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Financial Sector Induced Systemic Instability, 2010

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[Dec 18, 2010] "Why Aren't More Bankers Going To Jail?"

"The administration could not have been realistically expected to prosecute and jail the most generous contributors to it's victorious campaign."
David Zaring has a question:

Why Aren't More Bankers Going To Jail?, by David Zaring: Jesse Eisenger and Andrew Ross Sorkin have both written about the surprising lack of convictions in the wake of the financial crisis.

... ... ...

So maybe this kind of judicial reception, and the jury in Bear Stearns test case that failed, has made the government gun shy. Maybe New York defense lawyers are worth every penny, or maybe DC government types can't imagine throwing a wide swath of the financial community in jail. Maybe Madoff and Galleon distracted everyone. But I remain surprised. There's the flexible statutes available to the government, surely one could stop at AIG, Lehman, and Bear and satisfy the public ... My own tentative view is that it could be that for really high-ranking people to go to jail, someone has to have done something obviously criminal. So Lay and Skilling had Andy Fastow, Michael Milken had Ivan Boesky. But the out and out crook, for whatever reason has not turned up yet, which means that all the captains who went down with their Titanics can breath a bit more easily.

But that's speculation in the service of being as surprised as Sorkin et al, without necessarily wanting a parade of handcuffs.

rps said...

Why Aren't More Bankers Going To Jail?"

To quote Janet Tavakoli, SEC:Failed and Captured. Mary Shapiro as the head of the SEC: Appalling track record at FINRA (FINRA: Wall Street‟s enabler).

The current Feudal System has replaced Kings with Bankers. In this "feudal" system, the Board of Directors (kings) awards campaign contributions and/or post public servant careers as lobbyists/consultants (fiefs) to his most important congressmen (nobles), justices/presidents/treasury secretaries/secretary of states (barons), and fed chairmen (bishops), in return for their trusted public servant contributions to tax-cuts/ havens, dismantling of entitlement programs, captured de-regulation of monetary systems; banks/investment, and taxpayer punchbowl replenishment of incentivized Bank failures.

Solution - Nail the revolving door shut.


The feds missed their opportunity to lop off the heads of the banks - and the top 5 levels of management, while prohibiting them from participating in the finance industry -when it was doling out TARP funds. There should have been conditions on receiving that money, such as disgorgement of past bonuses, being barred from making a lot of money (that's how you hurt someone for whom money is everything), etc.

I didn't need to see anyone go to jail; I needed to see bankers humiliated, their homes vacated, their families reduced to no more than the average income, their wrongly paid bonuses paid back. That would have been enough.


Agree. The problem is not putting miscreants in jail - lawbreaking was a small part of what happened (and of the continuing problem of overpaid financial sector executives). We need a way of discouraging things like the Goldman bonuses. I'm afraid, though, that past bonuses for behavior that helped create our current malaise (such as the half billion 'earned' by Hank Paulson) will never be recovered.


I think the jail thing is mostly a metaphor for what djt described, or maybe not even as much. The problem maybe that our brand of society is centered so much around money that the concept of good standing has been diluted to a point where only formal convictions and possibly prison or equivalent sentences will make a strong impression.

On a related point, Stewart's Daily Show recently aired the censure of congressperson what's-his-name, pretty much proclaiming it a proceedings of no consequence on par with a joke. And the evidence seemed to bear it out. The whole thing had an air of "yeah, whatever" (let's get this over with).


William K. Black and Jamie Galbraith have been pounding this drum for over two years. Fraud was at the center of the bubble. My own view is that Team Obama (particularly Geithner) thought that fraud prosecutions would promote systemic risk, and we have seen how risk-averse this team is.

Obama still has two years to hire William K. Black. Looking back over the period since the crash, perhaps the biggest tell of the whole episode was Obama saying most of the banker's actions were all "perfectly legal." I'm surprised the GOP hasn't made an attack ad out of the sound bite.


The administration could not have been realistically expected to prosecute and jail the most generous contributors to it's victorious campaign. Nor will it, as it must run for re-election and so will reasonably expect further bankster support in recognition of it's forbearance.


As the nation turns from democracy to plutocracy - we are surprised that the wealthiest people aren't going to jail?

This is a bit like being surprised that Bank of America and their ilk are protected by the Obama administration from the consequences of their use of fraudulent documents in court. We have the mushmouth party, the Dems, yammering like this:

U.S. Housing and Urban Development Secretary Shaun Donovan said Wednesday that the Obama administration will attempt to protect homeowners and police the kind of paperwork fraud that led the nation's largest banks to temporarily halt foreclosures this month, but added that the administration had yet to find anything fundamentally flawed in how large banks securitized home loans or how they foreclosed on them.

"Where any homeowner has been defrauded or denied the basic protections or rights they have under law, we will take actions to make sure the banks make them whole, and their rights will be protected and defended," Donovan said at a Washington press briefing. "First and foremost, we are committed to accountability, so that everyone in the mortgage process -- banks, mortgage servicers and other institutions -- is following the law. If they have not followed the law, it's our responsibility to make sure they're held accountable."

First, airy but serious sounding abstraction about committment - second, a noseeum attitude that comes from the top down in Treasury. And this is the far left mushmouthers - the far right - or right - is clear that the law should distinguish between the wealthy, who get a pass on all offenses except if they are Hollywood stars saying nice things about Chavez or Soros, and the rest of the unwashed, who should go to jail on general principles first.

Was there some thought on the part of the technocrats that after making government a quick loan shop for the wealthiest for the past three years, this was going to have no consequence for democratic governance and things would get back to 'normal'? Are the techies that stupid?

The damage done over the past decade to democracy in the U.S. is going to take decades to recover from.

[Nov 28, 2010] A Hedge Fund Republic

inequality in the United States has soared to levels comparable to those in Argentina six decades ago — with 1 percent controlling 24 percent of American income in 2007.

At a time of such stunning inequality, should Congress put priority on spending $700 billion on extending the Bush tax cuts to those with incomes above $250,000 a year? Or should it extend unemployment benefits for Americans who otherwise will lose them beginning next month?

... ... ...

But there is also a larger question: What kind of a country do we aspire to be? Would we really want to be the kind of plutocracy where the richest 1 percent possesses more net worth than the bottom 90 percent?

Oops! That’s already us. The top 1 percent of Americans owns 34 percent of America’s private net worth, according to figures compiled by the Economic Policy Institute in Washington. The bottom 90 percent owns just 29 percent.

... ... ...

And then I see members of Congress in my own country who argue that it would be financially reckless to extend unemployment benefits during a terrible recession, yet they insist on granting $370,000 tax breaks to the richest Americans. I don’t know if that makes us a banana republic or a hedge fund republic, but it’s not healthy in any republic.

[Nov 28, 2010] Increasing taxes on the rich

Sometimes a few letters to the editor can restore one's faith in the sensibleness of fellow Americans.  I particularly like Jerry Trupin's Nov. 25, 2010 New York Times letter responding to Nicholas Kristof's article on hedge funds.  In A Hedge Fund Republic, New York Times, Nov. 18, 2010, Kristof noted that the US has long surpassed familiar "banana republics" in rampant inequality, with plutocrats in the top 1%  controlling 24% of American income in 2007.  In that context, it simply doesn't make economic sense, Kristof says, for Congress to plan to give $700 billion in tax cuts to the wealthiest amongst us for the next ten years and yet not be willing to extend unemployment benefits for the long-term jobless as a result of this recession.  The richest 0.1% of taxpayers would get an average tax cut of $370,000--no way, Kristof says, that they will hire enough new groundskeepers and garage maintenance personnel to make that a good way to jumpstart the economy,  compared to getting money in the hands of those at the bottom. Tax cuts didn't work to create jobs in the Bush II regime, and they're not going to work now.  Getting money into the hands of the poor and middle class--especially the unemployed--does. 

Trupin's brief letter says it all--as one of the fortunate whose taxes would increase if the Bush cuts aren't renewed for the wealthy, he benefited last year by being able to refuse to take out a 401(k) minimum distribution, saving himself $28,000 in taxes but not spending an additional penny.  That was a giveaway for the rich, as so many of our policies have been.  And it didn't do a thing to create jobs.

[Nov 28, 2010] When Bankers Met Their Waterloo


Napoleon Bonaparte, on bankers in general:

Money has no motherland; financiers are without patriotism and without decency; their sole object is gain.

from Liaquat Ahamed, Lords of Finance, the Bankers Who Broke the World

Hassan Azarm


The Bankers DNA is the main constant here as the times change they repeat the same sorry horror show albeit with different set of actors....

WE need Gene therapy/mutation for the Bankers and their political clients/benefactors/puppets.

Failing that I suggest straight jackets...


Napoleon is also quoted as having said this: "Never interrupt your enemy when he is making a mistake," That comment captures the reasons why I do not think a revolution will ultimately be needed to topple the financial titans from their lofty perch.

Either the pyramid is expanded exponentially until the money becomes worthless or the banks and sovereigns default on their debts.

If the latter, then the endgame is more protracted, because the big players will endeavor to manage the default process. Markets will eventually panic either way, as the authorities have already lost too many pieces to reliably control the situation. The debts are simply too large to be unwound in an orderly restructuring.

The central banks are trapped, doomed to be hoisted on their own petard. Interest rates will eventually soar and the affected economies involved will be forced into the inevitable default/devaluation crisis.
Pay now or pay later.

There is no exit from objective mathematical reality. The financial doomsday device was triggered a long time ago and there is no way to turn it off. Free thinkers are as prepared as they can be and have already stepped aside. The lemmings of the world are stampeding, oblivious, as always, as lemmings tend to be. Once they've vaulted the cliffs, things can get back to normal. A new generation and a new age will be born.

[Nov 28, 2010] Banks Financing Mexico Gangs Admitted in Wells Fargo Deal

When banksters are accomplices of real gangsters...

Just before sunset on April 10, 2006, a DC-9 jet landed at the international airport in the port city of Ciudad del Carmen, 500 miles east of Mexico City. As soldiers on the ground approached the plane, the crew tried to shoo them away, saying there was a dangerous oil leak. So the troops grew suspicious and searched the jet.

They found 128 black suitcases, packed with 5.7 tons of cocaine, valued at $100 million. The stash was supposed to have been delivered from Caracas to drug traffickers in Toluca, near Mexico City, Mexican prosecutors later found. Law enforcement officials also discovered something else.

The smugglers had bought the DC-9 with laundered funds they transferred through two of the biggest banks in the U.S.: Wachovia Corp. and Bank of America Corp., Bloomberg Markets magazine reports in its August 2010 issue.

This was no isolated incident. Wachovia, it turns out, had made a habit of helping move money for Mexican drug smugglers. Wells Fargo & Co., which bought Wachovia in 2008, has admitted in court that its unit failed to monitor and report suspected money laundering by narcotics traffickers -- including the cash used to buy four planes that shipped a total of 22 tons of cocaine.

The admission came in an agreement that Charlotte, North Carolina-based Wachovia struck with federal prosecutors in March, and it sheds light on the largely undocumented role of U.S. banks in contributing to the violent drug trade that has convulsed Mexico for the past four years.

‘Blatant Disregard’

Wachovia admitted it didn’t do enough to spot illicit funds in handling $378.4 billion for Mexican-currency-exchange houses from 2004 to 2007. That’s the largest violation of the Bank Secrecy Act, an anti-money-laundering law, in U.S. history -- a sum equal to one-third of Mexico’s current gross domestic product.

[Nov 26, 2010] The Column That I, Now Green with Envy, Wish That I Had Written

Compare with Soros's The Full Soros Speech on ‘Act II’ of the Crisis
Grasping Reality with Both Hands
Paul Krugmnan:

The Instability of Moderation - Brad DeLong writes of how our perception of history has changed in the wake of the Great Recession. We used to pity our grandfathers, who lacked both the knowledge and the compassion to fight the Great Depression effectively; now we see ourselves repeating all the old mistakes. I share his sentiments.

But watching the failure of policy over the past three years, I find myself believing, more and more, that this failure has deep roots – that we were in some sense doomed to go through this. Specifically, I now suspect that the kind of moderate economic policy regime Brad and I both support – a regime that by and large lets markets work, but in which the government is ready both to rein in excesses and fight slumps – is inherently unstable. It’s something that can last for a generation or so, but not much longer.

By “unstable” I don’t just mean Minsky-type financial instability, although that’s part of it. Equally crucial are the regime’s intellectual and political instability.

Intellectual instability:

The brand of economics I use in my daily work – the brand that I still consider by far the most reasonable approach out there – was largely established by Paul Samuelson back in 1948, when he published the first edition of his classic textbook. It’s an approach that combines the grand tradition of microeconomics, with its emphasis on how the invisible hand leads to generally desirable outcomes, with Keynesian macroeconomics, which emphasizes the way the economy can develop magneto trouble, requiring policy intervention. In the Samuelsonian synthesis, one must count on the government to ensure more or less full employment; only once that can be taken as given do the usual virtues of free markets come to the fore.

It’s a deeply reasonable approach – but it’s also intellectually unstable. For it requires some strategic inconsistency in how you think about the economy. When you’re doing micro, you assume rational individuals and rapidly clearing markets; when you’re doing macro, frictions and ad hoc behavioral assumptions are essential.

So what? Inconsistency in the pursuit of useful guidance is no vice. The map is not the territory, and it’s OK to use different kinds of maps depending on what you’re trying to accomplish: if you’re driving, a road map suffices, if you’re going hiking, you really need a topo.

But economists were bound to push at the dividing line between micro and macro – which in practice has meant trying to make macro more like micro, basing more and more of it on optimization and market-clearing. And if the attempts to provide “microfoundations” fell short? Well, given human propensities, plus the law of diminishing disciples, it was probably inevitable that a substantial part of the economics profession would simply assume away the realities of the business cycle, because they didn’t fit the models.

The result was what I’ve called the Dark Age of macroeconomics, in which large numbers of economists literally knew nothing of the hard-won insights of the 30s and 40s – and, of course, went into spasms of rage when their ignorance was pointed out.

Political instability:

It’s possible to be both a conservative and a Keynesian; after all, Keynes himself described his work as “moderately conservative in its implications.” But in practice, conservatives have always tended to view the assertion that government has any useful role in the economy as the thin edge of a socialist wedge. When William Buckley wrote God and Man at Yale, one of his key complaints was that the Yale faculty taught – horrors! – Keynesian economics.

I’ve always considered monetarism to be, in effect, an attempt to assuage conservative political prejudices without denying macroeconomic realities. What Friedman was saying was, in effect, yes, we need policy to stabilize the economy – but we can make that policy technical and largely mechanical, we can cordon it off from everything else. Just tell the central bank to stabilize M2, and aside from that, let freedom ring!

When monetarism failed – fighting words, but you know, it really did — it was replaced by the cult of the independent central bank. Put a bunch of bankerly men in charge of the monetary base, insulate them from political pressure, and let them deal with the business cycle; meanwhile, everything else can be conducted on free-market principles.

And this worked for a while – roughly speaking from 1985 to 2007, the era of the Great Moderation. It worked in part because the political insulation of central banks also gave them more than a bit of intellectual insulation, too. If we’re living in a Dark Age of macroeconomics, central banks have been its monasteries, hoarding and studying the ancient texts lost to the rest of the world. Even as the real business cycle people took over the professional journals, to the point where it became very hard to publish models in which monetary policy, let alone fiscal policy, matters, the research departments of the Fed system continued to study counter-cyclical policy in a relatively realistic way.

Financial instability:

Last but not least, the very success of central-bank-led stabilization, combined with financial deregulation – itself a by-product of the revival of free-market fundamentalism – set the stage for a crisis too big for the central bankers to handle. This is Minskyism: the long period of relative stability led to greater risk-taking, greater leverage, and, finally, a huge deleveraging shock. And Milton Friedman was wrong: in the face of a really big shock, which pushes the economy into a liquidity trap, the central bank can’t prevent a depression.

And by the time that big shock arrived, the descent into an intellectual Dark Age combined with the rejection of policy activism on political grounds had left us unable to agree on a wider response.

In the end, then, the era of the Samuelsonian synthesis was, I fear, doomed to come to a nasty end. And the result is the wreckage we see all around us.

We could go the other way--we could make micro about myopia: about psychological, behavioral, and institutional myopia. Then micro and macro would fit together in a stable whole, and the research frontier would be all about proper institution design.


 "But isn't that a reason to want to keep pursuing intelligent, honest, respectful dialog with people you disagree with"

Mr. Thomson, I don't know you and can't gauge your sincerity. You certainly do sound like a troll however.

Krugman's economic opponents have not wanted any dialogue with the "Samuelsonian" economists. They have treated Krugman et al. as morons and frauds. They despised anyone who thought that Keynes was a great economist

And now, faced with the breakdown of their models, the failure of their attempt to believe that a national economy works like a household economy, they are not conceding that there is something to learn from the Krugmans and DeLongs. Not at all. They are retreating into a dream castle of illusion.

Steve Bannister:

Rob said...

Shorter Mark Thomson:Why does Krugman have to be so shrill?

Because, Rob, and Mark, many economists and the political climate are dangerously wrong for the health of the macro-economy.

Better shrill opposition than lemmings approaching a cliff since they will take all down with them. What this conversation exposes is a true schism in the economics profession, and large difference from much of the public discourse. The shrill component has history on its side. Most refuse to study, let alone accept, the history.


 @Mark -- concern troll much?

As a profession that has pretensions to a scientific inclination, data and mathematics ought to trump politeness. And the first time, you try politely, of course. Krugman's got the data, he's made predictions about this slump, he's been proven correct, and he justifies his predictions with "his" theory. That's good enough for me.

The so-called "fresh-water crowd" cannot come up with water-holding explanations for the crash and slump, never mind that their predictions for our economy have failed to be fulfilled (I've got a fixed-rate mortgage, I'm waiting for this hyperinflation they've been predicting). May I suggest, politely, that their understanding of economics has (as we say in my business) "upside potential"? If they cannot explain what happened, and fail to correctly predict what will happen, what good, exactly, are they?

Note that the entire field of microeconomics relies on some assumptions that are at best approximately correct. "Keeping up with the Joneses" implies dependent utility functions implies no proof of general welfare maximization -- just for example.

Proof fails, you're in the land of faith, not theorems. Perfect information and rationality -- not only does that sound like a poor model for most of the people I know, it's been proven that (for example) it is possible to construct CDO bundles for which deriving useful information about their value requires solving a member of a famous family of computationally hard problems (strictly speaking, the hardness of said hard problem is "faith-based", but that is because legions of computer scientists have been taking a crack at solving it, and all have failed).

Maynard Handley:

 "the kind of moderate economic policy regime Brad and I both support – a regime that by and large lets markets work, but in which the government is ready both to rein in excesses and fight slumps – is inherently unstable. It’s something that can last for a generation or so, but not much longer."

OK, Brad, better late than never.

How about, however, that you take the next step and start understanding the corollary: I don't care how technically justified it is --- if the government's response to the failure of big finance is to shovel money at the rich while ignoring the poor, that's ALSO going to lead to nasty nasty consequences.

Otherwise Paul is going to be writing another column in fifteen years bemoaning how America in the 2010's learned nothing from the growth of fascist parties all over Europe in the 1930's.

Omega Centauri:

"Otherwise Paul is going to be writing another column in fifteen years bemoaning how America in the 2010's learned nothing from the growth of fascist parties all over Europe in the 1930's."

Well stated Maynard. When I start running on about what the optics of the policy may be doing, thats what I'm getting at.

hartal said...

Phyllis Deane, 1989:

"While the prevailing orthodoxy conformed to what was generally thought of as Keynesian economics--as it did for most of the 1950s and 1960s--the standard undergraduate introductory text expounded the fundamental principles of the discipline in two compartments. Part I typically described a macro-economic model inspired by Keynes's General Theory. Part II presented neo-classical micro-economic theory leading to the traditional conclusion that, in freely competitive markets, the operations of the price system tend over the long run to maximize aggregate output. This sat uneasily with the Keynesian message that in an uncertain world, effective demand tends to fall short of the level required to bring all available labour and capital into productive use."

There was another attempt to square the circle. How could one square a sanctification of the micro-economic logic of markets with a macro-economic recognition of unemployment equilibrium? Simply by insinuating that the unemployed are genetically incapable of the the productivity levels demanded in a high tech economy. That is, they are too expensive and there is nothing the market can do about it.

James Rytting:

Prof. Krugman's gives economic Ideas a hegelianesque life of their own, which to an extent they have. However, as always, one gets a feeling that the theme is a way to dodge issues of class and power.

Intellectual trends, especially those closely wedded to ideology, such as economics, it appears to me, are frequently, although not always, rationalizations of attempts by dominant groups to impose their goals on society and extirpate others.

Here, the post war objective (because of labor and social movements during WWII and to a lesser extent Vietnam) was not to disprove the "Samuelson synthesis" through learned syllogisms, but to undermine politically those groups -- labor unions, civil rights organizations, and fractions of academia and democratic party -- who pushed the Fed to make full employment a primary goal; that meant, by-the-by, undermining the legitimacy of a theory in which full employment is necessary for a stable macroeconomy.

However, underneath it all was the drive of corporations, and coteries of privileged individuals that own and enrich themselves through them, to regain the power and control they formerly enjoyed and believe themselves presently entitled.

Turning to Prof. DeLong's comment with that in mind, it would follow that plans for institutional design requires more than overcoming myopia, namely, a long struggle, against vicious, self-righteous opposition.

[Nov 22, 2010]  The Full Soros Speech on ‘Act II’ of the Crisis

...It is important to realize that the crisis in which we find ourselves is not just a market failure but also a regulatory failure, and even more importantly, a failure of the prevailing dogma about financial markets. I have in mind the Efficient Market Hypothesis and Rational Expectation Theory. These economic theories guided, or more exactly misguided, both the regulators and the financial engineers who designed the derivatives and other synthetic financial instruments and quantitative risk management systems which have played such an important part in the collapse. To gain a proper understanding of the current situation and how we got to where we are, we need to go back to basics and re-examine the foundation of economic theory.

I have developed an alternative theory about financial markets which asserts that financial markets do not necessarily tend toward equilibrium; they can just as easily produce asset bubbles. Nor are markets capable of correcting their own excesses. Keeping asset bubbles within bounds have to be an objective of public policy. I propounded this theory in my first book, “The Alchemy of Finance,” in 1987. It was generally dismissed at the time, but the current financial crisis has proven, not necessarily its validity, but certainly its superiority to the prevailing dogma.

Let me briefly recapitulate my theory for those who are not familiar with it. It can be summed up in two propositions. First, financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. This is the principle of fallibility. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times it is quite pronounced. When there is a significant divergence between market prices and the underlying reality I speak of far from equilibrium conditions. That is where we are now.

Second, financial markets do not play a purely passive role; they can also affect the so-called fundamentals they are supposed to reflect. These two functions that financial markets perform work in opposite directions. In the passive or cognitive function, the fundamentals are supposed to determine market prices. In the active or manipulative function market, prices find ways of influencing the fundamentals. When both functions operate at the same time, they interfere with each other. The supposedly independent variable of one function is the dependent variable of the other, so that neither function has a truly independent variable. As a result, neither market prices nor the underlying reality is fully determined. Both suffer from an element of uncertainty that cannot be quantified. I call the interaction between the two functions reflexivity. Frank Knight recognized and explicated this element of unquantifiable uncertainty in a book published in 1921, but the Efficient Market Hypothesis and Rational Expectation Theory have deliberately ignored it. That is what made them so misleading.

Reflexivity sets up a feedback loop between market valuations and the so-called fundamentals which are being valued. The feedback can be either positive or negative. Negative feedback brings market prices and the underlying reality closer together. In other words, negative feedback is self-correcting. It can go on forever, and if the underlying reality remains unchanged, it may eventually lead to an equilibrium in which market prices accurately reflect the fundamentals. By contrast, a positive feedback is self-reinforcing. It cannot go on forever because eventually, market prices would become so far removed from reality that market participants would have to recognize them as unrealistic. When that tipping point is reached, the process becomes self-reinforcing in the opposite direction. That is how financial markets produce boom-bust phenomena or bubbles. Bubbles are not the only manifestations of reflexivity, but they are the most spectacular.

In my interpretation equilibrium, which is the central case in economic theory, turns out to be a limiting case where negative feedback is carried to its ultimate limit. Positive feedback has been largely assumed away by the prevailing dogma, and it deserves a lot more attention.

I have developed a rudimentary theory of bubbles along these lines. Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception, a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced. Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved.

A twilight period ensues during which doubts grow and more and more people lose faith, but the prevailing trend is sustained by inertia. As Chuck Prince, former head of Citigroup, said, “As long as the music is playing, you’ve got to get up and dance. We are still dancing.” Eventually a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.

Typically bubbles have an asymmetric shape. The boom is long and slow to start. It accelerates gradually until it flattens out again during the twilight period. The bust is short and steep because it involves the forced liquidation of unsound positions. Disillusionment turns into panic, reaching its climax in a financial crisis.

The simplest case of a purely financial bubble can be found in real estate. The trend that precipitates it is the availability of credit; the misconception that continues to recur in various forms is that the value of the collateral is independent of the availability of credit. As a matter of fact, the relationship is reflexive. When credit becomes cheaper, activity picks up and real estate values rise. There are fewer defaults, credit performance improves, and lending standards are relaxed. So at the height of the boom, the amount of credit outstanding is at its peak, and a reversal precipitates false liquidation, depressing real estate values.

The bubble that led to the current financial crisis is much more complicated. The collapse of the subprime bubble in 2007 set off a chain reaction, much as an ordinary bomb sets off a nuclear explosion. I call it a superbubble. It has developed over a longer period of time, and it is composed of a number of simpler bubbles. What makes the superbubble so interesting is the role that the smaller bubbles have played in its development.

The prevailing trend in the superbubble was the ever-increasing use of credit and leverage. The prevailing misconception was the belief that financial markets are self-correcting and should be left to their own devices. President Reagan called it the “magic of the marketplace,” and I call it market fundamentalism. It became the dominant creed in the 1980s. Since market fundamentalism was based on false premises, its adoption led to a series of financial crises. Each time, the authorities intervened, merged away, or otherwise took care of the failing financial institutions, and applied monetary and fiscal stimuli to protect the economy. These measures reinforced the prevailing trend of ever-increasing credit and leverage, and as long as they worked, they also reinforced the prevailing misconception that markets can be safely left to their own devices. The intervention of the authorities is generally recognized as creating amoral hazard; more accurately it served as a successful test of a false belief, thereby inflating the superbubble even further.

It should be emphasized that my theories of bubbles cannot predict whether a test will be successful or not. This holds for ordinary bubbles as well as the superbubble. For instance, I thought the emerging market crisis of 1997-98 would constitute the tipping point for the superbubble, but I was wrong. The authorities managed to save the system and the superbubble continued growing. That made the bust that eventually came in 2007-8 all the more devastating.

What are the implications of my theory for the regulation of the financial system?

First and foremost, since markets are bubble-prone, the financial authorities have to accept responsibility for preventing bubbles from growing too big. Alan Greenspan and other regulators have expressly refused to accept that responsibility. If markets can’t recognize bubbles, Greenspan argued, neither can regulators — and he was right. Nevertheless, the financial authorities have to accept the assignment, knowing full well that they will not be able to meet it without making mistakes. They will, however, have the benefit of receiving feedback from the markets, which will tell them whether they have done too much or too little. They can then correct their mistakes.

Second, in order to control asset bubbles it is not enough to control the money supply; you must also control the availability of credit. This cannot be done by using only monetary tools; you must also use credit controls. The best-known tools are margin requirements and minimum capital requirements. Currently, they are fixed irrespective of the market’s mood, because markets are not supposed to have moods. Yet they do, and the financial authorities need to vary margin and minimum capital requirements in order to control asset bubbles.

Regulators may also have to invent new tools or revive others that have fallen into disuse. For instance, in my early days in finance, many years ago, central banks used to instruct commercial banks to limit their lending to a particular sector of the economy, such as real estate or consumer loans, because they felt that the sector was overheating. Market fundamentalists consider that kind of intervention unacceptable, but they are wrong. When our central banks used to do it, we had no financial crises to speak of. The Chinese authorities do it today, and they have much better control over their banking system. The deposits that Chinese commercial banks have to maintain at the People’s Bank of China were increased 17 times during the boom, and when the authorities reversed course, the banks obeyed them with alacrity.

Third, since markets are potentially unstable, there are systemic risks in addition to the risks affecting individual market participants. Participants may ignore these systemic risks in the belief that they can always dispose of their positions, but regulators cannot ignore them because if too many participants are on the same side, positions cannot be liquidated without causing a discontinuity or a collapse. They have to monitor the positions of participants in order to detect potential imbalances. That means that the positions of all major market participants, including hedge funds and sovereign wealth funds, need to be monitored. The drafters of the Basel Accords made a mistake when they gave securities held by banks substantially lower risk ratings than regular loans: they ignored the systemic risks attached to concentrated positions in securities. This was an important factor aggravating the crisis. It has to be corrected by raising the risk ratings of securities held by banks. That will probably discourage loans, which is not such a bad thing.

Fourth, derivatives and synthetic financial instruments perform many useful functions, but they also carry hidden dangers. For instance, the securitization of mortgages was supposed to reduce risk through geographical diversification. In fact, it introduced a new risk by separating the interest of the agents from the interest of the owners. Regulators need to fully understand how these instruments work before they allow them to be used, and they ought to impose restrictions guard against those hidden dangers. For instance, agents packaging mortgages into securities ought to be obliged to retain sufficient ownership to guard against the agency problem.

Credit-default swaps (C.D.S.) are particularly dangerous. They allow people to buy insurance on the survival of a company or a country while handing them a license to kill. C.D.S. ought to be available to buyers only to the extent that they have a legitimate insurable interest. Generally speaking, derivatives ought to be registered with a regulatory agency just as regular securities have to be registered with the S.E.C. or its equivalent. Derivatives traded on exchanges would be registered as a class; those traded over-the-counter would have to be registered individually. This would provide a powerful inducement to use exchange traded derivatives whenever possible.

Finally, we must recognize that financial markets evolve in a one-directional, nonreversible manner. The financial authorities, in carrying out their duty of preventing the system from collapsing, have extended an implicit guarantee to all institutions that are “too big to fail.” Now they cannot credibly withdraw that guarantee. Therefore, they must impose regulations that will ensure that the guarantee will not be invoked. Too-big-to-fail banks must use less leverage and accept various restrictions on how they invest the depositors’ money. Deposits should not be used to finance proprietary trading. But regulators have to go even further. They must regulate the compensation packages of proprietary traders to ensure that risks and rewards are properly aligned. This may push proprietary traders out of banks, into hedge funds where they properly belong. Just as oil tankers are compartmentalized in order to keep them stable, there ought to be firewalls between different markets. It is probably impractical to separate investment banking from commercial banking as the Glass-Steagall Act of 1933 did. But there have to be internal compartments keeping proprietary trading in various markets separate from each other. Some banks that have come to occupy quasi-monopolistic positions may have to be broken up.

While I have a high degree of conviction on these five points, there are many questions to which my theory does not provide an unequivocal answer. For instance, is a high degree of liquidity always desirable? To what extent should securities be marked to market? Many answers that followed automatically from the Efficient Market Hypothesis need to be re-examined.

It is clear that the reforms currently under consideration do not fully satisfy the five points I have made, but I want to emphasize that these five points apply only in the long run. As Mervyn King explained, the authorities had to do in the short run the exact opposite of what was required in the long run. And as I said earlier, the financial crisis is far from over. We have just ended Act II. The euro has taken center stage, and Germany has become the lead actor. The European authorities face a daunting task: they must help the countries that have fallen far behind the Maastricht criteria to regain their equilibrium while they must also correct the deficiencies of the Maastricht Treaty which have allowed the imbalances to develop. The euro is in what I call a far-from-equilibrium situation. But I prefer to discuss this subject in Germany, which is the lead actor, and I plan to do so at the Humboldt University in Berlin on June 23. I hope you will forgive me if I avoid the subject until then.

[Nov 24, 2010] Fighting America's 'Financial Oligarchy'

The FED is part of the oligarchy. The financial debacle is actually a political crisis. The country was converted into Bankostan. And the dominant ideology of Bankostan is  "What is good for financial oligarchy, is good for America" runs deep and have strong supporters such as Goldman.  This is all about power and with Obama who definitely wants some lucrative position after presidency there is no chance that government will take strong stance of the vampire squid.  The question is: what is the countervailing force to fight financial oligarchy? I see none.  If crisis became more deep then countervailing forces can large, but right now financial oligarchy is still calling all the shots.
April 15, 2009 | NPR

Former International Monetary Fund chief economist Simon Johnson has advised many countries in financial crisis. When it comes to America's current economic woes, Johnson says that U.S. suffers from "financial oligarchies" — government officials and elite members of the financial sector that run the country like a profit-seeking company.

In his article "The Quiet Coup" in the May issue of The Atlantic Monthly, Johnson explains that the close connections between government officials and financial leaders are a major part of the U.S.'s economic problems:

"We face at least two major, interrelated problems," Johnson writes. "The first is a desperately ill banking sector that threatens to choke off any incipient recovery that the fiscal stimulus might generate. The second is a political balance of power that gives the financial sector a veto over public policy, even as that sector loses popular support."

Johnson insists the U.S. must temporarily nationalize banks so the government can "wipe out bank shareholders, replace failed management, clean up the balance sheets, and then sell the banks back to the private sector." But, Johnson adds, the U.S. government is unlikely to take these steps while the financial oligarchy is still in place.

Unless the U.S. breaks up its financial oligarchy, Johnson warns that America could face a crisis that "could, in fact, be worse than the Great Depression — because the world is now so much more interconnected and because the banking sector is now so big."

Johnson was the chief economist at the International Monetary Fund during 2007 and 2008. He is a professor at MIT's Sloan School of Management

R H (littlehunt):

Oligarchy is the perfect word to use for America. We aren't truly democratic or capitalist. Oligarchy properly describes our economics and politics and the way in which our country has truly come to function. 9 out of 10 of those who control everything in America (and the world for that matter) aren't elected by anyone and are usually never known to the average person.

BJ Bonin (Seismic):

What Mr. Johnson points out that the financial debacle is actually a political crisis. The "in" corporations will continue to pocket taxpayer money until their political power is broken a la Teddy Roosevelt vs. Standard Oil.

For example: Goldman Sachs posted a record profit after taking billions in TARP money though the front door, receiving billions more in taxpayer money via AIG though the back door, and finally billions in fees for underwriting government bailout money for other corporations through the sewers. The taxpayers are NOT bailing out Goldman Sachs, rather Goldman Sachs (and their cohorts) are looting the United States of America. This is the biggest heist in history, and the Federal Government is helping them do it.

[Nov 24, 2010] The World’s Financial System Has Become Unstable

Economist's View

Simon Johnson argues that while China bears some responsibility, the main reason that the world "is on the brink of a nasty confrontation over exchange rates" ... is ... Europe’s refusal to reform global economic governance, compounded by years of political mismanagement and self-deception in the United States."

But his main concern is not the prospect of a currency war, it's the stability of the world's financial system:

Who Caused the Currency Wars?, by Simon Johnson, Commentary, Project Syndicate: ...the US has run record current-account deficits over the past decade, as the political elite – Republican and Democrats alike – became increasingly comfortable with overconsumption. These deficits facilitate the surpluses that emerging markets such as China want to run...

Leading Bush administration officials used to talk of the US current-account deficit being a “gift” to the outside world. But, honestly, the US has been overconsuming – living far beyond its means – for the past decade. The idea that tax cuts would lead to productivity gains and would pay for themselves (and fix the budget) has proved entirely illusory. ...

[T]he net flow of capital is from emerging markets to the US – this is what it means to have current-account surpluses in emerging markets and a deficit in the US. But the gross flow of capital is from emerging market to emerging market, through big banks now implicitly backed by the state in both the US and Europe. From the perspective of international investors, banks that are “too big to fail” are the perfect places to park their reserves – as long as the sovereign in question remains solvent. But what will these banks do with the funds?

When a similar issued emerged in the 1970’s – the so-called “recycling of oil surpluses” – banks in Western financial centers extended loans to Latin America, communist Poland, and communist Romania. That was not a good idea, as it led to a massive (for the time) debt crisis in 1982.

We are now heading for something similar, but on a larger scale. The banks and other financial players have every incentive to load up on risk as we head into the cycle; they get the upside (Wall Street compensation this year is set to break records again) and the downside goes to taxpayers.

The “currency wars” themselves are merely a skirmish. The big problem is that the core of the world’s financial system has become unstable, and reckless risk-taking will once again lead to great collateral damage.

Won't the recent resolution authority announced by the FDIC end the too big to fail problem and the moral hazard (excessive risk taking) that comes with it? It's not clear that it will:

This is the Republican strategy for beating back effective regulation: just claim that what we’re really doing is telling big banks, sternly, that there will be no more bailouts — they’re not too big to fail.

