolf’s view, the separation of utility banking from casino activities would be insufficient as there still would be a risk of the temptations of shadow banking leading to new bubbles and collapses. It seems that Wolf has taken the points made by Carmen Reinhart and Kenneth Rogoff in their recent book “This Time Is Different: Eight Centuries of Financial Folly” to heart. Wolf’s review of the book was published in the FT a couple of days ago. A few notable quotes from Wolf:

    Cycles of confidence and panic are inevitable in our world of debt, be that debt public or private, domestic or foreign. Credit is extended freely and then withdrawn brutally.

    Financial systems are accidents waiting to happen.

    The final lesson is that financial liberalisation and financial crises go together like a horse and carriage. It is no surprise, therefore, that the last 30 years have seen waves of financial crises, of which the latest one is merely the biggest.

    Importantly, Wolf concludes that regulation thus far has not been the answer but rather part of the problem. He seems to be recommending that large parts of financial activity may have to be outlawed altogether and that status quo is not an option:

    The most important point is that where we are now is intolerable. Today’s concentrations of state-insured private wealth and power must surely go. At present, the official sector believes tighter regulation, particularly higher capital requirements, can contain these risks. But this is likely to fail. If it does, we will need to be radical. Yet narrow banking would still not be enough. We would need to rule out quasi-banking. Otherwise, we would soon return to the world of fragility and bail-outs. Funds that replace banks would have to pass the risks directly on to the outside investors. The authorities will not entertain such radical ideas right now. But the financial system is so inherently fragile that radical reform cannot be pronounced dead. It is only dormant.

    So, to conclude, Wolf proposes changes to society that would be truly revolutionary, not as a means to achieve lofty and utopian ideals, but rather as a strategy for economic survival. Interestingly, the IMF yesterday published its new Global Financial Stability Report which contains an analysis of the inadequate policy responses by governments thus far and recommendations for future action. The parallels with Wolf’s thinking are striking, although the IMF obviously uses a different language:

    A clear vision of future financial system regulation is needed to provide clarity and boost confidence.

    In addition to a well-defined strategy for unwinding unconventional policies, confidence in the financial system will be bolstered by clarity over future regulatory reforms needed to address systemic risks. The recent easing of tail risks should not prompt authorities to relax their efforts to map out the path to a more robust financial system. A holistic, understandable approach needs to be formulated so that the private sector can plan appropriately. The priority should be to reform the regulatory environment so that the probability of a recurrence of a systemic crisis is significantly reduced. This includes not only defining the extent to which capital, provisions, and liquidity buffers are to rise, but also how market discipline is to be reestablished following extensive public sector support of systemic institutions in many countries.

    There are already proposals that will go some way toward removing procyclicality in the financial system and increasing buffers against losses and liquidity dislocations. But hard work lies ahead in devising capital penalties, insurance premiums, supervisory and resolution regimes, and competition policies to ensure that no institution is believed to be “too big to fail.

    So, if we accept that the existing system is deeply flawed and that the necessary and desirable reforms are seriously lagging, the next question is; who is going to do the lifting? Wolf is entirely mute on this point but one has to assume that since the theme of his column is finance as such, unilateral UK action is not what he has on his mind. If Wolf’s thinking is limited to the UK alone then the City as we know it would be transformed into a museum. In order for Wolf’s vision for a new financial order to be effective, action would have to cover as many jurisdictions as possible. In fact the IMF Report discusses what it views as a need for globally coordinated policymaking and warns against regional solutions:

    A macroprudential approach to global policymaking is needed to restore market discipline and ensure that the benefits of financial integration are preserved.
    The further challenge is to place these reforms in the context of an integrated macroprudential policy framework in which both domestic and cross-border institutions can operate securely. There is now recognition that a combination of microprudential and macroeconomic policies operated procyclically and led to a buildup of leverage and systemic risk. Policymakers will need to address ways in which their own actions exacerbate systemic risks, regardless of whether they oversee monetary, fiscal, or financial policy. Cooperation and consistency in the policy field must extend across borders. Cross-border relationships between institutions and markets have made it impossible for policymakers to act unilaterally without consequences for others. Following the crisis, however, there is a danger that some countries will want to ring-fence their institutions and withdraw from global markets to protect their domestic economies from external shocks. What is needed instead is a way to benefit from increasing financial integration, while ensuring that potential negative spillovers are contained and clarity exists about the roles of home and host authorities. As policymakers move forward on this difficult task, the IMF can play a catalytic role through its surveillance activities and work on global macrofinancial linkages.

    While I would agree with the IMF on the principle, I think it is wholly unrealistic to think that the Fund would be in a position to develop and broker the type of fundamental change that Wolf and, as it seems, the IMF, at least to some degree, are advocating. I furthermore have no expectations at all that the U.S. would be in a position to introduce the kind of reforms Wolf are suggesting, even if it, miraculously, wanted to.

    This leaves us with the EU. The EU’s response to the crisis thus far clearly falls short of what Wolf is suggesting although a thorough analysis and reform program of EU policy for the financial sector is under way. The EU however possess the legal competence, the scope and the clout to undertake the kind of reforms that Wolf is suggesting although such a program would be as comprehensive and far-reaching as the introduction of the Euro and would entail a clear break with existing policies. Impetus for a grand projet to re-design the EU’s approach to finance would have to come from the highest political level with the full support of Germany and France. With Merkel re-elected on a platform of financial reform, Sarkozy unthreatened on the domestic political scene and with support from the European Parliament and Commission, such a development could not be ruled out entirely. Since the IMF now estimates that we still have a 1,5 trillion in writedowns ahead of us, at least, politicians might soon have to consider all options, including Wolf’s revolutionary ideas.

    It would be interesting to hear what Wolf has to say on how his ideas for radical reform should be implemented and by whom. Perhaps for his next FT column?


    Guest Post: Why Concentration in the Banking Industry Threatens Our Economy By George Washington

    As everyone knows, the big banks have gotten bigger and bigger. Noted economist Mark Zandi says we have an oligopoly of banks, and that “the oligopoly has tightened”.

    The TARP Inspector – Neil Barofsky – told Huffington Post yesterday that, because of the consolidation in the banking industry:

    I think we may be in a far more dangerous place today than we were a year ago.


    Economists and other financial experts could provide many reasons why concentration is dangerous. Certainly, their very size distorts the markets. and the economy cannot fundamentally recover while the giants continue to drag our economy down the drain.

    But I would like to use an analogy from science to discuss why our current, highly-concentrated banking lineup presents a huge threat to our economy  (analogies can sometimes be useful; e.g. Taleb talks about black swans).

    It has been accepted science for decades that when all the farmers in a certain region grow the same crop – called “monoculture” – the crops become much more susceptible.


    Because any bug (insect or germ) which happens to like that kind of crop could take out the whole crop on pretty much all of the region’s farms.

    For example, one type of grasshopper – called “differential grasshoppers” -  love corn.  If everyone grows corn in a town in the midwest, and differential grasshoppers are anywhere nearby, they may come wipe out the entire town’s crops (that’s why monoculture crops require much more pesticides).

    On the other hand, if farmers grow a lot of different types of crops (”polyculture”) , then a pest might get some crops, but the rest will survive.

    I believe that the same principle applies to our financial system.

    If power and deposits are concentrated in a handful of mega-banks, problems with those banks could bring down the whole system.  As Zandi noted, there is an oligopoly in the banking industry (and “the oligopoly has tightened”).

    Moreover, the mega-banks are huge holders of derivatives, including credit default swaps. JP Morgan Chase, Bank of America, Goldman Sachs, Citigroup, and Morgan Stanley together hold 80% of the country’s derivatives risk, and 96% of the exposure to credit derivatives.

    Even though JP, B of A, Goldman and Citi are separate corporations, they are so interlinked and intertwined through their derivatives holdings that an attack by a “pest” which swarmed in on their derivatives could take down this “monoculture” of overly-leveraged, securitized, derivatives-heavy banking.

    Indeed, taking just one example – JP Morgan – independent analyst Reggie Middleton notes:

    As of June 30, 2009, JPM had exposure of $85 billion (or 108% of its tangible equity) towards off balance sheet lending commitments and guarantees…

    As of June 30, 2009, the total notional amount of derivative contracts outstanding as of June 30, 2009 was about $80 trillion (or 101,846% of its tangible equity)…

    Gross fair value (before FIN 39) of the derivative receivables and derivative payables was $1,798 billion (or 2,276% of its tangible equity) and $1,749 billion (or 2,214% of its tangible equity), respectively. The, fair value of JPM’s derivative receivables (after FIN 39) was $84 billion (or 106% of its tangible equity) while the fair value of JPM’s derivative payables (after FIN 39) was $58 billion (or 73% of its tangible equity). FIN 39 allows netting of derivative receivables and derivative payables and the related cash collateral received and paid when a legally enforceable master netting agreement exists between JPM and a derivative counterparty…

    About 23% of the derivative receivables (in terms of fair value after FIN 39) were below investment grade (less than BBB or equivalent) while 12% were rated BBB or equivalent…

    Within the dealer/client business, JPM utilizes credit derivatives by buying and selling credit protection, predominantly on corporate debt obligations, in response to client demand for credit risk protection on the underlying reference instruments. Protection may be bought or sold by the Firm on single reference debt instruments (”single-name” credit derivatives), portfolios of referenced instruments (”portfolio” credit derivatives) or quoted indices (”indexed” credit derivatives). The risk positions are largely matched as the Firm’s exposure to a given reference entity under a contract to sell protection to a counterparty may be offset partially, or entirely, with a contract to purchase protection from another counterparty on the same underlying instrument. Any residual default exposure and spread risk is actively managed by the Firm’s various trading desks. After netting the notional amount of purchased credit derivatives where the underlying reference instrument is identical to the reference instrument on which the Firm has sold credit protection, JPM has net protection purchased of $82 billion along with other protection purchased of $77 billion.

    So that’s it. They are square, then. Of course unless the sellers of their protection default. If they do, then it may very well cause a daisy chain reaction that could get very ugly … If you thought Lehman caused problems, compare Lehman’s counterparty exposure to JPM’s.

    The bottom line is that our current banking monoculture threatens not only the biggest banks, but the entire financial system. Pesticides become less effective as pests develop resistance – and, as a byproduct, we poison friendly critters.  Likewise, the giants “creatively” work their way around regulations so that the regulations are no longer effective (or at least not enforced, and regulatory capture is widespread.  And too much regulation stifles productivity,as an unintended byproduct.

    Having power and deposits spread out among more, smaller banks would greatly increase the stability of the financial system. And having more power and deposits in banks using a wider variety of business models (e.g. among banks that aren’t heavily invested in derivatives and securitized assets) will create a banking “polyculture” which will lead to a much more stable financial system.

    In other words, if we decentralize power and deposits and increase the variety of banking models, we will have a healthier financial system, we won’t have such an urgent need to try to micromanage every aspect of the banking system through regulation,and the regulations we do have will be more effective.

    By the way, I would argue that that is one of the reasons why Glass-Steagall was so important: it enforced diversity – depository institutions on the one hand, and investment banks on the other.   When Glass-Steagall was revoked and the giants started doing both types of banking, it was like a single crop cannibalizing another crop and becoming a new super-organism.  Instead of having diversity, you’ve now got a monoculture of the new super-crop, suscectible to being wiped out by a pest.