And then, when the next financial crisis arrives — well, it will play just like 2008. President Palin or whoever will find themselves staring into the abyss — and conclude that they have to bail out the financial sector anyway.

In a crisis, the financial system will be bailed out. That’s just a fact of life. So what we have to do is regulate the system to reduce the chances of crisis and the taxpayer costs when the bailout occurs.

In addition, attempts to come to agreement on international resolution authority have not gone well, and it's not clear that an agreement will be reached anytime soon. If banks will be bailed out in a crisis, then they have an incentive to take on too much risk, and strict regulation is needed to prevent that from happening.


"In a crisis, the financial system will be bailed out. That’s just a fact of life."

"If banks will be bailed out in a crisis, then they have an incentive to take on too much risk, and strict regulation is needed to prevent that from happening."

What the bankers are going is extortion: "give us more money to lose or your economy gets destroyed." In 2008, the government made it clear that they did not have the stomach to risk a much deeper, but shorter, downturn to hold the bankers accountable. That bailout, as well as related programs, such TLGP, which guaranteed bank bonds through 2012, made it financially and cognitively harder for the politicians avoid future bailouts. (Consider how hard it is for people to walk away from a losing investment.) Once then-Senator Obama voted for TARP, he became beholden to the bankers whether he knew it or not.

The bankers have every incentive to allow or create more "crises" so that the taxpayers will shift more of the banks' losses on to the public. The endless media campaign justifying past bailouts, and warning of the risk of discouraging future bailouts, are intended to prepare the American people for this fact.

There are two historical precedents that may apply here: Barbary pirates and the Cold War. In both cases, the other side's demands for endless concessions were stopped by showing the other side that they had something to lose and that American people were willing to sacrifice to make sure that they did lose. Unless modern Americans are willing to sacrifice to show that the bankers can lose everything, the endless bailouts will continue.

If early 19th Century Americans had, instead of deciding "millions for defense, one cent for tribute," continued to pay the Barbary pirates protection money and allowed them to abduct our citizens as White slaves, we would still be sacrificing to bailout the pirates and their business model. Every time they needed more money, they would create another "piracy crisis."

During the Cold War, both sides understood that a major attack on either side would quickly result in the Mutually Assured Destruction (MAD) of both sides. As long as both sides knew that the the other could and would destroy them, the US and USSR avoided large-scale direct conflict, preferring wars in Korea, Vietnam, Afganistan, and the USSR crushing popular uprisings in Hungary, East Germany, Poland, and Czechoslovakia.

Here, the bankers need to be made to understand that, if they credibly threaten the American economy, we would let them completely fail no matter the cost. TARP showed that we were not willing to do this. Just as the elites in the USSR did not want to preside over a nuclear wasteland, the bankers do not want to preside over banks and shadow banks that are completely bankrupt and holding debts that no one will enforce. Unless and until the bankers are made to understand that the US government is willing to take the bankers down with us, these bailouts will continue.

Shadow Banking and Financial Regulation — The Harvard Law School Forum on Corporate Governance and Financial Regulation

Posted by Morgan Ricks, Harvard Law School, on Saturday September 18, 2010 at 10:11 am

Tags: , , , , ,

Editor’s Note: Morgan Ricks is a visiting assistant professor at Harvard Law School. Through June 2010, he was a Senior Policy Advisor and Financial Restructuring Expert at the U.S. Treasury Department. The views expressed herein do not necessarily reflect the views of the Department of the Treasury or the U.S. Government. This post is based on his paper “Shadow Banking and Financial Regulation,” available here.

Without a safety net, banking is unstable. This proposition finds support in economic theory. In an influential analysis, Douglas Diamond and Philip H. Dybvig showed that banks without deposit insurance exhibit multiple equilibria—one of which is a bank run. [1] And financial history confirms this hypothesis. Banking panics were common in the U.S. before the enactment of deposit insurance, but nonexistent thereafter.

The apparent instability of banking has given rise to a standard policy response in the form of a social contract (a phrase borrowed from a marvelous speech by Paul Tucker of the Bank of England). [2] That contract entails certain privileges that are unavailable to other firms: most notably, access to central bank liquidity and federal deposit insurance. These privileges amount to a safety net, and they stabilize banking. The social contract also imposes obligations—activity restrictions, prudential supervision, capital requirements, and deposit insurance fees. These obligations are designed to counteract the moral hazard incentives implicit in the safety net and protect taxpayers from losses.

Historically, this social contract has been limited to depository banking—firms that take deposits and use them to invest in illiquid loans. This limitation is not surprising. At the time the social contract was established, and for decades thereafter, depository banking was the dominant form of credit intermediation in the U.S. financial system.

In recent years, however, this situation changed. A set of institutions emerged that performed the basic functions of depository banks, but without submitting to the terms of the social contract. Indeed, the very existence of many of these institutions has been predicated on being free from inconvenient constraints. Collectively, these institutions have come to be known as the “shadow banking” system.

The term “shadow banking” suggests something mysterious or elusive, but the reality is rather mundane. As used herein, “shadow banking” refers simply to maturity transformation—the funding of pools of longer-term financial assets with short-term (that is, money-market) liabilities—that takes place outside the terms of the banking social contract. A non-exhaustive list of shadow banking institutions would include: repo-financed dealer firms; [3] securities lenders; structured investment vehicles (SIVs); asset-backed commercial paper (ABCP) conduits; some varieties of credit-oriented hedge fund; and, most importantly, money market mutual funds, which absorb other forms of short-term credit and transform them into true demand obligations.

These institutions share a common feature: They obtain financing at short duration through the money markets, and they invest these funds in longer-term financial assets. This activity is the essence of “banking,” and the short-term financing sources on which it relies are the functional equivalent of bank deposits. The quantity of uninsured short-term liabilities issued by financial firms is the most meaningful measure of shadow banking. And, by this measure, shadow banking came to far surpass depository banking in its aggregate scale.

Importantly, while the social contract (and the associated safety net) applies only to depository banks, the instability of maturity transformation does not observe such formalities. Runs and panics are not limited to “banking” narrowly defined. Rather, they are more general phenomena. As the Diamond-Dybvig paper observes, any firm that funds long-term assets with short-term obligations will exhibit the same unstable qualities. Put differently, there is no characteristic unique to bank deposits that creates the propensity for liquidity crises. The short-term obligations of shadow banks are just as susceptible to runs and panics.

The instability of shadow banking became apparent in the recent financial crisis. Indeed, at the height of the crisis, very nearly the entire emergency policy response was designed to prevent shadow bank defaults through a series of “temporary” and “extraordinary” interventions. These interventions were very likely necessary to prevent an economic catastrophe and were skillfully executed. Their success is a testament to the determination and skill of a group of dedicated public servants. Still, no one views this situation as a triumph of policy.

The discussion above makes no claims to novelty. Various strands of this narrative have appeared in works by Timothy Geithner, Gary Gorton, Paul Krugman, and Paul Tucker, among other places. [4] But this discussion raises an obvious question: If the safety net is conducive to stability, why not extend it to shadow banks?

The conventional response is that the perimeter of the safety net should not expand—that it should, if anything, contract. The reason is moral hazard. Extending the safety net to shadow banking would vastly expand the government’s explicit commitments to the financial system. And safety nets encourage risky behavior, giving rise to inefficient resource misallocation and burdening taxpayers with losses once insurance funds are exhausted. This line of reasoning implies that, far from extending the safety net, we should look for ways to reinforce “market discipline” by short-term creditors of maturity-transformation firms. (Retail-oriented deposit insurance is generally admitted as an exception, on consumer protection grounds.)

Advocates of this conventional view often acknowledge that shadow banking poses a problem for financial stability. However, they typically propose that this problem be addressed not with a safety net, but rather with regulatory restrictions—such as risk controls, supervision, and capital requirements. In other words, their solution is to apply to shadow banks the obligations, but not the privileges, of the banking social contract. (The recent financial reform bill, insofar as it addresses shadow banking at all, more or less adopts this approach.)

But even proponents of this risk-constraint approach admit that it has shortcomings. First, regulatory risk constraints are costly from an efficiency perspective: They reduce credit formation and commercial activity. And second, there is no identifiable level of such constraints that is certain to ensure stability. Indeed, the Diamond-Dybvig view implies that only a safety net for short-term creditors can ensure stability by addressing the basic collective action problem that produces run-behavior. If this view is correct, then “market discipline” by the short-term creditors of maturity-transformation firms is inconsistent with systemic stability—indeed, runs and panics are the very manifestations of market discipline by short-term creditors.

This discussion seems to point toward a discouraging conclusion: Either we extend the safety net to cover shadow banking, resulting in a very substantial expansion of explicit government commitments to the financial system; or we seek to reduce the instability of shadow banking through regulatory risk constraints alone, and learn to live with a costly and incomplete response to the shadow banking problem.

But perhaps the question should be posed in a slightly different fashion. We have asked whether the social contract (including the safety net) should be extended to shadow banks—a question that implicitly takes the dimensions of the existing maturity-transformation industry as a given. But if the objective is to ensure that all maturity transformation takes place within the social contract, there is of course another alternative: We might disallow financial firms outside the banking social contract from engaging in maturity transformation—that is, preclude such firms from financing themselves in the money markets (i.e., require them to “term out” or rely on “term funding,” in industry parlance).

And, of course, it is possible to adopt a combination of both techniques. We might expand access to the social contract to include some categories of firms that are currently shadow banks, while disallowing the remaining shadow banks from conducting maturity transformation. In any case, the phenomenon of “shadow banking” would no longer exist. By definition, shadow banks brought within the social contract would no longer be “shadow” banks, but rather just banks. And shadow banks precluded from relying on money-market funding would no longer be shadow banks, but rather term-funded financial intermediaries of one type or another. (In reality, many of these institutions would not be economically viable on a term-funded basis.)

This approach would represent a significant departure from existing methods of financial regulation. It would impose legal funding restrictions on many types of financial intermediaries that traditionally have enjoyed unfettered access to the institutional money markets. And it would necessitate the development of functional policy criteria to determine eligibility to engage in maturity transformation.

The author’s recent paper, Shadow Banking and Financial Regulation, explores some of the implications of this approach to financial stability regulation from the standpoint of economic efficiency, and compares it with available alternatives.

The full paper is available for download here.


[1] Douglas W. Diamond and Philip H. Dybvig, “Bank Runs, Deposit Insurance, and Liquidity,” Journal of Political Economy (1983) 91, 401–19.
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[2] Paul Tucker, “Shadow Banking, Financing Markets and Financial Stability,” Remarks to BGC Partners Seminar (2010).
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[3] A shadow bank can exist within a consolidated group that contains one or more insured depositories. The most obvious examples are the dealer operations of the large money-center banks (JP Morgan, Bank of America, and Citigroup). Those operations rely heavily on overnight financing through the repo markets.
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[4] Timothy Geithner, “Reducing Systemic Risk in a Dynamic Financial System,” Remarks at the Economic Club of New York (2008); Gary Gorton, “Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007,” paper prepared for the Federal Reserve Bank of Atlanta’s 2009 Financial Markets Conference (2009); Paul Krugman, The Return of Depression Economics and the Crisis of 2008 (2009); Paul Tucker, “Shadow Banking, Financing Markets and Financial Stability,” Remarks to BGC Partners Seminar (2010).
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[Sep 19, 2010] Our Best Economic Minds Are Failing Us by Michael Hirsh


The most terrifying moment in modern economic history occurred two years ago this month. For several long days after the fall of Lehman Brothers on Sept. 15, 2008, the financial system was in danger of total collapse, and the United States seemed on the precipice of another Great Depression in that “Black September.” Just as bad, our economists and senior policymakers had barely any idea why this was happening. The assumptions of an entire era had been proved wrong. The “Great Moderation”—the period of post–Cold War prosperity in which capitalism was said to have been tamed and risk mastered—was revealed to be an illusion. Alan Greenspan professed his “shocked disbelief” that the Wall Street institutions he had trusted in were so reckless as to blow themselves up. “The whole intellectual edifice has collapsed,” the former Fed chairman told Congress that fall. Economists said they would have to come up with new theories for how markets worked, in particular how the financial system functioned and interacted with the “real” economy. “Large swaths of economics are going to have to be rethought on the basis of what happened,” Larry Summers, the presidential adviser who doubles as a world-renowned economist, told me in an interview shortly after Barack Obama took office.

Two years on, that rethinking has barely begun, and only with the most painful reluctance by economists. Meanwhile, policy and political debates still driven by outdated economic theory have been racing out of control, bitterly dividing the nation. Whether the arguments are about stimulus, financial reform, health care, or jobs, the discussions in Washington tend to be dominated by simplistic black-and-white views that are little different from the conceptual framework that prevailed before the collapse: markets always work better than governments. Advocates of government spending are socialists. Champions of markets are laissez-faire ideologues or slaves of Wall Street. And never the twain shall meet. A vast new regulatory framework has been set in motion, but many experts say it has done little to change the way Wall Street or the real economy functions, and there is no new economic theory underlying it.

The Financial Meltdown's Best Quotes

The Financial Meltdown's Best Quotes The failure of the economics profession to address our deeper problems theoretically is mirrored by the failure of other sciences on a more practical level. To wit: America’s best minds are still heading to Wall Street to an unnerving, even pathological degree—further evidence that finance remains the dominant sector of the economy. The evolution of the financial sector’s trading and banking practices into arcane rocket science in recent decades had a lot to do with…rocket scientists. After the end of the Cold War and the collapse of the Soviet Union in late 1991, top physicists and engineers and other major-league brains weren’t needed as much. With the advent of the “peace dividend” (read: Pentagon cuts), many of them headed for Wall Street and became “quants.” This trend brought two new, big things to Wall Street: a whole-new level of intellectual horsepower—the upper reaches of the IQ scale—and a new layer of important players who had no reason to doubt that markets worked as formulaically as the weapons systems they had once puttered over. That’s partly how “structured finance,” derivatives, and other products have grown so complex that not only regulators but even Wall Street CEOs can no longer understand them.

Yet this trend in turn can’t change without a reordering of what economists call “incentives.” Pay scales on Wall Street continue to outstrip those in other professions outrageously. The Obama administration and Congress have done little legislatively or through use of the bully pulpit to try to reorient compensation practices so that perhaps some of our greatest minds won’t go into useless financial engineering but instead will begin to consider real engineering again. Wall Street execs have been whining for two years that to reduce pay incentives and bonuses would cost the firms their best talent. The government’s response should be YES! That’s precisely the idea. Finance was once a means to an end: the growth of the real economy. Banking once served industry and services. Now finance has become the end, and the real economy is subservient to financial services (it’s no surprise that after the crisis, over-the-counter derivatives trading quickly climbed back up to more than $600 trillion). “At some point in our recent past, finance lost contact with its raison d’être,” European Central Bank chief Jean Claude Trichet said earlier this year. “Finance developed a life of its own…Finance became self-referential.” As long as this pathological state of affairs persists, questions of global growth and social welfare will continue to depend on Wall Street and the enduring fallacies of free-market finance.

Recently, the National Science Foundation sent out a query asking economists and social scientists to draw up “grand challenge questions that are both foundational and transformative”—a request that one recipient, Andrew Lo, a highly regarded financial economist at MIT, says is a first in his experience. But one problem is that the economics profession “has gotten much more intolerant of divergence from orthodoxy,” says Philip Mirowski, an economic historian at Notre Dame. “The range in which dissent happens is so narrow. In a sense they still cannot imagine the system can operate to undermine itself. That is not a position that is allowed anywhere in the economics profession. The field got rid of methodological self-criticism. This Great Moderation stuff was just arrogance, hubris.” Indeed, the joke on economists, says one of them, Rob Johnson, is that they create simplistic models that depend on people behaving as rational actors motivated by self-interest, yet “they have a blind spot regarding themselves.” The way they squabble mulishly to defend now-indefensible positions is itself evidence of how flawed those rational-actor models are.

New thinkers say they are still having trouble breaking in. Among the new NSF grant awardees is J. Doyne Farmer, a physicist at the Santa Fe Institute who is trying to bring the idea of complexity back into economics by making use of advanced computing power to map human economic behavior the way weather or climate change is tracked. But Farmer says he got his $450,000 grant for a three-year study of systemic risks in markets only after a sympathetic NSF case officer overruled negative assessments by “neoclassical economists” who reject any model that doesn’t tend toward general equilibrium. “The established view just holds this stuff back,” Farmer says. “One of the dangerous cultural patterns that economics has fallen into is an excessive emphasis on theorem proof for its own sake rather than what gives you scientific results. That’s led to a disdain for computer simulation.” Johnson, who is director of the new Institute for New Economic Thinking funded by George Soros, says: “You do see some new thinking, but it doesn’t get traction in terms of policy. It’s a symptom of how far right society has gone.”

The great names in the profession have not necessarily helped. The top economists in the Obama administration—Summers; Christina Romer, the just-departed chair of the Council of Economic Advisers; and her replacement, Austan Goolsbee—are all part of the orthodoxy. Critics say Summers should know as well as anyone how the old thinking has been outstripped. As a Harvard professor, Summers wrote after the 1987 stock-market crash that it was impossible to believe any longer that prices moved in rational response to fundamentals. He even cautiously advocated a tax on financial transactions. Yet Summers, one of the world’s most astute economists, later abandoned these positions in favor of Greenspan’s view that markets will take care of themselves. And in the current era, Summers and the rest of the Obama team seem to have underestimated the depth and systemic nature of the economic crisis. Stimulus spending was timid (in deference to political antipathy to big government), mortgage workouts meager, and financial reform minimalist. The administration maintains it did as much as it could under the political constraints, but others disagree. “The financial-reform bill and other changes in the regulatory landscape are more incremental,” says MIT’s Lo. “It’s a reaction to the most immediate set of events as opposed to a more profound rethinking about the underlying causes of the crisis.”

A little history is in order here: it was largely because the field of economics came to be dominated by “neoclassical” thought—or the idea that markets are rational and can reach “equilibrium” on their own—that so-called financial innovation on Wall Street was allowed to run amok in recent decades. That led directly to the crisis of 2007–09. No matter how crazy or complex the products got, the theory was that, with little government oversight, the inherent stability of markets would keep things from getting too out of hand. It was in large part because of this way of thinking that government intervention of any kind in the markets, including regulation, came to be seen as a kind of heresy, especially after the Soviet Union collapsed and command economies and “statism” were thoroughly discredited.

The new financial-reform law has changed that to some degree, but it still leaves most of the major decisions about government oversight to the same regulators who failed last time. We are still, to a large extent, flying blind in conceptual terms. Just as the Great Depression demonstrated to John Maynard Keynes and his followers that markets often behaved badly—leading to the Keynesian reinvention of economics in the ’30s—this present crisis drove home the truth, or should have anyway, that rational models of markets don’t work well because there are too many unknowns. People most often don’t behave as rational actors. There is no real equilibrium in the real world. Above all, market economies are capable of destroying themselves. This is especially true in the world of finance, which has always worked according to different rules than other sectors of the economy and is much more prone to panics and manias. In 1983, a young Stanford economist named Ben Bernanke published the first of a series of papers on the causes of the Great Depression. The financial system, Bernanke said, was not unlike the nation’s electrical grid. One malfunctioning transformer can bring down the whole system. “I’ve never had a laissez-faire view of the financial markets,” Bernanke told me, “because they’re prone to failure.” Even Friedrich Hayek, the godfather of 20th-century laissez-faire thinking, believed that financial markets were more subject “to bouts of instability,” says one of his biographers, Bruce Caldwell of Duke University, a self-described libertarian scholar.

Yet amid the free-market triumphalism of the post–Cold War era, all this hard-won wisdom about the differences in finance was forgotten or ignored. To policymakers in Washington, it seemed silly and nitpicky to treat finance as a different animal. The dominant thinkers were the “rational expectations” economists of the Chicago school who simply assumed capital flows, no matter how open, would be stable.

We now know differently. But the question remains: how should we think about our outsized financial sector now, and how can it be made to serve the larger economy—rather than the other way around? Shouldn’t we have learned our lesson from the Great Recession, just as economists did after the Great Depression? Should there not be a new economics that develops fresh concepts reordering the balance between markets and governments, accepting the necessity of both? The great economist Paul Samuelson used to say, paraphrasing the physicist Max Planck, that “economics progresses one funeral at a time.” It was necessary for the old lions to pass on, in other words, before new seminal thinking took hold. But we may not have time to wait upon funerals. Policy is driving relentlessly ahead, and the economics profession and other sciences have been left far behind.

Hirsh is the author of the newly published Capital Offense: How Washington’s Wise Men Turned America’s Future Over to Wall Street.

[Sep 19, 2010] Capital Offense How Washington's Wise Men Turned America's Future Over to Wall Street (9780470520673) Michael Hirsh Books

How the best and brightest led us into economic disaster, September 12, 2010 Wayne Klein

Ever wonder how America got into the fine economic mess it's in? "Capital Offense: How Washington's Wise Men Turned America's Future Over to Wall Street" tells you right in the title. Somehow Washington has confused what's good for Wall Street as what's good for the national economy.

Author Michael Hirsh takes us to the root of the problem going back to the fall of the USSR, the charismatic economic guru Milton Friedman and a political climate where both parties dismantled the organizations that policed Wall Street (making the same mistake that occurred just prior to the Great Depression) going as far back as the Reagan Administration. The absurd idea that any company will police itself and that it is in a company's best interest to be honest and produce good products without flaws is at the heart of the deregulation of Wall Street allowing the creation of products that increasingly became so complex that it took people with advanced degrees in mathematics to understand them.

Hirsch creates a breezy surprisingly enjoyable reading experience for a neophyte like myself who wouldn't claim to understand every element of our complex economy but who has enough common sense to recognize if you leave money out without any supervision, someone will steal it. While we had economic gurus like Greenspan and Friedman pushing for less and less regulation, we saw more and more money being put on the table. I won't pretend to understand the complexities of derivatives or how Wall Street packaged high risk commodities without full disclosure but Hirsh's book made me aware of enough of the foolishness in Washington from lobbyists lining the pocket's of those in Washington to folks like Rubin discounting alarms raised by Born because of their sex or simply because THEY didn't come up with it themselves. Ego drives the economy and it also can drive us to disaster.

Hirsh's book gives us the history of how America thrived under Keyesian policies, continuing to thrive under Friedman's philosphy until lobbyists and the government proceeded to dismantle the departments that policed Wall Street. As the products became increasingly complex where Wall Street often didn't understand them and higher risks were taken, America's economy began to fall apart culminating in the collapse of major banking/investing institutions. Often full disclosure as to how high risk the investments were might not be dislcosed (which, for example, caused the investments of an entire city in Ohio to be worth nothing)putting cities, states and investors at risk for major losses.

For example when Brooksley Born the chairwoman of the Commodity Futures and Trading Commission became alarmed by the size and lack of regulation (as well as understanding) of the derivatives market and the big Wall Street firms involved in marketing these to investors, she went to Bob Rubin. She was also concerned tha Congress was going to be passing more resolutions "freeing" the Wall Street giants allowing tehm to play fast and loose with trading derivatives. She found herself attacked by Bob Rubin (and sexism reared its ugly head as part of this attack because she was a "woman" trying to prevent disaster in a "man's market")and found his and other departments in the back pocket of Wall Street (or departments run by former Wall Street CEO's)trying an end run behind her back to prevent her from doing anything from preventing the looming economic disaster she warned her colleagues and superiors about.

It's easy in retrospect for those who prevented Born from doing her job and protecting our national economy to claim they didn't see the disaster coming but the irony is that they were TOLD by someone they discounted without looking into her evidence. They chose to remain ignorant and blindly led the U.S. economy into the worst meltdown in decades by refusing to remove the blinders that industry cheerfully provided them with.

Hirsh makes a compelling argument for the conflict of interest of pulling individuals from industry to oversea our economic policy. He documents how the disaster occurred methodically and with detail. He's also pretty fair balanced in terms of assigning credit where its due to those who helped avert disaster (Rubin by bailing out Wall Street and preventing a depression)and led us right into its mouth (Rubin and his ilk by ignoring ALL the warning signs).


[Sep 15, 2010] Why Do We Keep Indulging the Fiction That Banks Are Private Enterprises

September 15, 2010 | naked capitalism

It may seem perverse to use a particularly strong piece by Martin Wolf of the Financial Times, who even on his intermittent less than stellar days is at reasoned and readable, to illustrate a deep rooted problem that even critical thinkers in the mainstream media have in dealing with the financial crisis, namely, that certain ways of framing issues are simply off limits. But those forbidden vantages are sometimes the most descriptive and potentially the most effective in galvanizing public opinion.

Wolf’s article today is a wonderful bit of high dudgeon, a shredding of Basel III, the latest incarnation of BIS rules on bank capital (our Richard Smith was similarly less than impressed and provided more detail on the shortcomings). Treasury Secretary Geithner, who tacitly admits that the so-called Dodd Frank bill fell short of the level of intervention needed to prevent another financial crisis, has taken to touting the idea that getting enough capital into the banking system will do the trick., which means he is effectively fobbing the problem off on Basel III.

Now narrowly speaking, the idea that enough bank capital would do a lot to prevent future crises isn’t wrong, but it begs the question of what “enough” is. Absent a lot of other coordinated measures (constraints on off balance sheet entities, much tougher accounting, limits on rehypothecation, securitization reform), “enough” would need to be a very big number. Steve Waldman, who wrote a definitive post on why bank equity figures are at best a conjecture, put the needed level of bank equity ex other measures at 30% of assets, a level that Wolf independently deems to be within the required range.

It’s great fun to see the Basel III rules, which for the most part been treated with undue reverence by the media and many commentators, get the drubbing they deserve. Per Wolf:

To celebrate the second anniversary of the fall of Lehman, the mountain of Basel has laboured mightily and brought forth a mouse. Needless to say, the banking industry will insist the mouse is a tiger about to gobble up the world economy. Such special pleading – of which this pampered industry is a master – should be ignored: withdrawing incentives for reckless behaviour is not a cost to society; it is costly to the beneficiaries. The latter must not be confused with the former. The world needs a smaller and safer banking industry. The defect of the new rules is that they will fail to deliver this.

Am I being too harsh? “Global banking regulators . . . sealed a deal to . . . triple the size of the capital reserves that the world’s banks must hold against losses,” says the FT. This sounds tough, but only if one fails to realise that tripling almost nothing does not give one very much…. the new standards are also to be implemented fully by 2019, by when the world will probably have seen another financial crisis or two.

This amount of equity is far below levels markets would impose if investors did not continue to expect governments to bail out creditors in a crisis, as historical experience shows (see chart). It would not take much of a disaster to bring such leveraged entities close enough to insolvency to panic uninsured creditors….. We might think of the new requirements as a “capital inadequacy ratio”.

Wolf then points out that the banking industry has managed to gin up analyses, using dubious assumptions, that endeavor to show that considerable cost to growth of higher bank capital levels. Funny, then, that the far from bank-unfriendly BIS did its own assessment and its estimate was 1/8 the level of the banking industry scaremongers.

Wolf then comes perilously close to making a fundamentally important observation, but pulls back (emphasis ours):

We cannot assess the costs of regulation without recognising a few facts: first, both the economy and the financial system have just survived a near death experience; second, the costs of the crisis include millions of unemployed and tens of trillions of dollars in lost output, as the Bank of England’s Andy Haldane has argued; third, governments rescued the financial system by socialising its risks; finally, the financial industry is the only one with limitless access to the public purse and is, as a result, by far the most subsidised in the world.

Read the boldfaced part again. Big finance has an unlimited credit line with governments around the globe. “Most subsidized industry in the world” is inadequate to describe this relationship. Banks are now in the permanent role of looters, as described in the classic Akerlof/Romer paper. They run highly leveraged operations, extract compensation based on questionable accounting and officially-subsidized risk-taking, and dump their losses on the public at large.

But the subsidies go beyond that. To list only a few examples: we have near zero interest rates, which allow bank to earn risk free profits simply by borrowing short and buying longer-dated Treasuries. We have the IRS refusing to look into violations of REMIC rules, which govern mortgage securitizations. We have massive intervention to prop up real estate prices, with the main objective to shore up banks; any impact on consumers is an afterthought.

The usual narrative, “privatized gains and socialized losses” is insufficient to describe the dynamic at work. The banking industry falsely depicts markets, and by extension, its incumbents as a bastion of capitalism. The blatant manipulations of the equity markets shows that financial activity, which used to be recognized as valuable because it supported commercial activity, is whenever possible being subverted to industry rent-seeking. And worse, these activities are state supported.

Consider Fannie and Freddie pre-conservatorship. They were at least branded more accurately as “government sponsored enterprises” and “agencies” making their public/private role explicit. Yet they were over time allowed more and more latitude to act as private enterprises, particularly as far as employee pay was concerned. We know how that movie ended.

Consider now the banking industry. Admittedly, banks do not fund at the tight spreads over Treasuries that Freddie and Fannie enjoyed pre-crisis, and regulators are trying to convince investors and the broader public that they will allow big banks to be resolved and are prepared to impose losses on bondholders, but does anyone believe this will happen? Winding down even a medium sized broker-dealer is a market-disrupting activity, and the “living wills” requirement looks like window dressing. But aside from the saber rattling of Pimco about why bondholders needed to be spared any pain, we also heard troubling rationalizations, such as bank bonds are held by pension funds. Well, yes, it’s risk capital. Investors are supposed to diversify holdings and losses are part of the game. And perhaps most important reason during the crisis for not cramming down bondholders was fear of contagion: imposing losses on bondholders of one bank would lead bondholders of other at-risk firms to run for the exits, raising their funding costs and potentially putting them in a death spiral.

So, the reality is that banks can no longer meaningfully be called private enterprises, yet no one in the media will challenge this fiction. And pointing out in a more direct manner that banks should not be considered capitalist ventures would also penetrate the dubious defenses of their need for lavish pay. Why should government-backed businesses run hedge funds or engage in high risk trading, or for that matter, be permitted to offer lucrative products that are valuable because they allow customers to engage in questionable activities, like regulatory arbitrage? The sort of markets that serve a public purpose should be reasonably efficient and transparent, which implies low margins for intermediaries.

A good post by Jay Rosen of NYU explains why this sort of observation don’t get traction with the press and why that is undermining its legitimacy:

In the age of mass media, the press was able to define the sphere of legitimate debate with relative ease because the people on the receiving end were atomized– connected “up” to Big Media but not across to each other. And now that authority is eroding….

Picture 24

1.) The sphere of legitimate debate is the one journalists recognize as real, normal, everyday terrain. They think of their work as taking place almost exclusively within this space. (It doesn’t, but they think so.) [Daniel] Hallin: “This is the region of electoral contests and legislative debates, of issues recognized as such by the major established actors of the American political process.”…

Perhaps the purest expression of this sphere is Washington Week on PBS, where journalists discuss what the two-party system defines as “the issues.” Objectivity and balance are “the supreme journalistic virtues” for the panelists on Washington Week because when there is legitimate debate it’s hard to know where the truth lies. There are risks in saying that truth lies with one faction in the debate, as against another— even when it does. He said, she said journalism is like the bad seed of this sphere, but also a logical outcome of it.

2. ) The sphere of consensus is the “motherhood and apple pie” of politics, the things on which everyone is thought to agree. Propositions that are seen as uncontroversial to the point of boring, true to the point of self-evident, or so widely-held that they’re almost universal lie within this sphere. Here, Hallin writes, “journalists do not feel compelled either to present opposing views or to remain disinterested observers.” (Which means that anyone whose basic views lie outside the sphere of consensus will experience the press not just as biased but savagely so.)….Whereas journalists equate ideology with the clash of programs and parties in the debate sphere, academics know that the consensus or background sphere is almost pure ideology: the American creed.

3.) In the sphere of deviance we find “political actors and views which journalists and the political mainstream of society reject as unworthy of being heard.” As in the sphere of consensus, neutrality isn’t the watchword here; journalists maintain order by either keeping the deviant out of the news entirely or identifying it within the news frame as unacceptable, radical, or just plain impossible. The press “plays the role of exposing, condemning, or excluding from the public agenda” the deviant view, says Hallin. It “marks out and defends the limits of acceptable political conduct.”

Anyone whose views lie within the sphere of deviance—as defined by journalists—will experience the press as an opponent in the struggle for recognition. If you don’t think separation of church and state is such a good idea; if you do think a single payer system is the way to go; if you dissent from the “lockstep behavior of both major American political parties when it comes to Israel” (Glenn Greenwald) chances are you will never find your views reflected in the news. It’s not that there’s a one-sided debate; there’s no debate.

Yves here. Ambrose Bierce, in The Devil’s Dictionary, described a partnership as “When two thieves have their hands so deeply plunged into each other’s pockets that they cannot separately plunder a third party.” Pointing out that banks are de facto partners of the state, enjoying substantial privileges (that unlimited checkwriting on official coffers when things go bad, the ongoing subsidies, the lavish private sector pay) without commensurate duties opens a huge can of worms. It goes beyond the usual, relatively anodyne “privatized gains and socialized losses” and opens up the terrain of “What do we mean by private enterprise?” Part of the American ideology is that there is a hard line between government and business. But entire industries suck off the state with far too few strings attached. The black/white distinction is illusory; what we instead have is a gradient.

But looking hard at the degree of looting and abuse of taxpayers, particularly in light of lavish CEO pay, not only raises uncomfortable questions, but calls for remedies that are politically unpalatable. Even though the state is deeply involved in enterprise, our ideology is that explicit industrial policy or other forms of involvement is a bad thing, the government will screw it up (when in fact some foreign governments do a decent job but we’d never deign to learn from them). So we’d rather limp along with a defective and increasingly costly model than challenge deeply held political beliefs.

Tim Coldwell

At least it looks like the governor of the BofE gets it. 
The PolyCapitalist
Yves, your headline says it perfectly. The banking system is an an extension of the state and should be regulated accordingly. This includes compensation.

Krugman had a great article on this topic last year titled “Making Banking Boring”: 

Thanks for continuing to bring attention to this issue.

Richard Kline
Yves: “But the subsidies go beyond that. To list only a few examples: we have near zero interest rates, which allow bank to earn risk free profits simply by borrowing short and buying longer-dated Treasuries. We have the IRS refusing to look into violations of REMIC rules, which govern mortgage securitizations. We have massive intervention to prop up real estate prices, with the main objective to shore up banks; any impact on consumers is an afterthought.

The usual narrative, “privatized gains and socialized losses” is insufficient to describe the dynamic at work. The banking industry falsely depicts markets, and by extension, its incumbents as a bastion of capitalism. The blatant manipulations of the equity markets shows that financial activity, which used to be recognized as valuable because it supported commercial activity, is whenever possible being subverted to industry rent-seeking.”

Beneath the surface of most economic outcomes lies a political equation. This is why the discipline was originally ‘political economics.’ This was also why factions aligned with the political equation worked so very hard 1880-2010 to make economics a ’scientific discipline;’ which requires removing emotion; which means setting politics aside. Which means eating the poppy paste and facilitating the political equation.

Our political system has become captured by the wealthy. In consequence, it isn’t possible to fix our economic problems because the fix is in for the political equation underneath them. We’ll only get fairer economic outcomes if we overwrite the political equation. . . . No one said this was going to be easy.

Let’s be realistic. During the Go-Go Boom days prior to the Crash, bankers were lionized. Their images graced the covers of not only Fortune and Forbes, but Time, Newsweek, Vanity Fair and People (a dubious honor, I know). They were icons and conquering heroes, representing everything that was Good and Right about America and American Capitalism.

Then most Americans learned that they were living an illusion created and maintained by Wall Street and Washington. They got angry with all the wealth being made (stolen) by Wall Street. There was no revolt, though, since in their hearts Americans could not overcome their Horatio Alger delusions nor cast their Gods down from their pedestals.

Instead, Americans gnash their teeth, weep, and complain to Congress. And once the bubble starts inflating equally again, they will rain ticker tape down on the heads of the Geniuses of Wall Street who guided them through the Dark Days of the Great Recession and saw them safely out the other side. Wall Street is, for them, serving a public, national role as the provider of liquidity and the creator of wealth, therefore there is no problem with it suckly mightly at the public tit.

America has the political system and economy it wants. It will change when this system gets too far advanced, but for now the delusions are fully operative.

fresno dan
Very insightful post. I agree – it is one of those obvious things that is just not spoken of – the banking system is completely dependent upon the Federal Reserve – which would be an interesting debate in and of itself – does the FED exist to benefit the banks, or the public? As I have noted before, the FED believes in its heart that SAVING banks is good for the economy. If you have a system in which the failure of any one business causes a crisis, you don’t have a very good system, nor a free enterprize system.

“The sphere of legitimate debate is the one journalists recognize as real, normal, everyday terrain.” Why I read blogs – journalists arern’t bad people – they simply lack the training and knowledge to ask deep probling questions. So they stick to the “consensus” which can more accurately be characterized as a straitjacket. Undoubtedly why we get constant coverage of insane soapbox preachers in Florida.

This post is much appreciated, Yves.

We need to socialize the idea that the banking system is a leach that is killing the host.

Unfortunately, 99% of the population does not give a crap. As long as their supply chain pumps salt/fat/sugar when they push down on the handle, they will be uninterested in how/why it works. Someday they will push on the handle and a bubble will blow through.

Seems like that day is approaching rapidly.

Yes, the MSM is not just biased, and not just savagely biased, but a vicious attacker of the people.

….but calls for remedies that are politically unpalatable. Even though the state is deeply involved in enterprise, our ideology is that explicit industrial policy or other forms of involvement is a bad thing, the government will screw it up (when in fact some foreign governments do a decent job but we’d never deign to learn from them). So we’d rather limp along with a defective and increasingly costly model than challenge deeply held political beliefs.

It sounds like this is falling a little bit (terminologically) into the trap the post describes.

Putting real constraints on the banks (if not smashing them completely, which is what really needs to be done) wouldn’t be politically unpalatable at all to the people. There’s nothing “deeply held” about the self-justifications of these worthless criminal parasites. It’s only unpalatable to the criminal elite and their criminal media.

(On another terminological note, I wish people would make a point of purging the terms “earn” and “compensation” from discourse on this subject. “Pay” is objective in the journalistic sense, I suppose. “Extract” is technically neutral but has a richer connotation. “Loot”, “rob”, “steal” are rationally and morally true.)

Very interesting post indeed.

The concept of bank nationalization reminds me of the 80s. In that period several Capitalist countries did that to greater or lesser extent: France, Israel, Mexico, Sweden (in the 1990s). Within this major crisis several West European countries have also nationalized some or even most of their banks: Iceland, Ireland, Germany, Portugal.

Certainly banks, as borrowers of the state (or ‘looters’ as you say well) and key piece of the economy are too public to be merely private. A nationalization approach is in this case very reasonable, even within a pragmatic Capitalist ideology. Capitalism cannot exist in a void, after all it’s the state (and hence the national economy) which guarantees even the very existence of money, a reasonably safe market, private property… But today’s states are showing up as incredibly weak in most cases before Big Capital and this is particularly true and shocking in the case of the USA.

Rosen’s analysis of the media generated “spheres” is very interesting too. Left me wondering how can this be described now taking in account the Internet, which certainly breaks the system to at least some extent.

A great post.

When observed from afar, it is hard to notice mismanagement of an electrical power plant. The quality of power does not gradually deteriorate over time. Everything looks fine to the end user right up until the point that all the lights go off. And then everyone is screwed.

Banks by their very nature are vulnerable to sudden and spectacular collapse. We cannot observe mismanagement at a bank from a distance — through earnings reports and such — because banks are always well capitalized right up until the point that they are insolvent. But because banks are essential to the proper functioning of our economy, we have no choice but to bail them out when they fail.

We would never put the reliability of our electrical power supply in the hands of an unregulated marketplace. We can’t just let power companies fail, since everyone needs electricity. The same goes with banks. Banks serve a fundamental public purpose, and should be regulated like public utilities.

Parvaneh Ferhad
I enjoyed reading this post, it’s spot on. It seems to me that the actual deviance is happening with people labouring to establish said consensus, as their value system is completely at odds with that of the overwhelming majority of the population.
“Now narrowly speaking, the idea that enough bank capital would do a lot to prevent future crises isn’t wrong, but it begs the question of what “enough” is.”

No, it doesn’t BEG the question, it PROMPTS the question of how much capital is enough.

Brilliant commentary. What goes beyond understanding is that the same ’subsidizing’is at work on both sides of the Atlantic, ‘patronized’ de facto by what I refer to as the real owners of the casino, the central banks, the banks being the ’smooth operators’

For anyone who has followed the Basel III’s horse-trading process, the ‘new rules’ got more watering down from the central bankers’input than from the industry lobbyists, mainly the ECB and the FED, to name the ‘usual suspects’, both ‘insitutions’whose governors’have now been given official status as bank regulators,following a crisis which, in hindsight, they ‘failed’to see coming, laxness in regulation, etc. And,meanwhile, the FSB, tasked by the G20, must have become a cricket team..

9:25 am Following my previous comment, just to bring to light a great paper ( published shortly before Basel ) debunking a few current beliefs in relation to the ‘vicious circle’: ‘Governments, central bankers and regulatory supervision: Does independence matter ?’ 

It’s impossible to price a CDO Analysis & Opinion

The whole sorry episode I think was fairly summed up by Goldman CEO Lloyd Blankfein when he said that “we participated in things that were clearly wrong and have reason to regret”.

[Sep 04, 2010] Is the Economy as Broke as Lehman Was  by Michael Hudson

The Angelides Committee Sidesteps the Mortgage Fraud Issue

What is the difference between today’s economy and Lehman Brothers just before it collapsed in September 2008? Should Lehman, the economy, Wall Street – or none of the above – be bailed out of bad mortgage debt? How did the Fed and Treasury decide which Wall Street firms to save – and how do they decide whether or not to save U.S. companies, personal mortgage debtors, states and cities from bankruptcy and insolvency today? Why did it start by saving the richest financial institutions, leaving the “real” economy locked in debt deflation?

Stated another way, why was Lehman the only Wall Street firm permitted to go under? How does the logic that Washington used in its case compare to how it is treating the economy at large? Why bail out Wall Street – whose managers are rich enough not to need to spend their gains – and not the quarter of U.S. homeowners unfortunate enough also to suffer “negative equity” but not qualify for the help that the officials they elect gave to Wall Street’s winners by enabling Bear Stearns, A.I.G., Countrywide Financial and other gamblers to pay their bad debts?

There was disagreement last Wednesday at the Financial Crisis Inquiry Commission hearings now plodding along through its post mortem on the causes of Wall Street’s autumn 2008 collapse and ensuing bailout. Federal Reserve economists argue that the economy – and Wall Street firms apart from Lehman – merely had a liquidity problem, a temporary failure to find buyers for its junk mortgages. By contrast, Lehman had a more deep-seated “balance sheet” problem: negative equity. A taxpayer bailout would have been an utter waste, not recoverable.

Only a “liquidity problem,” or a balance sheet problem of negative equity?

Lehman CEO Dick Fuld is bitter. He claims that Lehman was unfairly singled out. After all, the Fed lent $29 billion to help JP Morgan Chase buy out Bear Stearns the preceding spring. In the wake of Lehman’s failure it seemed to gain the courage to say, “Never again,” and avoided new collapses by bailing out A.I.G. – saving all its counterparties from having to take a loss.

Was this not a giveaway? Mr. Fuld implied. Why couldn’t the Fed and Treasury do for Lehman what they did with other Wall Street investment firms and stock brokers: let it reclassify itself as a bank so it could pawn off its junk mortgages at the Fed’s discount window for 100 cents on the dollar, sticking taxpayers with the loss? (And by the way, will these firms ever be asked to buy back these mortgages at the price they borrowed against from the government? Or will they be allowed to walk away from their debts in a Wall Street version of “jingle mail”?)

This is the soap opera that Americans should be watching, if only it weren’t conducted in the foreign language of jargon and euphemism. At issue is whether Lehman’s crisis was merely a temporary “liquidity problem,” that time would have cleaned up much like BP’s oil spill in the Gulf; or, did the firm suffer a more deep-seated “balance sheet problem” (negative equity), as Federal Reserve Chairman Ben Bernanke claims – a junk balance sheet, composed of assets that not only had no buyers at the time, but had no visible likelihood of recovering their market price even after the $13 trillion the Treasury and Federal Reserve have spent to bail out Wall Street.

Insisting that Lehman should have shared in Washington’s $13 trillion giveaway, Mr. Fuld testified that his firm was just as savable as Countrywide or A.I.G. – or Fannie Mae for that matter. Lehman was perversely singled out, he claims. Was it not indeed as savable as the Fed and Treasury claim the U.S. real estate sector is? Like over-mortgaged homeowners, all it needed was enough time to finish selling off its portfolio, given enough loan support to tide it over.

The problem, of course, is that the securities that Lehman hoped to pawn off were fraudulent junk. American homeowners are victims, not crooks. Wall Street bailed out crooks at Countrywide and its cohorts. The credit-rating agency Fitch has found financial fraud in every mortgage package it has examined. And these are the packages that have made Wall Street rich and powerful enough to gain Washington bailouts to establish them as a new ruling class, bailouts to use for buying up Washington politicians and lawmakers, and for buying out the popular press to tell people how necessary Wall Street financial practice is to “support” the economy and “create wealth.”

Could any other daytime telecast have a more typecast villain than Mr. Fuld? A novelist would be hard-put to better personify greed, arrogantly playing bridge with his boss while Lehman burned. Yet his testimony has a certain logic. If the negative equity suffered by a quarter of U.S. homeowners can be saved, as the Fed claims it can, where should the line be drawn?

Or to put this question the other way around, why are ten million American homeowners being treated like Lehman, if the Fed believes that they are as savable as Countrywide and A.I.G.?

Huge sums are at stake, because the bailout has left little for Social Security, and nothing to bail out the insolvent states and cities, or for more stimuli to pull the national economy out of depression.

Most relevant in Mr. Fuld’s self-pitying defense before the Angelides Committee is not what he said about his own firm, but his accusation that the Fed and Treasury rescued the rest of Wall Street. Weren’t other firms just as bad? Why was Lehman singled out?

The Fed’s witnesses gave a devastating reply. They drew a clear distinction between a temporary “liquidity problem” and outright negative net worth – the “balance-sheet problem” of insufficient assets to cover one’s debts. Lehman was so badly managed, the Fed claimed – so reckless and arrogant in its belief that it could cheat its customers by selling junk at a huge markup – that it could not have been rescued except by an outright taxpayer giveaway.

As the Fed’s Chief Counsel, Scott Alvarez, put matters: “I think that if the Federal Reserve had lent to Lehman … in the way that some people think without adequate collateral … this hearing and all other hearings would have only been about how we had wasted the taxpayers’ money – and I don’t expect we would have been repaid.” Like downtown Los Angeles, there was no “there” there.

Included in the hearings’ evidence is an exasperated e-mail sent by Treasury Secretary Hank Paulson’s chief of staff, Jim Wilkinson, on Sept. 9, 2008: “I just can’t stomach us bailing out lehman. Will be horrible in the press.” Five days later, on Sept. 14, he added that unless a private buyer could be found (e.g., as JP Morgan Chase stepped forward to buy Bear Stearns), “No way govt money is coming in … also just did a call with the WH [White House] and usg [U.S. Government] is united behind no money … I think we are headed for winddown.”[1]

Lehman’s problem was not just temporary illiquidity. It had a fatal balance-sheet problem: Its assets were not worth anywhere near what it owed. So with poetic justice, it was in the same position as the subprime borrowers whose junk mortgages it had underwritten and sold to investors gullible enough to believe Moody’s and Standard and Poor’s AAA ratings. This fraudulent junk was supposed to be as safe as a U.S. Treasury bond. But it turned out to be only as safe as Social Security and state pension promises are in today’s “Big fish eat little fish” world.

Yet Mr. Fuld is correct in pointing out that not only Bear Stearns and A.I.G., but also Morgan Stanley and Goldman Sachs would have failed without state support. So the question remains: Why bail out these firms (and their counterparties!) but not Lehman?

This is too narrow a scope to pose the proper question. What needs to be discussed is the result of Washington arranging for Wall Street to repay its TARP, A.I.G. and other bailout money – including that of Fannie Mae and Freddie Mac – by “earning its way out of debt” at the “real” economy’s expense. Why has Washington refused to write down the bad debts of homeowners, states and cities, and companies facing bankruptcy unless they annul their pension promises to their employees? Why is Washington is treating the American economy like it treated Lehman and telling it to “Drop dead”?

The explanation is that a double standard exists. The wealthy get bailed out – the creditors, not the debtors. And even the fraudsters, not their victims.

Sidestepping the Fraud Issue: Bailing out fraudsters instead of saving America’s economic base
Recent federal bankruptcy proceedings have exposed Lehman’s deceptive off-balance-sheet accounting gimmicks such as Repo 105 to conceal its true position. No fraud charges have yet been levied, but this is the invisible elephant in the Washington committee rooms. “Everyone was doing it,” so that makes it legal – or what is the same thing these days, non-prosecutable in practice. To prosecute would be to disrupt the financial system – and it is Fed doctrine that the economy cannot survive without a financial system enabled to “earn its way out of debt” by raking off the needed wealth from the rest of the economy?

So the Fed, the Treasury and the Justice Department have merely taken the timid baby step of pointing out that Lehman suffered from such bad management that no firm was willing to buy it out. Barclay’s was interested, but Mr. Fuld was so greedy that he found its offer not rich enough for his taste. So he ended up with nothing. It is a classic morality tale. But evidently not fraud.

The fraud issue lies as far outside the scope of the financial committee meetings as does the question of how the economy should cope with its unpayably high mortgage, state and local debts in the face of its inadequately funded pension obligations. Fed Chairman Bernanke testified on Thursday, Sept. 2, that “the market” itself breeds what most people would call fraud. Widening the market for home ownership necessarily involves lowering loan standards, he explained. But as the Lehman failure illustrates, where should we draw the line between “illiquidity” and insolvency on the one hand, and higher risk and outright fraud?

The Fed argues that the economy cannot recover without a solvent financial system. But what about that large part of the financial system based on fraud? Would the economy fall apart without it – without mortgage fraud, without deceptive packaging of junk mortgages, and for that matter without computerized gambling on derivatives? What of the credit-ratings agencies whose AAA writings were as much up for sale as the conscience and honesty of politicians on the Senate and House Banking Committees? Do we really need them?

And does the economy need more credit (that is, debt)? Or does it need jobs? Does it need to un-tax the banks and give tax-favoritism to Wall Street (“capital gains” tax rates) to enable it to earn its way out of debt at the expense of the production-and-consumption economy?

The question that Washington financial committees should be asking (and economics textbooks should be posing) is whether wider home ownership is really dependent on easier and looser lending standards. After all, the effect of easy credit is to enable borrowers to bid up housing prices. Is this really how to make the U.S. economy more competitive – given the fact that industrial labor now typically pays 40% of its wage income for housing?

Or, does the Fed’s easy-money policy deregulation of oversight open the way for asset-price inflation that puts home ownership even further out of reach – except at the price of running up a lifetime of debt to the banks that write the loans on their keyboard at steep markups over their cost of funding from the compliant Fed?
Qui bono?

Who is to benefit from the Fed’s easy money policy – consumers and homeowners, or Wall Street?

This is the broad issue that should be discussed. What would have happened without the bailout? (Remember, Republican Congressmen opposed it – before that fatal Friday when Maverick John McCain rushed back to Washington and said he would not debate Mr. Obama that evening unless Congress approved the bailout of is Wall Street backers.) What if debtors had been bailed out by a write-down of bad debts, instead of the lenders who had made bad loans and the large institutions that bought them?

The bailout has saddled taxpayers not only with $13 trillion that now must be sacrificed by the economy at large (but not by Wall Street), but with the cost of a decade-long depression resulting from keeping the bad debt on the books. This is what rightly should be deemed criminal.

Defenders of Wall Street insist that there was no alternative. And the committee hearings are carefully only listening to such people, because these are very respectable hearings. They are writing mythology, almost as if they are crafting a new religion. In this new ethic, Wall Street financial institutions – “credit creators,” that is, debt creators – are supposed to fund industry, not strip assets or make bad loans. Without rich people, who would “create jobs”? Such is the self-serving logic of Wall Street. For them, Wall Street is the economy.

The wealth of a nation is worth whatever banks will lend, by collateralizing the economic surplus for debt service.

What the Angelides Commission really should focus on is whether this is true or false. That would make it a soap opera worth watching. The Fed so far has stonewalled attempts to discover just who was bailed out in autumn 2008? But most important of all is, what dynamic was bailed out? What class of people?

The answer would seem to be, financial firms employing and serving the nation’s wealthiest 1%? Any and all fraudsters among their ranks? (There has not been a single prosecution, as Bill Black reminds us.) Or the remaining 99% of the population – their bank deposits and indeed, their jobs themselves?

Academic textbooks pretend that the economy is all about production and consumption – factories producing the things their workers buy. The distribution of wealth does not appear, nor is it regularly tracked in statistics. But in Washington and at the hearings, the economy seems to be all about lending and debt, all about balance sheets.

I believe that the beneficiaries were fraudsters, and that the system cannot be saved. Trying to save it by keeping the debts in place – and letting Wall Street banks “work their way out of debt” at the U.S. economy’s expense – threatens to lock the economy in a chronic debt deflation and depression.

At issue is the concept of capital. Does money that is made by short-term, computer-driven financial trades qualify as “capital formation” and hence deserving of tax breaks? Are the billions of dollars of “earnings” reported by Wall Street speculators to be taxed at the low 15% “capital gains” rate? That is only a fraction of the income-tax rate that most workers pay – on top of which is piled the 11% FICA wage withholding for Social Security and Medicare that all workers have to pay on their salaries up to the cut-off point of about $102,000 (This cut-off frees from this tax the tens of millions of dollars that hedge fund traders pay themselves).

Or should these trading gains – a zero-sum activity where one party’s gain is, by definition, another’s loss (usually one’s customers) – be taxed more highly than poverty-level income of workers?

A short while ago the Blackstone hedge fund’s co-founder, Stephen Schwarzman, characterized the attempt to tax short-term arbitrage trading gains at the same rate that wage-earners pay as analogous to Adolph Hitler’s invasion of Poland in 1939. It is a class war against fraudsters and criminals – an unfair war as serious as World War II.

In Mr. Schwarzman’s inspired vision the Democrats are re-enacting the role of Adolph Hitler by mounting a fiscal blitzkrieg to force billionaires to pay as high a tax rate as workers. Are not Wall Street firms doing “God’s work,” after all, as Goldman Sachs chairman Lloyd Blankfein, put it last fall? And if they are, then are not those who would tax or criticize Wall Street “God-killers”?

If religion can be turned on its head like this – where the Invisible Hand of Wall Street (invisible to the Justice Department, at least) is elevated to a faux-Deist moral philosophy – is it any surprise that economic orthodoxy and formerly progressive tax policy is succumbing?

The rentiers are fighting back – against the Enlightenment, against Progressive Era tax policy, and against hopes for U.S. economic recovery.

Given today’s florid emotionalism when it comes to discussing Wall Street finances, it hardly is surprising that the Angelides hearings do not dare venture into such territory as to ask whether the bottom 90% of the U.S. economy might need to be bailed out with debt relief just as Wall Street’s elites were.

Yesterday (Thursday), Fed Chairman Bernanke tried to put the financial flow of funds that led up to the crisis in perspective. In his testimony before the Financial Crisis Inquiry Commission he described a self-feeding process that actually started with the U.S. balance-of-payments deficit that made foreigners so flush with dollars. They understandably wanted yields higher than the Treasury was paying, as the Fed was flooding the economy with credit to keep asset prices afloat to save the banks from having to take loan write-downs and admit that debt creation was not really the same thing as Alan Greenspan euphemized in calling it “wealth creation.” So foreign financial institutions became a large but overly trusting market for packaged junk mortgages.

“The market made us do it.”
When asked just who was pushing the great explosion of mortgage lending, Mr. Bernanke pointed to the mortgage packagers – Wall Street profiting from the commissions and rake-offs it was making by pretending that the loans were not bad.

However, he reminded his audience, there also had to be popular demand for housing. People were panicked. They worried that if they did not buy a home back in 2005, they could not afford to buy in the future. And they were cajoled with financial televangelists assuring them that they would always enjoy the option of selling at a profit. But Mr. Bernanke said nothing about fraud in all this. To widen the market for home ownership, banks had to write more mortgages, and this required lowering their standards.

So they did it all for us, for “the people” – and the backers of Fannie Mae and Freddy Mac who egged them on.

Where does “lowering loan standards” turn into outright fraud? Has that simply become part of “the market”? This is what the commission seems to fear to address. But it is getting late – already we are in September, and the report is scheduled for December. So is this really going to be “it”? This would be like a soap opera ending in the middle of the desert, with the main protagonists stranded.

This seems to be where the Commission is leaving the U.S. economy as it waits for the recommendations of the Joint Commission to Roll Back Social Security, or whatever the name of Mr. Obama’s Republicanized Democratic commission is more formally called. The result is more like the cliffhanger of a serial, leaving the viewer to try and imagine how the protagonist – in this case, the economy – will ever manage to be saved.


[1] Tom Braithwaite, “Fuld criticises Fed for letting Lehman fail,” Financial Times, September 2, 2010, and John D. McKinnon and Victoria McGrane, “Clashing Testimony Over Lehman Bankruptcy,” Wall Street Journal, Sept. 2, 2010. Jimmy Stewart is Dead Ending the World's Ongoing Financial Plague with Limited Purpose Banking (9780470581551) Laurence J. Kotlikoff Books

Amazon Exclusive: Q&A with Author Lawrence Kotlikoff

1. What is limited-purpose banking?

First I want to point out that Jimmy Stewart Is Dead is only partly about this proposal. It’s in large part a layman’s tour of the financial collapse conducted by an economist who can talk in plain English and is holds no bars. If you really want to understand what happened in fundamental economic terms, please read the book. And if you really want to know how to fix the problem, please read the book and then send it to your Senator or Congressman.

Limited Purpose Banking puts takes the multifaceted fraud out of our financial system by turning all banks, insurance companies, hedge funds, etc. into fully transparent mutual fund companies. Limited Purpose Banking also abolishes over 115 federal and state regulatory authorities and replaces them with the Federal Financial Authority, which verifies, fully and immediately discloses, and independently rates and appraises all securities held by the mutual funds.

In a nut shell, Limited Purpose Banking makes Wall Street safe for Main Street. Under Limited Purpose Banking we will never again experience financial collapse and contagion. The proposal is receiving significant attention by Mervyn King, Governor of the Bank of England, and other top policymakers throughout the world.

2. Another term that is mentioned a lot these days is narrow banking. What is the difference between narrow banking and LPB and why is LPB a better option?

Narrow Banking says that the monies invested in checking accounts and similar short-term deposits must be invested in very safe securities, like federal government Treasury bills. It lets the rest of the financial system do its own thing and tells that part of the system – “Boys and girls, you’re on your own.” If you borrow money to invest in fraudulent or simply risky securities and lose your shirts, we’re not going to bail you out. Well, this was tried in the case of Lehman’s failure and it blew up in the government’s face.

Limited Purpose Banking includes cash mutual funds, which are held strictly in cash. So one element of LPB is narrow banking. But LPB is much broader. It precludes any financial intermediary of any kind, which is protected by limited liability, from doing anything but marketing mutual funds and the mutual funds are themselves never leveraged. So the entire financial piping system is made safe, not just a few pipes that weren’t at much risk to begin with.

3. What are the advantages of implementing a system like limited-purpose banking and how will it differ from our current banking system?

We’ll never have another financial collapse. We’ll never see a run on banks ever again. We’ll never see insurance companies insuring the uninsurable. We’ll get rid of all the con jobs underlying the current financial system. There will be no more insider rating deals, liar loans, director sweetheart deals, bonuses which amount to corporate theft, bribing of Congress, and the list goes on. The financial plague will be cured, once can for all.

The biggest difference between what we now have and Limited Purpose Banking is we’ll have a financial system that’s honest and that we can trust. This will make all the difference in the world in getting the American economy back on its feet.

4. You’ve recently been referred to as Mervyn King’s (Bank of England) “Guru”. Do you anticipate that the UK might be more amenable to a proposal like LPB than the US? Why?

First, Mervyn King needs no guru, and I’m not his guru. He’s a brilliant economist and an outstanding public servant. I’ve learned a lot more from him over the years than he’s learned from me.

Many of the ideas contained in Limited Purpose Banking were being independently conceived and considered by other economists at the time the book appeared. This includes Mervyn King and other superb economists at the Bank of England.

Governor King, Alisdair Turner, and other top members of the British government are taking this plan very seriously. It’s very simple and if the UK adopts it, the U.S. is likely to follow.

But the U.S. may move first. If you look at who endorsed the book – former Treasury Secretary and Secretary of State George Shultz, former Senator Bill Bradley, former Secretary of Labor, Robert Reich, two former CEA chairmen (Michael Boskin and Murrar Weidenbaum), two former chief economists of the IMF (Simon Johnson and Ken Rogoff), a former chief economist of the SEC, a former deputy Comptroller General of the Currency, and … not to mention FIVE Nobel Laureates in Economics, you see that there is extremely widespread support for this plan in U.S. policy circles and academia. The endorsements are coming from all sides and ends of the political aisle.

5. What do you anticipate as the reaction by the banking industry to LPB?

If the banking industry is smart, they will realize this is the best way to go. The American public is extremely angry and is not up for business as usual. 15,000,000 people are unemployed and many other millions are underemployed or have dropped out of the labor force. Wall Street has destroyed the economy and millions of innocent economic lives. Wall Street did this by engaging in fraud – left, right, and center and then turning to the tax payer to pay for the havoc it created. These problems continue to this day. They need to be fixed fundamentally. The status quo seems safe, but as the book shows, it’s extremely risky. And because it is so risky, Wall Street will either need to be baby sat in a manner it won’t like or it can operate honestly under LPB. These are its only two options.


Review in U.S. News and World Report by Philip Moeller, March 12, 2010

This review is from: Jimmy Stewart is Dead: Ending the World's Ongoing Financial Plague with Limited Purpose Banking (Hardcover)

In his latest book, "Jimmy Stewart Is Dead," Boston University economist Laurence Kotlikoff says the fundamental soundness of our financial system is so compromised that nothing short of revolutionary fixes will save this patient, and set our economy on a healthier trajectory. Harking back to Jimmy Stewart's movie role as small-town banker George Bailey in "It's a Wonderful Life," Kotlikoff says the era of responsible banking has been replaced by the highly leveraged and morally bankrupt system whose crash brought on the worst downturn since the Great Depression.

Remember the classic science experiment? A frog immersed in warm water will adjust so well as the temperature is gradually increased that it will allow itself to be cooked alive without jumping out of the water. Well, Kotlikoff says, we are the frogs in a financial experiment that's gone terribly wrong:

Jimmy Stewart, the honest, warm, kind, and trusting soul is not your local banker. Jimmy Stewart is dead. Your local banker is some underpaid clerk who's been in place for six months and knows nothing about you, your family, or your business, and frankly could care less. His job is not to apply personal knowledge in deciding to lend you money or call your loan. His task is to plug your credit rating, income, loan request, appraisals, and other data into a computer and tell you what the computer tells him, namely how much you can borrow and at what rate.

Our bankers are desperately attached to the current system for good reason. It lets them socialize risks and privatize profits. Socializing risk means having the public take the hit when things go south. Privatizing profits means earning big fees in normal times.

These thoughts are not original. But Kotlikoff (disclosure: I know Larry and have written about him before) provides a particularly chilling review of the problems that brought on the crash and how they are part of a larger series of calamitous economic trends. Washington, in his view, may well be the last place we should look for a solution. Its policies enabled and encouraged the reckless behavior of our financial institutions. Its proposed remedies fall far short of solving our problems. And there has been little progress in the past 18 months in enacting even these limited cures. "Nothing short of economic open-heart surgery will save the American dream," he writes.

If the Tea Party folks haven't discovered this book, they should. Larry says what's on his mind, is not particularly concerned with making friends in government or business, and has solid credentials to back up his conclusions. In reviewing our meltdown, he doesn't spare himself or his colleagues from criticism, either. "With rare exceptions, those of us manning the watch -- the economists hired by the government and the business world -- missed what was coming, were shocked when it happened, exacerbated the public's fear, and are now helping resurrect the system that failed so miserably."

Such behavior, Kotlikoff says, is part of a broader pattern of financial malfeasance. The federal government is able to print money and spend its way out of jams. Unable to resist the allure of the next election, our leaders have literally promised Americans they will spend upwards of $80 trillion on future benefits that the government simply has no way of obtaining. Short of hyper-inflating the money supply with devalued currency, we will not meet those promises. We are, in Kotlikoff's less than humble opinion, bankrupt. Yet our leaders find it easier to look the other way or engage in political brinkmanship than get down to work.

Looking the other way also explains why financial firms were allowed to become too big to fail and put our money at risk and not theirs. They adopted and then over-dosed on highly leveraged financial instruments. These securities are still not fully understood by even sophisticated financial experts, and certainly not by the politicians who are supposed to fashion remedies. While tougher regulations are being sought in Washington, Kotlikoff notes that there are roughly 115 financial regulatory agencies already. The problem is not that banking is under-regulated; it's that the regulators looked the other way instead of doing their jobs.

Kotlikoff's antidote to what ails us would be very bitter medicine for financial firms to swallow. First, he wants to forbid them from putting our money at risk. Second, he wants to replace those 115 regulators with a single agency. Its major job would not be just to police the banks but to become, in effect, the information marketplace and traffic cop for a new kind of banking that he calls limited purpose banking.

In this system, banks wouldn't be able to take any risks themselves, so they could never put depositor or taxpayer money at risk. Every business transaction involving a financial firm would be treated as if it were a mutual-fund holding. For example. if you wanted to borrow money to buy a home, your demand for loan funds would be matched up with an investor interested in buying your loan on mutually known and acceptable terms. The bank would receive some fees as an intermediary but the home loan would never be on its books.

By settling up special mutual funds for all sorts of economic activities, borrowers and lender-investors could be brought together for literally any reason. Kotlikoff's single regulator would make sure borrowers and investors met certain standards. Transparency would be king in his world. Nothing would limit people from taking extraordinary risks, which Kotlikoff recognizes come with the territory in a market-based economy. But under limited purpose banking, those risks would never sit on a bank's books and thus would never come back to bite the public in the form of bailing out a failed institution. Even your bank deposits would be placed in such a fund. And because deposits would be fully backed, dollar for dollar, we would no longer need deposit insurance.

"Jimmy Stewart Is Dead" makes for provocative reading. We certainly have squandered much of America's business and economic strength in the pursuit of personal gain and huge if not obscene bonuses. Yet the odds of such a system reset as limited purpose banking are slim. One can only shudder at how much worse things would have to become to consider such extreme changes. It might just be easier to find another Jimmy Stewart. I'd call him Mr. Smith. And I'd ask him to go to Washington.

[Aug 22, 2010] Does Income Inequality Help Cause Financial Crises

August 22, 2010 | naked capitalism


Unequal wealth concentrations are invariably used as weapons against those who are economically weaker and against the public interest as a whole (so they’re never “neutral” or “innocent”, the way the textbooks fraudulently claim).

In the question at hand, this concentrated wealth is deployed to buy deregulation to free itself up even more. Yet at the same time, in the classical contradiction of capitalism, the more wealth concentrates the fewer productive investment outlets it can find, and the more it’s forced into ever more destructive speculation, including the global capital flows described above.

I don’t know which of dereg or global financialization is a greater proximate factor correlated with financial crises. The deeper cause is always the mismatch between production (including the false “production” of bubbles) and consumptive capacity.

Wealth concentration’s role here is dialectical. The original accumulation empowers it to aggressively seek to further concentrate itself by making ever more destructive “investments”, which in turn concentrate it further and further empower it.

Everybody knows crisis is hardwired into this vicious circle, so as the speculator willfully helps generate the crisis conditions and hastens the crisis itself, we can say he intentionally causes it. And since the 50s neoclassical economics has been ideologically clear that crises should be intentionally triggered and exploited as just another tactic of concentration, disaster capitalism.

We’ve just seen the textbook play – the looting process was getting bottlenecked, the bubble had to burst, so the elites intentionally triggered the crisis (by which I mean, they knew it was coming as a result of their continued course of action, they acted to hasten it, and were fully prepared to exploit it) with the full intent of using it as the pretext for the Bailout, the next stage of looting since looting-via-bubble had run out of room.

“Austerity” is then the next stage of robbery as the Bailout and its own bubble reflations (like stocks) become insufficient to keep up the requisite looting level.

In all of this, the overwhelming imperative for the elites is to keep concentrating wealth and power. They will not and cannot stop until they’re forcibly stopped.


I think inequality , excess financialization , and gov’t policy promoting both , are self-reinforcing. Positive feedbacks occur : increased financialization increases the polical clout of financiers as they come to represent a growing portion of the economy ; this clout also results in tax policy more and more in favor of the rich , contributing to growing inequality ; inequality means workers have to work more hours to maintain some semblance of progress in their standard of living , and more workers and worker hours reduces their ability to command a fair share of wages ; unions are busted to further favor capital over labor , making wage gains even more unlikely ; concentration of capital at the top contributes to hot money flows as productive areas of investment are reduced due to sagging demand from the increasingly stressed working class ; workers readily take on debt as a way to compensate for their difficulty in maintaining a decent lifestyle , and the piles of hot money in search of yield , combined with finance innovations enabled by captured legislators and regulators , provide an endless supply of that debt ; much of the debt flows to consumption rather than to productive enterprise , so no basis for sustained growth or higher wages is established , and soon , it’s Ponzi Time.

These are some graphs that show the identical patterns in inequality , top marginal tax rates , savings rates , financial deregulation , and relative pay in the financial sector , going back to the early 1900s :

Relative financial wage , deregulation , and top 1% income shares :

Savings rates and top 1% shares :

Top marginal rates : ( imagine this one on an inverted scale , to line up with the others )

or here you can see top rates and top income shares together :

I don’t see the question of what came first as too important. Once the philosophy of laissez-faire and trickle-down was widely adopted , the outcome was a foregone conclusion. We went through this process prior to the Depression , learned from it , and created a stable , just economy that worked just fine for about 40 years , even without the help of financiers and all their crises.

The fact that we’re even debating the issue today shows how completely we’ve unlearned that lesson.


Galbraith argued something like this, in The Great Crash. From memory, the argument was that the working population was unable to afford the goods they as a whole were making, and this led to lack of demand. If I recall correctly, he mentions this in connexion with ‘profitless prosperity’. He talks about a phenomenon in 28-9 of high economic activity but no profits.

His implication seems to be that if only there had been some means of increasing salaries, the crash would never have occurred. So the argument is for strong unions and labor market regulation. It is of a piece with the rest of the argument, which seems to have as a subtext that the bubble occurred because of an excess of greed.

The counter argument, which you find argued in Rothbard, is that falling or static real wages in the middle of apparent prosperity is what always characterizes a credit bubble. It is the credit bubble that causes the static wages, and it is the inevitable bursting of the credit bubble that leads to the crash.

If you accept that, you look for the cause of income inequality in the credit bubble, and find it readily enough, since a credit bubble delivers enormously raised levels of financial transactions, and therefore delivers rewards and employment to those engaged in them. This is a form of malinvestment. There is too much credit around, and the finance sector gets to be far bigger than either the manufacturing or service sector requires for purposes of investment and day to day cash management.

You then get to the next step, which is the argument about what caused the crash to be followed by a depression…


Also, puffed up asset values become essential to ‘rising prosperity’ during periods of extreme inequality. This is why the #1 objective of Bernanke and Co is to prop up the stock market and housing.

Ms Hedgehog:

It seems to me that income inequality is the *intended* result of the behaviour that leads to the crisis.

if professor Black is correct, then the whole reason for making (and allowing to be made) lots of really bad loans is to create short term profit and take home a LOT of money in bonuses. That creates income inequality, because you got a giant chunk of income. That was the whole point.

It also causes a crisis, because the loans are not going to get paid back, but only later, and the agents who behave like this are personally indifferent to that.


[Aug 22, 2010] William K Black on 'Financial Racketeering;' Government Coverup; a 250% Tax Increase

The interview with William K. Black starts at 13:00 in this video and is well worth seeing.

Gresham's Dynamic: The least ethically inclined have an advantage in the US financial system (in which regulatory capture nullifies enforcement) driven by perverse incentives of oversized bonuses and the failure to investigate and prosecute criminal activity.

In addition to the overhang of unindicted and undeclared fraud that is still in place, distorting the clearing of the markets, there is the issue of an imbalanced economy in which an oversized financial sector exacts what amounts to a draconian tax on the real economy, that is, fees and tariffs and other unproductive drains in excess of anything that the government is levying.

What Do You Get for a 250% Tax Increase?

As I recall the percentage of financial sector profits to corporate profits recently peaked at 41%, from a long run average of less than 16%. Granted, this is a bit theoretical because of the pervasive accounting fraud in the banks and the corporations.

I wonder what the percentage of profit, pre-bonus, is being enjoyed now?

This can be viewed as a form of a tax. If the government raised taxes from 16% to 41% what do you think the impact on the US economy would be? And yet there is little discussion of this, or the racketeering that accompanied such a festival of looting.