    The kinds of things which threaten depository institutions are not necessarily the same type of things which threaten investment banks, hedge funds, etc.

    The above is yet another reason we should break up the giant banks using antitrust or other laws.

    Note: Wells Fargo’s derivatives holdings are substantial, but much less than the other big boys. But rumors are that Wells might be in real trouble as well due to its commercial real estate and other portfolios.

    Guest Post- Sarkozy, Stiglitz & capitalism’s inherent contradictions

    naked capitalism

    Sarkozy related to the fundamental flaws of the current system through a number of examples, for instance by referring to the public having been told that the exponential increase of modern finance was a positive, while it in reality almost threw the world “into chaos”. He went on saying that in recent years, citizens have seen their economic situation deteriorating, despite available statistics and acknowledged measurements indicating positive economic developments. The divide between how citizens experience their situation and how it is presented centrally is destroying democracy, Sarkozy went on to say and said added that people believe that they are being lied to - and they are not entirely wrong to believe so.

    Governments need to modify their behavior, first by changing how they account for the situation in society by including questions about the overriding purposes of society and public policy; “our certitudes have evaporated, everything has to be put into question and re-invented”. Current methodologies fail to take externalities into account with the risk of booking developments as progress while, in reality, the opposite is true. Growth has in some regards destroyed more than it has achieved.

    Economic Donkeys

    with 87 comments

    Early in the First World War, British generals decided to attack German trenches with an initial light bombardment, followed by infantry walking in close order across No Man’s Land.  The result was tens of thousands killed in a series of military disasters, but the generals reacted with only small adjustments to their approach and essentially persisted in repeating the same mistakes for years.  “The English soldiers fight like lions,” one German general remarked. “True.  But don’t we know that they are lions led by donkeys?” was the reply.

    Today, a year after global financial collapse and the ensuing tragedy for millions, our economic leaders are lining us up to suffer again (and again) through the same horrible experiences.

    The collapse of Lehman Brothers in September 2008 demonstrated just how far our economic system in general and bank management in particular have gone awry.  Lehman borrowed at low interest rates in global credit markets, and invested over half a trillion dollars of other people’s money in assets which, today, are worth next-to-nothing: failed ski hills in Montana, now empty suburban housing in California, and crazy bets on derivatives (options to buy or sell securities, in various complex combinations).

    Worries about these failed investments sparked a run on the bank.  And, after a mad weekend of trying to save Lehman, the U.S. “authorities” – meaning Henry Paulson (Secretary of the Treasury), Ben Bernanke (chairman of the Federal Reserve Board), and Timothy Geithner (President of the New York Fed) – decided to let it go bankrupt.   Creditors, realizing no major bank is safe if our leaders might now let them fail, pulled cash from major financial institutions and bought relatively safe US Treasuries and UK Gilts.

    Today Lehman’s senior debt trades at a mere 10 cents on the dollar, suggesting its $600 billion in assets were a mirage.  This outcome is even more startling when compared to senior debt at Kazakhstan’s defaulting large banks, where management is now accused of serious malfeasance, yet that debt trades at 20 cents on the dollar – twice the price of Lehman’s debt.

    At the G20 meeting of finance ministers last week, political leaders united behind two key steps which they claim will “prevent another Lehman”: tighter controls on the pay of executives and more capital for banks.  France and Germany blame the crisis on lax regulation in Anglo-Saxon markets and excessive pay packets that encourage irresponsible risk taking.  The British and Americans counter that European banks have too much debt (i.e., in the jargon, are “overly leveraged”), and need to raise more capital.  The final communiqué proposes to do both, and we will hear more of the same at the upcoming G20 heads of government summit in Pittsburgh.  But, in reality, both sides want only minor adjustments that cannot solve the real problems posed by our financial system.

    Tim Geithner, now US Treasury Secretary, is pushing for higher capital requirements for banks, i.e., they need to have more shareholder funds to protect against future losses.  But he surely knows that two weeks prior to its bankruptcy, Lehman’s management reported they were well-capitalized, with a tier one capital ratio of 11% — roughly twice what the United States currently considers is needed for a well-capitalized bank, and much higher than the American side is proposing in private conversations.

    Christine Lagarde, France’s Finance Minister, and Angela Merkel, President of Germany, helped convince the G20 that bank compensation policies need to be amended to encourage long term incentives.  They want compensation packages to be limited and bonuses to be locked up, so we can be sure employees’ incentives are consistent with the long term survival of their banks.

    President Merkel and Minister Lagarde need to look no further than Lehman for a model of how to introduce a good policy to align incentives.  The top management and many employees in the company were largely compensated in shares of the company which vested over many years, so when Lehman Brothers went down, it brought crashing down the lives and finances of its 20,000 employees.  Dick Fuld, the highly compensated head of Lehman, lost many million dollars – and presumably a large part of his total wealth.  Apart from criminal penalties (of the kind not seen for banking in a century), can we think of a better way of aligning incentives with the outcomes for a bank?

    The real problem with our financial system is that our economic and political system work together to encourage excessive risk, and this risk in turn leads to cycles of prosperity and collapse.  In 1998, a much smaller Lehman Brothers was placed in financial peril by the aftermath of the Asian financial crisis and failure of Long Term Capital Management, a major hedge fund.  The Federal Reserve responded by lowering interest rates and other central banks followed suit.   This reduced the cost of obtaining funds, effectively bailing out Lehman and other institutions in trouble.

    As markets have grown to recognize how quick the Federal Reserve is to bail out institutions (and executives) in trouble, they naturally respond.  In the 1990s, people talked about the “Greenspan Put” a term which derisively suggests that it is always safe to invest in risky assets, because the Federal Reserve is ready to bail out investors (a put is effectively a promise to buy an asset at a fixed price if you are unable to sell it to someone else at a higher price – this is a way to lock-in profits or limit losses on investments).  However, in months following the collapse of Lehman, we learned that the “Bernanke Put” is even more valuable since Chairman Bernanke, alongside the Bank of England, the European Central Bank, and central banks in much of the rest of the world, is prepared to take drastic measures to prevent asset prices from falling when there are risks of global collapse.

    This policy of responding to the aftermath of bubbles, rather than addressing them before they get going, through tighter regulation, has become the mantra of most central banks.  It is usually combined with fiscal policy stimulus and other measures to support the economy.  Each time banks fail, by bailing the system out again, we teach our finance sector a lesson:  you can safely take too much risk because, when you lose, the taxpayer will pick up the bill.  We also send a simple message to creditors:  it is safe to lend to Goldman Sachs, or Barclays Bank, because taxpayers and our nations’ savers are standing by to cover your losses.  Rational bank executives and creditors respond as any person would: creditors lend to banks at low interest rates, and our banks gamble heavily hoping to make large profits.  Such a system is destined to fail, but the party can run for a long time.

    While Ben Bernanke has done a wonderful job of preventing financial meltdown, his calls in 2002-2003 for very low interest rates, without fixing our financial system, contributed to the credit expansion that led us into the current mess.  In the United Kingdom, the Conservatives plan to transfer regulatory powers to the Bank of England, despite the fact that, like the Federal Reserve, the Bank of England has been a key component of our ever growing cycles of credit expansion and bust.

    The “collapse or rescue” decision forced by Lehman’s failure is a symptom of a much larger systemic problem.  We need leaders, both in the financial world and in public service who recognize that our financial sector too often causes social harm.  There is no doubt that it also provides valuable services that are vital to the well-being of our pensioners and savers, and help manage and mitigate risk for our corporations.  Yet too often these activities cause losses, which, either directly or indirectly, become a burden on the rest of society.

    The pre-crisis activities and portfolios of Barclays, Goldman Sachs, and other “survivors” of this crisis were only slightly different from Lehman Brothers or Bear Stearns, which failed.  The “good” banks also securitized subprime assets, helped build the intricate web of IOUs between banks and insurance companies, and leveraged their balance sheets to enormous levels.  The winners were not better, they were just smart enough to make sure someone else held the bad assets when the music stopped, and they were powerful enough to win generous bailout packages from their governments.

    The danger we face is that, by bailing out these institutions and rewarding failed managers with new powerful positions, we have now created a much more dangerous financial system.  The politically well-connected, knowing they will most likely do fine in the next crisis, is now highly incentivized to take even greater risk.

    Once we admit this profound problem in our system, we can begin to think of the radical measures needed to solve it.  There is no doubt these solutions will include much greater capital requirements, so that bank shareholders know that they face substantial losses if their ventures fail.

    But, we also need to ensure that our regulators are not captured by the banks that they are meant to oversee.  This means we need to put checks on financial donations to political parties, and we need to buttress our regulators with more intellectual firepower and financial resources, along with rules that ensure independence, in order to be sure they can act in the interests of the broader population.

    We also need to close the revolving door, through which politicians and regulators leave office to earn their nest eggs in finance, and “financial experts” move directly from failing banks to designing bailout packages.  The conflicts of interest are abundant and most dangerous.

    Last week the UK’s chief financial regulator, Adair Turner, faced heavy criticism from the City, Chancellor Darling, Boris Johnson, and editorials in the Financial Times and Wall Street Journal.  His main offense was daring to raise the issue of whether parts of our financial system have become socially dysfunctional, in an interview with Prospect Magazine.  He called for greater capital requirements at banks, and he pondered how it would be possible for regulators to preserve the valuable parts of our financial system, while ensuring that regulation limited the harmful parts.  These are eminently sensible questions which anyone with a public spirit should understand are critical policy issues today.   

    Sadly, these public rebukes to Lord Turner are a further indication that very few of our leaders are prepared to even discuss the real problem, let alone seek a sufficient solution.  Smart people and well-organized governments can, as in the past, behave like donkeys.

    By Peter Boone and Simon Johnson

    An edited and shorter version of this post appeared today in the Sunday Times (of London).

    Uncle Billy Cunctator

    1. You are smart people, but your outward behaviour resembles that of donkeys too (I respectfully submit). We have another article in which we hear “they did bad things and they’re going to keep doing bad things and we need to do something about it. How? Specifically? We are not lions, we are sheep, led by wolves. The leaders are doing what is profitable for themselves by using “us.”

      We need to bring the us and the them a lot closer together. Angelo Mozilo used to justify his 100’s of millions by saying that he has a large family. The “leaders” don’t want to think of the rabble as their family; only as drones they can use to enrich themselves. We have a case of a too-successful species. I think we need a ceiling on financial success, as well as a floor.

      The flaw with Capitalism is that it creates its own positive feedback loop, snowballing to the point where the accumulation of wealth and power hurts people — eventually even those at the top of the food chain. Perhaps this means global governance? The UN has no teeth and is notoriously byzantine and corrupt. IMF and World bank are seen as grotesque resource-sucking machines. Who is to choose the people that would run such an enterprise? Those who participated in in the privatisations that we now see as Mafia Gone Wild?

      I think we need to think about this globally because the corporates have gone global and will use geographic arbitrage. If we can somehow create a level playing field world-wide, this might have a chance. No more paying kids in the 3rd world pennies a day to achieve competitive advantage. No more hiding money in Panama. Don’t give them a place to hide. So, again, you are saying most of the right things, but… why? And what are your actual policy recommendations? We know pretty much what we need to do. How are we going to do it?

      (By the way, war stories give me the heebeejeebies. Did someone go to war college?)