Yet conceptually this is what has been accomplished through the deregulation of the banks and the repeal of Glass-Steagall, and of course, regulatory capture. The financial sector acts primarily as a capital accumulation and allocation system, and secondarily to facilitate wealth transferals through pure investment and speculation, the famous school of winners and losers. I would suggest that this latter function has grown out of control like a cancer, and metastasized to drain and debilitate the better part of the political system and the non-financial economy.

I would suggest that this system is broken, and that there can be no sustainable recovery until it is fixed. How can confidence return when most of those in the know realize that the fraud is still in play? Who can take positions with confidence in such a corrupt environment wherein the government acts as the handmaiden to a handful of powerful Banks which engage in large scale frauds as a mainstay of their business, and with virtual impunity?

Stimulus that is not targeted, and especially any subsidy that passes through the Banks, is liable to this tax. It reminds me of warlords stealing charitable relief as it arrives in a Third World country before it can be distributed to the people.

But austerity is even worse, because the kinds of austerity being discussed are specifically targeting the ordinary people who have been badly used already to say the least, and not the perpetrators of one of the biggest financial frauds in the history of the world, and those wealthy few who benefited from a culture of deception which they helped to form.

This is a compounding of the suffering and injustice. If one were to set a recipe for a social and civil revolution it would fit the bill nicely. No one ever said that the pigmen are not self-destructive in their lifestyles and obsessions.

The comparison to the aftermath of the Savings and Loan crisis could not be more stark. Why the inability and reluctance to investigate and indict? What is the government covering up? Who is pulling Obama's strings?

[Aug 15, 2010] Gordon Gekko Reborn

Project Syndicate

In the 1987 film Wall Street, the character Gordon Gekko famously declared, “Greed is good.” His creed became the ethos of a decade of corporate and financial-sector excesses that ended in the late 1980’s collapse of the junk-bond market and the Savings & Loan crisis. Gekko himself was packed off to prison.

A generation later, the sequel to Wall Street – to be released next month – sees Gekko released from jail and returned to the financial world. His reappearance comes just as the credit bubble fueled by the sub-prime mortgage boom is about to burst, triggering the worst financial and economic crisis since the Great Depression.

The “Greed is good” mentality is a regular feature of financial crises. But were the traders and bankers of the sub-prime saga more greedy, arrogant, and immoral than the Gekkos of the 1980’s? Not really, because greed and amorality in financial markets have been common throughout the ages.

Teaching morality and values in business schools will not tame such behavior, but changing the incentives that reward short-term profits and lead bankers and traders to take excessive risks will. The bankers and traders of the latest crisis responded rationally to compensation and bonus schemes that allowed them to assume a lot of leverage and ensured large bonuses, but that were almost guaranteed to bankrupt a large number of financial institutions in the end.

To avoid such excesses, it is not enough to rely on better regulation and supervision, for three reasons:

As a result, any reform of regulation and supervision will fail to control bubbles and excesses unless several other fundamental aspects of the financial system are changed.

First, compensation schemes must be radically altered through regulation, as banks will not do it themselves for fear of losing talented people to competitors. In particular, bonuses based on medium-term results of risky trades and investments must supplant bonuses based on short-term outcomes.

Second, repeal of the Glass-Steagall Act, which separated commercial and investment banking, was a mistake. The old model of private partnerships – in which partners had an incentive to monitor each other to avoid reckless investments – gave way to one of public companies aggressively competing with each other and with commercial banks to achieve ever-rising profitability, which was achievable only with reckless levels of leverage.

Similarly, the move from a lending model of “originate and hold” to one of “originate and distribute” based on securitization led to a massive transfer of risk. No player but the last in the securitization chain was exposed to the ultimate credit risk; the rest simply raked in high fees and commissions.

Third, financial markets and financial firms have become a nexus of conflicts of interest that must be unwound. These conflicts are inbuilt, because firms that engage in commercial banking, investment banking, proprietary trading, market making and dealing, insurance, asset management, private equity, hedge-fund activities, and other services are on every side of every deal (the recent case of Goldman Sachs was just the tip of the iceberg).

There are also massive agency problems in the financial system, because principals (such as shareholders) cannot properly monitor the actions of agents (CEOs, managers, traders, bankers) that pursue their own interest. Moreover, the problem is not just that long-term shareholders are shafted by greedy short-term agents; even the shareholders have agency problems. If financial institutions do not have enough capital, and shareholders don’t have enough of their own skin in the game, they will push CEOs and bankers to take on too much leverage and risks, because their own net worth is not at stake.

At the same time, there is a double agency problem, as the ultimate shareholders – individual shareholders – don’t directly control boards and CEOs. These shareholders are represented by institutional investors (pension funds, etc.) whose interests, agendas, and cozy relationships often align them more closely with firms’ CEOs and managers. Thus, repeated financial crises are also the result of a failed system of corporate governance.

Fourth, greed cannot be controlled by any appeal to morality and values. Greed has to be controlled by fear of loss, which derives from knowledge that the reckless institutions and agents will not be bailed out. The systematic bailouts of the latest crisis – however necessary to avoid a global meltdown – worsened this moral-hazard problem. Not only were “too big to fail” financial institutions bailed out, but the distortion has become worse as these institutions have become – via financial-sector consolidation – even bigger. If an institution is too big to fail, it is too big and should be broken up.

Unless we make these radical reforms, new Gordon Gekkos – and Charles Ponzis – will emerge. For each chastised and born-again Gekko – as the Gekko in the new Wall Street is – hundreds of meaner and greedier ones will be born.

Nouriel Roubini is Professor of Economics at the Stern School of Business, NYU, Chairman of Roubini Global Economics (, and co-author of the book Crisis Economics. He has a cameo role in Oliver Stone’s new film Wall Street: Money Never Sleeps.

[Aug 14, 2010]   Capitalism's Greatest Vulnerability (the link to the original article is broken)

Apr 21, 2009 | PrudentBear

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).

[Aug 07, 2010] Do Capital Markets Create Their Own Fuel? By Kent Thune

"Stock markets, outside of IPOs are pure casino activity, not really productive economic activity"... Regardless how you call it (circularity, feedback loop, reflexivity) the stock market “feeds” on itself; fear creates more fear, greed – more greed. It works, but only to a point, like a Ponzi scheme.
August 5, 2010

Economic forecasters sometimes describe capital markets as a leading economic indicator, which assumes that share prices of equity securities anticipate good or bad economic conditions:  Share prices rise when investors expect economic growth, and fall when economic recession is expected; or so the conventional wisdom says.

But can capital markets actually create or destroy the very economic conditions that their participants are anticipating?  Isn’t this the purpose of a “capital market,” to facilitate the buying and selling of securities (equity or debt), in the interest of raising capital for corporate and government objectives, which is usually to finance growth of the respective enterprises?

Are the participants in capital markets (investors) buying or selling in anticipation of future economic conditions AND thus contributing to the anticipated economic condition?  Do capital markets have an inherent self-fulfilling prophecy effect?  Do capital markets create their own fuel?

These are not rhetorical questions.  I would like some education. I’m a CFP with an MBA but certifications and degrees don’t help me (or anyone) as much as the study of philosophy, which makes me fully aware of my own ignorance.

So please read a bit more and share your wisdom with me and others in the comments…

The idea for this post, and thus the inspiration for the questions I’d like for you to answer, came from a statement made by Alan Greenspan this past Sunday on Meet the Press (full transcript here):

“…as I’ve always believed, we underestimate the impact of stock prices on economic activity. Asset prices are having a profoundly important effect. What created the extent of the contraction globally was the loss of $37 trillion in market value. It collapsed the value of collateral in the system and it disabled finance. We’ve come all the way back–maybe a little more than halfway, and it’s had a very positive effect. I don’t know where the stock market is going, but I will say this, that if it continues higher, this will do more to stimulate the economy than anything we’ve been talking about today or anything anybody else was talking about.”

Do we really “underestimate the impact of stock prices on economic activity?”  Greenspan’s statement, at first, seems to make sense; but aren’t stock prices a leading economic indicator, a discounting mechanism, reflecting an anticipation of future economic conditions?   Or are capital markets a creator and destroyer of economic conditions?  If so, what makes stock prices rise or fall?

Consider the logic of this statement:

Stock prices rise when investors anticipate a growing economy; and the economy grows as a result of rising stock prices.

In philosophy, this statement might be considered fallacious logic, or what is called a circular argument; where one assumes in the premises the same that is to be proved in the conclusion.  I thought of this circularity when I heard Alan Greenspan speak.

But is this circularity, or might it be something akin to the idea of momentum investing?  Furthermore, what was the first mover starting the rise in stock prices in 2009?  Was it just hope or was it anticipation of a growing economy? Are there times when stock prices are not actually forecasting economic conditions in the near future; but they are actually creating the capital that stimulates the economy;  and hence creating a kind of self-fulfilling prophecy?

So which is it: Are capital markets leading economic indicators or are they leading economic funding for growth?  Is it both?  Is it sometimes one or the other?

“Nobody goes there anymore; it’s too crowded.” ~ Yogi Berra

This brings to my curious mind another question, which may bring up other questions:  If you think the economy is headed for a double-dip recession, and therefore investors are “wrong” for buying into long positions of stock, might this seemingly poor judgment end up fulfilling its own prophecy by enabling economic growth, making these supposed foolish optimists “right” for buying now?

As Barry has said here at TBP before, the crowd is “right” most of the time.

Also, perhaps part of a greater-known investing mantra, “Don’t fight the Fed,” may help answer some of my questions here today: With Greenspan’s statement that stock prices “will do more to stimute the economy,” he implicates the Fed’s wink-wink relationship with Wall Street; to provide fuel for capital markets, which indirectly fuels the growth of the US Economy.

Or perhaps Ben Graham answers some of my questions in his famous assertion: “In the short run, the market is a voting machine but in the long run it is a weighing machine.”

“True wisdom comes to each of us when we realize how little we understand about life, ourselves, and the world around us.” ~ Socrates

Please share your wisdom.   I reserved this post idea specifically for you, Barry’s readers, because I knew you would provide a diverse array of wise, educational and/or colorful comments…

What are your thoughts?


Kent Thune is blog author of The Financial Philosopher.

The Curmudgeon:

Indeed, there are both inflationary and deflationary feedback loops for the prices of assets:

Let’s say the monetary authorities increase the supply of currency past what is needed to account for any increases in the quantity of good and services demanded. Prices will rise. People will buy now, instead of later. Businesses will expand to meet what appears to be an expansion in demand. Eventually, though, the signals that assets are increasing in value will be muted by increases in their cost structures, and the feedback loop will peter out, at a higher price level, but not at a higher relative value, ceteris paribis. With a severely expansive monetary policy that keeps feeding the loop, output will expand until oversupply becomes so extreme that everything crashes: US 1929; 2009.

It works in reverse for deflationary spirals/feedback loops.

What Greenspan is really saying is that his inflationary monetary policies backfired, and prices crashed in response. He’s also hinting at the connection between herd emotions and economic activity. Herds prefer inflationary feedback loops, because it deludes them into thinking things are getting better, which itself creates a positive feedback loop, spurring economic activity. Herds loath depressing deflationary loops, an emotion that also feeds back into the loop, worsening it. The stock market, in the short run, reflects the herd’s immediate psychology, which is always looping in small circles enough to make it seem loopy.


Personally I look at it this way.

Stock markets, outside of IPOs are pure casino activity, not really productive economic activity. Yes a rising stock price makes people feel good but companies balance sheets are not affected much by stock prices. Its their sales and debt payments that are most important to their decisions to hire, open another branch/factory etc.

Of course people who are purchasing stocks in the secondary market are doing it with money they dont need for every day consumption. So this is why (I think) there is a huge disconnect between the Dow and the economy at large.

People playing in the stock market are using “after consumption” dollars and those who need all they earn to consume wont play in the market. The market has moved with such low volumes lately,is it any surprise? The few people with lots of spare cash are driving the markets right now but they arent creating growth with job creation and adding to the potential buyers of stock. This is why I think this market is likely to crash in the near future, too few buyers. If I want to sell something I like my chances of getting my price if there are 500 people looking at it instead of 5.


Kent, as a CFP you should understand that the majority of wealth for the average U.S. citizen is not created by the returns on their investment portfolio. Wealth is created by disciplined, systematic saving of wages and salaries, frugal consumption, and minimal use of debt. Greenspan’s statement is supporting of the fallacy that true wealth (financial security) and well being can be attained through successful(?) investing in the capital markets. The capital markets have evolved from a realistic means of participating in the growth of the American economy, to a casino where the returns are not necessarily determined by a companies success, but by the a minority group of traders and insiders. It is clear in my mind that Greenspan has a clear case of “pretzel logic.”


There is some feedback. Part is what Keynes called “animal spirits.” Higher prices lead to more confidence, which leads business people to do more, which improves the economy, which leads to higher prices. Part is financial – capital is cheaper for business, so they do more, which improves the economy, which leads to higher prices.

Read Shiller on how bubbles form.

There’s also a wealth effect. I believe the typical projection as around 2%-3% of increased portfolio wealth is spent, which boosts aggregate demand, which improves the economy, which leads to higher prices.

The other thing that’s going on is that the same projections are underlying the market and business. In other words, better animal spirits (or whatever) boosts both the market and the economy.


stock prices rise, net wealth of individuals and corps rise, people/corps spend more, pushes economy positive, drives growth, stock prices rise further, and vice versa; unless i am missing something it’s chicken and egg


I don’t understand why Mr. Thune is even asking these questions, because he himself answered them!
Regardless how you call it (circularity, feedback loop, reflexivity) the stock market “feeds” on itself; fear creates more fear, greed – more greed. It works, but only to a point, like a Ponzi scheme. Eventually it reaches mega-bubble levels (such as nasdaq and japanese bubble) that cannot any longer “feed” the real economy, and then it all crashes. The crash takes a lot less time than the building of a bubble, which is why the always bullishly-tilted “crowd” is right most of the time.

Also, regarding the question “what was the first mover starting the rise in stock prices in 2009?” , I think it was exactly the same phenomenon that created a 28% rally from July 2006 until October 2007, all the while RE was crashing, corporate profits were falling, Wall St was running out of cash, and oil priced more than doubled. Namely, it was an implicit (or perhaps even explicit) promise by the Treasury and the Fed to create conditions for the Big Banks to rip profit, hoping that higher stock prices would “trickle down” into real economy. Well, for a while everyone could keep pretending that everything in the economy is OK, simply because the stock market was rising. How did that work out in 2008?

The entire “extend and pretend” policy rests on hope that rising stock market would re-inflate the economy, and Geithner/Bernanke/FRBNY/FASB/Administration are doing everything they can to enable it. This is their first, last and only hope…. and it’s been working for over a year, but IMHO short of 75% devaluation of the USD, in another year or so the market will be back to the March 2009 lows.

dead hobo:

Thank you for such a wonderful question. I hope I can be concise.

Basically, there are two questions here. One deals with pumped stock prices. The other deals with the velocity of money. Greenspan conflates the two in some bizarre and incomprehensible way.

Greenspan was exceptionally wrong when he stated the bit about high stock prices stimulating the economy. Stock prices rise when there is a demand for financial assets. Pumping the price of stock alone, hoping that it will stimulate the economy is an example of trickle down economics. When stock prices alone are stimulated, there is a rush for the cash being used for the pump. Like a flood of water, all boats in the water or near the water rise when the rush first happens and all fall back when the water soaks away. Except for the few who managed to get some of the free money, eventually it all goes away. If you weren’t near the water when it rushed by, you got nothing.

You build a home from the foundation and go up. You don’t build a home by starting at the roof and building down towards the basement. Trickle down economics is an excuse to convince a gullible government that everyone benefits if you make the wealthy even wealthier.

Capital markets create fuel when there is a demand for assets, real or otherwise. Assume I buy assets for $1B and, due to fortunate financial conditions, they are soon worth $1.5B. I sell them to you, book a real profit, and turn that original $1B around to finance a new investment. That original $1B just created a lot of investment because there was a demand for investments. Since few people have $1B in their pocket, most of the $1B was borrowed from someone. This means that people must be lending in order for funds to be available to borrow. So, to create flowing capital, you need lending, borrowers, and investment. The capital isn’t created. It’s really recycled.

Right now, we have fewer borrowers because they’re paying down assets that are no longer worth what they originally paid for them. We still have lots of lenders, but most of their money is going to finance the deficit, not create jobs. Thus, money has a slow velocity. This creates low asset prices.

HFT flows emulate velocity in the stock markets, but there are just empty calories. You need real buyers and sellers to know value. HFT is 70%+ of the market and just bot to bot selling, with the occasional sucker deciding to play. This is the market Greenspan thinks is good.

Kent Thune:

Wow! Thanks for all the thoughts! I’ll read them later this afternoon and add a few more of my own. For the moment, I’ll respond to one comment:

b_Thunder says, “I don’t understand why Mr. Thune is even asking these questions, because he himself answered them!”

It is all in the nature of philosophic inquiry; to create a dialogue, whether it is only within my own mind or with others (or both). I don’t “know” all the answers; therefore I prefer to ask questions.

Capital markets are mysterious and it is impossible to know with certainty the answers to many of the questions they have inspired for decades. This is primarily why I find it entertaining when economists and the media talking heads speak with such apparent authority and confidence. It is they who are the fools.

“Those who have knowledge, don’t predict. Those who predict, don’t have knowledge.” ~ Lau Tzu

“He who establishes his argument by noise and command shows that his reason is weak.” ~ Michel de Montaigne

napster Says:

August 5th, 2010 at 5:13 pm
Without reading any of the comments, my first response is that surplus cash or surplus capital assets than can be securitized into cash are the driving force behind asset or stock prices. If there is more surplus cash and assets that are easily securitized (convertible into cash, or sold like a bond) then there is a lot of money looking for growth and income. Since population and resource allocation inevitably gets tied up into this system, any surplus beyond the needs of a growing population that isn’t hindered by resource bottlenecks will be in some bank account or find some asset that yields interest, if not altogether directly invested in the creation of a business. Surplus income also creates consumer Demand and Demand gives potential profit for business investment, all of which is self-reinforcing.

The price of a stock or asset is not independent of this process of surplus driven economic accumulation. The collective herd is not driven by a wisdom of the market seeking the most efficient value. The collective herd is simply making decisions to buy or sell upon imperfect information, based upon an ability to do so because of Surplus cash. When there is no Surplus cash, there is no support for the engine that drives the financial markets.

The world is full of transition. Some companies are able to continue profit extraction for longer periods of time than other companies. But a company’s financial wherewithal is not a function of it’s stock price. The two can coincide, but there are just as many examples of when they don’t to dissuade us from assuming “high price” means “solid company”. The price can be associated with the history of earnings and the market share at a given point of time, but then fall apart 10 years later due to unforeseen circumstances. History seems to always have the last laugh.

DG_Allen Says:

August 5th, 2010 at 5:15 pm
I read the book The Origin of Financial Crises: Central Banks, Credit Bubbles and the Efficient Market Fallacy by George Cooper. He’s also somone how points to market created feedback loops stimulating the economy. A rising market certainly seems to simulate via wealth effect and the creation of equity upon which consumers will borrow.

He also goes into Efficient Market theory and how it adds more fuel to the feedback loop fire. Some CEO’s take this to the extreme and think that any method to pump a stock price hire reflects intrinsic increase in the companies worth, becasue the market is effieient and therefore sets the price correctly. To which I ask the questino, if a company spent all it’s profit repurchasing it’s own stock, would it become infinitely valuable??

Bruman Says:

August 5th, 2010 at 5:36 pm
Soros’s theory of reflexivity, as presented in “The Alchemy of Finance” describes these feedback loops. Also Shiller’s (and coauthor’s) “Animal Spirits.”

In general, the stock market is taken to be a leading indicator of markets, but the relationship is not one-to-one. As the near future becomes clearer to us, the bullish or bearish update their views and the market tends to move up or down as one or the other views weaken. Basically, by the time the evidence for recovery or depression is in, the major players have already updated their views to accommodate the reality, which is why, when you look back at the market, it seems to have “predicted” or “led” the economy. Of course, if you remember how you were feeling while it was supposedly predicting good times, you will realize that it wasn’t nearly as clear at the time as it seems in retrospect.

If people panic, and send stock prices down, this does mean that companies cannot raise capital at inexpensive rates, and so investment in expansion may drop off, and conceivably trigger a recession. So there is definitely a feedback loop on the capital supply side.

There is also a feedback loop on the demand side. Many consumers feel free to spend when their investment accounts are flush, and so a crash in asset prices can precipitate a slowdown in spending, which in turn can stimulate a recession.

So rapid changes in asset prices can cause the very thing that they supposedly predict (which would still be consistent with prices “explaining” a recession or recovery). What’s important to remember is that the stock market being a leading indicator of the economy looks a lot more obvious in retrospect than it does as it’s happening. The reason is that typical stock charts do not really capture the sense of risk that goes on as a market bottoms, and we often forget that feeling of risk after events are over. Because of this risk, the upturn in the stock market does not look nearly as obvious as it does after we know how things panned out.

alfred e Says:

August 5th, 2010 at 5:40 pm
Fascinating conversation. But seems to not yet include one key point: the market is basically a zero-sum game, algos, middlemen and bots excepted. For a stock to be bid up means someone is willing to pay more for the stock than previous transactions. The money goes from one person to another. Changing or differing expectations. IPOs are a different matter, but represent a minuscule different part of the market.

Rising stock prices could be caused by many factors. But there can be no doubt too much money chasing too few income opportunities can juice stock prices. But it’s still zero-sum. People simply moving money around to improve their fate hopefully.

gloppie Says:

August 5th, 2010 at 6:03 pm
Very interesting posts, most above my pay grade :c)
Most here already know I’m not the Financial type, I work in engineering; and as such I may contribute albeit in limited fashion with this:
I have noticed that the feedback loop concept is very murky, and I believe the reason for this is that some people use the descriptors [positive] or [negative] feedback loop in a way that describe the perceived benefits of the direction in which the system looked at is heading (better market=positive feedback loop). This is wrong.
Other people use the terms in a correct (as far as engineers are concerned) manner, which is that a positive feedback loop is a situation when the change of a system’s condition generates more change in the same direction that created the change, in opposition to negative feedback loop, where a change in the condition of a system generates more change in the direction opposite to the one creating the change.
Positive feedback tends to amplify the changes (all the way to noise or chaos) while negative feedback tends to less change and self-regulation.
The typical thermostat > HVAC unit > air in the room > loop is a negative feedback loop.
If it is hot, apply cold, if it is cold apply heat. Good for the user, but negative.
I read a lot of financial info, and there are a lot of commenter out there that apply the wrong descriptor, and it tends to make understanding difficult. I do not mean anybody in particular on this blog, my intention is not to point fingers, just attempt to clarify this.
Case in point, if you examine the above loop and insert the user > thermostat > HVAC unit > air in the room > user, this very same loop can become positive, where “She / He just need to get off the damn thermostat damnit”, but that is another story. :c)

Captain Jack Says:

August 5th, 2010 at 7:19 pm
Soros in his own words, from a June speech as archived here:

I have developed an alternative theory about financial markets which asserts that financial markets do not necessarily tend toward equilibrium; they can just as easily produce asset bubbles. Nor are markets capable of correcting their own excesses. Keeping asset bubbles within bounds have to be an objective of public policy. I propounded this theory in my first book, “The Alchemy of Finance,” in 1987. It was generally dismissed at the time, but the current financial crisis has proven, not necessarily its validity, but certainly its superiority to the prevailing dogma.

Let me briefly recapitulate my theory for those who are not familiar with it. It can be summed up in two propositions. First, financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. This is the principle of fallibility. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times it is quite pronounced. When there is a significant divergence between market prices and the underlying reality I speak of far from equilibrium conditions. That is where we are now.

Second, financial markets do not play a purely passive role; they can also affect the so-called fundamentals they are supposed to reflect. These two functions that financial markets perform work in opposite directions. In the passive or cognitive function, the fundamentals are supposed to determine market prices. In the active or manipulative function market, prices find ways of influencing the fundamentals. When both functions operate at the same time, they interfere with each other. The supposedly independent variable of one function is the dependent variable of the other, so that neither function has a truly independent variable. As a result, neither market prices nor the underlying reality is fully determined. Both suffer from an element of uncertainty that cannot be quantified. I call the interaction between the two functions reflexivity. Frank Knight recognized and explicated this element of unquantifiable uncertainty in a book published in 1921, but the Efficient Market Hypothesis and Rational Expectation Theory have deliberately ignored it. That is what made them so misleading.

Reflexivity sets up a feedback loop between market valuations and the so-called fundamentals which are being valued. The feedback can be either positive or negative. Negative feedback brings market prices and the underlying reality closer together. In other words, negative feedback is self-correcting. It can go on forever, and if the underlying reality remains unchanged, it may eventually lead to an equilibrium in which market prices accurately reflect the fundamentals. By contrast, a positive feedback is self-reinforcing. It cannot go on forever because eventually, market prices would become so far removed from reality that market participants would have to recognize them as unrealistic. When that tipping point is reached, the process becomes self-reinforcing in the opposite direction. That is how financial markets produce boom-bust phenomena or bubbles. Bubbles are not the only manifestations of reflexivity, but they are the most spectacular.

In my interpretation equilibrium, which is the central case in economic theory, turns out to be a limiting case where negative feedback is carried to its ultimate limit. Positive feedback has been largely assumed away by the prevailing dogma, and it deserves a lot more attention.

I have developed a rudimentary theory of bubbles along these lines. Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception, a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced. Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved. A twilight period ensues during which doubts grow and more and more people lose faith, but the prevailing trend is sustained by inertia. As Chuck Prince, former head of Citigroup, said, “As long as the music is playing, you’ve got to get up and dance. We are still dancing.” Eventually a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.

Typically bubbles have an asymmetric shape. The boom is long and slow to start. It accelerates gradually until it flattens out again during the twilight period. The bust is short and steep because it involves the forced liquidation of unsound positions. Disillusionment turns into panic, reaching its climax in a financial crisis.

The simplest case of a purely financial bubble can be found in real estate. The trend that precipitates it is the availability of credit; the misconception that continues to recur in various forms is that the value of the collateral is independent of the availability of credit. As a matter of fact, the relationship is reflexive. When credit becomes cheaper, activity picks up and real estate values rise. There are fewer defaults, credit performance improves, and lending standards are relaxed. So at the height of the boom, the amount of credit outstanding is at its peak, and a reversal precipitates false liquidation, depressing real estate values.

The bubble that led to the current financial crisis is much more complicated. The collapse of the subprime bubble in 2007 set off a chain reaction, much as an ordinary bomb sets off a nuclear explosion. I call it a superbubble. It has developed over a longer period of time, and it is composed of a number of simpler bubbles. What makes the superbubble so interesting is the role that the smaller bubbles have played in its development.

The prevailing trend in the superbubble was the ever-increasing use of credit and leverage. The prevailing misconception was the belief that financial markets are self-correcting and should be left to their own devices. President Reagan called it the “magic of the marketplace,” and I call it market fundamentalism. It became the dominant creed in the 1980s. Since market fundamentalism was based on false premises, its adoption led to a series of financial crises. Each time, the authorities intervened, merged away, or otherwise took care of the failing financial institutions, and applied monetary and fiscal stimuli to protect the economy. These measures reinforced the prevailing trend of ever-increasing credit and leverage, and as long as they worked, they also reinforced the prevailing misconception that markets can be safely left to their own devices. The intervention of the authorities is generally recognized as creating amoral hazard; more accurately it served as a successful test of a false belief, thereby inflating the superbubble even further.

It should be emphasized that my theories of bubbles cannot predict whether a test will be successful or not. This holds for ordinary bubbles as well as the superbubble. For instance, I thought the emerging market crisis of 1997-98 would constitute the tipping point for the superbubble, but I was wrong. The authorities managed to save the system and the superbubble continued growing. That made the bust that eventually came in 2007-8 all the more devastating.

Kent Thune Says:

August 5th, 2010 at 7:51 pm
Thanks, Capt Jack, for that piece on Soros and his ideas on reflexivity and feedback loop. As I stated in a previous comment, I’ve not read Soros but I know his education is in philosophy, which makes me more open to his ideas.

Tarkus Says:

August 5th, 2010 at 7:53 pm
IMO Greenpan is focused on the psychological “Wealth Effect”, but is falsely conflating money with wealth. The first derivative (money, as a means of exchange) is necessary for commerce, but distortions occur when secondary, tertiary, etc, are allowed to be created at will, because all subsequent “creations” will ultimately place a demand on the first derivative. It is akin to the fractional reserve system, but outside of the banking system and with no constraints.

CDOs were created with fraudulent valuations, swapping them for the first derivative (dollars or equivalents) in what was little more than a bait and switch. Late in the cycle, when the artifice constructed to create the ancillary derivatives of money goes bust (the illusion/bubble that inflated the perception of wealth via the Wealth Effect), what was a centrifugal wave (created by “products” falsely fractionalizing the money supply) becomes a centripetal one, collapsing all subsequent derivatives back toward the original (the time when “cash is king”).

A stock at issuance serves to foster a company’s growth with financing. Thereafter it is mostly speculation – not contributing to wealth creation but just wealth redistribution.

Since the price of a stock is quantified in money, and is therefore by definition valued as a derivative of money/cash, is it any wonder that Greenspan thinks that rising stock prices will “stimulate” the economy? Stock is to money what near-beer is to beer, but as long as you can pass it’s nearness off as beer, that means everyone thinks they are richer in beer – and we get beer bubbles.

His market assertion is only placing the middleman of a “stock” between his perception of “prosperity” and an increase in the money supply. Remove the middleman of near-money and you are back to the same old ideology he held as Fed Chairman.

willid3 Says:

August 5th, 2010 at 7:56 pm
do we really have a capital market any more? i suspect the vast majority of stocks sold have very little to do with providing capital to a company (except for the sale of course). and how many investors really know the company they just bought stock in? if you are buying selling every day (or many times) just how much time are you spending to know that company?

wildbluyonder Says:

August 5th, 2010 at 7:57 pm
I suppose there are a variety of reasons different age groups “got back in to the market” around March 09, but a thirty-something (married w/child) informed me of his reasoning of why he invested heavily in Apple…”if the economy got worse, then it would take us all down anyway, .e., worthless dollar…so faced with the ripple effect of global economic collapse the rationale alternative was to bet the farm on securities and Apple, in particular, made the most sense at the time…”

In spite of the above anecdote, I believe that Thune has a made excellent point with respect to re-thinking the models that Economists use to describe or comprehend the driving forces behind daily rise & fall of stock prices versus the relationship to future earnings, company management, etc

xynz Says:

August 5th, 2010 at 8:18 pm
I think I’m fairly qualified to answer this question: I’m a philosopher and a scientists with some expertise in the philosophy of science.

If you haven’t already read it, I highly recommend Kuhn’s “The Structure of Scientific Revolutions”

Going forward, I’ll use “Finance” and “Financial Markets” to refer to everything related to the flow of money in the economy: consumer spending, economic activity, stock market trading, banking, etc.

“Science” and “Finance” are both social systems that interact with external systems. Scientific theories and financial theories are socially derived system models; they are used to predict and exploit the behavior of the external systems which they study. In the case of the scientific theories, the external system being studied is the physical world. In the case of financial theories, the external system being studied is the economic system.

Kuhn coined a now widely used term for the “socially derived system models” that are used in science: they are called “paradigms”.

From a philosophical point of view, these paradigms impose an order upon the chaos of the systems being studied. Here, the term “chaos” refers to the systems’ highly divergent and nonlinear dynamics.

For the moment, we’ll ignore how the use of paradigms can directly effect the systems they model. In both science and finance, the paradigms being used to study their respective systems have inherent biases which skew the acquisition and perception of data. This is because paradigms are LITERALLY imposing an order on how we perceive the data. Kuhn has explained how such biases operate in the social system that is called “Science”. In the world of finance, “Marxism” and the “Efficient Market Hypothesis” are examples of paradigms which impose their own biases on data acquisition and analysis.

In the literal and philosophical sense: how the world looks, depends upon your point of view.

Beyond these biases of perspective, there are also interactions between the observer and the observed. At the most basic and fundamental level of physics, this interaction is quantified as “The Heisenberg Uncertainty Principle“. HUP operates this way: if you want to know an electron’s state, then you measure it, by bouncing a photon against it. But when you do this, some of the photon’s energy is transferred to the electron: that changes the electron’s momentum. So the act of observing the photon’s state is changing the state being observed. You can minimize this energy transfer, by using less energetic photons.

But low energy photons have longer wavelengths; which yield a less precise measure of the photon’s location. If you want to have arbitrarily precise information about a photon’s momentum, you have to accept less precision about its location. If you want arbitrarily precise information about a photon’s location, you have to accept less precision about its momentum.

This uncertainty relation is quantified as:

(dp*dx) >= h/(4*pi)

dp = uncertainty of momentum

dx = uncertainty of location

h = Planck’s Constant

So, we have two ways in which our paradigms will affect the systems being studied.

1. Paradigms introduce biases which affect the way we interact with the system

2. No matter what paradigm is used, the interactions themselves will perturb the system

In “The Money Game“, Adam Smith explored precisely these kinds of issues. He showed that the theories of Technical Analysis being employed at the time, had inherent biases that affected how trader’s approached the market. He also showed how these approaches could, in turn, affect overall market behavior.

So Capital Market paradigms have two effects upon the economic system:

1. They impose biases affecting how traders CHOOSE to interact with the economic system

2. These interactions will change the dynamics of the economic system itself

As it is currently structured, the financial system is very sensitive to the mechanics of “self fulfilling prophecies”. For example: Enron’s high market value had no basis in reality; it was quite literally a figment of the market’s collective imagination.

Enron’s collapse is a metaphor that has largely gone unheeded. The structural deficiencies in our current economic system are unsustainable. Resource depletion, global warming and environmental despoliation are all “Repo 105’s” which artificially and temporarily inflate corporate profits. The physical world’s limits cannot be deferred, amortized or depreciated indefinitely….at some point, these debts will come due and the system that is the real world will be demanding immediate repayment.

When these debts are finally “deleveraged”, we won’t be able to cover them with any TARP.

barbb Says:

August 5th, 2010 at 8:30 pm
Is this a version of does demand create it’s own supply (or vice versa)?
I’ll go with the micro influencing the macro. More co’s with better expected earnings put upward pressure on the overall market (macro). Overall.
Are markets self perpetuating? Are there cycles? Sure. Markets must have a sustainable micro support to show sustained macro progress. Bubbles are a special circumstance.
The wealth effect of the overall market should continue until most factors can’t support it. Then there are the side-effect of contrarians and speculators, etc .
Greenspan’s circular logic only works when you have solid support for growth. Stock prices have a wealth effect, and can influence that if you’re invested directly or indirectly.

MayorQuimby Says:

August 5th, 2010 at 9:06 pm
I think the man is insane. Why this is even being debated is pretty shocking. There are dozens of reasons why this statement os false we could discuss this insanity for weeks or even months.

Transor Z Says:

August 5th, 2010 at 9:42 pm

Capital markets create fuel when there is a demand for assets, real or otherwise. Assume I buy assets for $1B and, due to fortunate financial conditions, they are soon worth $1.5B. I sell them to you, book a real profit…

OK, just stop right there. You made $500 million. You are now officially a genius, a financial guru and a legend. I think it’s called “sociology of knowledge,” but I just think of Tevya singing, “When you’re rich they think you really know.”

The Dead Hobo Fund becomes a primo destination. Your smarmy self-congratulatory monthly newsletters say as much. You hire a ghost writer to write them, a guy who learned his trade writing daily horoscopes. He sprinkles in folksy humor and recycled bits of other people’s wisdom. This “voice” becomes part of your brand, the Dead Hobo brand. You remind people on CNBC of that incredible call you made last year when you said, “There’s a big opportunity in commodities.” I now worship you because you “made me money” when I traded copper for a nice score at some point last year (before or after your great call, not sure and don’t care to check). And I think that and am grateful to you because I’m a groupthink hack.

Soon you become a Market Mover, the Oracle of Potters Field. You hire some bright guys from big trading desks to help you fuck over your own clients for fun and profit… and you’re off to the races, baby.

It’s not just observer effect. It’s sociopath effect, full of intentionally created distortions, scams, disinformation, and fraud. You know — garden variety human activity. You can call it a “complex system” and throw words like “Game Theory” and “Heisenberg” around if you like, but the smart monkeys DH alludes to above will always find ingenious ways to load the dice.

hdoggy Says:

August 5th, 2010 at 9:46 pm
To add to the general them of this I have to go back to the simple mechanics of buying and selling securities in the secondary market. It’s good to read this about once a year to refresh on the basics.

Key paragraph:

“In any case, stock prices don’t change because money goes “into” or “out of” the market. Prices change because buyers are more eager than sellers, or vice versa. If a dentist from Poughkeepsie is eager to buy a single share of General Electric (which has about 10 billion shares outstanding), and pays $33.30 instead of $33.20 for that single share, that one trade will increase the stock market’s capitalization by a billion dollars. But at the end of the day, all securities that were originally in existence are still in existence, and there is just as much “cash on the sidelines” as there was before.”

I don’t deny that higher sentiment may allow organizations offering primary issues to raise more cash than otherwise with higher stock market values or that companies selling treasury stock or securities to raise cash for investment may be able to get more cash than otherwise in a higer valued market, but the key here is that there was not loss of collateral as Greenspan states, there was only a loss of capital available to investors because sentiment turned its back on them. This does not really refute the “fuel” argument, it just helps explain the mechanics of possibly how a higher valued market would create more opportunities to raise capital in certain markets. I think Greenspan is correct when he said the collateral was lost, it was just lost to certain parties, probably favored parties.

Cooter Says:

August 5th, 2010 at 10:03 pm
“what was the first mover starting the rise in stock prices in 2009?”

b_thunder has it right on. It was the conditions that implied a “promise by the Treasury and the Fed to create conditions for the Big Banks to rip profit, hoping that higher stock prices would “trickle down” into real economy” that formed the bottom.

If Mr Thune wants a solid answer, I suggest he asked BR directly himself. If I remember correctly, BR was holding his nose and buying around the March lows because he felt the amounts of liquidity pumped by the central banks meant stocks had nowhere to go but up. (I am paraphrasing on this)

Another point regarding why stocks bottom: At some point during a crash, the speculative aspect of a stock’s price is taken too far. People sell below the stock’s intrinsic value because the fear of further losses is unbearable. A recent example of this is BP. The stock hit a dead stop just south of 27.50 once the prospect of BP’s asset sales or takeover by Exxon became the dominant MSM story. People were suddenly reminded that BP was actually a real business with real assets, and its capital STOCK was worth something. Therefore, arbitrage and value investors form a floor in the price because they quanitify a fundamental value for the capital stock of the business. Additionally, a high profile situation such as BP’s asset sales/takeove allows a new speculative theme to develop that helps drive the stock price higher.

The stock market is worth something. The game is about how much below/above that value the speculative sentiment drives it.

Bruman Says:

August 5th, 2010 at 10:20 pm
I love Hussman’s stuff, and his point about how the amount of “cash” on the sidelines doesn’t change addresses something that always struck me as strange. Basically, since cash is held as treasuries, which are obligations that are going to be paid off one way or another, all that happens when a stock is bought is that what is called “cash” changes owner. The only systemic thing seems to be how much cash the owner is willing to exchange for the stock, and there is the same amount of cash as before.

And yet, we feel richer when our portfolios are up, and so how can that be, if there is the same amount of cash in the system?

Basically when a stock price goes up, it’s because the marginal guy in the market place would rather hold the stock than the t-bill. Why? Well, we don’t necessarily know why… maybe they think that future cash flows are going to be better (for justifiable or imaginary reasons) or maybe they suddenly have developed a higher risk tolerance (which similarly, may be justified or not).

All we can tell is that, at certain times, people are willing to value future uncertain cash flows more than certain ones, and at these times, stocks and other assets are simply valued more. At the end of the day, it is these perceptions of the value of something risky vs. something less risky that determines the market value of stocks.

To the extent that future cash flows actually come in as anticipated, higher stock prices are justifiable, but the rest is about the emotionality of risk aversion.

Sudip Adhikari Says:

August 5th, 2010 at 10:52 pm
I always love to go back to basics. I am trying to go back to basics in my way. The fundamental of all financial statute and institution is money. Money by its very nature can be defined as a promise. As human we promise more and deliver less. That delta of missed promise accumulated put us in trouble.

jonagil Says:

August 5th, 2010 at 11:37 pm
I posit that there are two types of individuals in this world:

(i) He who feels more wealthy when his paper profits (i.e. unrealized profits) increase; and
(ii) He who does not (i.e. only when realized, if then)

Follow this chain of logic and I believe you will get your answer. A behavioral economist should get on this question quickly, as a general segmentation of the two above types would be helpful. I recommend a study on MEW, which Barry has covered exhaustively.

The casino comments mentioned above, with a caveat for IPOs and true growth capital (whether debt or equity), would seem to hold water in public markets. That is, the real economy has nothing to do with Wall Street, and that Wall Street is a glorified casino – albeit one which can be exploited (for those in the know) more quickly than private markets.

Capital is neither created nor destroyed – it is merely transferred, undervalued, or over-marketed. That may be too simplistic, but follow this matter-analogy logic and you will get a glimpse into your question.

alfred e Says:

August 5th, 2010 at 11:50 pm
Actually reviewing my previous comment, that finally got un-moderated, it’s not about too much money chasing too few opportunities. As so many have pointed out, the volume is at record lows.

So someone is juicing the market. DUH.

There are still some suckers out there willing to be bled dry. Or so someone thinks.

Well, hey, they are most likely TBTF playing with 0% money from the FED.

More power to you.

Broken Says:

August 6th, 2010 at 1:04 am
@willid3 said: “do we really have a capital market any more?”

There has been $150-200 billion in secondary equity in the US so far this year (my lazy guess). Since equity doesn’t burden income like debt does, this equity is economic stimulus (even though it dilutes shareholders).

The higher equity prices are, the more companies choose equity financing over debt financing. This is good because debt financing weighs on earnings power.

This is the point Greenspan was making, which I called a feedback loop, that higher equity prices are stimulative because companies can raise capital easily, grow faster, and yield higher equity prices.

Greenspan is not always wrong.

Peter Davies Says:

August 6th, 2010 at 2:07 am
Regarding Greenspan’s remark, I think an important thing is being missed here. I believe his assertion on the stimulative impact of a rising stock market is right. I further believe that the current rise in the equity markets has been due primarily to the intervention of the President’s Working Group on Financial Markets, aka Plunge Protection Team. First, the turn-around started just as the S&P 500 was about to seriously breach the important 1040 level. Second, the market rose despite almost consistently bad macro-economic news and some supposedly good news on the earnings and outlook front, despite much of this being well known in advance. Even when the markets were showing weakness, there’s was always a rally in the last hour of trading to secure a gain or, at worse, a very modest loss.

For political reasons, any further major governmental stimuli are off the table prior to the November elections but the Government is also concerned about the impact of a severe market sell-off before then, so what to do: call in the PPT. For some reason the mere mention of the PPT seems to throw the mainstream financial media into a flat spin leading to disparaging jokes, accusations against conspiracy theorists, etc. ‘Pumping the markets’ is relatively easy to do particularly on light volume summer days. Given the enormous interventions in the financial sector by governments and central banks since 2008, it should come as no surprise that market pumping (that requires only modest funding) is going on .

obsvr-1 Says:

August 6th, 2010 at 2:39 am
another interesting read

Subpar Recovery Gets Premium Market Valuation

JohnC Says:

August 6th, 2010 at 6:16 am
Do Capital Markets create their own fuel? That is, do markets lead/drive economic actions? And, if they do, can we manipulate the capital markets with any degree of certainty so as to achieve a desired range of economic outcomes?

My underlying bias is that markets are made up of prices, prices matter and that the message that the prices send to the participants in the market help frame their actions both in the market and in other related areas.

With that confession out of the way…

The answer to the first question is yes but not always. Markets create their own fuel and Mr. Soros’ Reflexivity Concept is a pretty good way to to visualize what is going on. Why? Because real people bet real money. Those bets change prices, which sends signals both to the original trader and every other participant in the market place. Sure, some trading like HFT (which is just a computerization of the NYSE Specialist/NASDAQ Market Maker) is agnostic. But HFT only impacts the markets when someone throws a wrench in the works (because when things get rough, it does not act like a Specialist or Market Maker to attempt to maintain an orderly market).

The answer to the second question is a qualified yes. Sometimes the signals (the fuel) from the market influence economic action. Sometimes they don’t. The key is the transmission mechanism which is rarely as smooth or quantifiable as the models would have you believe. Why do the models fail? Because no matter how much processing power is brought to bear on one plane of operation, the systems cannot match the kind of decision making that takes place on many planes in the average human brain. A lower interest rate may cause people to refinance a house or issue a bond…or it may not. Perhaps we think the interest rates may go lower shortly and we want to save the expenses of financing twice. Perhaps we are afraid of looking foolish for jumping the gun. Or maybe we have more pressing matters to deal with and we pull the trigger now. Sum those responses in real time and the reaction to the sum…

And that brings us to the third question: Can we influence economic decisions by manipulating the market? The answer to this is maybe because the market has to respond correctly (in the eyes of the manipulator) to the manipulation and then the market participants must transmit the correct secondary response into the real economy. Mr. Greenspan suffers from a bit of hindsight bias. He was enormously influential in the markets as he experimented with the liquidity taps and the FEDs power to intervene in a market crisis (LTCM). But much of his impact derived from the relative forbearance of previous FED chiefs. And, he had the wind at his back economically as the global economy benefited from the integration of India and China as well as the rationalization of Europe and some positive developments in South America and Africa. It’s easy to look smart in a bull market.

That’s why the current team is having so much trouble following the Greenspan playbook. The FED, which by fiat alone has run interest rates to zero, should be able to dictate terms to the market. But the market is creating its own “fuel.” The message is clear: potentially ugly outcomes are on the horizon. Businesses in the US are responding by hoarding $1.8 trillion on their balance sheets. In the bond/money market arena, the low interest rates are telegraphing zero final demand for loans to the banks who rationally respond by taking the best risk/reward option out there by lending their money back to the US Government, thereby self-fulfilling the zero final demand message from the markets.

I think the most valuable part of Mr. Soros’ speech is the part where he admits he doesn’t have it all worked out. So, the answer to the question is yes, the markets create their own “fuel” but that is far from the end of the process.

dead hobo Says:

August 6th, 2010 at 7:07 am
Transor Z Says:
August 5th, 2010 at 9:42 pm


OK, just stop right there. You made $500 million. You are now officially a genius, a financial guru and a legend. I think it’s called “sociology of knowledge,” but I just think of Tevya singing, “When you’re rich they think you really know.”

I am humbled.

wally Says:

August 6th, 2010 at 8:37 am
“Stock prices rise when investors anticipate a growing economy; and the economy grows as a result of rising stock prices.”

I wouldn’t call it a circular argument; I’d call it a self-fulfilling prophecy. And yes, the stock values matter. Right now, for instance, you can find stocks that have very good potential years ahead – almost regardless of the overall economic conditions (within reason) – and you can buy them cheaply. Some people are searching out and buying those today. In a few years everybody else will wonder how those people got in on the ground floor. In that respect, the market fluctuations due to expectations are the very definition of the fear and greed that famously compete in an arena that, in the long run, rewards fundamentals more.

wally Says:

August 6th, 2010 at 8:45 am
I commute about 14 miles on a multi-lane highway every morning and night. I watch the patterns… if you stay in a particular lane you sometimes work ahead of the adjacent lanes, sometimes you fall behind. Usually after the full 14 miles you are still near the same cars and trucks you were with when you first got on the highway. But one thing is certain: you will never gain any ground at all on the cars in front of you – in your lane – unless you change lanes.
The lanes speeding up and slowing down are the general market movements. Lane-changing is trading.

AHodge Says:

August 6th, 2010 at 9:59 am
answer; yes
there are three parts
1 investors bet on momentum because it works
2 a higher stock price is real good for a company’s fundamentals
3 higher stock market gives households more to spend– the wealth effect–which boosts the economy–which boosts stocks– and so on…
Soros laid out the first two over 20 years ago. not that you could get anything from his quote above. That is dam near unreadable if you havent followed him for 20 years. For stocks: reflexivity is
a) that a higher stock price makes that company’s financing easier and cheaper
b) paying in options makes labor costs much cheaper, and
c) if they have a defined benefit pension, the stock market going up makes paying eventual pensions much cheaper.

He did not do wealth effect that i saw, but with my old company WEFA globalinsight I did detailed work that showed about 2% of the change in stock market wealth got spent. But only with long lags running a year or more. House price wealth effect much higher– about 8%– and gets spent more quickly with fewer lags

AHodge Says:

August 6th, 2010 at 11:04 am
thats partly how an honest bubble blows with no govt help
but you can add
1 fake asset inflation with lying accounting, that will inflate even with bonus withdrawals–noted by others
2 procyclical govt liquidity
3 minsky type (short memory) credit cycle with excesses near the top, pessimism at the bottom–also described by soros

Greg0658 Says:

August 6th, 2010 at 11:17 am
Q: how many of you think you can extract your principle when you wish to .. be honest with a global perspective in mind? ….. I wish I knew then what I know now when I voted to put IT (the raise) into a pension account instead of the old guys who said “put it on the check” says another “I’ll watch it myself” ….. so our (my) savings invested in foreign territories for a multitude of reasons … but we (I) shot ourselves in the foot ….. the bright side – at least the dirty factories are overseas – retribution in 100 years

Kent Thune Says:

August 6th, 2010 at 11:38 am

The idea of financial systems being social systems is fascinating, and a bit too scientific for my simple mind; but I can make the connection intuitively and it makes sense.

Please allow me to make a logical stretch and see if your knowledge of philosophy and science can affirm my thoughts on this:

If financial systems are social systems, can one make the stretch to saying that social systems, being human creations, will abide by the laws of nature; because they are nature.

Financial systems as social systems (and as nature), will follow the same patterns of nature (cycles).

Where I am going with this is away from science and western philosophy and toward ancient eastern philosophy, such as Taoism, which generally focuses on nature and humans’ relationship to the universe and to each other (as one organism or “social system”).

Can we say that financial systems are social systems and thus systems of nature; therefore financial systems simply follow the same type of rhythms and cycles as nature itself?

For example, chaos, disorder and randomness are natural and smaller pieces that make up quite an orderly, larger, non-random system of nature where everything is acting and reacting as it should (naturally).

What do you think?

“Turning back is how the way moves.” ~ Lau Tzu

Dogfish Says:

August 6th, 2010 at 12:00 pm
I would posit that increasing median wages and jobs would do more to stimulate a consumer economy such as ours than an increasing stock market. But then looking at median wages doesn’t reinforce the perceived bond between our economy’s future and that of our oligarchs as much as attempting to peg it to the DJIA does.

Dogfish Says:

August 6th, 2010 at 12:02 pm
Above mainly referencing Greenspan’s comment. As for capital markets being a self-fulfilling prophecy, I absolutely agree with that. In a way, it is an organism, and just like optimism/hope or pessimism/fear in animals (including humans), mood affects behavior.

Transor Z Says:

August 6th, 2010 at 1:30 pm
Kent said:

Please allow me to make a logical stretch and see if your knowledge of philosophy and science can affirm my thoughts on this:

If financial systems are social systems, can one make the stretch to saying that social systems, being human creations, will abide by the laws of nature; because they are nature.

Financial systems as social systems (and as nature), will follow the same patterns of nature (cycles).

Where I am going with this is away from science and western philosophy and toward ancient eastern philosophy, such as Taoism, which generally focuses on nature and humans’ relationship to the universe and to each other (as one organism or “social system”).

Can we say that financial systems are social systems and thus systems of nature; therefore financial systems simply follow the same type of rhythms and cycles as nature itself?

For example, chaos, disorder and randomness are natural and smaller pieces that make up quite an orderly, larger, non-random system of nature where everything is acting and reacting as it should (naturally).

What do you think?


Can we PLEASE stop talking about sex?

A little Woody Allen reference there.

formerlawyer Says:

August 6th, 2010 at 1:47 pm

“The other lane is always faster.” – Me.

Chibi Says:

August 6th, 2010 at 6:53 pm
Or perhaps Ben Graham answers some of my questions in his famous assertion: “In the short run, the market is a voting machine but in the long run it is a weighing machine.”

I’ve been thinking this metaphor is a bit dated. “Voting machine” seems too polite. It’s more like Lord of the Flies out there these days.

Kent Thune Says:

August 6th, 2010 at 10:45 pm
@ wally formerlawyer:

There is never a good reason to change lanes: If you leave early or on time, there are no worries. If you are late, changing lanes won’t make you “on time.”

Arrive unharmed.

Safe travels…



[Aug 04, 2010] The Road to Serfdom Is Lawlessness: Inside Goldman Sachs

Jesse's Café Américain
"Giving sophisticated models and fast computers to traders is like giving handguns and tequila to teenage boys. Only complete mayhem can result (and as we saw recently, complete mayhem did result)."
Here is a piece I found interesting from a quant who left Goldman Sachs. It matches what I have seen first hand over the years doing business with the brokers and exchanges, and from friends who joined other high energy Wall Street firms including Lehman and Bear Stearns and Morgan Stanley.

The investment banks and brokers are an adolescent culture, high on macho and low on expansiveness in thinking to put it politely.

I do not have a problem with that, per se. I enjoyed hanging with most of these guys, their odd sense of irreverent cynicism and gallows humour, and the grab-asstic frat life style. It is fun, if you do not take it too seriously. I used to follow an annual race on the stairs among brokers in a large NY skyscraper with interest, a friend phoning in the results. Big money was bet on it. It's a good time, and a means of relieving the tremendous pressures of a high stress profession.

The difficulty is that over the past ten years the financial sector, including the once staid commercial banks, has been absolutely overwhelmed by the hedge fund and investment banking mentality, and that power in turn has been influencing serious policy discussions in Washington to the detriment of the nation, because money is power. Most of it had to do with deregulation.

Banks must keep up with their competitors, and if one does it, they all must do it to stay in business. That is why regulation is so vital in this highly competitive sector. One cannot be virtuous as a commercial entity with obligations to shareholders and customers under brothel rules.

Goldman Sachs is primarily a big hedge fund with a lot of political clout and an inside line with the Fed. They have a trading, hedge fund culture these days. It was not always like this. At one time a firm's reputation and their word was everything in a system founded on confidence. With a trading culture it's all about the bottom line, with profit as virtue, and deceit in the name of profit is no vice. You do not wish to have fellows with this mindset running any substantial part of your country.

Quite a bit of that came with their change in status from a predatory trader to mainstream bank in name only, with a predator's instincts and reward system. And this multiplied their potentially negative impact and influence on the entire financial system.

Even worse, their self-centered and short term thinking and clever manipulation of the rules has become the tail wagging the big dog of the country, because the political climate in Washington, and elsewhere, has been largely corrupted by money. And in a bubble economy, the financial centers are where the money is.

Wall Street is like the Gauls (or the Ferengi for the sci-fi fans), ruthlessly obvious and lacking in subtlety, wallowing in the raw and often ostentatious use of amoral power for gain. Washington, on the other hand, tends to effete decadence and studied pretense, the sly and subtle subornation of character and too often the law in the service of power. The mix of these two cultures is an antichrist on the rocks, a deadly cocktail indeed.

I had the opportunity to work with several congressional and even presidential campaigns and administrations starting with Nixon. I don't claim to be an insider, but I have seen a side of things that is transparent to most. I liked that culture as well. I used to go to Washington for the State of the Union message each year, to meet old acquaintances from the Staffs for drinks and chat at Bullfeathers or The Palm to catch up on things, while the big dogs were attending the show. You get the best view of things from the servants, especially if you are benign, an interested non-player.

The deterioration in Washington is evident. These men are not the brightest stars in the firmament, and at times they are downright ignorant of things we might take for granted because they often live a rarefied existence with access to people and information managed by staffs. That is a necessity because they are drinking from a firehose of information.

Their chief ability seems to be to know what to say and to whom, what levers to pull to get something done, making deals, gaining and trading power, and how to get elected. They are great at networking. But this leaves them terribly vulnerable to influence, and group think, and brother, inside the Beltway these days it is all about lawyers, guns (power) and money.

There has always been an element of this, but over the past twenty years, with the whole deregulatory movement, it has become supersized, like a feeding frenzy. I have had the opportunity to discuss this with some older friends in the business and they tend to agree that things have changed.

There are always creepy and seriously warped people who are attracted to the halls of power. I have met a few who were simply chilling. More common are the broken people, with drugs and drink and sex filling the holes in their being, hollowed out by the power and fame that lured them in. But these were always the exceptions.

In government there always had been an element of service to the country and a kind of dignity underpinning the system, a kind of shared camaraderie, that seems to have been tossed in a ditch of expediency and greed, and the lust for power on a mass scale.

What had been the exception is now the rule, at least beneath the urbane, often pietistic, veneer. You can still be tossed out of office in the government for doing things that would still make you a legend on Wall Street.

When the politicos were doing something wrong back then at least they knew it, and they were ashamed of it, despite the usual bluff and bravado. A stiff conversation with a federal prosecutor would make a Congressional staffer's blood run cold. Now it is more like business as usual, and even getting caught is not all that bad, given the current trend to bipartisan professional courtesy, mavericks excepted.

Greed is indeed the greatest good, the fatal flaw behind the decline of the 'me generation.'

The law, that much maligned government of regulations and restraints, abused and fallible as it may sometimes be, is the bulwark of society, and often the only thing standing between the people and packs of ravening wolves.

Those who would tear down the law in some misguided pursuit of reform, or of an adolescent anarchy or utopia of 'no rules' at all, might find it hard to stand when the cold winds of avarice and tyranny of power blow across the land, with no laws to stop or restrain them. The madness serves none, consuming all.

"Equal protection" under the law is the best safeguard that the average person enjoys. Remove the law and you remove the protection, and it is every man for himself, and the individual is irrelevant.

This is why the Banks must be restrained, and the financial system reformed, with balance restored to the economy, before there can be any sustained recovery. And underpinning all of this is the integrity of the regulatory and law enforcement process, and a serious pass at campaign finance reform and limitation of the power of large corporations and organizations to buy influence with other people's money.

The story of the 21st century will be the struggle of the individual versus the organization, the machine controlled by the elite few. A cyclical theme no doubt, but the powerful few seem to become more efficient in their promotion of tyranny on each iteration.

Why founding a three-person startup with zero revenue is better than working for Goldman Sachs
By Antonio
23 Jul, 2010

I joined Goldman Sachs in 2005, after five flailing years in a physics Ph.D. program at Berkeley.

The average salary at Goldman Sachs in 2005 was $521,000, and that’s counting each and every trader, salesperson, investment banker, secretary, mail boy, shoe shine, and window cleaner on the payroll. In 2006, it was more like $633,000.

In the summer of 2005, I took one look at my offer letter and the Goldman Sachs logo above it, another look at my sordid grad student pad, and I got on a plane to New York within the week. I packed my copy of Liar’s Poker for reference.

My job on arrival? I was a pricing quant on the Goldman Sachs corporate credit trading desk1. We traded credit-default swaps, both distressed and investment-grade credit, and in the bizarre trading experiment assigned to me, the equity part of the corporate capital structure as well.

There were other characters in this drama. The sales guys were complete tools, with a total IQ, summing over all of them, still safely in the double digits. The traders were crafty and quick-witted, but technically unsophisticated and with the attention span of an ADHD kid hopped up on meth and Jolly Ranchers. And the quants (strategists in Goldman speak)? Mostly failed scientists (like me) who had sold out to the man and suddenly found themselves, after making it through two years of graduate quantum mechanics, with a bat-wielding gorilla peering over their shoulder (that would be the trader) asking them where their risk report was.

Wall Street is inward-looking and all-consuming. There exists nothing beyond the money game, and nothing that can’t be quantified into dollars and cents...

[Jul 24, 2010] “Innovation” and the Social Purpose of Financial Services

The scam of "financial innovation" serves as powerful destabilizing force..." ...opacity, leverage, and moral hazard are not accidental byproducts of otherwise salutary innovations; they are the direct intent of the innovations."
naked capitalism

...Wall Street no longer serves the interests of broader society.

Now before you say, “Well that is just how markets are,” the markets in which major capital markets firms operate are hardly natural constructs. The modern securities industry grew out of the heavily regulated US equity markets; all the leading firms today either were long-established players or bank aspirants who drew on securities industry know-how. Firms are regulated and subject to licensing requirements. Even the rating agency business has restricted entry and capital requirements. So these were always regulated businesses precisely because financial services was understood to serve public ends. Yet the industry managed to persuade government officials and the public that it could be trusted to operate its businesses responsibly and everyone would benefit from more “innovation”. As we noted in ECONNED:

Institution after institution was bled dry. Yet economists and central bankers applauded the wondrous innovations, seeing increased liquidity and more efficient loan intermedation, ignoring the unhealthy condition of the industry.

The firms that had been silently drained of capital and tied together in shadowy counterparty links teetered, fell, and looked certain to perish. There was one last capital reserve to tap, U.S. taxpayers, to revive the financial system and make the innovators whole. Widespread anger turned into sullen resignation as the public realized its opposition to the looting was futile.

The authorities now claim they will find ways to solve the problems of opacity, leverage, and moral hazard.

But opacity, leverage, and moral hazard are not accidental byproducts of otherwise salutary innovations; they are the direct intent of the innovations. No one at the major capital markets firms was celebrated for creating markets to connect borrowers and savers transparently and with low risk. After all, efficient markets produce minimal profits. They were instead rewarded for making sure no one, the regulators, the press, the community at large, could see and understand what they were doing.

Nearly two years after the worst phase of the crisis the bogus premise of what passes for innovation in banking is largely unchallenged. Entire swathes of the industry that were once thought to live and die on their merits are now government backstopped (”living wills” and resolution authorities are public-placating headfakes, even though some members of the officialdom may be so naive as to believe they will work on globe-spanning megafirms). So both the scale of damage done and the recognition that capital markets activities and payment functions are now government supported means the case for regulating major financial players like utilities is even strong than ever, but instead, we are more or less back to status quo ante.

In the UK, some members of the media are questioning this sorry state of affairs. John Plender notes in the Financial Times:

First, Lord Turner, head of the UK’s Financial Services Authority, put the cat among the pigeons by questioning the social utility of much financial innovation. Then Paul Volcker declared that the only financial innovation that had impressed him over the past 20 years was the automated teller machine. Yet, despite these reservations the world remains remarkably tolerant of anti-social behaviour in the markets and in the wider business environment.

Exhibit A is high-frequency trading. This type of computerised dealing exploits the millisecond gaps between news events and their impact on the markets. With the regulators sitting on their hands, such trading has expanded rapidly to the point where, on some estimates, it accounts for 60-70 per cent of the trading volume in US equities. Much of this volume is conducted by a very small number of companies.

A big reason for concern is that exchanges appear to have joined in an unholy alliance with this small group, which is allowed to see orders before the public. In effect, these people are privileged insiders who are profiting at the expense of those who are innocently saving for retirement and what have you.

Worse, the exchanges, which have a business interest in high volume, encourage co-location whereby traders can route their orders to servers in the same location as the exchanges’ computer matching systems. Reducing geographical distance in this way cuts milliseconds off the time it takes for buy or sell messages to be sent into or back from an exchange.

This is all a form of front-running, even if the trading is not taking place in front of a client order. Proponents argue that anyone can co-locate, but genuine private investors cannot engage in this with an entry price measured in thousands of dollars. The supposed benefit is greater market liquidity. But the resulting market liquidity is far more than is needed for genuine investment. Why should a difference in the milliseconds be relevant to meeting pension liabilities with a 20-, 30- or 40-year duration? And, as the “flash crash” of May 6 showed, the activity can be highly disruptive.

Now that the regulators are taking an interest, they will probably focus on making the playing field more level. Far better would be to recognise that this competitive technological battle reduces social welfare in a similar way to an arms race. The fact that a handful of traders are creaming off big profits at the expense of genuine investors undermines the integrity of the market. A more draconian regulatory response would be appropriate.

Yves here. We haven’t said much about HFT because, in all honesty, as offensive as it is from a fairness and integrity of markets perspective, the damage done by it pales in comparison to the devastation wrought by abuses in the credit markets, where we normally focus. And truth be told, equity investors are a vocal lot, and many commentators had taken up the attack on HFT.

So it is remarkable that a highly visible abuse, one that unlike the bad practices in the credit markets, can be addressed readily, in isolation, without widespread ramifications, still persists. And as Plender points out, the planned remedies look certain to be inadequate.

This says that critics need to keep hammering on the observation that financial services is only a support function to commerce, that when it is too big and profitable, that means it has become parasitic and extractive. The public understands that intuitively; it’s time the media and government officials have the nerve to state the obvious.

[Jun 21, 2010]   Why is No One Willing to Say Wall Street is Overpaid

naked capitalism

The New York Times yesterday featured an article by Yale economist Robert Shiller in which he discussed how financial reform had fallen short of addressing the conditions that caused the crisis. He focused on the failure to implement effective pay reform at the large financial firms that too big or otherwise too crucial to fail:

The issues facing us are complex. Let’s look at just one of them: the provisions in the Congressional bills on executive compensation.

Certainly, executive pay has grown enormously in recent decades, and there has been much suspicion that it contributed to the crisis. But it’s not the high level of executive salaries that helped cause the financial collapse. Efforts to reduce executive salaries have perversely created the wrong incentives. A 1993 law discouraging companies from paying their chief executives more than $1 million a year appears to have led to a de-emphasis of salaries and an increase in stock options.

So here is one of those epiphanies: Those stock options didn’t lower total compensation. And they probably encouraged C.E.O.’s to expose their companies to more risk, because options’ value grows as risk does. In fact, legislators’ misunderstanding of the law’s true incentives may have contributed to the severity of the crisis.

Yves here. Um, so how exactly doe d s this little discussion disprove Shiller’s aside, that the level of pay did not contribute to the crisis? Answer: it doesn’t. He instead shows that not-fully-thought out reform created results the reverse of what was intended: it allowed pay levels to escalate when the level of executive compensation had already become worrisome, and worse, in a way that encouraged undue risk taking.

Now some readers will argue that financial services industry pay is market determined and therefore virtuous. That’s a misconstruction. Compensation in the financial services is a classic example of market failure.

The big banks and broker dealers ALL went into the crisis badly undercapitalized. Why? Because the industry engaged in a variety of practices that allowed them to rely on what amounted to fictive capital. For instance, credit default swaps allowed them to hedge risk with undercapitalized counterparties like AIG and the monolines. When the hedges failed, the banks showed spectacular losses. Similarly, banks shifted assets into structured investment vehicles and other off balance sheet entities, but earned fees both for setting them up and providing services to them. When these entities started showing serious losses, the banks discovered they weren’t so “off balance sheet” and tool losses.

If the banks had accounted for these risks properly, they would have had to carry higher capital levels and would therefore have had to retain more in the way of earnings and pay less to employees. And the idea that escalating pay levels was needed to retain “talent” was dubious. The threat was that the best staffers would leave for hedge funds. But let’s face it, they did regardless, and hedge funds employ comparatively few people in comparison to the banks and broker dealers.

Another reason compensation across the firms was excessive was that earnings are what economists call pro-cyclical. Banks and broker dealers are structurally long. Even Goldman, which endeavored to short subprime, was still long mortgages and credit instruments generally. When interest rates fall and risk spreads narrow, banks and brokers will show profits if they do absolutely nothing. They will show profits on the rise in the value of their assets. This has nothing to do with employee actions, yet they were paid bonuses on profits that would have shown up regardless. And those profits turned quickly to losses when risk spreads widened, but no one was forced to disgorge what amounted to undeserved compensation.

In 2007, John Whitehead, former co-chairman of Goldman, debunked the idea that the current levels of pay were warranted (mind you, 2006 bonus were dwarfed by 2007 and 2009 levels):

“I’m appalled at the salaries,” the retired co-chairman of the securities industry’s most profitable firm said in an interview this week. At Goldman, which paid Chairman and Chief Executive Officer Lloyd Blankfein $54 million last year, compensation levels are “shocking,” Whitehead said. “They’re the leaders in this outrageous increase.”

Whitehead, who left the firm in 1984 and now chairs its charitable foundation, said Goldman should be courageous enough to curb bonuses, even if the effort to return a sense of restraint to Wall Street costs it some valued employees. No securities firm can match the pay available in a good year at the top hedge funds.

“I would take the chance of losing a lot of them and let them see what happens when the hedge fund bubble, as I see it, ends.”

More support comes from Andrew Haldane of the BIS, who in a March 2010 paper compared the banking industry to the auto industry, in that they both produced pollutants: for cars, exhaust fumes; for bank, systemic risk. While economists were claiming that the losses to the US government on various rescues would be $100 billion (ahem, must have left out Freddie and Fannie in that tally), it ignores the broader costs (unemployment, business failures, reduced government services, particularly at the state and municipal level). His calculation of the world wide costs:

….these losses are multiples of the static costs, lying anywhere between one and
five times annual GDP. Put in money terms, that is an output loss equivalent to between $60
trillion and $200 trillion for the world economy and between £1.8 trillion and £7.4 trillion for the
UK. As Nobel-prize winning physicist Richard Feynman observed, to call these numbers
“astronomical” would be to do astronomy a disservice: there are only hundreds of billions of
stars in the galaxy. “Economical” might be a better description.

It is clear that banks would not have deep enough pockets to foot this bill. Assuming that a crisis
occurs every 20 years, the systemic levy needed to recoup these crisis costs would be in excess of
$1.5 trillion per year. The total market capitalisation of the largest global banks is currently only
around $1.2 trillion. Fully internalising the output costs of financial crises would risk putting
banks on the same trajectory as the dinosaurs, with the levy playing the role of the meteorite.

Yves here. So a banking industry that creates global crises is negative value added from a societal standpoint. It is purely extractive. Even though we have described its activities as looting (as in paying themselves so much that they bankrupt the business), the wider consequences are vastly worse than in textbook looting.

Yet its incumbents tout their ‘talent” and insist on their right to mind-numbing pay because their services are allegedly so valuable to the economy.

Yet after applying a wrecking ball to the global economy, the banks got big handouts, and like Fannie and Freddie pre crisis, the banks get to borrow at cheaper rates than would otherwise apply because investors understand full well that governments stand behind big financial firms. Haldane again:

It is possible to go one step further and translate these average ratings differences into a monetary measure of the implied fiscal subsidy to banks…The resulting money amount is an estimate of the reduction in banks’ funding costs which arises from the perceived government subsidy..

For UK banks, the average annual subsidy for the top five banks over these years was over £50 billion – roughly equal to UK banks’ annual profits prior to the crisis. At the height of the crisis, the subsidy was larger still. For the sample of global banks, the average annual subsidy for the top five banks was just less than $60 billion per year. These are not small sums…

On these metrics, the too-big-to-fail problem results in a real and on-going cost to the taxpayer and a
real and on-going windfall for the banks.

Barry Ritholtz in a post today, correctly takes apart Shiller’s recommendation (deferring a substantial portion of pay, which would be forefit if a company were bailed out or failed) and recommends a superficially appealing solution, returning to a partnership model:

The thought process behind this is that risky corporate activities should also become a risk to the firm’s executives…The hope is that “this will transform executives’ thinking about risks — and may help prevent another disaster.”

I sincerely doubt it. Similar disincentives were already in place — and they failed miserably.

At each and every one of the companies that went bust due to their excessively risky speculations — from AIG to Bear to Citi to Fannie Mae to Lehman to WAMU — every executive had huge amounts of stock, stock options, and future salaries at risk. Lehman’s Dick Fuld reputedly lost over $500 million dollars in stock value, and a few of Bear Stearns execs lost close to a $ 1 billion dollars each in asset value.

The mere threat of future losses has already proven insufficient to moderate behavior. Holding back $100s of 1000s of dollars — or even millions of dollars — is a meaningless inconvenience to the people whose net worth is measured $100s of millions or billions of dollars.

Barry then offers partnerships as a model:

I did discover one group of Wall Street firms whose senior management took a very measured approach to managing risk..

The group? Wall Street partnerships…

Partners have “joint and several liability.” Every partner is fully liable, up to the full amount of the relevant obligation, for the actions of every other partner. This has the effect of focusing the minds of management on exactly what the worst case scenario of their behavior can wreak….the creditors can proceed to recover losses from the personal assets of every partner. Bank accounts, Houses, boats, vacation property, 401ks, cars, jewelery, watches, etc. are all fair game for creditors.

Not surprisingly, none of the Wall Street partnerships got into trouble…

Yves here. While I agree 100% that Barry’s proposal is superior to Shiller’s it’s not the panacea he makes it out to be. First, partnerships were reckless in the 1920s and many failed in wake of the Great Crash. Ironically, Barry cites Brown Brothers as an example of a modern partnership that has behaved prudently, but the current Brown Brothers was born of the merger of the teetering Brown Brothers & Co. into the stronger Harriman & Co. in 1931. There was another large wave of partnership failures and mergers in the wake of the 1960s back office crisis, but because these firms got into trouble as the result of operational problems, as opposed to the misuse of borrowed money, it did not have wider economic fallout.