  • MC Morley Your article tops off a weekend of retrospective amazement at how little progress has taken place over the past year. The NYT had a good overview yesterday. Huffington Post drew my attention to a piece in the Washington Post – So many intimate liaisons between Wall Street and Washington – all on the record – and that’s in addition to any secret affairs!

    As described so well in your article these relationships underlie and reinforce the policies supporting bubbles and “cycles of prosperity and collapse”.

    Your article leads me to think about the nature of the fear that must be driving the policy makers. Hobbes described fear as a primal driving force – but now it is not just materially based. The collective of public officials in this tale who are not speaking out and taking risks (as did Lord Turner) must be terrified of losing what I call ‘the mother bubble’ that is, the “ideological bubble” that holds their world together. Naturally, those in a position to materially benefit are simply delighted to re-enforce and take advantage of such fear. In light of all this, it is increasingly difficult to see how the fear of policy makers is driven or connected to well-intentioned effort to protect democratic society. What is becoming ever more obvious with the “cycles of prosperity and collapse” is that democracy itself is more and more threatened with each new wave of defensive measures to protect this ideological bubble.

    Maybe almost everyone who enters public service can not help but be seduced by the Wall Street ‘romancers’? It makes the policy makers who refuse to question and challenge the inevitability of bubbles look like victims in a very abusive relationship (albeit maybe with some hope of material security) that they can not help but “love” – the sort where the source of fear has to be dragged out of the sub-conscious – collectively in this case!

    p.s. This weekend was punctuated with other thought about democracy and freedom since I got to see the Last Night at the Proms for the first time (in my life) – ie. the HD live version… I learned from one of the commentators that Handel’s “Rule Britannia” composed in 1745 was a celebration of peace and rule of the people – the rise of democracy in its rudimentary form. It was an ironic experience (yes – and a little bit emotional too!) to hear so many people unite in this song – while I was also thinking about the weekend’s review of the past year in finance and politics.
    So if this reaction to your article this morning is too ‘emotional’ – I’ll blame it on “the Proms”!

  • whessAllowing the markets to work by allowing the banks and investment houses to fail seems part of the solution since backing their overvalued assets merely encourages bad bets. Proposed regulatory reform seems inadequate at this point because even Lehman prior to its collapse met the new proposals.

    However, when Lehman went down, Wall Street panicked. So it seems we have built a house of cards that is so risk-laden that the collapse of one card risks bringing the whole structure down.

    So everyone plays nice. The regulators and the bankers go to the same restaurants. A lot of the players have vested interests in the current system, as was recently reported in light of the Madoff scandel that the SEC regulators all wanted to get jobs with hedge funds and financial houses. The cyclical bubbles tend to hurt the already downtrodden more than the affluent.

    Simon implies that more radical change is needed that better aligns assets with their real world value (a point the Krugman makes in his critique of macroeconomics in the NYTimes), interest rates be allowed to respond to demands for credit, and that risk remain with the risk-takers.

      • Allowing the markets to work by allowing the banks and investment houses to fail…

        Free markets work best when monopolists or oligopolists are propped up with unlimited government support.


        September 13, 2009 at 12:02 pm




          do not forget the support for real-goods-markets in the form of the military securing shipping lanes, air ports etc.

          ooops, government is always evil and military is always blood-thirsty and stupid (except when they happen to be convenient and obedient)

    1. “The politically well-connected, knowing they will most likely do fine in the next crisis, is now highly incentivized to take even greater risk.”

      For this, the above, to be the outcome both after what we have been through and what we still face is tantamount to the ruling clique’s launching of a war of aggression on the people. But there is no surprize here. And it is not merely a question of there being a passive difference between disperate elements in a system who at the same time happen to be pursuing different ends, it is rather the vision of our entire political leadership that the people are a resource to be plundered, exploited. To them we are a vast pool of wealth there solely for their personal enrichment, rubes as it were, or “the colonized”, even better.

      Even to speak of a future repleate with reform when after having caused what has to be the greatest crisis in 80 years, its progenitors are on their feet for round two is, at best, imbecilic, and at worst, collusionary. In a political environment where ownership of the very persons charged with protecting its integrity is in the hands of special interest paymasters, one no longer has democracy but a tyranny of warlords. Would you have tried to reform Willie Sutton?

      All that remains to the people of the United States are mass demonstrations and economy stopping strikes. And anyone handicapped enough to believe that the recent brownshirt rage over healthcare and government spending has the endemic corruption at the core of the system as its object needs to change emetics and quickly. We’ve overfulfilled our fascist quota for the year, thank you.

          • “I mean what can you say on behalf of an intellectual culture that has brought us much of what we’ve had in the last 30 or 40 years, Larry Summers, for example. I mean really.”

            Same people who did not see anything wrong with the system that led to the worst economic downturn in decades are now arguing for caution in implementing any changes that might reign in the big banks.


            September 13, 2009 at 5:21 pm




      Jared Diamond (in Collapse) noted that societies in which elites can shield themselves from the consequences of the crises they cause typically fail badly. He also noted that elites have short term interests. Both comments aptly describe our current situation. Disproportionate executive compensation signaled (and continues to signal) that any mechanism for short-term gain however risky it might be (cloaked in the fairy tale of efficient markets theory) will be pursued. It is also clear that financial elites and their political epigones will survive not only the current crisis but also any attempt at regulatory reform.
      At least in the wake of the collapse of 1929-32, financial elites were divided (many commercial banks opposed to Morgan and international financiers such as Warburgs) and this appears to have made possible reforms. Similarly, many industrial corporations wanted managed competition rather than a free for all. Currently (with perhaps the exception of Frank in the house) the Senate is effectively in the hands of the financial community (e.g. Dodds, Schummer, Lieberman)

      D. Christopher Leonard

      September 13, 2009 at 2:55 pm




      “He also noted that elites have short term interests”

      He doesn’t seem to be referring to the elite of the elites, then. Was Rothschild thinking short term when he dispatched each son to a different country. We have some dynasties and custodians of the fortunes of dynasties that manage to plough through history.

      Uncle Billy Cunctator

      September 13, 2009 at 4:05 pm




        Although going by my gut I would vote for their having long term interests but I’m beginning to doubt that “they” are into empire-building – maybe those of you with children can check your own feelings …
        it seems to me that when the dynasties of old placed their children all over the world (tu felix Austria nube) there was a wish for eternal life, for outwitting death involved – you had to have somebody to have mess read for your soul and probably a lot of other things – as we have created the mobile flexible with-it cool type as an ideal I wonder as he/she see their children still as an entrance ticket to eternal life


        September 13, 2009 at 4:20 pm




      A former Bank of Canada governor, David Dodge said the global recession and economic downturn will be longer than forecast and Capitalism will emerge changed. It will be interesting to learn what he meant by this.

      I am looking forward to the philospher Michael Sandel’s lecture series to begin this fall and aired on PBS. I find his argument persuasive. That free market fundamentalism is flawed and has occupied too central a place in governing political, social and economic paradigms. I take him to mean is that other values need to occupy a central place in our governing paradigms.

      Our time and place in history is different from all others in that literacy and numeracy are no longer exclusive to ruling elites. And we have this wonderful new tool for communication called the internet. I count myself among those who feel we need to revisit the paradigms which govern our world.

      It seems MIT where SJ now teaches is developing course work on “social entrepreneurship”. This is a good start.

      I saw a program on Frontline World this weekend. It is incredibly sad. The Taliban have taken their war into Pakistani cities. The Americans did not want another Vietnam in Afghanistan. So it appears the Pakistanis have shouldered this burden of fighting a guerilla war they did not start and its consequences. The Taliban are now recruiting child soldiers in the slums of Karachi. This is all very alarming and depressing. Utter madness born out of desparation.


      September 13, 2009 at 4:05 pm




        “So it appears the Pakistanis have shouldered this burden of fighting a guerilla war they did not start”

        why oh why do I seem to remember that the Security Service of Pakistan (SIS?) liked the idea of establishing the Taliban very very very much and the Taliban gave a safe haven to Al Qaida?
        but of course that part of the story is obviously Western propaganda ;-(


        September 13, 2009 at 4:23 pm



    1. TonyForestaIt astounds me that our socalled leaders are so week and cowardly to allow a bunch of swindling thieves, PONZI scheme operators, and criminals to threaten the financial security of the US, the global financial system, and cause irreparable harm to the American people.

      “The real problem with our financial system is that our economic and political system work together to encourage excessive risk, and this risk in turn leads to cycles of prosperity and collapse.”

      I don’t understand how our leaders are so enthralled by people who are such grotesque FAILURES and wanton criminals?

      Is it simply money, the capture issue. Is it the false imaginings these monsters truly being allknowing exceptional masters of the Universe?

      What on earth could possibly compel our leaders to bailout FAILED institutions whose FAILED management bruted and pimped FAILED, (not to mention criminal PONZI scheme) products? I’m mystified. If it is money alone, and all the indications lead one to believe it is, – then the solution is obvious and critical. LIMIT the AMOUNT of MONEY anyone, or any LOBBY, or any OLIGARCH, or CARTEL, or PONZI scheme shade can contribut to ANY and EVERY politicial, or POLITICAL PARTY!!!

      Our socalled leaders have betrayed the American people! Thefew have way to much power and sway over themany. Which leads then to the question of what exactly is America. Are we an Oligach, and Kleptocracy? What the hell are we. One thing I am certain of, based on the dastardly deeds of our financial titans and the government officials they own and control – is that America is no longer a democracy. The people have absolutely NO say, and NO representation in the conduct of our government. If they did, then Goldman Sachs, CITI, BofA, Morgan Stanley, et al would no longer exist, and thier FAILED, CRIMINAL, PONZI SCHEME operators, would be in jail or (if there was any real justice) worse, and all the FAILED products and socalled innovative products would be banned, or harshly regulated and controlled.

      Instead we have a situation, where worst, most criminal, most heartless, most greedy, most unAmerican operators are given carte blanc from a captured government at the taxpayers expense, to the extremely deleterious impact on the greater society, and the other 99.5% of the population who are not predator class.

      One last point, relating to the lion metaphor which my erudite brother Nick Foresta articulated. In the wild, male lions have basically three main functions in the evolution of the pride. They mate, they sleep, and they take care of the hyena’s or any threat to the pride. Our financial lions have perverted this evolutionary necessity, – FAILING to care of or eliminate hyena’s or any threat to the pride.

      “This policy of responding to the aftermath of bubbles, rather than addressing them before they get going, through tighter regulation, has become the mantra of most central banks. It is usually combined with fiscal policy stimulus and other measures to support the economy. Each time banks fail, by bailing the system out again, we teach our finance sector a lesson: you can safely take too much risk because, when you lose, the taxpayer will pick up the bill. We also send a simple message to creditors: it is safe to lend to Goldman Sachs, or Barclays Bank, because taxpayers and our nations’ savers are standing by to cover your losses. Rational bank executives and creditors respond as any person would: creditors lend to banks at low interest rates, and our banks gamble heavily hoping to make large profits. Such a system is destined to fail, but the party can run for a long time.”

      Until our leaders and our financial oligarchs learn or (preferably are taught) that there is no future if the pride, – the collective society is protected and defends against marauders and wanton abuse, – what little remains of our once more perfect union or the grand experiment in democracy that defined America – is doomed!