Second, there are a lot of ways that executives can slip the leash, from putting assets in countries where it would be hard to repatriate, or even locate them (there is a reason Jews fleeing persecution used to sew diamonds into their clothing, it is a compact and portable form of wealth) to quitting at the first sign of business troubles, to only taking risk in very long-dated exposures (again, to shift responsibility for any blowups on to successor management) And who would want to take on that sort of liability unless he could an exhaustive audit of the banks’ exposures? Thus, if someone were to turn down a high level position, rumors could easily start that the bank was in trouble, which in a worst-case scenario would precipitate a run.

Third, how would you draft regulation to deal with sales of severely weakened firms? Look at the sale of Merrill to Bank of America, which was lauded as a coup by John Thain (in terms of the value received by Merrill shareholders). It sure was, Bank of America later cut a deal with the government to cover Merrill losses. And this sort of partnership liability concept would lead the authorities to write waivers to firms like JP Morgan that step in to buy troubled firms like Bear.

One of the reasons that Barry forgets that partnerships led to more caution wasn’t simply the prospect of unlimited losses. It was also that partners had most of their wealth tied up in the firm, and could withdraw it only gradually after they retired. This led them to take a long-term perspective and also prevented the pursuit of a lavish lifestyle. And it further lessened mobility among junior staff. Partners would only take people into the partnership that they had observed over long periods of time. Unless he was exceptionally talented, someone who came in mid-career to a firm would be at a disadvantage relative to those who had spent their career there.

But the focus on executive pay divers attention from the fact that pay levels across the big players is wildly out of line, given their ever-growing government guarantees. n a paper by Piergiorgio Alessandri and Haldane, “Banking on the State” (hat tip reader Scott), they describe how support to the financial system has ratcheted up in the wake of crises, which only makes it more attractive for banks to gamble. They note:

This is a repeated game. State support stokes future risk-taking incentives, as owners of banks adapt their strategies to maximise expected profits….the latest incarnation of efforts by the banking system to boost shareholder returns and, whether by accident or design, game the state. For the authorities, it poses a dilemma. Ex-ante, they may well say “never again”. But the ex-post costs of crisis mean such a statement lacks credibility. Knowing this, the rational response by market participants is to double their bets. This adds to the cost of future crises. And the larger these costs, the lower the credibility of “never again” announcements. This is a doom loop.

The “St Petersburg paradox” explains how a gambling strategy which starts small but then doubles-up in the event of a loss can yield positive (indeed, potentially infinite) expected returns. Provided, that is, the gambler has the resources to double-up in the face of a losing streak. The St Petersburg lottery has many similarities with the game played between the state and the banks over the past century or so. The banks have repeatedly doubled-up. And the state has underwritten any losing streak.

Yves here. In other words, given the inability of bankers to avoid crises, this destructive pattern will continue until the banks break their backers, meaning the state, or we find a way to stop the game. Loudly contesting the idea that the pay levels at the major capital markets players are in any way warranted is part of the process of bringing the industry to heel.

Selected Comments



The issues facing us are complex.

No. They’re not. Conceptually the problem is very simple.

We have pure parasite gangsters who produce nothing who are stealing a vast amount of the wealth created by society. They’ll keep stealing every cent they can until they’re completely destroyed. Period.

But when one is too much of a moral coward to face this clear fact, one must artifically complexify the “issues” to justify seeking “solutions” in a fantasy world walled off from the real one.

Yves here. In other words, given the inability of bankers to avoid crises, this destructive pattern will continue until the banks break their backers, meaning the state, or we find a way to stop the game. Loudly contesting the idea that the pay levels at the major capital markets players are in any way warranted is part of the process of bringing the industry to heel.

That’s the way it is. The Bailout State is already starting to crack under the pressures of the Bailout, which is the real reason the system wants to move to “austerity” everywhere. The Bailout will soon be insufficient to keep the loot flowing, so the kleptocracy has to move from the bailout’s relatively indirect robbery to the direct robbery of stealing pensions and abdicating on services so more public money can be freed up to be stolen.

So one of the parts of the process should be to meet every hint of the fraudulent notion that any of this “compensation” looting is justified (and never let them get away with absolutely fraudulent words like “compensation” or “earn”), or that the “issues” are “complex”, with the clear truth:

These are parasites and criminals who produce nothing but needless cost.

Every cent they extract is being stolen.


IMHO pretty nearly everyone earning Wall Street money is probably overpaid. Sure, there will be the odd exception – the researcher who has discovered a new drug which saves the lives of thousands. But do sports figures deserve their money? Don’t think so. Entertainment figures? Nope again. Etc.

So maybe, rather than trying to figure out a way to make Wall St. compensation lower, we should just raise taxes a lot on higher earners, and figure out better ways to stop these earners from moving their money off-shore.

Frank Powers:

@ a:

Again, I’d like to point out Sam Pizzigatti’s “Greed an Good”, wherein he outlines a simple mechanism for the restriction of “compensations” – namely a maximum wage amounting to ten times the minimum wage currently paid, combined with increased taxes on assets and liabilities, if I remember correctly. That would still enable executives et al. to increase their maximum compensation, but at the same time require that the average pay level goes up as well, resulting in a smaller, more just and socially more beneficial spread of income. The whole, excellent book is available for download on his webpage,


You’re damned right. We’re being ripped-off, all of the time. Neo-feudalism, anyone?


The deeper question is this: why is money the best (or only) reward mechanism we can/have come up with? Or: Is money a reward/punishment mechanism that can only overdo it? It always seems to be that the rich get richer and the poor poorer.

Then there’s the chance happening of overpaid sports people and entertainers. Their value to society can hardly equal the ludicrous share of the pot they earn, compared to say good nurses and teachers. But because money yields, over time, a society obsessed with financial profits, social goods like health and education are forced to take a back seat. We end up prioritizing those things that make loads of money, no matter the cost to society.

What do we need to do to money to correct this obvious failing?

Frank Powers:

An essential part of the money problem is that money not only acts as a direct reward machanism, but as a (psychological) self-enhancement mechanism as well: up in the high ranks of corporate leadership (or billionaire country, for that matter), money has long lost its direct exchange-value and rather functions as a kind of score, allowing for a direct comparison between the “players” and their peers.

The game they’re playing is the one everyone plays, the game of raising one’s self-worth, quelling one’s anxiety in the face of life and one’s own mortality and aggrandizing one’s self-esteem. Pity is they’re using the source stuff itself for that purpose, removing it from its original role as a mere medium of exchange, and turning it into something they never can have enough of. Because let’s face it: There are only so many cars, mansions, and yachts you can reasonably buy and use, only so many suits you can wear, and only so many banquets you can feast on. After all, “enough is as good as a feast”, as the saying goes. Unfortunately, taking into account money’s changed role as a signifier of score, they never can have enough, as the score never gets settled and the “game” goes on and on. So they continue to rob and rip off and will always do so, until they or we find a different way to quiet their existential Angst.

Of course, we could also just throw them in jail. But whoever moves up probably won’t be any better. And we might be able to instigate a new set of rules, like the one Pizzigati ( advocates, or any different one – but still, until we get a change in consciousness and in handling the basics of our human existence, the temptation to highjack any reward system for our personal needs of (a false) security and self-aggrandizement will always be there.


Why aren’t more people talking about nationalizing credit? Not temporarily, as an emergency measure, but permanently?

This is one of Michael Hudson’s proposals in the following excellent interview on “Guns and Butter,” at KPFA (”Listener -supported Pacifica radio” in Berkley):
Guns and Butter – June 16, 2010 at 1:00pm


ALL of them are overpaid.

But the question that should be looked at is HOW do they get overpaid? The only way this can happen is if they are charging their customers excessively, thus generating the excess cash to be able to comp people excessively.

Customers SHOULD be asking – WHY are we paying you so much for your services? Isn’t anyone willing to provide the same services at less cost? If not, then it sounds like there is some sort of monopoly there.

Siew Lee:

On the point that compensation as evidence of market failure, the link below is to a moving story on something similar, how the medical insurance can put the health care system at odds with the wishes of the patient.


Why does the market allow for such high compensation? There’s two possiblities that I can see: a complete failure of corporate governance (the bankster theory) or these high paying jobs are hard to get and to keep (the actual reason).

Your basic wall street trader, salesperson, fund manager had a hard time getting their job and has very low job security. Also, there’s not a ton of these jobs that pay so well – there are more press articles and blog posts on the subject than there are high paying wall street jobs.

So all this regulation of banks will work, kinda. Less risk at the big banks will mean less risk to the risk taking employees of the banks and less sexy (scary) stuff for the banks to sell. So job security will rise, comp will fall.

The fallout:

Some risky, hard to get jobs remain and they pay even better because there’s less of them (why do you think Goldman made so much in 2009?).

The 3-10 people who work in support of that risky job get fired (don’t even try to tell me this doesn’t happen – see layoffs at Bear from the JPM buyout).

These risk takers and salepeople are smart and they like to make money so they’re not going to just start looking for minimum wage jobs – they’ll go to or form those partnerships and small companies you spoke of. This is risky and they’ll get paid based on real earnings, many will get payed more than you would like I’ll guess. Others will have to move on. Others still will work at different banks.

Just because you don’t like what they do doesn’t mean they’ll listen to your bull****.

So I work on wall street – here’s a news flash – 60-80% of the professionals I know have lost there jobs over the last two years – but almost every one of them have found another job doing the same thing either at another established company or at a small newer one. Less money, more money, families disrupted, whatever – we’re all evil anyway…

[Jun 21, 2010] The Growing Push to Impose a Transaction Tax

June 17, 2010 |

Among the hot button issues that Wall Street will be following closely next week at the Group of 20 economic summit meeting in Toronto is the idea of imposing a worldwide tax on financial transactions. The move, championed by the Europeans, is aimed at curbing excess speculation and building revenue.

For now, the Obama administration is not supportive of such a tax, but international pressure and the widening budget deficit could possibly prod the United States to fall in line eventually.

Financial transaction taxes are nothing new. Britain has had a 0.5 percent tax on stock transfers for years. The United States had a transaction tax from 1914 until it was phased out in 1966, and it has not been seriously considered as a revenue source until now.

The Institute for Policy Studies, a left-leaning think tank, issued a report on Thursday promoting the benefits of such a tax. The report, titled “Taxing the Wall Street Casino,” contends that a transaction tax could raise $177 billion a year and could have even prevented last month’s so-called flash crash, in which stocks took a huge dive in just minutes and then suddenly shot back up.

The origins of the flash crash are still unknown, but many people believe that it had to do with high-frequency trading programs gone haywire. High-frequency trading programs, which now dominate equity trading, rely on computers to execute millions of trades to profit from very tiny spreads in the market.

The institute’s report argues that a transaction tax would have reduced the incentive to trade in such a way by eating away at the slim profit margins that high-frequency trading programs seek out. If the tax were in place during the worst 20 minutes of the flash crash, it would have cost traders $142 million in profit, the report says.

A transaction tax would go beyond instant trades, though, and could be extended to mergers and acquisitions. The tax is considered small enough that is would not necessarily hinder deal activity, but large enough to produce significant income to the Treasury Department, the report says.

Bills in the House and Senate to put into effect a transaction tax have been marginalized, but they could be resurrected in the months to come as a potential revenue source to help pay for the banking bailout. Meanwhile, if it is determined that high-frequency trading was the main culprit behind the flash crash, there could be calls by legislators to enact such a tax to prevent another market disturbance.

For now, the Obama administration is pushing for a special tax on bank profits to help pay for the bailout.

“Geithner clearly sees their proposed levy on the top 50 banks as a preferred alternative, rather than a complement to a transactions tax,” Sarah Anderson, one of the authors of the report, told DealBook, referring to Treasury Secretary Timothy F. Geithner. “As we point out in the report, the bank levy would raise much less revenue, not directly affect speculation, and leave hedge funds and other financial institutions off the hook.”

Germany is close to imposing its own transaction tax to help fill the hole in its budget. The Germans, along with the French, are expected to push the United States in Toronto next week to do the same. But it is unlikely that Washington will budge at this point.

“They are talking about just going ahead with an E.U.-wide transactions tax,” Ms. Anderson said. “Then what would happen if we start to see them enjoy major benefits from this while the U.S. is out in the cold? I think it could become a real issue for U.S. economic competitiveness.”

– Cyrus Sanati

[Jul 17, 2010] Economist's View In Finance We Distrust

Looks like higher level of inequality produced more sociopaths in upper echelons of power. That is really observable in financial industry. See  also "The future of finance" a free ebook with entries by Adair Turner, Peter Boone and Simon Johnson among others:

One more before I hit the road to my high school class reunion (35 years):

In Finance We Distrust, by Michael Spence, Commentary, Project Syndicate: Around the world,, the debate about financial regulation is coming to a head. ...
It now seems universally accepted (often implicitly) that government should establish the structure and rules for the financial system, with participants then pursuing their self-interest within that framework. If the framework is right, the system will perform well. The rules bear the burden of ensuring the collective social interest in the system’s stability, efficiency, and fairness


Let me fill you in on something interesting about my take on Merck & Co and their pain killer Vioxx. I really thought the best of Merck. I never thought the managers would ever do anything to harm the reputation they built for themselves. So, as a stockbroker, I built a rather large position in their common stock. Then one day in late 2000, another broker who knew I had built that position in Merck approached me to fill me in on a paper he found about Vioxx. I'll never forget what he first said, "Do you really know what a Cox-2 inhibitor is?" I checked out the article he was referring to, and I began offing that position immediately when I realized people were going to die from Vioxx. As a matter of record, the highest price Merck traded at was from part of a 1500 share position I whacked for a customer in Jackson Hole, WY. I never looked back at Merck again. They knew damned well what they put on the market.

Enron's common stock was another company I traded in heavily, but was completely out of it before April 2001.

My feelings about corporate America changed while I was a trader, and I can't say I miss those days at all. Something happened to upper corporate management during the Reagan and Bush years. Accountability for their nefarious deeds was being overlooked by the DOJ, (unless of course you're Michael Milken, and not sharing your deals by opening a syndicate with the rest of the Street), so management began having no fear to hold more of their own stock, (to manipulate it), than ever before. The DOJ has developed a culture of looking the other way, and old Rudy Giuliani was the one who started it.

What surprises me is that I knew what was going on as far as the DOJ was concerned since the mid 1980's. Why I chose not care was because I wanted my piece of the pie first before I turned to walk away from it all.


I don't think it is possible to have effective cultural norms for the financial system when the distribution of income in this country is so skewed. The wealthy have always lived by somewhat different rules than the rest of us, but today in America the wealthy live in a completely different world. The point of cheating in finance is not just the money, it's to get yourself into the world where rules don't apply.


I agree with MT. Rules are paramount , and precede the widespread adoption and practice of the ethic.

We all have an innate sense of guilt , but a firm rule like "Thou shalt not covet thy neighbor's wife" , associated with the prospect of a vengeful God who might fuse your bare butt cheeks together with a lightning bolt , transformed that innate sense of guilt into a cultural ethic.

Write down the rules in stone , so to speak , then enforce them consistently , and the ethic will take hold , reducing both the frequency of offenses and the necessary enforcement costs.

The mistake we ( especially you , Bush and Greenspan ) made was in thinking that the ethic , once established , made rules and their enforcement unnecessary.


The H.R. 4173 Bill has been passed, is it not? Screw what we all think needs to be done, somebody needs to figure out exactly what this Bill does.

Nobody read it again, and it's 2000 pages long.

Regulation that makes sense, works for the masses = Good. Over Regulation that works for Politicians and Elites = Bad

Does anybody really know where the masses stand with this Bill? Probably not, but we gonna find out aren't we? With the geniuses we have selected for our leadership over the past thirty years...everybody better cross your fingers.

Bruce Wilder:

It's not your fingers you need to cross, not that it will do you any good.


I would recommend the just released "The future of finance" a book free to download with entires by Adair Turner, Peter Boone and Simon Johnson among others:


Right you are. This is a fallacy of the "invisible hand." Economics is amoral. Left to their own devices in pursuing self-interest, people will act immorally if there is no disincentive for doing so that counterbalances the gains from doing so.

What is the definition of "immoral." Basically, don't do to others what you yourself would dislike done to you. Conversely, the definition of morality is, do to others what you would like done to you. This is agreed upon by virtually all cultures, so it seem to be a feature of human nature. Indeed, recent research shows that primates exhibit an expectation of fairness, and react negatively when they deem themselves treated unfairly.

There is also the liberal paradox to consider, which shows that liberalism is incompatible with Pareto optimality.


Relying on individual morality is like relying on individual restraint to achieve orderly traffic. We have rules, regulations, and authorities with discretionary power to manage Such a (relatively) simple thing as traffic, so Financial System.....

Ohm :

....which swims in money, the most common root of immoral temptations!!


Exactly. This is why liberalism is fundamentally flawed as a political and economic philosophy. It idealizes free choice and doesn't pay enough attention to the consequences of free choice. Many "rational" decisions are based on the low probability of getting caught or being accountable if one happens to be caught. But it goes a lot further than that. Moral hazard in the financial industry is one example.

Another area is "the rest of the world." The assumption that free markets, free trade, and free capital flows will allocated real resources most effectively and efficiently. It's just fantasy. For example, big players hoard commodities and people in poor countries starve.

We need to redesign the box, and that will take out of the box thinking.


If you notice, the way International Trade currently operates, its a Libertarian design. You are free to price your goods, and your currency!, pretty much as you like, and there is no International Sales or Income tax on cross border trade. Infact, many exporting countries even exempt export in one from domestic income taxes. And Yet this Libertarian paradigm has reached its end time.....On its own!

All the dollars have accumulated with China while all the goods (to use the Krugman metaphor) are in landfills. The World Trade dysfunctionality and abject failure to endure within 2 decades of the WTO is, I would say, solid evidence that the Libertarian order doesnt endure for long. It produces a few Winners that take ALL, and the game STOPS. But an Economy is a flow, and circulation, Not a Stock Or a Game Final Score. 

In the case of World Trade, you cant even call someone a Winner when that entity actually Won by fiat-pricing its currency so low that none else could compete in the mirage of exchange rates.

Bruce Wilder:

You might start with the insight that one needs political power, to control the design of the box.

If you have the power, you can have quite conventional ideas, like, "don't lie and steal".

If you do not have power, being clever is, at best, just an idle pastime, and at worst . . . well, worse.


I for one am pleased that Spence's article is getting attention. This one really made my day.

It is important that everyone be continuously reminded how absolutely stark raving hysterical the concept of perfecting legalized collectivism with "ethics" actually is.

"The finance industry, regulators, and political leaders need to create a shared sense of collective responsibility...blah blah"

Right. Like, a higher level of consciousness, man. Everyone needs to smile more.

Let's also note here that all project syndicate's contributors are categorized as "Thought Leaders," the trademark self-congratulations of all those having made their careers at the center of our contemporary "leadership crisis," at least 10 years and running. Clearly the fog of irony is now so massive, and growing, it's no longer visible from the inside. The moral atavism so thoroughly baked in banality, it's forgotten even before it's uttered. It would be the type of thing made just for internet consumption, if not for the fact that it's still the stuff of real day-to-day decisionmaking authority, as we live, a catechism of festering malingery still stinking up the helms of so many of our critical civil institutions.

Indeed, the people behind such noise simply have no public purpose anymore but as living cautionary tales for serious adults on their way to work. Freakshows, if you will.

Please continue to put these, and all the other phony blubbering pleas of resolve from our nation's well-fed flower children, up for the rest of society to see, every day.


Thank you Mr. Thoma.


David Obey says it's "not just something that happened because of the forces of the market."

"I think the more important thing was what was my biggest failure. I think our biggest failure collectively has been our failure to stop the ripoff of the middle class by the economic elite of this country, and this is not just something that happened because of the forces of the market."

So , we've been ripped off ?

Surely they'll catch the crooks , recover the loot , and return it to us , right ?

I hope it's soon. Real soon.


Doctors as the comparative analogy is off the mark. Drs have face time with their patients and see the impact of their diagnosis. The better comparison of Financiers and ethics are children on the school playground. The rules are known and understood. The teachers punish the children for egregious behaviors according to the severity of the offense. Government as the authority refuses to enforce the punishment. Rather they choose to be the financial industry's friends and drinking buddies hoping to win a gig once their "public servant" post has been served. Bill Black has stated many a time the regulations are there and need to be enforced.

Under GWB's tenure, he removed 500 FBI personnel to homeland security and never replaced them. We need more enforcers in the SEC and FBI. Ethics, morals, code of honor and conduct are pretty ideologies and worthless unless shiny bracelets are the prize as a deterrent for bad behaviors that impact the financial structures of a society.

As I've told my kids, "I'm not your pal, buddy, or friend. I'm your parent and my job is help you grow into a responsible adult." It's an unenviable task as an enforcer but an important role in civilized society.


"Yet such values shape other professions. In medicine, there is a huge and unbridgeable gap in expertise and information between doctors and patients. The potential for abuse is enormous. It is limited by professional values that are inculcated throughout doctors’ training, and which are bolstered by a quiet form of peer review."

YES, if by "professional values" and "peer review" one means "hard written laws against fraud" and "men and women deputized and willing to enforce the rule of law."

Seriously. Somebody should be doing some research on the signaling value of Nobel Prizes among the professionals that are actually charged with cleaning up these messes year after year.


"......It can never be too often repeated, that the time for fixing every essential right on a legal basis is while our rulers are honest, and ourselves united. From the conclusion of this war we shall be going down hill. It will not then be necessary to resort every moment to the people for support. They will be forgotten therefore, and their rights disregarded. They will forget themselves but in the sole faculty of making money, and will never think of uniting to effect a due respect for their rights.

The shackles, therefore, which shall not be knocked off at the conclusion of this war, will remain on us long, will be made heavier and heavier, till our rights shall revive or expire in convulsion."

 Thomas Jefferson

Anne from Chicago:

Sadly, we've been following the Jeffersonian model of debtor financing for our dreams....

(Jefferson died $100,000 in debt - in 1826 dollars. Cannot even begin to imagine what the figure would be in today's $$! And this debt meant that the shackles of slavery would remain on Jefferson's human assets - they needed to be sold in order to finance some of that debt.)


"The question [w]hether one generation of men has a right to bind another. . . is a question of such consequences as not only to merit decision, but place also among the fundamental principles of every government. . . . I set out on this ground, which I suppose to be self-evident, 'that the earth belongs in usufruct to the living' . . .." TJ

Anne from Chicago :

In pharma, when there are transgressions, the company tends to pay a massive fine. A year after the financial system collapsed, Pfizer was slapped with a $2.3 billion fine for illegally promoting its products - see:

What happened to those who trashed the economy? They got their bonuses.

There has been no repercussions for the behaviors that dragged the global economy off the cliff. In fact, TBTF has grown even larger. I believe Goldman Sachs - as profitable as they've been since the collapse - still has an umbilical cord to no interest money from the feds.

In finance, we've got a system that continues to privatize profit and socialize loss. Why would anyone in an investment bank change their behavior?

What has been a stunning revelation to me - the defense of immoral, indefensible business practices within finance - selling products to consumers while simultaneously selling insurance to others so they can profit when the products fail. I cannot translate that business practice to any other sector. (Help me out if you know where that happens legally elsewhere!)

The moral bankruptcy of our financial sector preceded the financial crash. There is no integrity on Wall Street - and yet they want to be celebrated as heroes.


"Whereas most prior studies of corporate finance have worked out of a composite-capital setup, I argue that investment attributes of different projects need to be distinguished. I further argue that rather than regard debt and equity as 'financial instruments,' they are better regarded as different governance structures." Oliver Williamson

Something every financier has known for hundreds of years, and why "regulation," in times like this, worries them so. Let us have some hope that by the next crisis, FinReg will, at minimum, restore their free option to beg for liquidation on behalf of their shareholders, and take their old-fashioned sack like the heroes they think they are, rather than to produce such shame as to accept -- from the likes of Barry Obama -- preferred stock or DIP loans with conservatoresque comp limits and behavioral covenants...

"Transcend haggling over regulation" indeed. Receivership is next to godliness, and should never be denied our privatized creatures of the state.

I wonder if any such thoughts ever crossed Mr. Spence's mind during his courageous tenure atop celebrated bankruptcy zombie and eternal fraud vector, "Polaroid Company," back there in the roaring 80s. Perhaps, as a Thought Leader, he could type another article about what a caring attitude and collegial spirit did for markets while he was participating in them, as opposed to how well these qualities have done for, say, his awesome accumulations of academic awards and university chairmanships?


Tonite I heard Ken Feinberg giving a presentation to a crowd of Gulf Coast residents who were impacted by the BP blowout , imploring them to submit their claims and cataloging the variety of legitimate damages that they could cite as a basis for restitution.

It made me think that , in a just world , there would be several hundred Feinbergs out there , doing the same thing regarding the Wall Street blowout. The guilty parties are more numerous but they're just as identifiable , and the damages to innocent victims are multiples of those in the Gulf disaster.

Aghh , never mind.

Back to the real world. The unjust one.


And yet, for TBTF banks, the claims would be made on ourselves. Such is the paradox and guaranteed political albatross of systemically integrated FIs.

For example, I have seen a lot of indignation lately about how Obama should be "more like FDR" and "welcome the hatred of the plutocrat class" and damn the torpedoes, along with the law, et cetera.

Well, even if populism were the only variable, it's a little different these days, since the plutocracy is damn near the majority of the population, collectively through intermediated corporate ownership:


" since the plutocracy is damn near the majority of the population, collectively through intermediated corporate ownership"

I guess it depends on how loosely you define the term 'plutocracy'.

If America of 1928 fit the definition , I'd say it probably does today , as well. According to this , in 2007 the bottom 90% owned less than 10% of stocks , bonds , and mutual funds. The bottom 50% , only 0.5%.

The prior chart in the same series shows the bottom 90% with 28.5% of total wealth , also in 2007. Much of that would have been in the form of home equity , now much reduced , if not gone altogether.

Update those figures to July , 2010 , and I think you'd have a population the bulk of which would find an FDR-like populist message quite compelling.

If not now , though , before too long almost certainly. Things aren't exactly going swimmingly for the masses these days. The rich , well , let's just say they're different.


"Update those figures to July , 2010 , and I think you'd have a population the bulk of which would find an FDR-like populist message quite compelling."

Or, they would just like to have their vested accounts back looking lush and thriving again. Put that on a fantasy menu next to "industrial policy" or "judiciary reorganization" and most would just check the "just make me rich like before" option.

Gini measures are underappreciated and I like whenever they're brought up, but let's keep in mind what it means w/r/t equity ownership. If you are in the 5% percentile, then 5% ownership means just as much to you (or more) than the 90%-ers with all their excess liquidity stuffed up toward the top.

Indeed this is why the rich are different. They have quite a wealth of real options to go along with their cardinal wealth. People stuck in 401ks and rickety pensions, not so much. Nonetheless nearly 3/4 of the country's vested are employed. 20% real unemployment is surely high, that still implies a sound a majority of working adults who really just want their fund numbers back up.


According to the bestseller "The Sociopath Next Door" by former Harvard psychologist Martha Stout, 1 in 25 people are sociopaths. What does that mean? It's not anything like an internal struggle of conscience, a battle of good versus evil deep in the soul. It's much more frightening and diabolical than that. Similar to someone who is color blind being unable to see the colors red or green, a sociopath is unable to feel emotions like empathy, compassion or love. A sociopath could crush the skull of a puppy and feel nothing at all other than perhaps a passing sense of curiousity at best or, more villainously, a sense of sporting entertainment. After the first few million, I think it doubtful Bernie Madoff cared anything at all about the money. It was all about screwing the dumb suckers, taking it all from the pathetic little ants and getting away with it. I suspect that finance is an industry where the proportion of sociopaths in the population rises significantly greater than 1 in 25. Regulation may not be enough. The threat of harsh and lengthy prison sentences backed up by vigorous and vigilant prosecution may be in order.

K Ackermann :

I think the sociopath potential is in most people.

The police and the military have to train people to be able to aim a gun at another person and pull the trigger.

Some still never will, but for those that do, most report it gets easier the more they do it. Something gets shut off; it's not something missing or extra, it's just shut off.

Bruce Wilder :

Big bonuses tend to attract and/or train sociopaths.

Mbuna said...

Well, let's get to the heart of the problem. Teaching ethics and having it stick only occurs in a cultural circumstance. Certainly in the past (50 years ago let's say) there was a pretty clear delineation between what was right and ethical and what was not. The basis for such ethics of right and wrong was the Judeo-Christian culture that had a very prevalent voice in society back then.

I am stating as fact that the Judeo-Christian religious culture has lost a tremendous amount of influence in the last 50 years and that trend shows no sign of reversing. In fact I would say that the Renaissance was the real start of the world secularizing trend and it has continued to this day. The only real problem with this is that real culture will not last without some kind of real connection to the Source, the Divine, whatever you may wish to call it.

What we have now is no culture, or call it a secular culture if you will. Look back in history for any other secular cultures existence and you will not find one.

In all cultures to one degree or another, if you didn't follow the rules of the culture you were separated or ostracized, and this kept the core of the culture strong. Our present society lacks this necessary instrument of culture which is why I say we have no culture. Government laws do not suffice and if they did then we would have a police state.

So now lets jump back to ethics on Wall St. My point is that in a real culture you could be hired and everyone would not only understand what was required of them ethically but understand the wisdom of behind it. And that fundamental wisdom is the understanding of what works for the greater good of all. As long as we have this secular, adolescent, me first mentality, no amount of government structure and regulation will actually work because the people who need to make the regulation work will not be culturally dependable. This has already been and is currently being demonstrated, in spades. No one is culturally accountable period, so society just kind of festers into a me first free for all.

We all have to dig a lot deeper to begin to grasp the fundamental issue these times confront us with.


Judeo-Christians don't have a prominent voice in our culture? Give us a break. Or, how about an "indulgence."

"50 years ago there was a pretty clear delineation between what was right and ethical and what was not"

What is this, ancestor worship? 50 years ago, religious zealots beat their wives and lamented the uppity coloreds all six days between services. Only someone who never had to live back in those times would say something so inappropriately glorifying about such a savage era.

And what is currently being demonstrated is that over the last 10 years, the bureaucracy was overrun with foaming-at-the-mouth jesus-school sentinels. Right now is your recommended substitution of competence with "culture" on display.

How about this for a fundamental issue: The backward view that lawlessness is freedom, and ostentatious displays of religious piety is the same as accountability. That is what contempt for "secular" norms of objectivity brings to civilization

[Jun 16, 2010] Ideas on curbing bankers’ appetite for risk By Gillian Tett

June 15 2010 |

What is the best way to pay top bankers? That is a question that has haunted western politicians since the credit crisis started. After all, in the past two years the pay of most non-bankers – ie voters – has been flat or falling. But many bankers – or financial “fat cats” as they are dubbed – have continued to earn vast sums.

And while regulators widely agree that this banking compensation system is flawed, there has hitherto been little practical change. In Europe, some governments have tried to impose taxes on banker bonuses, or impose guidelines. Some, like the Dutch, are even imposing curbs.

Such moves have had limited bite, partly because in the US there has been virtually no change to the compensation system at all. Indeed, the current financial reform bills barely mention the topic, since the idea of Big Government trying to determine banker pay is something that still looks profoundly “un-American”.

However, in one place, at least, banker compensation is provoking some intriguing debate: namely the academic research arm of the New York Federal Reserve.

Hamid Mehran, a senior economist at the New York Fed, has been brainstorming the issue with colleagues and academic economists. Mr Mehran and others have concluded that one of the biggest problems with the fat cat financiers is that their pay is linked to share prices.

America’s vision of capitalism has tended to assume that the best way to run efficient companies is to give top executives incentives to maximise shareholder value, by linking pay to share prices.

But even if that creed works for non-financial companies, there is a basic problem with applying this principle to banks. The average non-financial company is composed of 60 per cent equity and 40 per cent debt. But at banks, leverage has been so high that debt can account for 95 per cent of value, and equity only 5 per cent.

Thus, if bank executives focus only on equity prices – say, by raising profits – but have less incentive to protect the long-term value of debt – most notably by creating a stable business – that creates a mismatch, particularly since bank debt is typically protected by governments. Or as a paper* recently co-authored by Mr Mehran says: “Structuring CEO incentives to maximise shareholder value in a levered form tends to encourage excess risk-taking.” Hence the credit boom.

Economists propose one obvious solution: bank boards and regulators should also link executive pay to the performance of bank debt, measured either by bond prices or the cost of insuring bank bonds against default using credit default swaps. That, they argue, would provide both a capitalist incentive and one to keep banks stable – and, better still, without Big Government control.

Could this fly? Don’t hold your breath. To most politicians and taxpayers the scheme probably sounds too complex or subtle to work. The CDS market is pretty politically controversial right now and the compensation committees of most investment banks are so shell-shocked by the crisis that they are keeping their heads down, not trying radical experiments.

Nevertheless, Mr Mehran’s idea certainly does deserve a wider audience, not least because it exposes a fundamental paradox in the current Washington financial reform debate.

Americans have taken it for granted that banks were designed to make profit and maximise shareholder value. But the crisis has shown that many politicians and voters also think banks have a wider public function as a utility. This second goal is driving much of the reforms.

The bitter truth is that it is extremely difficult to chase both goals, without endless government meddling. Banks cannot be safe utilities performing a social function and profit-maximising ventures – unless the state wraps the banks in endless rules to protect them from their own profit-seeking bankers. There is little sign the US wants that. But if it keeps paying bankers to boost the share price, it will be hard to build a stable system of finance – even with all the reforms being debated in Washington.

* Executive Compensation and Risk Taking; by Hamid Mehran, Patrick Bolton and Joel Shapiro; paper presented at Columbia University

[Jun 13, 2010] The War Against Finance

Bailing out banks instead of nationalizing them is Robin Hood in reverse
Sudden Debt

Whilst everyone is understandably worried about Europe'an PIIGS debt, it's also timely to examine what is happening with America's federal government debt, the grand-daddy of them all. In a word, it's horrible.  The debt-to-revenue ratio for the federal government is the highest since right after WWII, soaring to 396% in 2009 and  projected to rise further to 424% this year (see chart below).

... ... ...

The point I wish to make is that banking was boring, bankers were boring and anyone who wanted to be a banker was bonkers.  And that was a good thing.

By contrast, today's bankers and financiers (still) think of themselves as the swashbucklers of the world, moving billions at the press of a button or with a quip of "mine" over a direct phone line. They rarely, if ever, pause to ponder what it is that they actually provide to the real economy, what it is that they produce or even facilitate.  The most senior of them may mumble some stock phrase from the Chicago School prayer book, but deep down they know damn well that all they accomplish is to increase total systemic risk for the real economy.


Financial engineering, coupled with lax regulation and unquenchable thirst for ever more yield pickup, made it possible to slice and dice obviously crappy loans into tranches and then into bonds and derivatives that were transmuted into AAA assets.  And those were further leveraged, both by outright margining them  within portfolios and/or by turning them into even more esoteric, higher-order structured products (structural leverage)

No wonder the professionals who slapped these products together referred to them as "shitty deals".  It didn't matter that some ludicrous math priced them at stunningly low 30 basis points (0.30%) over  risk-free Treasuries. When the shitty (deal) hit the fan -- as it always does -- it was not the bankers who got whacked, but the homeowners, the construction workers, the factory workers, the realtors, the insurance brokers. Most outrageously, the bankers got bailed out and got record bonuses.  God's work, my ass.

I could go on, pointing out the complete absence of real economic benefit  or merit in activities like: high-frequency/bot trading in shares, 200-1 leveraged FX trading for individuals (also known as bucketshops), financial spread betting (also, also known as bucketshops), index tracker/reverse index tracker ETFs, etc. etc.

But it's Friday once again and I have better things to do.  And my hands no longer smell of grease (well, maybe a bit of bicycle grease..).

[May 24, 2010]   Reforming Credit Rating Agencies «

The Baseline Scenario

with 29 comments

This guest post was contributed by Gary Witt, an assistant professor in statistics and finance at the Fox Business School at Temple University. He was previously an analyst and then a managing director at Moody’s Investors Service rating CDOs from September 2000 until September 2005. Witt also caught one error in 13 Bankers, which I explain here.

Many readers will think that the last person whose opinion should be consulted on the issue of rating agency reform is a former rating agency employee. Maybe they’re right, but I did learn one thing from rating hundreds of complex securities. Contrary to what some may think, there are no easy solutions here. Unintended consequences are guaranteed. So here’s my humble take on the current CRA reform proposals.

What should be the goal of rating agency reform?

In 2007, as S&P and Moody’s were trying to decide how to rerate the entire structured finance debt market, I asked a shrewd fund manager what advice he would give to the management of a rating agency. He said they have to get the ratings right. No matter how hard it is, they have to focus on getting the ratings right.