      Heads must roll. Heads must roll!!!

    1. Yakkis
      • I don’t understand how our leaders are so enthralled by people who are such grotesque FAILURES and wanton criminals?

        That’s easy. They’re narcissists.

        By the way, every 2 and 4 years, you elect the same guys no matter what they do to you. Almost no one is even willing to consider electing someone from a third party. They’ve got ya and you’re going to keep electing the same group of republicrats until the human species dies out, or the U.S. finally collapses, whichever comes first.

    "The Most important First Step is to Limit Leverage"

    Update: Here is a link to the discussion.

    will be hosting a Firedoglake Book Salon for Robert Frank's The Economic Naturalist’s Field Guide today from 2:00 - 4:00 PST, and this column touches upon several of the topics likely to come up in the discussion (I'll add an update with a link to my opening comments when it begins, questions are encouraged and can be entered in comments at the link I'll provide):

    Flaw in Free Markets: Humans, by Robert H. Frank, Commentary, NY Times: There is broad agreement that Alan Greenspan ... was wrong to have believed that market forces alone would insulate society from excessive financial risk. ...[C]ritics fault Mr. Greenspan for having overestimated the strength of competitive forces, a point he essentially conceded... But the financial crisis was not caused by a shortfall in competition..., it was fueled by competition’s growing strength.
    Adam Smith’s theory of the invisible hand, which says that market forces harness self-serving behavior for the common good, assumes that markets are competitive... The invisible hand, however, requires not just strong competition but also two other preconditions. The economic models that spawned Mr. Greenspan’s former optimism simply assume those conditions, despite compelling evidence of their absence.

    First, those models assume that rewards depend only on absolute performance, but ... payoffs are often tightly linked to relative performance. When a valuable new piece of information becomes available to the investment community, for example, the lion’s share of the gain goes to whoever trades on it first. For an individual firm..., it is thus completely rational to invest millions of dollars in computer systems that can execute stock trades even a few seconds faster than others. But rivals inevitably respond with similar investments. Taken together, these expenditures are wasteful in the same way that military arms races are.

    A second problematic assumption of standard economic models is that people are properly attentive to all relevant costs and benefits... In fact, most people focus on penalties and rewards that are both immediate and certain. Delayed or uncertain payoffs often get short shrift. ...
    During the recent bubble, unregulated wealth managers created mortgage-backed securities that enabled investors to magnify their returns through financial leverage...
    Many experienced analysts had warned for years that those derivative securities were vastly overpriced, but Mr. Greenspan assumed that prudent concerns about the future would prevent investors from taking foolish risks. ...
    Wealth managers faced a tough choice..., many customers would desert them if they failed to offer the higher-paying, but riskier, investments. Managers also knew that if markets turned against them, penalties would be limited by the fact that almost everyone had been following the same strategy. The resulting collapse was all but inevitable.
    Memories are short. Immediately after a severe flood, most people are reluctant to build on a flood plain. But land on flood plains is cheaper, and the prospect of short-term advantage quickly lures many to abandon their caution. That is why many jurisdictions adopt strict regulations against building on flood plains.
    The same logic dictates regulation to limit the damage caused by financial bubbles. The ... most important first step is to limit leverage. ... Relaxed regulation and increased competition now confront investors with temptations that growing numbers of them are ill-equipped to resist.
    Alan Greenspan’s erstwhile faith in the invisible hand notwithstanding, it was never reasonable to have expected market forces to protect society from the consequences of this risky behavior.

    "Too Big to Take a Pay Cut"

    Dean Baker says "Tyler Cowen Is on the Money":
    Where Politics Don’t Belong, by Tyler Cowen, Commentary, NY Times: For years now, many businesses and individuals in the United States have been relying on the power of government, rather than competition in the marketplace, to increase their wealth. This is politicization of the economy. It made the financial crisis much worse, and the trend is accelerating.
    Well before the financial crisis erupted, policy makers treated homeowners as a protected political class and gave mortgage-backed securities privileged regulatory treatment. Furthermore, they allowed and encouraged high leverage and the expectation of bailouts for creditors... Without these mistakes, the economy would not have been so invested in leverage and ... the financial crisis would have been much milder.
    But we are now injecting politics ever more deeply into the American economy, whether it be in finance or in sectors like health care. ... President Dwight D. Eisenhower warned of the birth of a military-industrial complex. Today we have a financial-regulatory complex, and it has meant a consolidation of power and privilege. We’ve created a class of politically protected “too big to fail” institutions, and the current proposals for regulatory reform further cement this notion. ...
    We should stop using political favors as a means of managing an economic sector. Unfortunately, though, recent experience with health care reform shows we are moving in the opposite direction...
    One disturbing portent came over the summer when it was reported that the Obama administration had promised deals to doctors and to pharmaceutical companies under the condition that they publicly support health care reform. That’s another example of creating favored beneficiaries through politics. ...
    Even worse, these political deals threaten open discourse. The dealmaking may be inhibiting some people in health care from speaking out in opposition to the administration’s proposals. ... The banking sector has been facing similar constraints; if bankers criticize the Treasury or the Fed, they ... could get a bad deal when the next bailout comes. When major economic sectors can be influenced in this way, are we really very far from the nightmare depicted by Ayn Rand in “Atlas Shrugged”?
    So if we’re looking for a major lesson from our banking mess, it is undoubtedly this: We have made a grave mistake in politicizing the economy so deeply, and should back away now. ...
    In short, we should return both the financial and medical sectors and, indeed, our entire economy to greater market discipline. We should move away from the general attitude of “too big to take a pay cut,” especially when the taxpayer is on the hook for the bill. If such changes sound daunting, it is a sign of how deep we have dug ourselves in. ...

    "When the Going gets Tough, the Tough Run to the Government"

    Uwe Reinhardt notes that social insurance is much more pervasive than many people realize, and that many of the most vocal opponents of extending social insurance to health care are heavily dependent upon social insurance themselves:
    Lehman’s Last Contribution to Society: A Lesson on Social Insurance, by Uwe E. Reinhardt, Commentary, Economix: A year ago, century-old Lehman Brothers lapsed into bankruptcy... [T]he oligarchy that runs our nation’s financial sector. ... had fully expected to see Lehman bailed out by the federal government that serves them, especially after the government had dutifully bailed out Bear Stearns earlier in the year. When Lehman was not so served, panic set in, unleashing global economic turmoil and pain. ...
    In the end, like teenagers who hate Mother’s strictures when all is well, but run to Mommy whenever they get in trouble, the swashbuckling oligarchs of the financial sector ran to government for cover, owning up once again to the time-honored mantra of this country’s legendary rugged individualists:
    When the going gets tough, the tough run to the government. ...
    It is a social contract with government that Americans quietly love, but ... so often profess to hate — as when they cry for government to stay out of Medicare, or when they sit on their beachfronts in the Hamptons waxing worried about government intrusion in the economy, all the while basking in the security of federal flood insurance.
    After seeing the evaporation of so much of the wealth they had imagined to reside in their 401(k) plans, mutual-fund accounts and private pension plans,... millions of middle-class Americans surely must have gained a renewed appreciation for ... Social Security ... along with two other popular social insurance programs: Medicare and Medicaid.
    Social insurance is routinely called to the rescue also whenever governors of all political stripes ask the federal government for help after a natural disaster... Along with direct financial relief, the Federal Emergency Management Agency is an instrument of social insurance.
    It can be asked, of course, why that form of social insurance generally is judged highly desirable — even by the most staunchly conservative politicians — when so often they mistakenly decry as “socialism” proposals that government come to the assistance of an individual ... struck by a natural disaster called “illness,” like cancer. ... Why is it the American way ... to give financial help to a family whose beach house in Mississippi was blown down by a hurricane, but it is socialist and un-American to help a Mississippi woman struck by breast cancer?
    One of the most thoughtful recent books on the topic of government risk-management is “When All Else Fails: Government as the Ultimate Risk Manager” (2004), by David A. Moss, a Harvard Business School professor. ... Professor Moss explains that the first application of social insurance in our latitudes actually was aimed ... at ... supporting the growth of modern capitalism. Its main instrument to that end was the legal sanction of the principle of limited liability of the owners of corporations.
    Prior to this form of social insurance, the owners of a business were legally liable with their personal wealth for damages the business might have inflicted on others. With limited liability, the corporation’s shareholders are liable only up to their equity stake in the company. ... Beyond that, someone else in society — often the taxpayer — bears the financial risk for damages attributable to the corporation.
    One wonders how many business executives and members of chambers of commerce ... realize that the limited liability of shareholders is social insurance.
    The most pervasive form of social insurance for the business sector in recent times, of course, has been the massive government bailout of the financial sector following the Lehman Brothers bankruptcy. Without the huge array of public assistance ... the financial sector would have collapsed...
    One would hope that by now this lesson on the beneficial role of government in risk management in our society has sunk into the minds of the American public. One must also hope that eventually it will penetrate even the minds of economic theorists...

    On Krugman"

    Robert Levine of Rand emails this reaction to Paul Krugman's essay on the state of macroeconomics:
    On Krugman, by Robert A. Levine, Rand: Being a saltwater economist, by ideology and a bicoastal education and career, I of course think that Paul Krugman’s “How Did Economists Get it So Wrong?” made some major points that needed making, and as usual made them very well.
    But he also left two major omissions, inclusion of which may change the states of both theory and the economic outlook. Neither has either appeared in the commentaries I have seen.
    The first omission is of Joseph Alois Schumpeter.1 Krugman did mention the name in two sour asides; it apparently does not appear in any of the commentaries. Schumpeter is remembered by many of his colleagues as an unpleasant man as well as a political reactionary. I was not in a position, as an undergraduate in one of his courses shortly before he died, to judge the former. The latter was certainly true: he was a royalist.
    He was also one of the seminal economists of the 20th century. He was a rabid anti-Keynesian, but in fact his central concepts of innovation and entrepreneurship integrate well with Keynes and fill in a major gap. Keynes’s discussion of investment provides a complex analysis of the relationship of profits and interest rates; it says little about where the profits come from. That is what Schumpeter is about: not the routine buying and replacing of capital goods, strongly influenced by the close profit/interest relationship, but the “autonomous” investment stemming from doing new things in new ways. Such investment then invokes the Keynesian multiplier, the Keynesian (but post-Keynes) accelerator, and business cycles endogenous to the narrow profit/interest relationship but exogenously induced.
    In particular, Schumpeter’s emphasis on innovation-induced “long waves” (which he named after their discoverer, Nicolai Kondratieff), starting with the industrial revolution and continuing through railroads, the telegraph, the telephone, automobiles, aircraft, radio, and—after Schumpeter—television and computers and the “information revolution” fills a crucial gap in the saltwater/freshwater debate. Much of the causation for the really major macroeconomic movements since World War II simply lies outside of that debate as now waged..
    Schumpeter’s emphasis on the regular periodicity of Kondratieff and other shorter cycles has been generally and properly criticized; in the last century such regularity if it existed at all was interrupted at least by the two World Wars. But the concept of innovation, with creative destruction and all that goes with it, stands; it is widely accepted by economists—and then ignored as a macroeconomic factor, e.g., in the current debate.
    This leads to the second omission, the failure to treat with the fundamental causes of the dreadful decade of the 1970s. Krugman covers it as a cause of the major parting of the waters between salt and fresh, which it is, but in fact the major cause of the dismal economy and the consequent dismal economics lay outside of both; rather, it was in the fundamental global redistribution led by consolidation of OPEC and the oil boycotts stemming from the Yom Kippur war and then the Iranian revolution. The oil sheiks took control of a crucial portion of world product. Oil consumers had to adjust, cutting back on their own portion either by slowing growth and increasing unemployment, or bidding for what was left, thus engendering inflation. Economists adjusted by inventing, and then arguing about, rational expectations. Stagflation brought about no good responses either in the real world or the economics stratosphere.
    The 70s can be looked at as a Schumpeterian wave in reverse: instead of growth-engendering structural change, the assertion of power by the oil-producers was a growth-inhibiting (at least for the major developed economies) structural change—with consequences yet to be analyzed.
    The developed economies, and the rest of the world, recuperated from the 70s via a true Schumpeterian wave created by computers and information technology, and ending, as Schumpeterian waves do, in the bursting of the IT bubble in the late 1990s.
    Whether the housing/financial bubble has anything to do with Schumpeter is arguable: the attempt to spread home ownership through financial innovation might be treated as an example of useful entrepreneurship gone bad, or the pervasive financial devices themselves might be classed in the same genre.
    Underlying much of the current malaise, however, is another real-economy factor not mentioned in the current debate, the rise of the developing economies, led by China and India. Like the oil producers of the 70s, they are claiming increasing portions of world product. Unlike the sheiks, however, they are producing more rather than rather than grabbing existing product. The needed adjustments for the developed world may nonetheless be traumatic, including stagflation as the world economy (apparently already led by China and India) returns to growth.
    Whether this is “negative Schumpeterianism” is probably not worth worrying about. What we should worry about instead is coping with the consequences—to Us—of major economic restructuring. Financial reform and short-run monetary or Keynesian stimulus, necessary for short-run melioration have little to do with the long run. We may have to await the onset of another truly Schumpeterian technological wave, whenever that occurs.
    A term of the 1930s, long-since forgotten, was “secular stagnation”; when the Great Depression was ended not by technology but by deficit spending to finance World War II, the fears that growth had ended until an unforeseeable future were forgotten. One hopes that this time the turnaround will be based on technology, not war or even indefinite peacetime deficits, with positive change beginning soon.
    In my grandmother’s version of Keynes’s most famous statement, “We should live so long.”
    1 Another; name, completely omitted, is that of John Kenneth Galbraith, but his semi-institutional economics remains, of course, beyond the pale.
    (Much of this commentary is based on Robert A. Levine, “Adjusting to Global Economic Change: the Dangerous Road Ahead”, RAND OP-243-RC)

    Reducing Systemic Risk in the Financial Sector - Brookings Institution

    Reducing Systemic Risk in the Financial Sector

    U.S. Financial Market Regulation, Federal Reserve System, Financial Institutions, Financial Markets, U.S. Economy

    Alice M. Rivlin, Senior Fellow, Economic Studies

    House Committee on Financial Services & Senate Committee on Banking, Housing and Urban Affairs

    Mr. Chairman and members of the Committee:

    I am happy to be back before this Committee to give my views on reducing systemic risk in financial services. I will focus on changes in our regulatory structure that might prevent another catastrophic financial meltdown and what role the Federal Reserve should play in a new financial regulatory system.

    A demonstrator outside the NYSE.

    A demonstrator outside the NYSE.
    View Larger

    Shannon Stapleton/Reuters


    Research and Commentary

    Save to My PortfolioThe U.S. Financial and Economic Crisis: Where Does It Stand and Where Do We Go From Here?

    Martin Neil Baily, The Brookings Institution, June 15, 2009

    Research and Commentary

    Save to My PortfolioRegulating and Resolving Institutions Considered “Too Big to Fail”

    Martin Neil Baily, Senate Committee on Banking, Housing and Urban Affairs, May 06, 2009

    Research and Commentary

    Save to My PortfolioBank Nationalization: A Survival Manual

    Douglas J. Elliott, The Brookings Institution, April 21, 2009

    More Related Content »

    It is hard to overstate the importance of the task facing this Committee. Market capitalism is a powerful system for enhancing human economic wellbeing and allocating savings to their most productive uses. But markets cannot be counted on to police themselves. Irrational herd behavior periodically produces rapid increases in asset values, lax lending and over-borrowing, excessive risk taking, and out-sized profits followed by crashing asset values, rapid deleveraging, risk aversion, and huge loses. Such a crash can dry up normal credit flows and undermine confidence, triggering deep recession and massive unemployment. When the financial system fails on the scale we have experienced recently the losers are not just the wealthy investors and executives of financial firms who took excessive risks. They are average people here and around the world whose jobs, livelihoods, and life savings are destroyed and whose futures are ruined by the effect of financial collapse on the world economy. We owe it to them to ferret out the flaws in the financial system and the failures of regulatory response that allowed this unnecessary crisis to happen and to mend the system so to reduce the chances that financial meltdowns imperil the world’s economic wellbeing.

    Approaches to Reducing Systemic Risk

    The crisis was a financial “perfect storm” with multiple causes. Different explanations of why the system failed—each with some validity—point to at least three different approaches to reducing systemic risk in the future.


    • The highly interconnected system failed because no one was in charge of spotting the risks that could bring it down.
      This explanation suggests creating a Macro System Stabilizer with broad responsibility for the whole financial system charged with spotting perverse incentives, regulatory gaps and market pressures that might destabilize the system and taking steps to fix them. The Obama Administration would create a Financial Services Oversight Council (an interagency group with its own staff) to perform this function. I think this responsibility should be lodged at the Fed and supported by a Council.
    • The system failed because expansive monetary policy and excessive leverage fueled a housing price bubble and an explosion of risky investments in asset backed securities.
      While low interest rates contributed to the bubble, monetary policy has multiple objectives. It is often impossible to stabilize the economy and fight asset price bubbles with a single instrument. Hence, this explanation suggests stricter regulation of leverage throughout the financial system. Since monetary policy is an ineffective tool for controlling asset price bubbles, it should be supplemented by the power to change leverage ratios when there is evidence of an asset price bubble whose bursting that could destabilize the financial sector. Giving the Fed control of leverage would enhance the effectiveness of monetary policy. The tool should be exercised in consultation with a Financial Services Oversight Council.
    • The system crashed because large inter-connected financial firms failed as a result of taking excessive risks, and their failure affected other firms and markets.
      This explanation might lead to policies to restrain the growth of large interconnected financial firms—or even break them up—and to expedited resolution authority for large financial firms (including non-banks) to lessen the impact of their failure on the rest of the system. Some have argued for the creation of a single consolidated regulator with responsibility for all systemically important financial institutions. The Obama Administration proposes making the Fed the consolidated regulator of all Tier One Financial Institutions. I believe it would be a mistake to identify specific institutions as too big to fail and an even greater mistake to give this responsibility to the Fed. Making the Fed the consolidated prudential regulator of big interconnected institutions would weaken its focus on monetary policy and the overall stability of the financial system and could threaten its independence.

    The Case for a Macro System Stabilizer

    One reason that regulators failed to head off the recent crisis is that no one was explicitly charged with spotting the regulatory gaps and perverse incentives that had crept into our rapidly changing financial structure in recent decades. In recent years, anti-regulatory ideology kept the United States from modernizing the rules of the capitalist game in a period of intense financial innovation and perverse incentives to creep in.

    Perverse incentives. Lax lending standards created the bad mortgages that were securitized into the toxic assets now weighting down the books of financial institutions. Lax lending standards by mortgage originators should have been spotted as a threat to stability by a Macro System Stabilizer—the Fed should have played this role and failed to do so—and corrected by tightening the rules (minimum down payments, documentation, proof that the borrow understands the terms of the loan and other no-brainers). Even more important, a Macro System Stabilizer should have focused on why the lenders had such irresistible incentives to push mortgages on people unlikely to repay. Perverse incentives were inherent in the originate-to-distribute model which left the originator with no incentive to examine the credit worthiness of the borrower. The problem was magnified as mortgage-backed securities were re-securitized into more complex instruments and sold again and again. The Administration proposes fixing that system design flaw by requiring loan originators and securitizers to retain five percent of the risk of default. This seems to me too low, especially in a market boom, but it is the right idea.

    The Macro System Stabilizer should also seek other reasons why securitization of asset-backed loans—long thought to be a benign way to spread the risk of individual loans—became a monster that brought the world financial system to its knees. Was it partly because the immediate fees earned by creating and selling more and more complex collateralized debt instruments were so tempting that this market would have exploded even if the originators retained a significant portion of the risk? If so, we need to change the reward structure for this activity so that fees are paid over a long enough period to reflect actual experience with the securities being created.

    Other examples, of perverse incentives that contributed to the violence of the recent perfect financial storm include Structured Investment Vehicles (SIV’s) that hid risks off balance sheets and had to be either jettisoned or brought back on balance sheet at great cost; incentives of rating agencies to produce excessively high ratings; and compensation structures of corporate executives that incented focus on short-term earnings at the expense the longer run profitability of the company.

    The case for creating a new role of Macro System Stabilizer is that gaps in regulation and perverse incentives cannot be permanently corrected. Whatever new rules are adopted will become obsolete as financial innovation progresses and market participants find ways around the rules in the pursuit of profit. The Macro System Stabilizer should be constantly searching for gaps, weak links and perverse incentives serious enough to threaten the system. It should make its views public and work with other regulators and Congress to mitigate the problem.

    The Treasury makes the case for a regulator with a broad mandate to collect information from all financial institutions and “identify emerging risks.” It proposes putting that responsibility in a Financial Services Oversight Council, chaired by the Treasury, with its own permanent expert staff. The Council seems to me likely to be cumbersome. Interagency councils are usually rife with turf battles and rarely get much done. I think the Fed should have the clear responsibility for spotting emerging risks and trying to head them off before it has to pump trillions into the system to avert disaster. The Fed should make a periodic report to the Congress on the stability of the financial system and possible threats to it. The Fed should consult regularly with the Treasury and other regulators (perhaps in a Financial Services Oversight Council), but should have the lead responsibility. Spotting emerging risks would fit naturally with the Fed’s efforts to monitor the state of the economy and the health of the financial sector in order to set and implement monetary policy. Having explicit responsibility for monitoring systemic risk—and more information on which to base judgments would enhance its effectiveness as a central bank.

    Controlling Leverage. The biggest challenge to restructuring the incentives is: How to avoid excessive leverage that magnified the upswing and turned the downswing into a rout? The aspect of the recent financial extravaganza that made it truly lethal was the over-leveraged superstructure of complex derivatives erected on the shaky foundation of America’s housing prices. By itself, the housing boom and bust would have created distress in the residential construction, real estate, and mortgage lending sectors, as well as consumer durables and other housing related markets, but would not have tanked the economy. What did us in was the credit crunch that followed the collapse of the highly leveraged financial superstructure that pumped money into the housing sector and became a bloated monster.

    One approach to controlling serious asset–price bubbles fueled by leverage would be to give the Fed the responsibility for creating a bubble Threat Warning System that would trigger changes in permissible leverage ratios across financial institutions. The warnings would be public like hurricane or terrorist threat warnings. When the threat was high—as demonstrated by rapid price increases in an important class of assets, such as land, housing, equities, and other securities without an underlying economic justification--the Fed would raise the threat level from, say, Three to Four or Yellow to Orange. Investors and financial institutions would be required to put in more of their own money or sell assets to meet the requirements. As the threat moderated, the Fed would reduce the warning level.