There is an alternative school of thought. Instead of improving ratings, the reform agenda should be to be to eliminate their use. Since the rating agencies are hopelessly stupid or corrupt or both, just say no. End the market’s addiction to credit ratings by eliminating the SEC designation Nationally Recognized Statistical Rating Organization (NRSRO). Go cold turkey and end the practice of using ratings to assess credit risk by governmental or regulatory entities.

These two competing goals, improve credit ratings and eliminate credit ratings, can be viewed from a larger perspective, a Minsky mindset. If stability breeds instability, then trust breeds disappointment; the greater the trust, the bigger the disappointment. The rating agencies were over-trusted until 2007.

But looking forward, as a bi-polar sufferer might do, isn’t the best strategy to try to manage this fundamental aspect of our identity by taking off the peaks and troughs of our swings in trust? In trading terms, if trust is the underlying commodity, we should manage our mood by selling an OTM call to fund a long OTM put and avoid capitulation here at the bottom of the trough in our trust.

The Financial Stability Act of 2010

How does the financial reform act being considered in the US Senate address the rating agency problem? Two significant amendments were passed on May 13, one from Senator Franken and one from Senators LeMieux and Cantwell. They are bolder (or perhaps more theatrical) than the previous provisions and almost perfectly reflect each of the two very different strategies: improve credit ratings and eliminate credit ratings. It’s not so clear if the amendments work well together or with the other CRA provisions of the current financial reform bill.

Prior to those amendments, the existing provisions in the bill sought to both improve and de-emphasize but not eliminate credit ratings. That’s a good, sober approach that reflects the philosophy outlined by Assistant Treasury Secretary Michael Barr (Financial Institutions) in his remarks before the Banking committee in August:

“Our legislative proposal directly addresses three primary problems in the role of credit rating agencies: lack of transparency, ratings shopping, and conflicts of interest. It also recognizes the problem of over reliance on credit ratings and calls for additional study on this matter as well as reducing the over reliance on ratings.”

The Franken amendment would attempt to improve ratings by addressing the conflict of interest issue. In Franken’s amendment, a Rating Advisory Board would be appointed by the SEC to assign one qualified NRSO to rate each securitization. The criteria for assignment could have a random component assuring that all qualified agencies get to rate some transactions but the Credit Rating Agency Board is directed to consider “the effectiveness of the methodologies used by the qualified nationally recognized statistical rating organization.” This seems to invite a contradiction of Secretary Barr’s admonition that “the government should not be in the business of regulating or evaluating the methodologies themselves.”

Here’s a good description of Franken’s amendment with some context.

The LeMieux/Cantwell amendment cuts right through the problem of over reliance on credit ratings and ends Secretary Barr’s time for additional study. It deletes all references to credit ratings from the Securities Exchange Act, the Investment Company Act of 1940 and the Federal Deposit Insurance Act. While not actually eliminating the NRSRO designation, Senator LeMieux describes his amendment as follows:

“My amendment writes these organizations out of law. . . . In a way, we’re looking here and saying the astrology that we relied upon in the past didn’t work. Let’s have some new and better astrology.”

I don’t fault the Senator for the astrology remark. Credit ratings are predictions about the future. My question is, “Where is this better astrology?” His amendment seeks to eliminate but not replace credit ratings in regulation. If you try to replace something with nothing, you create a vacuum. Ironically, one of the unintended consequences here could play right into the hands of S&P and Moody’s. If you undermine the significance of the NRSRO designation, you risk hurting the seven newly minted NRSROs more than the well-known brand names.

In addition to the two recent amendments, the original rating agency-related provisions of the bill are summarized here.

New Requirements and Oversight of Credit Rating Agencies

1) New Office, New Focus at SEC: Creates an Office of Credit Ratings at the SEC with its own compliance staff and the authority to fine agencies. The SEC is required to examine Nationally Recognized Statistical Ratings Organizations at least once a year and make key findings public.

2) Disclosure: Requires Nationally Recognized Statistical Ratings Organizations to disclose their methodologies, their use of third parties for due diligence efforts, and their ratings track record.

3) Independent Information: Requires agencies to consider information in their ratings that comes to their attention from a source other than the organizations being rated if they find it credible.

4) Conflicts of Interest: Prohibits compliance officers from working on ratings, methodologies, or sales.

5) Liability: Investors could bring private rights of action against ratings agencies for a knowing or reckless failure to conduct a reasonable investigation of the facts or to obtain analysis from an independent source.

6) Right to Deregister: Gives the SEC the authority to deregister an agency for providing bad ratings over time.

7) Education: Requires ratings analysts to pass qualifying exams and have continuing education.

8) Reduce Reliance on Ratings: Requires the GAO study and requires regulators to remove unnecessary references to NRSRO ratings in regulations.

Here’s how I rate these provisions.

(1) AA

This one should have been included in the CRA Reform Act of 2006 but better late than never. There are three big questions in my mind. a. What type of staff? Will it include some people with relevant experience either at rating agencies or at issuing or underwriting firms who have dealt with rating agencies?

b. Will the new focus at the SEC include the measurement of rating agency performance? The SEC needs to perform this critical task in-house, not wholly delegate it to the rating agencies themselves. Of course, this too has staffing implications.

c. How would fines be assessed? If properly targeted, fines could be a powerful tool to change incentives. For instance, the SEC could specify up front that financially painful fines will be levied for poor performance especially for an excess percentage of losses for ratings in the highest category.

(2) BB

Transparency is good except when it isn’t. Rating agencies have been sharply criticized for revealing their methodology and thus allowing investment banks to “game” it. You cannot have it both ways. If a CRA has a transparent methodology, issuers or structuring bankers will use that knowledge to get better ratings. On balance I think transparency is good but issuers and underwriters will express strong opinions about anything that adversely affects them so investors and the SEC staff (see (1) above) need to voice their opinions about rating agency methodologies as well.

Regarding disclosure of rating agency track record, CRA’s have always had staff publishing self-assessments. That’s fine but it’s very difficult to compare rating agency performance using their own idiosyncratic self-assessments. Surely the SEC needs to measure and publish comparative studies of rating agency performance (again see (1) above)

(3) CCC

Toothless. The information “considered” by the rater is irrelevant. It’s the weight assigned to each piece of information that is critical. This is probably meant to help the plaintiff’s bar in number (5) but I doubt it will.

(4) B

This is worth keeping in the bill but incredibly weak. Franken’s amendment is definitely more effective at addressing the conflict of interest.

(5) B

OK but again weak. To avoid “knowing and reckless failures” the agencies will catalogue every conceivable risk in committee memos and thought pieces. I doubt this will affect actual rating decisions.

(6) A

Good but basically a nuclear option. The threat of deregistration is important but fines would be more helpful in practice to create incentives for better rating performance.

(7) BBB

Worth doing.

(8) AA

Good provision. Follows the main recommendation from Assistant Treasury Secretary Barr to the Senate Banking Committee in his testimony from August. LeMieux/Cantwell is a bridge too far.


Actually the bill may give the SEC all the power it needs but, how will the SEC use its new power? As Arturo Cifuentes said in his testimony about CRA reform before Senator Levin’s sub-committee on April 23,2010, the current CRA regulations are like a building code that prohibits tall buildings but does not define tall. I agree.

The SEC needs to do three things.

(a) Define rating standards [but not methodology].

(b) Measure and publish rating performance.

(c) Impose fines for poor performance.

By way of example, there could be five simple categories: A for securities expected to lose under 0.1%, B for expected losses between 0.1% and 1%, C for expected losses from 1% to 5%, D for expected losses from 5% to 10% and F for securities expected losses between 10% and 20%.

As you can see, I would do away with AAA. The notion that an essentially riskless category exists should not be encouraged.

The fines would be heavy only for large-scale losses of securities with an A rating. Again, as an example, levy big fines for losses on A rated securities in excess of 10% for a given category and vintage or in excess of 1% across all categories and several years.

The fines help address the conflict of interest in the rating agency business. Rating agencies need restoration of the balance between rating performance against short term profitability. In the past, rating analysts expressing concerns about inflated ratings were seen only as threats to profitability. Fines do not guarantee accurate ratings but at least future rating agency employees who express concerns about inflated ratings have a chance of being seen as loyal employees working to ensure future profitability.


[May 19, 2010] DOJ Banks Colluded with Municipal “Advisers” to Rig Bids on GICs « naked capitalism

Bloomberg has a detailed story up on its website about a pending Department of Justice suit that charges that municipalities were not simply played for fools by big financial firms and sold down the river by their supposed advisers. Sadly, that is all too common. What is noteworthy here is that the advisers engaged in widespread, open bid rigging to lower the income government entities received on their investments, and took kickbacks from the banks who were the beneficiaries of this process.

Understand further: the payments that were allegedly paid in these cases were significantly large as to require some level of management approval. There is no way management did not know this was afoot.

How this situation came about is that government-related bodies, just like big corporations, will sell bonds to raise money for long term projects. Typically, they don’t need all the dough at once. For instance, if you are building a school, the project expenses might extend over a period of three years. So you want to park your unused proceeds in an instrument that pays more than a bank account. A popular route was guaranteed investment contracts. Municipalities would organize a bidding process to see where to park their dough to receive the best return.

But this is where the process went off the rails. The “advisers” to the municipalities were peculiarly hired by the municipality, but ultimately paid by the bank that wins a piece of business. That of course is a terrible set of incentives if you want someone to work on your behalf. The advisers were were colluding with the banks to keep the bids low and being paid additional undisclosed fees for their assistance. And the banks involved are major names: Bank of America (which has admitted guilt and is turning state’s evidence), JP Morgan (this when its CEO gives sanctimonious speeches about doing the right thing), Citigroup, Lehman, plus eleven others.

Now municipal finance is admittedly a cesspool; in some places, such as Jefferson County, Alabama, the “adviser” was a crony of a corrupt local official and featherbedding was part of the job description. But there is every reason to think that for most part, the fleeced government bodies were chumps rather than complicit.

What struck me was that this story was on Bloomberg this morning and I did not see it until this evening, thanks to a message from reader Francois T. No blog in my RSS reader deemed this worthy of attention. Is corruption by the banking classes now such a normal state of affairs that no one bothers to take note unless the perps are called before Congress and made to squirm?

Some tidbits from the article, which I encourage you to read:

In the bid-rigging deals, CDR [a municipal adviser} gave false information to municipalities and fed information to bankers allowing them to win with lower interest rates than they were otherwise willing to pay, the indictment says. Banks took their illegal gains from the additional returns and paid CDR kickbacks, according to the indictment....

During more than three years of investigation, federal prosecutors amassed nearly 700,000 tape recordings and 125 million pages of documents and e-mails regarding public finance deals....

Bid rigging not only cheated cities and towns, it also illegally denied the IRS required taxes from GIC income, [retired IRS investigator Charlie] Anderson said. The evidence is clear in telephone recordings made on GIC desks, he said. “We could hear people talking about how everyone knew who was going to win the bid. You could tell it was just everyday business.”

Selected Comments

DownSouth 8:50:

Your innocence and naïveté, along with your abiding faith in the private sector, knows no bounds. And like all true believers who hail from the Libertarina-Austrian-Neoliberal (LANie) constellation, your universe is a world of half-truths and distortions.

“I suppose the difference is that, with my clients, it was THEIR money at stake, so they insist on total transparency in the negotiations,” you tell us. “With a municipal employee, it’s not THEIR money, so maybe they’re not as motivated to be vigilant.”

Then you use this as a departure point to launch off into your anti-government tirade: “This is the inherent problem with government, witness TARP. How much more educated would Congress have gotten if it was THEIR money going to AIG, et al?”

To begin with, your construct of how buyer-seller relationships work, although it does have a hint of truth to it, is for the most part a fiction. It is based on the assumptions about human behavior that inhere in neoclassical economic theory. The assumption is that both parties to a transaction have equal information, both are equally knowledgeable, and that each party will weigh up this information and make decisions in a totally rational, self-serving way.

Of course in the real world it doesn’t work that way at all. In our complex world it would be impossible for any one individual to gain the knowledge necessary in so many separate fields—-finance, medicine, real estate, automobiles, televisions etc.—-to make truly informed decisions. So the way it works is that people develop relationships with people (or companies), and it is these individuals and companies they trust to advise them in these complex decisions. People use a number of strategies to decide who it is they are going to trust and not trust, and these strategies can go awry. Much of advertising and other propaganda is expended on building these relationships of trust.

That is the first fiction your argument is based upon. The second fiction, really half-truth, you put forward is when you assert that “the inherent problem with government” is that “with a municipal employee, it’s not THEIR money” they’re handling. There is some truth in that, but totally missing from your simplistic black and white worldview (government = bad; private enterprise = good) is the fact that the public sector is not alone in being plagued with these problems. Your hallowed private sector has its share of these problems as well (I think George Soros calls them “agency problems”, and Bill Black calls them “control fraud.”). Do you believe that persons charged with making decisions on behalf of corporations don’t face similar conflicts? Do you believe that incentives in the private sector are always such that they motivate decision-makers to make the decisions that are in the best interests of the company they work for?

So to conclude, yours is a world of blind faith in private enterprise.

Reading your comments, along with those from many other LANie true believers that have commented on Naked Capitalism over the past few days, reminded me of another group of true believers—-the artists and architects who naively, but wholeheartedly and unquestioningly, threw their support behind the communist revolution in Russia As Victor Awas explains:

They were all extraordinarily polemical, often verbally prolix, and always violently certain in their assertions. They wrote and spoke a great deal of nonsense which was frequently incoherent and irrelevant, and undoubtedly alienated many of those they sought to convert or convince. Nevertheless, the cumulative effect of their words conveyed pure idealism, pure youth and the vibrancy of pure and total commitment. It is a touching testament to an entire generation of artists in every field who placed themselves at the service of a revolution which betrayed and destroyed most of them.
–Victor Awas, The Great Russian Utopia

Francois T 8:51 am:

There is also a little factor we shouldn’t forget: the Courts excessive leniency toward white collar crime, and the courts extreme cultural sensitivity to wealth. You need an airtight case to be reasonably sure a financier will have to do the perp walk.

It is also a sad fact of life in the USA that prosecutors are very reluctant to be harsh against higher up executives. Witness the inexcusable leniency toward Pharma executives of corporations that are serial offenders; any individual who would’ve engaged in the same type of activity would be behind bars at the 2nd offense, when not the first one.

Oh! I’d be remiss to forget to mention that things shall get far worse in the wake of the Citizens United case. Justices are now for sale in each and every state where there are judicial elections.

A banana republic without the bananas; the worst of both worlds we got there.

arby  8:21 am:

Please see the work of the Pa. Auditor General on interest rate swaps by school districts, municipal entities, transportation entities and other infrastructure entities in his state. Large sums skimmed off the taxpayers and sent to Wall Street — a tiny portion of the skim invested in campaigns.

[May 16, 2010] Stop Targeting Greedy Bankers  by Leo Kolivakis

Corruption of academics is the part of the story...  Academic hired gun will try to prove or disprove anything. In Rajan's caste system, banksters are UNTOUCHABLES.
05/14/2010 | zero hedge

Raghuram Rajan, professor of finance at the University of Chicago, and former chief economist at the International Monetary Fund was interviewed on Yahoo Tech Ticker peddling a message for Washington, Stop Targeting "Greedy Bankers" and Focus on Growth:

"What the U.S. has as the same lines as Greece is this, or the euro area I should say, is the constant bailing out of anything that goes wrong," says Rajan, author of a new book, "Fault Lines: How Hidden Fractures Still Threaten the World Economy."

But bailouts aren't the answer. Furthermore, "we've used all our bullets. We don't have any bullets left," Rajan recently told The New Yorker.

In "Fault Lines", Rajan makes the case that without a clear growth strategy, America eventually faces tough decisions -- higher taxes or budget cuts, or a combination of the two as Spain and Portugal announced this week.

"We are in for tougher political times," he tells Aaron in the accompanying clip. "And I think focusing on some of the greedy bankers as the answer to the crisis takes political heat off the politicians, but is not really the answer."

 Watch the interview below to get Mr. Rajan's take on how energy policy -- including a carbon tax -- could help spark America's economic growth.

DirtySouth  - 21:47:

Stop Targeting "Greedy Bankers"?

Yes.  It is not that hard of a concept to grasp.

El Hosel - 07:30

Stop targeting criminals,  pay them record bonuses and focus on screwing the taxpayers.   Rajan/Chicago/Obama/Goldman/Summers/Rubin

Glenjo  - 12:56

Finely chopped up "greedy bankers" is an excellent fertilizer (especially considering the large BS content) and promote excellent growth when mixed with crops, gardens and spread on lawns.

Strider  - 22:23:

Lloyd blankfein is NOT a greedy banker. He just wants everyone on the train to bankruptcy/ Auschwitz.

No money, no power, no threat.  Easy concept  as Dirty South says.

Heres Lloyd's comments on Goldman Sach's next move:

Are you in the audience or the train?

imaginalis  - 10:57:

I would rather be suffering on the train than a rent-boy for the bankerista criminals

Benzass Miphist  - 22:32:

What's wrong with multi-tasking?  Re-enacting Glass-Steagall will actually increase allocation of capital to authentically productive areas of the economy rather than to the FIRE economy. A two-fer!

JohnKing  - 22:33:

We would be well on the way to a real recovery if the "greedy bankers" had been allowed to fail and promptly jailed. There won't be any recovery or economic growth until law and order is restored, of that I'm sure. Who wants to invest, spend, innovate in an environment like this, we are not even going down with dignity.

Obama lost his second term by allowing this mess to fester, many in the Congress and Senate are getting payback now, nothing works until this is settled.

Apostate  - 22:43:

These guys just want "growth" because they want to stay employed in their shitty little jobs. The economy needs no more "growth." It needs severe contraction, and a methodology for putting all these elderly, lazy, moronic, corrupt, kleptocrats into a retirement warehouse.

Strider  - 23:36:


I believe the kids of the future need a middle class. The Oligarchy doesnt care.

Paul E. Math  - 06:44:

I agree.

What good is 'growth' to the rest of us when we have an economy that funnels any and all growth to the top 5% who produce no value?

We need a rebalancing, a restructuring of how our economy allocates GDP.

CEOoftheSOFA  - 22:48:

The Wall Street bankers were caught recommending stocks to their clients in companies that they knew to be insolvent.  They helped companies like Enron hide liabilities from their balance sheet.  They influence the ratings firms to give their securitized debt a AAA rating when 90% of the underlying securities are junk.  They manipulate the oil and gold markets.  They front-run trades to the detriment of their clients.  They pay off politicians to allow them to merge so they now have limited competition.  They pay off politicians to bail them out of bad Latin American loans.  They pay off politicians to bail them out of the most recent crisis.  They pay off politicians to get rid of mark to market rules so they can legally hide liabilities from their balance sheet.  In short, they find every opportunity to break the rules.  Their excessive influence on the politicians is turning the United States into a facsist country.  If there ever was a group of people that deserved to be targeted, this is it.

JackAz  - 14:51:


Short, succinct and to the point.

JohnKing  - 22:58:

Shit for brains third-worlder deems corruption as acceptable, like the old saying can take a man out of the Third World .... typical bullshit from the "international" crowd.

He needs to take his big brain back to India and deal with real issues like open defecation, growth is stymied over there because the peeps are shitting everywhere. Small wonder that wholesale corruption is acceptable to him, at least you can't smell that with your nose.

sgt_doom - 14:02:

In Rajan's caste system, we are ALL UNTOUCHABLES...... (love your remarks, JohnKing!!!!)

Kreditanstalt  - 23:03:

But the MSM, the administration and the masses NEED villains...!

We should just tell the truth: that the spendthrift, indebted, over-consuming middle classes - who saved and invested nearly NOTHING - are responsible for the mess.

True though it may be, it might not go over well...

Brett in Manhattan  - 09:22:

They invested in supposedly safe 401ks and houses that they were told never lose value.

How'd that work out?

That said, there were alot of deadbeats who were looking for a fast buck, but, as the saying goes, "Let the buyer beware."

When you lend someone money, you're "buying" their debt, right?


+1, apostate, the credit buildup has to be de-leveraged, the only question is how? Through deflation(depression) or inflation, or a combonation of both(inflationary depression)?

I'm sure the MSM will fall all over themselves trying to call it everything except that wich it is...double dip recession, jobless recovery, Double dip recession without a recovery...or whatever? The simple fact remains "growth" will have to be redefined!

I thjink we have some very "realistic" years ahead of us as a nation and a planet. I'm glad my portfolio is long guns,ammo,survival gear, and a live within my means philosophy.

"Banks Failing to Lend is Not the Problem"

Dean Baker takes on the "banks not lending" explanation for the persistence of the downturn and sluggish movement toward recovery:
Banks failing to lend is not the problem, by Dean Baker: One of the big myths of the current downturn is that the reason the slump persists is that banks are refusing to lend. The story goes that because the banks have taken such big hits to their capital as a result of the collapse of the housing bubble and record default rates, they no longer have the money to lend to small- and mid-sized businesses.
We then get the story about how small businesses are the engine of job creation, responsible for most new jobs. Therefore, if they can't get capital, we can't expect to see robust job growth.
This story of banks not lending is used to justify all sorts of special policies to help out small businesses and banks. In fact, the Obama administration has plans to make a special $30bn slush fund available to banks if they promise to lend it out to small businesses.
In reality, every part of this argument is completely wrong. First, small businesses are not special engines of job growth. Small businesses do create most new jobs, but they also lose most new jobs. Half of new businesses go under within four years after being started. Jobs do get created when the businesses start, but jobs are lost when the businesses fail.
The reality is that businesses of all sizes create jobs. There is no special reason to favor small businesses in promoting job creation. We should favor businesses that create good paying jobs with good benefits and conditions, regardless of their size.
The other parts of this story make even less sense. Let's hypothesize that many banks are crippled in their ability to lend because of the large hits to their balance sheets from bad mortgage debt. Well, not all banks got themselves over their heads with bad mortgages. There are banks with relatively clean balance sheets.
If it were the case that a substantial portion of banks are now unable to issue many new loans because of their inadequate capital, we would expect to see the healthy banks rushing in to fill the lending gap. There should be accounts of dynamic banks that are taking advantage of this once-in-a-lifetime opportunity and rapidly gaining market share.
While this may be happening, there certainly have not been many accounts in the media of banks that fit this description. In other words, it does not appear to be the view among banks, including those with plenty of capital, that there are many good potential customers who are unable to borrow money.
The other missing part of the story has to do with the nature of competition between small firms and their larger competitors. We know that large firms have no difficulty attracting capital at present. They can issue bonds at near record-low interest rates. They can also borrow short-term money at extraordinarily low interest rates in the commercial paper market.
If small and mid-sized companies were being prevented from expanding due to their inability to raise capital then we should be seeing larger companies rushing in to take market share. Retail stores should be opening up new outlets everywhere. Factories should be rapidly increasing output and transportation companies should be rushing into new markets.
Of course, we don't see any of this happening. If anything, most large businesses are expanding at a slower rate than they did before the crisis. If their competitors have been hamstrung due to a lack of credit, no one seems to have told Wal-Mart, Starbucks and the rest. They have both slowed the rate at which they are adding new stores, not sped it up as the credit-shortage story would imply.
There is truth to the credit-squeeze story, but it goes in the other direction. Stores that have seen their business plummet as a result of the downturn are, in fact, worse credit risks from the standpoint of banks. Many businesses that were profitable in 2006 and 2007 are now highly unprofitable and may not be able to stay in business. As a result, the banks that were happy to lend money just a few years ago are no longer willing to lend money to the same business. This drying up of credit happens in every downturn. It is just more serious this time because of the severity of the downturn.
The moral of this story is that we should not think that "fixing" the banks will get us out of the downturn. The problem is that we have to generate demand, which means having the government spend more money to stimulate the economy. Unfortunately, the politicians in Washington are scared to talk about larger deficits, so more spending seems off the table at the moment – therefore we get this nonsense about insufficient bank lending.
But hey, at the rate we created jobs in April, we should be back at full employment in seven years anyhow. Who could ask for anything more?

[May 13, 2010] PIMCO's McCulley Discusses The Ticking $3 Trillion Shadow Banking Time Bomb, Defends The Fed As Head Regulator

This is all about the financial nomenklatura of "shadow socialism"  criminal rent-seeking
May 12, 2010 | zero hedge

From the standpoint of what I want to talk about tonight, a great deal of it has already been discussed today. I feel a little bit like St. Louis Federal Reserve President Jim Bullard did at lunch when he said that Paul Krugman, who spoke just before Jim, had already given 90% of his speech. That’s basically true for me as well. Paul’s speech was superb, laying out six possible culprits in the financial crisis.1

I want to focus on Paul’s Number 3, the Shadow Banking System. Paul was drawing a lot of his comments today from the work of Professor Gary Gorton of Yale, which is absolutely fantastic material. Have a lot of you read Gary’s essay, “Slapped in the Face by the Invisible Hand”?2 I see a lot of nods here. That’s where the phrase that Paul used, “Quiet Period,” came from. Gary coined it. He’d be a great person to have here next year at the Minsky Conference.

And one of the fascinating things that he details is the nature of banking. That’s where I want to start tonight. Let’s start with first principles. If we do, then I think we can understand why we shouldn’t look at the conventional banking system and the Shadow Banking System as separate beasts, but intertwined beasts.

The essence, or the genius of banking, not just now, the last century or the century before that, but since time immemorial, is that the public’s ex-ante demand for assets that trade on demand at par is greater than the public’s ex-post demand for these types of assets. Let me repeat this, because this is a first principle: The public’s ex-ante demand for liquidity at par is greater than the public’s ex-post demand. Therefore, we can have banking systems because they can meet the ex-ante demand, but never have to pony up ex-post. In turn, the essence or the genius of banking is maturity, liquidity and quality transformation: holding assets that are longer, less liquid and of lower quality than the funding liabilities.

A second principle: A banking system is solvent only if it is believed by the public to be a going concern. By definition, if the public’s ex-post demand for liquidity at par proves to be equal to its ex-ante demand, a banking system is insolvent because a banking system ends up, at its core, promising something it cannot deliver. Everyone following me here?

Professor Gorton, in his paper, goes through how that promise was dealt with during the 19th century, before the New Deal Era. There were panics all the time, otherwise known as runs, because we didn’t have a lender of last resort and we didn’t have deposit insurance. During the 19th century, the system dealt with its reoccurring panics in lots of novel ways, including clearing houses which would de facto be a central bank, and suspension of convertibility of deposits into cash. So the problems we’ve been dealing with in the last couple of years are not new. They go back to the origin of banking.

The Quiet Period, from the New Deal Era until the Panic of 2007, was actually unique in history. And the Quiet Period came about, I think, for a lot of the reasons that were articulated earlier today in that banks, conventional banks, after the Great Depression, were considered to be special. And, in fact, banks are special. If you think that the banking system can be guided to stability as if by an invisible hand, then you are deluding yourself. But, that is, in fact, what happened with the explosive growth of the Shadow Banking System.

Banking is a really profitable business. In its most simple form, think in terms of a bank issuing demand deposits, which are guaranteed to trade at par because they’ve got FDIC insurance around them and also because the issuing bank can rediscount its assets at the Fed in order to redeem deposits in old-fashioned money, also known as currency.

In fact, let’s take a look at the $1 bill I am holding in my hand. It says right at the very top, “Federal Reserve Note.” It also says right down here, “This note is legal tender for all debts, public and private.” This is what the public ex-ante wants: the knowledge that they can turn their deposits into these Federal Reserve Notes. And if the public knows they can turn them into these notes, they don’t. With me here? If I know I can, I don’t.

Now, this is a unique note. This is a Federal Reserve liability. And, actually, it’s really cool. It’s missing two things. It doesn’t have a maturity date on it. So, it’s perpetual. And it doesn’t have an interest rate on it. I would love to be able to issue these things. It would make me very, very happy to issue these things. But it would be against the law! But, in fact, that’s what banks did in the 19th century. They issued currency. After the creation of the Federal Reserve, it was given monopoly power to create currency, which I think was a pretty bright idea. But demand deposits issued by banks are just one step away from a Federal Reserve Note.

Conceptually, demand deposits have a one-day maturity. I can write a check on it, and it goes out at par tomorrow, if not today. Demand deposits, conceptually, have a one-day maturity. But in aggregate, they have a perpetual maturity. So, therefore, banking can engage in maturity, liquidity and quality transformation: a very profitable business. Banks can issue, essentially, perpetual liabilities – call them demand deposits – and invest them in longer dated, illiquid loans and securities, earning a net interest margin. It’s a really, really sweet business.

In the early years of the Quiet Period, we regulated that really sweet business. I think that was a really bright idea. In order for that business not to be prone to panics and, therefore, financial crises, you needed to have deposit insurance. Deposit insurance, by definition, cannot come about as if by the invisible hand. Deposit insurance cannot be, cannot be a private sector activity. It is a public good. The deposit insurer must be a subsidiary of the fiscal authority. And in extremis, the monetary authority can monetize the liabilities of the fiscal authority. I’m not saying that pejoratively. I’m not being pejorative at all. Just descriptive. Bottom line: Deposit insurance is inherently a public good.

Access to the Fed’s balance sheet is also inherently a public good, because the Federal Reserve is the only entity that can print currency. So essentially, banking has two public goods associated with it. Therefore, naturally, it should be regulated.

That was the Quiet Period Model. And regulation took the form of what you could do, how you could do it and how much leverage you could use in doing it. And, as was mentioned by Paul Volcker a number of times earlier this afternoon, the regulatory burden that has historically come with being a conventional bank has been actually quite high. During the early years of the Quiet Period, however, banking was nonetheless a very profitable endeavor.

There was a quid pro quo, which actually led to the old joke – which was actually said about the savings and loan industry – that banking was a great job: Take in deposits at 3, lend them out at 6, and be on the golf course at 3. 3-6-3 banking was a pretty nice franchise. So, therefore, bankers had a pretty strong incentive not to mess it up. Essentially, there were oligopoly profits in the business. I think Gary Gorton is actually right on that proposition.

The invisible hand, however, naturally wanted to get the oligopoly profits associated with banking while reducing the impact of some regulation. Thus, the Shadow Banking System came into existence, where the net interest margin associated with maturity, liquidity and quality transformation could be earned on a much smaller capital base.

And, in fact, that’s what happened starting essentially in the mid-1970s, accelerating through the 1980s and 1990s, and then exploding in the first decade of this century.

The birth of the Shadow Banking System required that capitalists be able to come up with an asset – which actually for shadow bankers is a liability – that was perceived by the public as just as good as a bank deposit. Remember, the public has an ex-ante demand for something that trades on demand at par. Therefore, shadow bankers had to be able to persuade the public that its asset – which is actually the shadow banker’s liability – was just as good as the real thing. If they could do that, then they could have one whale of a good time.

That asset – which, again, is the bank’s liability – needed, in Gary Gorton’s terms, to be characterized by “informational insensitivity,” meaning that the holder didn’t need to do any due diligence, just taking it on faith that this asset could be converted at par on demand. And, in fact, money market mutual fund shares achieved that status. With one small exception prior to the Reserve Primary Fund breaking the buck, they always traded at par. And if there was any danger they wouldn’t trade at par, the sponsor would step in and buy out any dodgy asset at par. So, essentially, the money market mutual fund industry was at the very core of the growth of the Shadow Banking System.

It created a liability perceived as just as good as a demand deposit wrapped with deposit insurance, issued by a bank with access to the Fed. It was a great game. But in and of itself, that didn’t lead to the explosive growth in the Shadow Banking System. There needed to be another link in the chain. Yes, money market mutual funds needed an asset that the public perceived as just as good as a bank deposit. But they also had to put something on the other side of the balance sheet.

What went on the other side of the balance sheet? Money market instruments such as repo and commercial paper (CP). And under Rule 2a-7, they were allowed to use accrual accounting for their assets. The assets didn’t have to be marked to market. So, therefore, 2a-7 funds could actually maintain the $1 share price, unless they did something really dumb.

At their peak, money market mutual funds were about $4 trillion. They are about $3 trillion now. They interacted with the larger Shadow Banking System. And the largest shadow banks were the vehicles of investment banks, funded heavily with repo and CP. So, explosive growth of the Shadow Banking System was logically the result of the invisible hand of the marketplace wanting to get the profitability of the regulated banking system, but without the regulation. Shadow banks created information-insensitive assets for the public that were perceived as just as good as a demand deposit, and then levered the daylights out of them into longer, less liquid, lower-quality assets. And it all worked swimmingly well, for a while. But then they embarked on the Forward Minsky Journey.3

Shadow banks were the predominant place where securitizations of subprime mortgages were placed, as well as securitizations of other types of assets. So the Shadow Banking System was, essentially, mirroring the banking model, which had deposits and loans.

Turn the deposit into asset-backed commercial paper. Turn the loan into a security. What you end up with is the same vehicle as a bank from a functional standpoint, but you have it outside the conventional bank regulatory structure. Actually, let me correct myself. There was a de facto regulator in the Shadow Banking System. They are called the rating agencies.

In order to do the trick of creating a shadow bank, you had to have the rating agencies declare that your senior short-dated liabilities were just as good as bank deposits. In fact, most money market mutual funds get themselves rated, and S&P, Moody’s, and Fitch do have particular rules for giving a AAA rating to a 2a-7 money market fund, mirroring SEC Rules. But, for the rest of the Shadow Banking System, the rating agency rules evolved on the fly, often under the guidance of shadow bankers themselves. It didn’t work out very well, as the Shadow Banking System became the lead owner of what was created in the originate-to-distribute model of mortgage creation.

On August 9, 2007, game over. If you have to pick a day for the Minsky Moment, it was August 9. And, actually, it didn’t happen here in the United States. It happened in France, when Paribas Bank (BNP) said that it could not value the toxic mortgage assets in three of its off-balance sheet vehicles, and that, therefore, the liability holders, who thought they could get out at any time, were frozen. I remember the day like my son’s birthday. And that happens every year. Because the unraveling started on that day. In fact, it was later that month that I actually coined the term “Shadow Banking System” at the Fed’s annual symposium in Jackson Hole.

It was only my second year there. And I was in awe, and mainly listened for most of the three days. At the end, Marty Feldstein always does the wrap-up. Everybody wanted to talk. And since I was a newbie, I didn’t say anything until almost the very end. I stood up and (paraphrasing) said, “What’s going on is really simple. We’re having a run on the Shadow Banking System and the only question is how intensely it will self-feed as its assets and liabilities are put back onto the balance sheet of the conventional banking system.”


This article expands my frame of reference of finance like many ZH posts. I should feel good about learning something for my time. But actually the emotion I am experiencing right now is disgust. Why? The author invokes the elitest framework that the origin of the money used to backstop the losses was from the Fed.

I see it differently. The labor that produces the tax dollars that will ultimately pay back the treasury/Fed will be the middle class worker of the future, yours and my kids. In the short run the devaluation by inflation or default may harm todays middle class. Who are the greatest beneficiaries of the Fed backstop/bailout I ask?

Those who already have large holdings in their retirement funds or are very wealthy, particularly those with large holdings in the "big five". This shift of funds at par for toxic assets[full payment from an insolvent AIG of CDS on CDOs with TARP funds to Goldman et al] was robbery.

Eventually the victims of the theft will wake up. The Fed is not the Bank of Dad because it doesn't earn the money, I know how that feels because I earn for two college students and two teens in high school , 39%Fed tax+ 9% local sales tax+ much insurance to backstop my risks. I feel the weariness when money is spent. The Fed feels nothing but hubris.

I agree with the historical cause and effect in slowing the run described by Mr. McCulley, but the shifting of the losses to the American taxpayer was wrong and the Fed should not be exalted for doing so.

Rant complete.


"... A banking system is solvent only if it is believed by the public to be a going concern. By definition, if the public’s ex-post demand for liquidity at par proves to be equal to its ex-ante demand, a banking system is insolvent because a banking system ends up, at its core, promising something it cannot deliver."

This is what the smoke and mirrors from our current governments is all about.. This is what an audit of the FED would reveal.


So I missed something ...

  1. Shadow banking created to mimic banking and get part of monopoly NIM profits
  2. Shadow banking went overboard and forward integrated into mortgage origination, bought out rating agencies and created fraudulent securities ... replacing NIM with origination and structuring fees
  3. Commercial banks bought the crap that shadow banks created and suffered capital hits
  4. Fed and US Treasury recapitalized commercial banks (and shadow banks who wore commercial bank drag to get TARP ... shameless bas#ards), bot toxic securiries at par and generally licked the shadow banks' b#lls
  5. Toxic sludge now sitting on Commercial Banks', Fed's, Fannie's, Freddie's and US Treasury's off-balance sheet Cayman accounts (oops, did I say that?) getting radioactive and smelling really nasty and going nowhere and preventing lending to good businesses and killing the US economy



You forgot (6), the regulatory regime pursued by Congress and the ex-CEO of Goldman Squid, Bob Rubin, made it so that the toxic securities arms of the banks could merge with your deposits. They got to use ordinary joes' funds to lever the shit out of everything.