    The Fed already has the power to set margin requirements—the percentage of his own money that an investor is required to put up to buy a stock if he is borrowing the rest from his broker. Policy makers in the 1930s, seeking to avoid repetition of the stock price bubble that preceded the 1929 crash, perceived that much of the stock market bubble of the late 1920s had been financed with money borrowed on margin from broker dealers and that the Fed needed a tool distinct from monetary policy to control such borrowing in the future.

    During the stock market bubble of the late 1990s, when I was Vice Chair of the Fed’s Board of Governors, we talked briefly about raising the margin requirement, but realized that the whole financial system had changed dramatically since the 1920s. Stock market investors in the 1990s had many sources of funds other than borrowing on margin. While raising the margin requirements would have been primarily symbolic, I believe with hindsight that we should have done it anyway in hopes of showing that we were worried about the bubble.

    The 1930’s legislators were correct: monetary policy is a poor instrument for counteracting asset price bubbles; controlling leverage is likely to be more effective. The Fed has been criticized for not raising interest rates in 1998 and the first half of 1999 to discourage the accelerating tech stock bubble. But it would have had to raise rates dramatically to slow the market’s upward momentum—a move that conditions in the general economy did not justify. Productivity growth was increasing, inflation was benign and responding to the Asian financial crisis argued for lowering rates, not raising them. Similarly, the Fed might have raised rates from their extremely low levels in 2003 or raised them earlier and more steeply in 2004-5 to discourage the nascent housing price bubble. But such action would have been regarded as a bizarre attempt to abort the economy’s still slow recovery. At the time there was little understanding of the extent to which the highly leveraged financial superstructure was building on the collective delusion that U.S. housing prices could not fall. Even with hindsight, controlling leverage (along with stricter regulation of mortgage lending standards) would have been a more effective response to the housing bubble than raising interest rates. But regulators lacked the tools to control excessive leverage across the financial system.

    In the wake of the current crisis, financial system reformers have approached the leverage control problem in pieces, which is appropriate since financial institutions play diverse roles. However the Federal Reserve—as Macro System Stabilizer—could be given the power to tie the system together so that various kinds of leverage ratios move in the same direction simultaneously as the threat changes.

    With respect to large commercial banks and other systemically important financial institutions, for example, there is emerging consensus that higher capital ratios would have helped them weather the recent crisis, that capital requirements should be higher for larger, more interconnected institutions than for smaller, less interconnected ones, and that these requirements should rise as the systemic threat level (often associated with asset price bubbles) goes up.

    With respect to hedge funds and other private investment funds, there is also emerging consensus that they should be more transparent and that financial derivatives should be traded on regulated exchanges or at least cleared on clearinghouses. But such funds might also be subject to leverage limitations that would move with the perceived threat level and could disappear if the threat were low.

    One could also tie asset securitization into this system. The percent of risk that the originator or securitizer was required to retain could vary with the perceived threat of an asset price bubble. This percentage could be low most of the time, but rise automatically if Macro System Stabilizer deemed the threat of a major asset price bubble was high. One might even apply the system to rating agencies. In addition to requiring rating agencies to be more transparent about their methods and assumptions, they might be subjected to extra scrutiny or requirements when the bubble threat level was high.

    Designing and coordinating such a leverage control system would not be an easy thing to do. It would require create thinking and care not to introduce new loopholes and perverse incentives. Nevertheless, it holds hope for avoiding the run away asset price exuberance that leads to financial disaster.

    Systemically Important Institutions

    The Obama Administration has proposed that there should be a consolidated prudential regulator of large interconnected financial institutions (Tier One Financial Holding Companies) and that this responsibility be given to the Federal Reserve. I think this is the wrong way to go.

    It is certainly important to reduce the risk that large interconnected institutions fail as a result of engaging in highly risky behavior and that the contagion of their failure brings down others. However, there are at least three reasons for questioning the wisdom of identifying a specific list of such institutions and giving them their own consolidated regulator and set of regulations. First, as the current crisis has amply illustrated, it is very difficult to identify in advance institutions that pose systemic risk. The regulatory system that failed us was based on the premise that commercial banks and thrift institutions that take deposits and make loans should be subject to prudential regulation because their deposits are insured by the federal government and they can borrow from the Federal Reserve if they get into trouble. But in this crisis, not only did the regulators fail to prevent excessive risk-taking by depository institutions, especially thrifts, but systemic threats came from other quarters. Bear Stearns and Lehman Brothers had no insured deposits and no claim on the resources of the Federal Reserve. Yet when they made stupid decisions and were on the edge of failure the authorities realized they were just as much a threat to the system as commercial banks and thrifts. So was the insurance giant, AIG, and, in an earlier decade, the large hedge fund, LTCM. It is hard to identify a systemically important institution until it is on the point of bringing the system down and then it may be too late.

    Second, if we visibly cordon off the systemically important institutions and set stricter rules for them than for other financial institutions, we will drive risky behavior outside the strictly regulated cordon. The next systemic crisis will then likely come from outside the ring, as it came this time from outside the cordon of commercial banks.

    Third, identifying systemically important institutions and giving them their own consolidated regulator tends to institutionalize ‘Too Big to Fail’ and create a new set of GSE-like institutions. There is a risk that the consolidated regulator will see its job as not allowing any of its charges to go down the tubes and is prepared to put taxpayer money at risk to prevent such failures.

    Higher capital requirements and stricter regulations for large interconnected institutions make sense, but I would favor a continuum rather than a defined list of institutions with its own special regulator. Since there is no obvious place to put such a responsibility, I think we should seriously consider creating a new financial regulator. This new institution could be similar to the UK’s FSA, but structured to be more effective than the FSA proved in the current crisis. In the US one might start by creating a new consolidated regulator of all financial holding companies. It should be an independent agency but might report to a board composed of other regulators, similar to the Treasury proposal for a Council for Financial Oversight. As the system evolves the consolidated regulator might also subsume the functional regulation of nationally chartered banks, the prudential regulation of broker-dealers and nationally chartered insurance companies.

    I don’t pretend to have a definitive answer to how the regulatory boxes should best be arranged, but it seems to me a mistake to give the Federal Reserve responsibility for consolidated prudential regulation of Tier One Financial Holding Companies, as proposed by the Obama Administration. I believe the skills needed by an effective central bank are quite different from those needed to be an effective financial institution regulator. Moreover, the regulatory responsibility would likely grow with time, distract the Fed from its central banking functions, and invite political interference that would eventually threaten the independence of monetary policy.

    Especially in recent decades, the Federal Reserve has been a successful and widely respected central bank. It has been led by a series of strong macro economists—Paul Volcker, Alan Greenspan, Ben Bernanke—who have been skillful at reading the ups and downs of the economy and steering a monetary policy course that contained inflation and fostered sustainable economic growth. It has played its role as banker to the banks and lender of last resort—including aggressive action with little used tools in the crisis of 2008-9. It has kept the payments system functioning even in crises such as 9/11, and worked effectively with other central banks to coordinate responses to credit crunches, especially the current one. Populist resentment of the Fed’s control of monetary policy has faded as understanding of the importance of having an independent institution to contain inflation has grown—and the Fed has been more transparent about its objectives. Although respect for the Fed’s monetary policy has grown in recent years, its regulatory role has diminished. As regulator of Bank Holding Companies, it did not distinguish itself in the run up to the current crisis (nor did other regulators). It missed the threat posed by the deterioration of mortgage lending standards and the growth of complex derivatives.

    If the Fed were to take on the role of consolidated prudential regulator of Tier One Financial Holding Companies, it would need strong, committed leadership with regulatory skills—lawyers, not economists. This is not a job for which you would look to a Volcker, Greenspan or Bernanke. Moreover, the regulatory responsibility would likely grow as it became clear that the number and type of systemically important institutions was increasing. My fear is that a bifurcated Fed would be less effective and less respected in monetary policy. Moreover, the concentration of that much power in an institution would rightly make the Congress nervous unless it exercised more oversight and accountability. The Congress would understandably seek to appropriate the Fed’s budget and require more reporting and accounting. This is not necessarily bad, but it could result in more Congressional interference with monetary policy, which could threaten the Fed’s effectiveness and credibility in containing inflation.

    In summary, Mr. Chairman: I believe that we need an agency with specific responsibility for spotting regulatory gaps, perverse incentives, and building market pressures that could pose serious threats to the stability of the financial system. I would give the Federal Reserve clear responsibility for Macro System Stability, reporting periodically to Congress and coordinating with a Financial System Oversight Council. I would also give the Fed new powers to control leverage across the system—again in coordination with the Council. I would not create a special regulator for Tier One Financial Holding Companies, and I would certainly not give that responsibility to the Fed, lest it become a less effective and less independent central bank.

    Thank you, Mr. Chairman and members of the Committee.


    Lessons Learned and Soon Forgotten

    with 22 comments

    One year after the collapse of Lehman, the controversial “rescue” of AIG, and the ensuing collapse of world financial markets there are two questions: what have we learned, and what good will it do us?

    The second question is essential, because we have learned so much about the functioning of our financial system – and the three main lessons are all rather scary.

    First, our financial system has become dangerous on a massive scale.  We knew that the banks were playing games, e.g., with their so-called off-balance sheet activities, but we previously had no idea that these huge corporations were so badly run or so close to potential collapse.

    Second, we also learned the hard way – after many revelations – that pervasive mismanagement in our financial system was not a series of random accidents.  Rather it was the result of perverse incentives – bank executives felt competitive pressure to behave as they did and they were well-compensated on the basis of short-term performance.  No one in the financial sector worries too much, if at all, about risks they create for society as a whole – despite the fact that these now prove to be enormous (i.e., jobs lost, incomes lowered, and fiscal subsidies provided).

    Third, weak government regulation undoubtedly made financial mismanagement possible.  But poorly designed regulations and weak enforcement of even the sensible rules were in turn not a “mistake”.  This was the outcome of a political process through which regulators – and their superiors in the legislative and executive branches – were captured intellectually by the financial system.  People with power really believed that what was good for Wall Street was great for the country.

    But how much good does all this new knowledge now do for us?  There is very little real reform underway or on the table.  We can argue about whether this is due to lack of intestinal fortitude on the part of the administration or the continued overweening power of the financial system, but the facts on the ground are simple: our banks and their “financial innovation” have not been defanged.

    In fact, they are becoming more dangerous.  The “Greenspan put” has morphed into the “Bernanke put”, to use the jargon of financial markets, where “put” means the option to sell something at a fixed price (and therefore to limit your losses).  The Greenspan version was always a bit vague, involving lower interest rates when a speculative bubble ran into trouble; the Bernanke version is huge, involving massive cheap credits of many kinds (as well as interest rates set essentially at zero).

    Bernanke’s Federal Reserve has shown that, when the chips are down, it can save the financial system even in the face of unprecedented global panic.  But this will now just encourage more reckless risk-taking going forward.  In the absence of full re-regulation of the financial system, the Fed’s policies are asking for trouble.

    Lou Jiwei, the chairman of China’s large sovereign wealth fund, summed up the view of big international financial players last week, “It will not be too bad this year. Both China and America are addressing bubbles by creating more bubbles and we’re just taking advantage of that.  So we can’t lose.”

    We have lived through a massive crisis – and learned how close we came to a Second Great Depression – yet nothing is now happening to prevent a repeat of something similar in the near future.

     By Simon Johnson

    This is a slightly edited version of a post that appeared first on the NYT’s Economix blog.  It is reproduced here with permission. - Comment - Opinion - To fix the system we must break up the banks

    By Philip Augar and John McFall

    Published: September 10 2009 21:56 | Last updated: September 10 2009 21:59

    In coming up with solutions that address the immediate crisis but fail to tackle dangerous systemic issues, the Group of 20’s emerging ideas on the banking industry bear a striking resemblance to the Americans’ response to the dotcom crash of 2001-02. Back then, the burst bubble exposed biased research and stock price manipulation on Wall Street and dubious accounting practices in US companies. Out came a new set of rules cleaning up the links between research analysts and investment bankers and laying a heavy hand on corporate chief executives.

    These measures extinguished the fire but neglected more fundamental problems. By the time the regulations were in place, the investment banks and elements of the corporate sector were already deeply involved in new and even more dangerous practices. We speak, of course, of the derivatives-based leverage of banks’ balance sheets that brought down a range of previously sound institutions, dragged the global economy into recession and ripped up accepted economic theories.

    We see exactly the same mistakes being made this time around. If effectively implemented (not the only possible outcome), the G20 finance ministers’ steer towards more and better capital, constraints on leverage and contingency plans for banking failures would help to avoid a repetition of the current crisis. But they are barely sufficient to give the financial services system the kind of radical overhaul it needs.

    That would entail tackling a defective business model. Banks are allowed to mix plain vanilla deposit-taking and lending with high-risk investment banking. They are allowed to act for clients on both sides of a trade and take a proprietary turn out of the middle. In capital markets transactions they are able to act for those seeking capital and those providing it. Conflict of interest is embedded and this is unfair on other market users. It is “heads we win, tails you lose” as the banks make off like bandits in the good times and become pious onlookers as the taxpayer foots the bill when it all goes wrong.

    Fixing the system requires this business model to be broken up and we would go beyond conventional Glass-Steagall type solutions. Activities such as corporate finance, providing advice for investors and proprietary trading should be separated from each other as well as being split off from deposit-taking. This would create smaller, less profitable institutions and solve a number of problems, many of which have been caused by financial institutions over-trading. The system we advocate would restore the balance of economic power towards industries other than finance. It would stem the flow of capital that goes into bankers’ bonuses (a problem that the proposals coming out of G20 seem unlikely to solve) and would rid the world of financial institutions that were too big to be allowed to fail.

    Many heavyweight thinkers have dismissed narrow banking (a less radical option than the one we advocate) as, to quote Lord Turner, chairman of the UK’s Financial Services Authority, “not feasible”. They point out that although Northern Rock was not an investment bank and Lehman was not a deposit-taking bank, both failed. This is another example of fighting the last war. The real problems are not the specific causes of the crises of 2008 (banks) or 2001 (dotcom) or 1998 (Long-Term Capital Management) or 1989 (US Savings and Loans), but the enduring power of finance to be socially and economically disruptive.

    We do not expect politicians and regulators to restructure the global financial services industry at what is still a critical moment for the economy. But it is regrettable that they appear to have shut the door on even having such a conversation. A starting point, as we have argued before, would be to set up a banking commission informed but not dominated by people from outside the industry. Its remit would be to consider structural change and how the financial services industry can serve the wider social and productive needs of the economy.

    This crisis has offended people’s basic notions of fairness. The connection between effort and reward must be proportionate and the playing field needs to be level if we are to secure a fully functioning market economy underpinned by political stability. That is why there is no option but to start the discussion we advocate.

    John McFall is chairman of the Commons Treasury committee. Philip Augar is a former investment banker and the author of Chasing Alpha

    Why some economists could see the crisis coming By Dirk Bezemer

    September 7 2009 |
    From the beginning of the credit crisis and ensuing recession, it has become conventional wisdom that “no one saw this coming”. Anatole Kaletsky wrote in The Times of “those who failed to foresee the gravity of this crisis” – a group that included “almost every leading economist and financier in the world”. Glenn Stevens, governor of the Reserve Bank of Australia, said: “I do not know anyone who predicted this course of events. But it has occurred, it has implications, and so we must reflect on it.” We must indeed.

    Because, in fact, many had seen it coming for years. They were ignored by an establishment that, as the former Federal Reserve chairman Alan Greenspan professed in his October 2008 testimony to Congress, watched with “shocked disbelief” as its “whole intellectual edifice collapsed in the summer [of 2007]”. Official models missed the crisis not because the conditions were so unusual, as we are often told. They missed it by design. It is impossible to warn against a debt deflation recession in a model world where debt does not exist. This is the world our policymakers have been living in. They urgently need to change habitat.

    I undertook a study of the models used by those who did see it coming. They include

    Central to the contrarians’ thinking is an accounting of financial flows (of credit, interest, profit and wages) and stocks (debt and wealth) in the economy, as well as a sharp distinction between the real economy and the financial sector (including property). In these “flow-of-funds” models, liquidity generated in the financial sector flows to companies, households and the government as they borrow. This may facilitate fixed-capital investment, production and consumption, but also asset-price inflation and debt growth. Liquidity returns to the financial sector as investment or in debt service and fees.

    It follows that there is a trade-off in the use of credit, so that financial investment may crowd out the financing of production. A second key insight is that, since the economy’s assets and liabilities must balance, growing financial asset markets find their counterpart in a growing debt burden. They also swell payment flows of debt service and financial fees. Flow-of-funds models quantify the sustainability of the debt burden and the financial sector’s drain on the real economy. This allows their users to foresee when finance’s relation to the real economy turns from supportive to extractive, and when a breaking point will be reached.

    Such calculations are conspicuous by their absence in official forecasters’ models in the US, the UK and the Organisation for Economic Co-operation and Development. In line with mainstream economic theory, balance sheet variables are assumed to adapt automatically to changes in the real economy, and can thus be safely omitted. This practice ignores the fact that in most advanced economies, financial sector turnover is many times larger than total gross domestic product; or that growth in the US and UK has been finance-driven since the turn of the millennium.

    Perhaps because of this omission, the OECD commented in August 2007 that “the current economic situation is in many ways better than what we have experienced in years . . . Our central forecast remains indeed quite benign: a soft landing in the United States [and] a strong and sustained recovery in Europe.” Official US forecasters could tell Reuters as late as September 2007 that the recession in the US was “not a dominant risk”. This was well after the Levy Economics Institute, for example, predicted in April of that year that output growth would slow “almost to zero sometime between now and 2008”.

    Policymakers have resisted inclusion of balance sheets and the flow of funds in their models by arguing that bubbles cannot be easily identified, nor their effects reliably anticipated. The above analysts have shown that this is, in fact, feasible, and indeed essential if we are to “see it coming” next time. The financial sector is just as real as the real economy. Our policymakers, and the analysts they rely on, ignore balance sheets and the flow of funds at their peril – and ours.

    *No One Saw This Coming’: Understanding Financial Crisis Through Accounting Models, MPRA

    The writer is a fellow at the economics and business department of the University of Groningen in the Netherlands

    Copyright The Financial Times Limited 2009. You may share using our article tools. Please don't cut articles from and redistribute by email or post to the web.

    [Apr 21, 2009]  Capitalism's Greatest Vulnerability:


    The great Hyman Minsky postulated that Capitalism was “flawed.”  Over the years I’ve taken exception with this particular view, countering that Capitalism is more appropriately described as “vulnerable.”  As part of this line of analysis, I have used the analogy of the human eye.  We would not think of its delicate nature and susceptibility to injury as some “flaw” in our eye’s design.  Instead, this inherent vulnerability is fundamental to the nature of this important organ’s functionality.  We worry much less about our elbows, but they’re not going to do an adequate job detecting light and transmitting visual signals to our brains.   

    I have argued over the years that an extraordinary backdrop has beckoned for the necessary keen focus to protect our Capitalistic system from its inherent vulnerabilities - just as one would don sun glasses on a sunny beach or ski slope or insist upon tight-fitting safety goggles before entering a metal-working shop.  One must first recognize inherent vulnerabilities and then take more aggressive preventative measures as necessary in response to riskier environments.

    We, as a society, failed to take preventive action.  Now, Capitalism as we have known it is under fierce attack from many directions and on various levels.  At the same time, there is regrettably scant indication that we now possess any clearer understanding of the nature of Capitalism or its inherent vulnerabilities.  We’re still entwined in Mistakes Beget Mistakes.

    But there’s lots of blame being bandied about.  Many pinpoint “Wall Street greed.”  The securities firms, reckless traders, hedge funds, rank speculation and egregious leverage are viewed today as the major culprits.  Executive pay and Wall Street bonuses are pilloried for fomenting dangerous excess.  Others trumpet the failure of regulation and corporate governance.  Some even attribute the mess to the Asian propensity to save.  There’s a more sensible case that flawed banking and Wall Street risk models played an integral role in the fateful Bubble.  Many that participated in the bountiful upside of the speculative Bubble these days posit that the rating agencies were at fault for garnishing “AAA” ratings on Trillions of risky securities and debt instruments.  And a very strong argument can be made that hundreds of Trillions of derivatives played a fundamental role in the near financial implosion.  But how could it be that so many things went so wrong all at the same time?

    I have over the years expressed disdain with the “free market ideologues” for their steadfast refusal to even contemplate the possibility that “Capitalism” could possess vulnerabilities of need of recognition and corrective action.  Yet, economic history is replete with boom and bust cycles, along with a bevy of post-Bubble writings providing us fertile ground for cogent analysis of system vulnerabilities.  Contemporaneous analysis during the Great Depression focused clearly on the acutely susceptible U.S. Credit system that emerged from “Roaring Twenties” lending and speculative excesses.  During the forties, fifties and even into the early-sixties there was some adroit analysis of the Credit system’s role in the boom and subsequent depression.  This entire fruitful line of analysis was, however, stopped dead in its tracks with the emergence of a revisionist view of the twenties as the “Golden Age of Capitalism” needlessly terminated by post-crash policy blunders.  

    The Great Depression and today’s turmoil expose Capitalism’s vulnerabilities.  And as easy (and accurate) as it would be for me to write that the problem lies first and foremost in the “Credit system,” I have come to believe that it is vital to dig deeper to get to the root of the problem:  Capitalism’s Greatest Vulnerability lies with Risk Intermediation.  

    The essence of Capitalism is one of a predominantly private system of allocating resources based on market price signals.  A private-sector Credit mechanism is fundamental to financing the economic system in a manner that effectively allocates both financial and real resources.  And we can stop right here and recognize potential pitfalls.  First, Credit flows may be inadequate to finance sound investments or to sustain economic activity.  Second, there may be too much Credit.  I have for some time argued that Credit excess (“Credit inflation”) is the Bane of Capitalism.  Credit excesses distort the various costs of finance throughout the system, while inflating asset prices and fostering distorted spending and investing patterns (among other effects).  And, importantly, Credit inflation inherently fosters self-reinforcing Credit inflation through asset price, economic, and speculative Bubble dynamics.  In short, “Credit excess begets Credit excess,” with its subtle but corrosive effect upon pricing mechanisms.

    But how on earth does the always-existing nature of “Credit Begetting Credit” somehow morph into the history’s greatest Credit Bubble? One way:  Unfettered Risk Intermediation. 

    I often referred to “Wall Street Alchemy” - the process of various methods of intermediation (Wall Street securitization structures, myriad Credit insurance and financial guarantees, liquidity arrangements, dynamic hedging, explicit and implicit government backing, etc.) transforming risky loans into coveted instruments perceived by the marketplace as safe and liquid (“money-like”).  I have also theorized that a boom predominantly financed by, say, junk bonds would never run too far before the market lost its appetite for the inflating quantity of (conspicuously) risky debt.  In contrast, our recent Credit Bubble was financed by endless Trillions of “AAA” debt instruments (GSE debt, MBS, ABS, CDOs, CP, “repos”, auction-rate securities, top-rated guaranteed muni debt, Treasuries, bank deposits and such) ran to unmatched excess. 

    Importantly, there was a direct relationship between our contemporary system’s capacity to intermediate Credit risk and the expanding scope of the Bubble.  Over years, risk was in varying degrees distorted, camouflaged, or deceptively concealed to the point that it was no longer even possible to monitor, analyze or regulate it.  Worse yet, the risk intermediation process was self-reinforcing instead of self-adjusting and correcting.  Wall Street “alchemy” was the true source of this period’s “easy money.”

    Our Credit system’s capacity to intermediate Trillions of mortgage and consumer debt into “money-like” instruments was instrumental in fueling real estate and asset Bubbles throughout.  It was the capacity of Credit system intermediation to create Trillions of instruments (chiefly Treasuries, agency debt, MBS, and “Repos”) perceived as safe and liquid by our foreign trading partners that accommodated our massive current account deficits (and attendant domestic and international imbalances).  It was contemporary risk intermediation at the heart of a historic mispricing of finance for, in particular, mortgages and U.S. international borrowings.  And it was the potent interplay of contemporary risk intermediation and contemporary monetary management/central banking (i.e. “pegged” interest rates, liquidity assurances, and asymmetrical policy responses) that cultivated unprecedented financial sector and speculator leveraging. 

    Most historical analyses of busts (going back about 300 years to John Law!) focus on banking ineptness, negligence, excesses and nuances.  Banks, creating “money-like” (i.e. deposit) liabilities in the process of intermediating loans, have historically been at the center of boom/bust cycles.  Contemporary finance – with its focus on marketable debt instruments - took intermediation risk to a completely new danger level.  For one, traditional bank capital and reserve requirements no longer provided any restraint on the quantity of Credit that could be extended and intermediated (in the “market” or “off balance sheet”).  Furthermore, the marketable nature of these instruments (created in the intermediation process) cultivated speculative demand for leveraging higher-yielding securities (i.e. hedge funds buying collateralized debt obligations that had acquired private-label subprime MBS).  Cheap finance literally flooded the riskiest sectors of the economy

    All of this led to extreme systemic distortions in the pricing of risk - along with the attendant massive over-expansion of Credit and the economy-wide (and global) misallocation of real and financial resources.  Buyers of intensively intermediated instruments (say “AAA” senior CDO tranches or auction-rate securities) in many cases could not have cared less with regard to the type of underlying loans being financed.  Elsewhere, the buyer (leveraged speculator or trade partner) of agency securities could not have been less concerned with GSE balance sheet issues or California home prices.  This entire process of contemporary (marketable instrument-based) intermediation developed an overwhelming propensity for financing asset-based loans instead of real economic wealth-producing investment (unlimited supplies of mortgages were viewed as a more appealing asset class than more limited quantities of corporate loans).  It is not only in hindsight that this process of risk intermediation should be viewed as central to system asset price distortions and economic maladjustment. 

    I am tempted to write “I am as tired writing about the previous Credit Bubble as readers are reading about it.”  But I’m not tired.  And this topic is not as much about rehashing the past as it is about providing a perspective as to why I believe the current course of policymaking will inevitably end in failure.  Why?  Because of the very complex and unresolved issue of Risk Intermediation.

    Wall Street “finance” self-destructed in the process of intermediating Trillions of risky loans.  It was the quantity of Credit and the nature of resulting spending patterns (resource allocation) that both doomed this endeavor and ensured a deeply maladjusted economic structure.  This terribly flawed financial structure has morphed into a system where our government has stepped forward to supplant Wall Street as predominant risk intermediator.  Basically, the Fed and Treasury are in the process of intermediating risk on a system-wide basis – to the tune of tens of Trillions – with little possibility of extricating themselves from this endeavor going forward. 

    This development may be welcomed by Wall Street and the markets - and it certainly goes a long way toward getting the Credit wheels rolling again.  It would be expected to help spur some level of global economic “recovery.”  I would argue, however, at the end of the day we will see that it has only exacerbated the problems of risk mispricing, Monetary Disorder, financial and real resource misallocation, and economic maladjustment. 

    Our Capitalistic system has been severely injured.  I don’t expect meaningful structural recovery until there is some semblance of restoration to our Credit system’s mechanism for the pricing and allocation finance.  This, I believe, will require our system to wean itself both off of its dependence on enormous Credit expansion and away from Washington’s newfound role of chief system risk intermediator and allocator (the “Government Finance Bubble).

    [May 30, 2008] Minsky on 'Flawed Capitalism', 'Flawed Economics'

    I am a fan of Hyman Minsky's work, but have not read — until now — any of his books. I am currently reading Stabilizing an Unstable Economy. Here is a timely quote, from Chapter 12, "Introduction to Policy", emphasizing our current plight both as to our political economy and misguided economic ideology/methodology. It could have been written yesterday but was first published in 1986:

    … We need to embark on a program os serious change even as we need to be aware that a once-and-for-all resolution of the flaws in capitalism cannot be achieved. Even if a program of reform is successful, the success will be transitory. Innovations, particularly in finance, assure that problems of instability will continue to crop up; the result will be equivalent but not identical bouts of instability to those that are so eviedent in history.


    Political leaders and the economists who advise them are to blame for promising more than they or the economy can deliver. The established advisers have failed to make the political leadership and the public aware of the limitations that economics processes and the the ability to administer impose on what policy can achieve. … [O]ur economic leadership does not seem to be aware that the normal functioning of our economy leads to financial trauma and crises, inflation, currency depreciations, unemployment, and poverty in the midst of what could be virtually universal affluence—in short, that financially complex capitalism is inherently flawed.

    Economic advisors, whether liberal or conservative, believe in the fundamental "soundness" of the economy. Finding fault with one thing or another, they may advocate policies such as changing Federal Reserve operating techniques, tax reforms, national health insurance, and wars on poverty, but all in all they are satisfied with the basic institutions of modern capitalism. According to today's gospel [extant faults] are due to secondary, not to fundamental, characteristics.

    [T]he economists of the policy-advising establishment differ about details: some propose to fine-tune the economy by fiscal tinkering, others want to achieve a natural rate of employment through steady monetary growth. Neither, however, sees anything basically wrong with capitalism as such. The credit crunch of 1966, the liquidity squeeze of 1970, the banking crises of 1974-75, the inflationary spiral of 1979-80 and the distress, national and international, of 1981-82 are, in their view, aberrations, due to either "shocks" or "errors." Since nothing is basically wrong, they also hold that incisive corrective measures are not needed.

    The truth of the matter is that something is fundamentally wrong with our economy. As we have shown, a capitalist economy is inherently flawed because its investment and financing processes introduce endogenous destabilizing forces. The markets of a capitalist economy are not well suited to accommodate specialized, long-lived, expensive capital assets. In fact, the underlying economic theory of the policy establishment does not allow for capital assets and financial relations such as exist. The activities of Wall Street and the inputs of bankers to production and investment are not integrated into, but are added onto, the basic allocation-oriented theory.

    Economic policy discussions in recent years have centered on how much more (or less) on the one—fiscal policy—and how much less (or more) of the other—monetary policy—is necessary for economic stability and growth. If we are to do better in the future, we must launch a serious debate that looks beyond the level and the techniques of fiscal and monetary policy. Such a debate will acknowledge the instability of our economy and inquire whether this inherent instability is amplified or attenuated by our system of institutions and policy interventions. ….

    Today's economic crisis is as profound … as that of the 1930s. … There is no consensus as to what we should do. Conservatives call for freeing up the markets even as their corporate clients lobby for legislation [to] institutionalize and legitimize their market power…. [C]orporate America pays lip service to Adam Smith, while striving to sustain and legitimize the very thing that Smith abhorred—state-mandated market power.

    Liberals, instead of articulating and incisive critique of our capitalism as such and pioneering innovative experimentation and change, are wedded to the past. They support minimum-wage increases without questioning whether these laws have served any real purpose since the Great Depression, when reflation was the policy objective. Liberals are unwilling to face up to the shortcomings of policies inherited from the past and are, fundamentally, timid about setting forth in new directions.

    As a consequence, instead of analysis and ideas, we get slogans: free markets, economic growth, national planning, supply-side, industrial policy—imprecise phrases that face up to neither the what nor the how of policy objectives. The various programs for change are based on misconceptions of both the strengths and the weaknesses of market processes. One of the reasons for the intellectual poverty of policy proposals is that they continue to be based on ideas drawn from neoclassical theory. Although economic theory is relevant to policy (without an understanding of how our economy works we cannot find cures), for an economic theory to be relevant what happens in the world must be a possible even in the theory. On that score alone, standard economic theory is a failure; the instability so evident in our system cannot happen if the core of standard theory is to be believed.

    Today's economic policy is a patchwork. Every change designed to correct some shortcoming has side effects that adversely affect some other aspect of economic and social life. Every ad hoc intervention breeds further intervention. If we wish to improve upon what we now have, we must embark upon an age of institutional and structural reforms that will check the tendencies toward instability and inflation. Standard theory, however, offers us no guidance on that score; for the problems are outside the domain of relevance of the theory. A new era of reform cannot be simply a series of piecemeal changes. Rather, a thorough, integrated approach to our economics problems must be developed; policy must range over the entire economic landscape and fit the pieces together in a consistent, workable way: Piecemeal approaches and patchwork changes will only make a bad situation worse.

    Poverty in the midst of plenty and joyless affluence are but symptoms of a profound disorder [Tibor Scitovsky, The Joyless Economy (New York: Oxford University Press, 1976)]. As we have pointed out, persistent financial and economic instability is normal in our capitalist economy. The commitment to growth through private investment—combined with government transfer payments and exploding defense spending—amplifies financial instability and chronic inflation. Indeed, our problems are in part the result of how we have chosen, inadvertently and in ignorance of the consequences, to run the economy. An alternative policy strategy is needed now. We have to go back to square one — 1933 — and build a structure of policy that is based upon a modem [modern?] understanding of how our type of economy generates financial fragility, unemployment, and inflation. [pp. 319-23]

    Note: whereas in Minsky's day inflation tended to be more self-grown, today's inflation tends to wander the globe accompanying unfettered capital mobility. Note further that Minsky was careful to introduce his policy 'remedies' with this caution: "Even as I warn against the handwaving that passes for much policy prescription I must warn the reader that I feel much more comfortable with my diagnosis of what ails our economy and analysis of the causes of our discontents than I do with the remedies I propose."
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