The banking collapse would not have spread to retail banks nor would ever have gotten as large as it was had this firewall between IBs and retail banking been broken down for the "greater good" of Wall Street.

The solution espoused above is to revalue worthless shit to par via monetization. Bcoz the banks and agencies that owned it or got in congested in their conduits were on the capital hook had it been valued fairly and there would have gone ALL our deposits.

This is what really happened; banks needed to offload the zillions of this shit and the music stopped. Every one of them had massive off-sheet vehicles intended to use leverage to aggregate crap for sale. Then the ponzi stopped and they were all on the hook to pay somebody what they'd borrowed. The collateral they borrowed against was all OUR money.

The appropriate measure to take would have been to have BROKEN UP the banks into retail facilities (utility like) and segregated the IBs and said fuck you to all those associated with them. Pursue your claims against the executives. That is what would have been fair.

Instead they put us all on the train tracks.


I'm not fan of central banking but even Bagehot said: lend freely but against good collateral and at punitive rates in the event of a credit crisis. But this was likely more of a solvency crisis and, besides, The Fed lent freely against crap collateral and at generous rates. The system and all the participants who are biased towards it are a disgrace.

trav7777 :

McCulley is a moron: what happened was not good.

The Fed made instruments that were literally WORTHLESS by design and made them into par instruments.

The error was in ever allowing dogshit to be sold as AAA paper. The bankers found a way to run a ponzi scheme; pure and simple. And the Fed just monetized all the worthless claims.

The shadow banking system DESERVED a run. Any time a banking system is shown to be KITING or lending what they do not have or let's say you catch the banker out BLOWING the deposits on hookers & coke, you HAVE to run the bank!

The bankers and all the firms responsible should have been imprisoned, broken up, hanged...and yes that includes Bob Jewbin and all the rest of these incestuous crooks. All the way to the top of the Treasury and Federal Reserve...hanged.

This PIMPCO idiot doesn't seem to understand what the cause was...when the future is contractionary, ALL debts become increasingly infeasible as a "going concern." It becomes clear at the point of debt saturation that these claims cannot be paid and so there is a rush to redeem first.


McCulley is brilliant and he writes superbly.

Everyone here who wants to abolish the Federal Reserve should be careful what they ask for. Studying this text will give the obvious reason why.

It is not the Federal Reserve which is the problem, it is its current officers who have chosen to serve a narrow based elite.

Apostate :

Actually this has been well known within the executive levels of the major investment banks for a long time.

The banks are obligated via fiduciary duty to prop up the governments that they operate in. It's just a matter of attempting to control whatever moron is in power to keep them from running everything off of the rails and to prevent the savages from beating each other up.

The trouble is that the intellectual culture within the US and elsewhere is fundamentally retarded. The media is garbage. They never grew out of the WWI period and afterwards.

Speaking of which, I had a great deal of fun playing Deep Throat to a New York Times consultant a couple months ago. I'm unsure of how it ultimately played out, but I started a Goldman Sachs LBO rumor.


pak :

The speach is so fluent but I get a sick feeling when I read it.

McCulley's logic: not making money through conventional banking? Create smth which walks like a banking system, talks like a banking system, looks like a banking system - but surprisingly, is not a banking system for regulatory purposes.

Make money, then mess the whole thing up - and get bailed out just as if your creature was a true banking system so that you make even more money, and mess it up again, on a truly magnificent scale.

Talk moral hazard!

I do understand that if we allow the "shadow" (read "fake") banking system collapse now, we'll be in real trouble, but there's no way I can accept this guy's definition of "good". We cannot move forward till we accept that this pseudo-banking-system serves no "public good" (I hope McCulley doesn't claim he coined that term, too) but is in practice just a rent-seeking parasite.

Yes, Mr. Volcker, you're right on "rent-seeking", but where were you 10, 20, 30 years ago?

And what I really don't get is why we need a "big government" to clean up the mess which could've been prevented by a much smaller government. Mr. McCulley, you're so greenspanish!

All in all, this is the financial nomenklatura of "shadow socialism" singing anthems to itself!


[May 13, 2010]   Stopping the wolfpack by Neil Hume

May 09, 2010 | alphaville

While we await details of the EU’s emergency lending mechanism and loan guarantee package for troubled countries – a statement is expected around 21.00 hrs (GMT) – here are the observations of Swedish Finance Minister Anders Borg…

as told to Reuters:

“We now see … wolfpack behaviours (on markets), and if we will not stop these packs, even if it is self-inflicted weakness, they will tear the weaker countries apart.”

and Bloomberg:

“In the night, when the markets are opening, we cannot afford a disappointment… “We now see herd behavior in the markets that are really pack behavior, wolfpack behavior.”

[Apr 14, 2010]  Pack of Fools « The Baseline Scenario

“That Wall Street has gone down because of this is justice,” says Steve Eisman at the end of the book (p. 251). But as we now know, it didn’t go down.

with 34 comments

By James Kwak

“I thought that I was writing a period piece about the 1980s in America, when a great nation lost its financial mind. I expected readers of the future would be appalled that, back in 1986, the CEO of Salomon Brothers, John Gutfreund, was paid $3.1 million as he ran the business into the ground. . . . I expected them to be shocked that, once upon a time on Wall Street, the CEOs had only the vaguest idea of the complicated risks their bond traders were running.

“And that’s pretty much how I imagined it; what I never imagined is that the future reader might look back on any of this, or on my own peculiar experience, and say, ‘How quaint.’”

That’s Michael Lewis in The Big Short (p. xiv), looking back on Liar’s Poker.

“Looking back, however, Salomon seems so . . . small. When the Business Week story was written, it had $68 billion in assets and $2.8 billion in shareholders’ equity. It expected to earn $1.1 billion in operating profits for all of 1985. The next year, Gutfreund earned $3.2 million. At the time, those numbers seemed extravagant. Today? Not so much.”

That’s the third paragraph of Chapter 3 of 13 Bankers. (This was a complete coincidence; I didn’t see The Big Short until it came out, and I have no reason to think that Lewis saw a draft of our book.)

I actually did not rush out to buy The Big Short, even though Michael Lewis is a great storyteller. I figured I knew the story already; Gregory Zuckerman’s The Greatest Trade Ever covered some of the same ground and some of the same characters, and I already knew plenty about CDOs, credit default swaps, and synthetic CDOs. But I’m very glad I read it, and not just because it’s a fun read.

Lewis’s central theme is the question of why some people were able to see a financial disaster that, in retrospect, seems so obvious, while almost everyone else — including even the people who concocted the machine that broke down so spectacularly — were so blind. This is the point of his epigraph, by Tolstoy:

“The most difficult subjects can be explained to the most slow-witted man if he has not formed any idea of them already; but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he knows already, without a shadow of a doubt, what is laid before him.”

But I enjoyed it most for its portrait of what was going on behind the scenes on Wall Street. The picture is not pretty.

Lewis’s book focuses on a group of people (mainly at hedge funds) who figured out that subprime-backed CDOs were going to collapse and set out to make money from that collapse. To do so, they bought credit default swaps on bonds issued by those CDOs. They had to buy these credit default swaps from their brokers — the big investment banks. These swaps had collateral requirements: as the price of the swap fell (or the price of the underlying bonds rose), they had to give collateral (cash or Treasuries) to the banks; as the price of the swap rose, the banks had to give collateral to them.

The problem was that the banks, as the swap dealers, got to decide what the swaps were worth. So, for example, Charlie Ledley bought an illiquid CDS on a particular CDO from Morgan Stanley. Five days later, in February 2007, the banks started trading an index of CDOs that promptly lost half its value. But, as Lewis writes, “With one hand the Wall Street firms were selling low interest rate-bearing double-A-rated CDOs at par, or 100; with the other they were trading this index composed of those very same bonds for 49 cents on the dollar” (p. 162).* That is, the market price of the already-issued CDOs didn’t affect the sale price of new CDOs. And what’s more, Ledley’s broker insisted that the price of his CDS (which should have soared as the index of CDOs fell) had not changed. Here you see the banks simultaneously ignoring a market price in two separate ways: once so they can continue selling new assets that are extremely similar — worse, if anything — to assets that they are trading as garbage; and again so they can avoid sending collateral to their hedge fund client.

In June 2007, the subprime-backed CDO market began to collapse for good. And, again, the banks suddenly couldn’t figure out how much their clients’ CDS were worth, so they could avoid sending them collateral. “Goldman was newly unable, or unwilling, to determine the value of those positions, and so could not say how much collateral should be shifted back and forth” (p. 195). Between June 15 and June 20, Michael Burry could not get ahold of his Goldman Sachs salesperson, who finally claimed that Goldman had had a “systems failure” — which was what Morgan Stanley and Bank of America also claimed. According to Burry, the only reason why the banks finally started marking his positions accurately was that they were getting in on the same trade.

This also happened between the dealers. At one point Greg Lippmann at Deutsche Bank, who had shorted the market, said to his counterpart at Morgan Stanley, who insisted that subprime CDOs were still worth 95 cents on the dollar: “I’ll make you a market. They are 70-77. You have three choices. You can sell them back to me at 70. You can buy some more at 77. Or you can give me my f—ing $1.2 billion” (the collateral owed) (p. 213). But even though Morgan Stanley claimed the securities were worth 95, they refused to buy more at 77 — even though that would have represented instant profits according to their “model.”

What’s the point here? It’s the same as yesterday. Free financial markets are supposed to create efficient prices. Every argument about the benefits of financial markets (optimal allocation of capital, liquidity, etc.) depends on this one point. But the prices in this market were being set based on the dealers’ own interests. Think about that.

Then there is the story of Howie Hubler (Chapter 9). Hubler was smart enough to buy credit default swaps on $2 billion of BBB-rated CDOs. But to pay the premiums on those CDS, he then went and sold credit default swaps on $16 billion of AAA-rated CDOs. In other words, he was betting that the housing collapse would wipe out the BBB tranches of the CDOs, but not the AAA tranches. At the time, CDS prices reflected a belief that the AAA tranches were only one-tenth as likely to default as the BBB tranches. So to be more precise about it, he was actually betting that the AAA tranches were less than one-tenth as likely to default as the BBB tranches.

So some trader misjudges the correlation between mortgage-backed securities (which determines the correlation of the AAA and BBB tranches) and makes a trade that turns out badly. So what? The problem is what we learn about the system.

First, we learn this: “The $16 billion in subprime risk Hubler had taken on showed up in Morgan Stanley’s risk reports inside a bucket marked ‘triple A’ — which is to say, they might as well have been U.S. Treasury bonds” (p. 207). (The VaR calculation for this position also showed virtually no risk, since it was based on historical volatility data.) So Morgan Stanley had no idea what it was holding onto.

This is incompetence. But is it innocent incompetence or willful ignorance? I doubt that anyone on the management team said, “Let’s design a stupid way of categorizing our positions so that our traders can make risky bets, hide them from us, and blow up the bank.” But think about this: this type of error only goes one way. Steve Randy Waldman has already made this point about capital:  “For large complex financials, capital cannot be measured precisely enough to distinguish conservatively solvent from insolvent banks, and capital positions are always optimistically padded.” The same is true about risk, which will always be underestimated. If a bank has a system that overestimates risk, the traders who understand the positions will (correctly) argue that real risk levels are lower; if the system underestimates risk, they will keep their mouths shut. Higher risk measures mean more capital means lower returns; all the internal pressures are to underestimate risk. The incentives of the system breed incompetence, and everyone benefits in the short term.

Eventually, Morgan Stanley lost $9 billion on the trade. In December 2007, CEO John Mack tried to explain the loss on an investor call. “The hedges didn’t perform adequately in extraordinary market condition of late October and November,” he said (p. 217). This wasn’t a hedge; it was a long-short bet. But on Wall Street, it’s second nature to call everything a hedge. When pressed by an analyst (from Goldman), Mack punted (“I am very happy to get back to you on that when we have been out of this, because I can’t answer that at the moment”). As Lewis said, “The meaningless flow of words might have left the audience with the sense that it was incapable of parsing the deep complexity of Morgan Stanley’s bond trading business. What the words actually revealed was that the CEO himself didn’t really understand the situation.”

This is a classic example of something that goes far beyond Wall Street: the CEO who has no idea what is going on inside his business. And, as Lewis says, Mack was generally considered one of the more competent ones. CEOs of large corporations exist on such a high level of abstraction relative to what actually happens that all they know is what their subordinates tell them, and their subordinates barely know what is going on as well. (I believe there is now a reality show based on this gap.) Mack probably really thought that Howie Hubler was putting on a hedge, because that’s probably what someone told him before he went on the call. And when CEOs show up before the Financial Crisis Inquiry Commission and say something like “we put the interests of our clients first in everything we do,” they may actually believe it — because they don’t know any better. (Which is very convenient, because ignorance allows you to say things that are not true without actually lying.)

So what kind of picture of Wall Street does The Big Short paint? Banks manipulating the prices of custom derivatives. Traders making stupid bets and taking home eight-figure bonuses. Painfully inadequate risk management systems. Management teams that have no idea what is going on. A toxic combination of cutthroat greed on the part of individual bankers and broken incentive systems on the part of banks.

This is not a finely-tuned machine for allocating capital and fueling the real economy. It’s a system whose rules have been twisted to allow the few smart people to get rich by screwing their customers or their employers. “That Wall Street has gone down because of this is justice,” says Steve Eisman at the end of the book (p. 251). But as we now know, it didn’t go down.

* I believe they were not the “very same bonds,” since the newly issued bonds were 2007 vintage and the ones in the index were earlier vintages; but if anything, that meant that the 2007 bonds, which were sold at par, were even worse.

[Apr 14, 2010]  Bob Litan on Derivatives Reform 1 Failure even with a Win « Rortybomb

Litan never names them, but footnote 39 refers to the top 5 banks/BHC at the OCC’s Quarterly Report on Bank Trading and Derivatives Activities controlling 96%-97% of the market for the top 25 BHCs. And from there, the top four are: 1. JPMorgan Chase (assets: $2,000bn) 2. Goldman Sachs ($850bn) 3. Bank of America ($2,200bn) 4. Citibank ($1,856bn). This doesn’t get at the entire market, as the OCC only can see US commercial bank data, but it gives you a sense of the players.

Litan never mentions this as part of a group of solutions, but It is worth noting that these four players, all TARP recipients, would be turned into 15 players with a size cap of around $500 billion dollars. There are good arguments against a size cap, but the two leading ones:

If you thought we’d at least get our arms around credit default swap reform from a financial reform bill, you should read this report from Litan as a giant warning flag. In case you weren’t sure if you’ve heard anyone directly lay out the case on how the market and political concentration in the United States banking sector hurts consumers and increases systemic risk through both political pressures and anticompetitive levels of control of the institutions of the market, now you have. It’s not Matt Taibbi, but it’s much further away from a “everything is actually fine and the Treasury is in control of reform” reassurance. Which should scare you, and give you yet another good reason for size caps for the major banks.

[Apr 14, 2010] Bob Litan on Derivatives Reform 1 Failure even with a Win « Rortybomb

Bob Litan of the Brookings Institute has a new paper out on derivatives reform (full pdf, summary). The paper is called “The Derivatives Dealers’ Club and Derivatives Markets Reform: A Guide for Policy Makers, Citizens and Other Interested Parties” and it’s a must read for two very important reasons.

Before we get there, I agree with his recommendations for regulating the over-the-counter derivatives market and especially the credit default swap market (CDS): create a strong presumption for over-the-counter derivatives to go through clearing, and to be traded on an exchange with pre-trade price transparency. Those that can’t should have margins posted and have post-trade price and volume transparency. This will be a major battle ground in the financial reform debate, and learning these terms will put you in a better spot to follow it. Litan walks you through each of the terms.

As his title states, Litan is worried about the “Dealer’s Club” of the major derivatives players. I particularly like this paper as the best introduction to the current oligarchy that takes place in the very profitable over-the-counter derivatives trading market and credit default swap market. I’m going to just give the high level overview of what he says (italics in original, my bold):

I have written this essay primarily to call attention to the main impediments to meaningful
reform: the private actors who now control the trading of derivatives and all key elements of the infrastructure of derivatives trading, the major dealer banks. The importance of this “Derivatives Dealers’ Club” cannot be overstated. All end-users who want derivatives products, CDS in particular, must transact with dealer banks…I will argue that the major dealer banks have strong financial incentives and the ability to delay or impede changes from the status quo — even if the legislative reforms that are now being
widely discussed are adopted
— that would make the CDS and eventually other derivatives markets safer and more transparent for all concerned…

Here, of course, I refer to the major derivatives dealers – the top 5 dealer-banks that control virtually all of the dealer-to-dealer trades in CDS, together with a few others that participate with the top 5 in other institutions important to the derivatives market. Collectively, these institutions have the ability and incentive, if not counteracted by policy intervention, to delay, distort or impede clearing, exchange trading and transparency

Market-makers make the most profit, however, as long as they can operate as much in the dark as is possible – so that customers don’t know the true going prices, only the dealers do. This opacity allows the dealers to keep spreads high…

In combination, these various market institutions – relating to standardization, clearing and pricing – have incentives not to rock the boat, and not to accelerate the kinds of changes that would make the derivatives market safer and more transparent. The common element among all of these institutions is strong participation, if not significant ownership, by the major dealers.

So Bob Litan is waving a giant red flag that the top dealer-banks that control the CDS market can more or less, through a variety of means he lays out convincingly in the paper, derail or significantly slow down CDS reform after the fact if it passes. Who are these dealer-banks?

Litan never names them, but footnote 39 refers to the top 5 banks/BHC at the OCC’s Quarterly Report on Bank Trading and Derivatives Activities controlling 96%-97% of the market for the top 25 BHCs. And from there, the top four are: 1. JPMorgan Chase (assets: $2,000bn) 2. Goldman Sachs ($850bn) 3. Bank of America ($2,200bn) 4. Citibank ($1,856bn). This doesn’t get at the entire market, as the OCC only can see US commercial bank data, but it gives you a sense of the players.

Litan never mentions this as part of a group of solutions, but It is worth noting that these four players, all TARP recipients, would be turned into 15 players with a size cap of around $500 billion dollars. There are good arguments against a size cap, but the two leading ones, (1) that there would be a cluster of banks around the cap and (2) the broken pieces would be perfect clones of the whole piece, aren’t at all relevant for the issue of an oligarchy capable of derailing credit default swap regulation and colluding to keep the margins high through market and institutional control.

If you thought we’d at least get our arms around credit default swap reform from a financial reform bill, you should read this report from Litan as a giant warning flag. In case you weren’t sure if you’ve heard anyone directly lay out the case on how the market and political concentration in the United States banking sector hurts consumers and increases systemic risk through both political pressures and anticompetitive levels of control of the institutions of the market, now you have. It’s not Matt Taibbi, but it’s much further away from a “everything is actually fine and the Treasury is in control of reform” reassurance. Which should scare you, and give you yet another good reason for size caps for the major banks.

[Mar 14, 2010]  Indefensible Men

March 13, 2010 | naked capitalism

From the December 2009 issue of The Baffler (no online version of this article available). For those not familiar with The Baffler, this is the revival of a magazine of business and culture edited by Thomas Frank that had previously been published from 1988 to 2007. This issue was called “Margin Call” and included articles by Matt Taibbi, Naomi Klein, Michael Lind. I believe readers will find this piece to be relevant. Enjoy!

Since inequalities of privilege are greater than could possibly be defended rationally, the intelligence of privileged groups is usually applied to the task of inventing specious proofs for the theory that universal values spring from, and that general interests are served by, the special privileges which they hold.

Reinhold Niebuhr, Moral Man and Immoral Society

A year on from its brush with Armageddon, the financial services industry has resumed its reckless, self-serving ways It isn’t hard to see why this has aroused simmering rage in normally complacent, pro-capitalist Main Street America. The budget commitments to salvaging the financial sector come to nearly $3 trillion, equivalent to more than $20,000 per federal income tax payer. To add insult to injury, the miscreants have also availed themselves of more welfare programs in the form of lending facilities and guarantees, totaling nearly $12 trillion, not all of which will prove to be money well spent.

Wall Street just looted the public on a massive scale. Having found this to be a wondrously lucrative exercise, it looks set to do it all over again.

These people above all were supposed to understand money, the value of it, the risks attendant with it. The industry broadly defined, even including once lowly commercial bank employees, profited handsomely as the debt bubble grew. Compensation per worker in the early 1980s was similar to that of all non-government employees. It started accelerating in 1983, and hit 181 percent of the level of private sector pay by 2007. The rewards at the top were rich indeed. The average employee at Goldman Sachs made $630,000 in 2007. That includes everyone, the receptionists, the guys in the mail room, the back office staff. Eight-figure bonuses for big producers became standard in the last cycle. And if the fourth quarter of 2009 proves as lucrative as the first three, Goldman’s bonuses for the year will exceed bubble-peak levels.

The rationale for the eye-popping rewards was simple. We lived in a Brave New World of finance, where the ability to slice, dice, repackage and sell risk led to better outcomes for all, via cheaper credit and better diversification. We have since learned that this flattering picture was a convenient cover for massive risk-taking and fraud. The industry regularly bundled complicated exposures into products and dumped them onto investors who didn’t understand them. Indeed, it has since become evident that the industry itself didn’t understand them. The supposedly sophisticated risk management techniques didn’t work so well for even the advanced practitioners, as both top investment banks and quant hedge funds hemorrhaged losses. And outside the finance arena, the wreckage is obvious: housing market plunges in the U.S., UK, Ireland, Spain, the Baltics and Australia; a steep decline in trade; a global recession with unemployment in the U.S. and elsewhere hitting highs not seen in more than 25 years, with the most accurate forecasters of the calamity intoning that the downturn will be protracted and the recovery anemic.

With economic casualties all about, thanks to baleful financial “innovations” and reckless trading bets, the tone-deafness of the former Masters of the Universe is striking. Their firms would have been reduced to sheer rubble were it not for the munificence of the taxpayer—or perhaps, more accurately, the haplessness of the official rescuers, who threw money at these players directly and indirectly, through a myriad a programs plus the brute force measure of super low interest rates, with perilous few strings attached.

Yet what is remarkable is that the widespread denunciations of excessive banking industry pay are met with incredulity and outright hostility. It’s one thing to be angry over a reversal in fortune; it’s one of the five stages of grief. But the petulance, the narcissism, the lack of any sense of proportion reveals a deep-seated pathology at work.

Exhibit A is the resignation letter of one Jake DeSantis, an executive vice president in AIG’s Financial Products unit, tendered in March 2009 as outcry over bonuses paid to executives of his firm reached a fever pitch. The New York Times ran it as an op-ed. “I am proud of everything I have done,” DeSantis wrote.

I was in no way involved in—or responsible for—the credit default swap transactions that have hamstrung A.I.G. Nor were more than a handful of the 400 current employees of A.I.G.-F.P. Most of those responsible have left the company and have conspicuously escaped the public outrage….

[W]e in the financial products unit have been betrayed by A.I.G. and are being unfairly persecuted by elected officials.…

I take this action after 11 years of dedicated, honorable service to A.I.G. … The profitability of the businesses with which I was associated clearly supported my compensation. I never received any pay resulting from the credit default swaps that are now losing so much money. I did, however, like many others here, lose a significant portion of my life savings in the form of deferred compensation invested in the capital of A.I.G.-F.P. because of those losses.

Anyone with an operating brain cell could shred the logic on display here. AIG had imploded, but unlike a normal failed business, it left a Chernobyl-scale steaming hulk that needed to be hermetically sealed at considerable cost to taxpayers. Employees of bankrupt enterprises seldom go about chest-beating that they did a good job, it was the guys down the hall who screwed up, so they therefore still deserve a fat bonus check. That line of reasoning is delusional, yet DeSantis had no perspective on it. And there is the self-righteous “honorable service,” which casts a well-paid job in the same terms as doing a tour of duty in the armed forces, and the hyperventilating: “proud,” “betrayed,” “unfairly persecuted,” “clearly supported.”

And to confirm the yawning perception gap, the letter was uniformly vilified in the Times’ comment section, but DeSantis’s colleagues gave him a standing ovation when he came to the office.

The New York press has served as an occasional outlet for this type of self-righteous venting. Some sightings from New York Magazine:

[I]f someone went to Columbia or Wharton, [even if] their company is a fumbling, mismanaged bank, why should they all of a sudden be paid the same as the guy down the block who delivers restaurant supplies for Sysco…?

I’m attached to my BlackBerry. … I get calls at two in the morning. … That costs money. If they keep compensation capped, I don’t know how the deals get done.

It never seems to occur to them, as Clemenceau once said, that the graveyards are full of indispensable men. So if the cohort with glittering resumes no longer deems the pay on offer sufficiently motivating for them to get out of bed, guess what? People with less illustrious pedigrees will gladly take their places.

And the New York Times has itemized how the math of a successful banker lifestyle (kids in private school, Upper East Side co-op, summer house in Hamptons) simply doesn’t work on $500,000 a year. Of course, it omitted to point out that outsized securities industry pay was precisely what escalated the costs of what was once a mere upper-middle-class New York City lifestyle to a level most people would deem stratospheric.

Although the word “entitlement” fits, it’s been used so frequently as to have become inadequate to capture the preening self-regard, the obliviousness to the damage that high-flying finance has inflicted on the real economy, the learned blindness to vital considerations in the pay equation. Getting an education, or even hard work, does not guarantee outcomes. One of the basic precepts of finance is that of a risk-return tradeoff: high potential payoff investments come with greater downside.

But how did that evolve into the current belief system among the incumbents, that Wall Street was a sure ride, a guaranteed “heads I win, tails you lose” bet? The industry has seen substantial setbacks—the end of fixed commissions in 1975, which led to business failures and industry consolidation, followed by years of stagflation, punitive to financial assets and securities industry earnings; the aftermath of savings and loan crisis, which saw employment in mergers and acquisitions contract by 75 percent; the dot-com bust, which saw headhunters inundated with resumes of former high fliers. Those who still had jobs were grateful be employed, even if simultaneously unhappy find themselves diligently tilling soil in a drought year, certain to reap a meager harvest.

But you never heard any caviling about how awful it was to have gone, say, from making $2 or $3 million to a mere $400,000 (notice how much lower the prevailing peak numbers were in recent cycles). And if you were having trouble paying your expenses, that was clearly bad planning. Everyone knew the business was volatile. Indeed, the skimpy salaries once served as a reminder that nothing was guaranteed.

So why the unseemly whining? It’s a symptom of longstanding pathologies in the industry that were once narrowly useful but which have gotten wildly out of hand.

It wasn’t always that way. I worked for a few years in the early 1980s in investment banking at Goldman Sachs, and later in the decade starting up the M&A business for a Japanese bank, then the second largest in the world, in that brief window when the island nation seemed to be buying up America. I have continued to consult to the industry.

Unfortunately, it isn’t hard to see how those on the investment banking meal ticket come to have an unduly high opinion of their worth.

Wall Street jobs have long been the prime objective at the top of the MBA food chain, and that has always been a function of the money. Aside from looking for people who are well groomed, articulate and reasonably numerate (image is important, given the fees charged to corporate clients), firms screen job candidates for money orientation and what is politely called drive. At Goldman, the word “aggressive” was used frequently a term of approbation.

But the firms are white-collar sweatshops with glamorous trappings. You do not know how hard you can work, short of slavery, unless you have been an investment banking analyst or associate. It is not merely the hours, but the extreme and unrelenting time pressure. Priorities are revised every day, numerous times during the day, as markets move. You have many bosses, each with independent demands and deadlines, and none cares what the others want done when. You are not allowed to say no to unreasonable demands. The sense of urgency is so great that waiting for an elevator is typically agonizing. If you manage to get your bills paid and your laundry done, you are managing your personal life well. Exhaustion is normal. On a quick run home en route to the airport after an all-nighter, a co-worker tried to shower fully clothed.

A setting that would seem to reward, nay require, cutting corners has another striking feature: intolerance for error. A computation mistake or a typo in a client document is a career-limiting event. Minor miscues undercut the notion that your firm can execute the more complex and risky elements correctly

And the dynamic doesn’t change much over the course of one’s career. The drill of being a medical resident (or pre-Iraq, a tour of duty) has a known endpoint. But investment bankers have signed a Faustian contract: You have no right to personal boundaries. The business says how high to jump, and you are expected to deliver. Yes, more senior people have more dignity, but the idea that your needs are second to those of the business never changes.

In my day, it wasn’t uncommon for the firm to ask associates to reschedule weddings if they conflicted with a deal. It wasn’t that firms were opposed to marriage; indeed, the partners knew a young man was theirs once he procured a wife and, better yet, kids. He was tied hopelessly into a personal overhead structure that would keep him in the business.

Not that there was any real risk that someone would leave voluntarily. Exhaustion and loss of personal boundaries are an ideal setting for brainwashing, which is why people who have spent much of their career in finance have such difficulty understanding why their firm and their worldview might not be the center of the universe, why they might not be deserving of their outsized pay.

The finance community has other elements in common with cults. One is the implicit and explicit reinforcement of bankers’ “specialness,” their elite status. In how many lines of work do you get to meet with CEOs at a tender age, much less work on matters where hundreds of millions, often billion, are routine? Senior people in the investment banks are political fundraising heavyweights and sit on high-prestige nonprofit boards. Anyone of a Calvinist persuasion would be impressed.

Another parallel to cult indoctrination is that the demands of the job remove new hires from established friends and family and plunge them into a new environment. Most people who come to Wall Street are not New York natives, and the extreme and erratic hours make it difficult to maintain old ties. Season tickets are likely to be given away. Vacations (save for the week before Labor Day and the Christmas-New Year’s period) are frequently rescheduled.

Class consciousness is felt nowhere more keenly than in the world of high finance. Wall Street denizens earn more money than most people—that’s the point, after all. And that means they become accustomed to the perks, such as eating at restaurants that might strain the budget of those less well situated. And, frankly, with their lives revolving around finance and business, other interests wither. In most cases, it’s more fun for them to talk shop than to relate to people outside their cloistered world. The incestuousness often extends to one’s personal life. When I was at Goldman, the only married women professionals who were not married to men at Goldman had come to the firm hitched.

These values become deeply internalized. One buddy, a vice president in hard-charging, testosterone-filled M&A, spent the better part of a weekend lying on her side on the floor of her office, reading deal documents. She kept reassuring concerned colleagues that she was fine, until the pain got so bad that she relented and called her boyfriend. He came and took her straight to the hospital. The doctors operated immediately, assuming she had appendicitis. They found instead diverticulitis, which usually afflicts the elderly, and she was so close to a colon rupture that they had to remove half of it.

The partners at her firm instructed her to not to return until she had recovered fully. But this was September. Bonuses were paid at year end, and as she read the unwritten code, and knew that staying away too long would be seen as a sign of weakness. She was back at the office three weeks later, looking wan.

She later became the first woman investment banking partner at her prestigious firm. Her instincts served her well. Or maybe not. She later lost 90 percent of the vision in one eye to glaucoma, an easily treated disease, because her overloaded schedule made eye exams seem like a luxury.

Trading, the other side of the business, is stereotyped as the antipode of investment banking, with the market makers and the dealmakers viewing each other in disdain. While there are other subcultures within large firms, the bankers and the traders are the alphas and set the tone.

In the old days, traders were almost without exception order flow traders who served the socially useful function of making markets in instruments that weren’t listed on exchanges. It’s an adrenaline-filled game, with quick highs and gut-wrenching lows. Unlike bankers, who can never truly take personal credit for the profits on a deal (even if they brought it in, the firm’s franchise usually played a role), traders see their P&L as their own output, even though they use the firm’s infrastructure, research and capital.

Historically, traders often came from modest backgrounds Indeed, some scrappy firms such as the former bond market king Salomon Brothers didn’t care if traders had two heads as long as they produced.

But as Wall Street became a bigger and more profitable, in part by eating commercial banks’ lunch, trading-related jobs became more sought after. Even Tom Wolfe took note in his 1987 novel Bonfire of the Vanities, portraying Sherman McCoy as inordinately proud of the Ivy Leaguers reporting to him.

As markets became more liquid, and more complex instruments were created, firms began creating specialist trading groups to make bets with house funds. Unlike the traditional market makers, they did not deal with customer orders but were strictly out to make money into more money. The pattern for the so-called proprietary traders was set nearly 20 years ago. Securities industry denizens were taken aback to learn that Larry Hilibrand, a member of Salomon Brothers’ bond arbitrage group, made $23 million in 1990, then an unseemly sum. But even that wasn’t enough for Hilibrand; he and his colleagues decamped to form the now infamous Long Term Capital Management, which did spectacularly well before nearly bringing down the entire financial system in 1998.

Trading is an autistic activity. Markets are impersonal. And despite the shows of bravura, there’s an ever-present undercurrent of terror. Even if things look to be working out well, they could turn swiftly into monstrous losses. And again, as LTCM illustrated, it’s all too easy for successful traders to lose that sense of fear, to start believing in their own genius and take risk recklessly.

The picture of traders, both in the media and too often in their own eyes, reveals more than a bit of a John Galt fantasy, casting them as brilliant, productive people, with others piggybacking on their earnings. That’s hogwash. Traders conveniently forget that they have managed to get themselves in a hugely advantageous position: They get a slice of their profits if they win, but don’t disgorge them when they screw up. The worst that happens is they lose their job. And a remarkable number fail upwards, or at least sideways. Witness how John Meriwether, is now raising his third fund after heading two firms (LTCM and JWM Partners) that failed.

Moreover, traders benefit from massive subsidies, such as artificially low interest rates (not just now, but certainly since 2001 and, some argue, even earlier), plus industry-serving policies that produced a highly concentrated structure, with a small number of firms sitting at the nexus of massive capital and information flows. The big Wall Street firm trader’s claim that he is an independent operator fully deserving his earnings is a wonderful bit of mythology. It’s like claiming prowess in hunting based on the results achieved at a well-stocked game reserve, with some of the prey drugged to boot.

Many psychological disorders are otherwise healthy tendencies carried too far, unchecked by other personal attributes. Single-mindedness, drive to succeed, aggressiveness and lack of remorse are useful traits in business, but when do they tip into the psychopathic? In the case of Wall Street, the collective psyche has suffered as important checks on ego and behavior have eroded.

One no longer operative constraint is the partnership form of ownership. In the days when partnerships prevailed, senior management had good reason to keep pay demands in line. The partners had most of their wealth tied up in the business; they lived poor and died rich. If the firm suffered a loss, the consequences were disruptive to catastrophic. You couldn’t replenish capital easily; mortgaging the house will only go so far. And the partners were personally liable. They were on the hook for any shortfall. Many once famous Wall Street names lost their independence due to weak performance or losses: Kuhn Loeb, First Boston (over a series of years), Bache & Company, A.G. Becker, Lehman Brothers Kuhn Loeb (in 1984), Drexel Burnham Lambert.

But despite the peril it posed to the owners, the partnership form had some compelling advantages: Compensation levels were confidential, so as not to annoy less well remunerated clients, and the firms were not exposed to double taxation. And the partnerships had a cachet that the public firms, mainly retail brokers, sorely lacked.

That mode of operation in turn produced a great deal of vigilance, at least in the firms that proved to be survivors. The management committees needed to set pay levels so that the business was also retaining sufficient capital to remain competitive. These owners also had narrow spans of control, acting as players in as well as managers of businesses they had grown up in. In the market-making businesses, they were usually the senior traders on the desks and knew the foibles of their subordinates.

And so performance-inducing levels of compensation and the long-term health of the business were held in balance. Moreover, the leadership had reason to rein in big egos, since they could feel emboldened to take risks that would jeopardize the firms.

In the early 1990s, Sallie Krawchek, then an equity analyst covering publicly owned investment banks for Sanford Bernstein, remarked, “It’s better to be an employee of a Wall Street firm than a shareholder.” Being public changed all the incentives. Management had less reason to be cautious. Indeed, that also showed up in her analysis. The most profitable business was fixed income, meaning the debt-trading business, and even then the firms were on a trajectory of taking on more risk.

And more risk changes the meaning of trader profits. The private partnerships had managed against the fact that the non-partner market-makers didn’t share in the downside, and a key device was making sure that joining the partnership was the richest reward. That alone encouraged underlings to be more judicious.

To illustrate how much values have shifted in a money-minded business, John Whitehead, the former co-chairman of Goldman who presided through 1984, blasted the current CEO Lloyd Blankfein over the “shocking” pay levels. “They’re the leaders in this outrageous increase,’’ Whitehead remarked in 2007. He urged the firm to be “courageous” enough to lower bonuses and re-instill a sense of propriety.

But Whitehead, like most seasoned hands trying to persuade younger generations of the error of their ways, was ignored.

In the “other people’s money” world, there was less reason for restraint. Indeed, an expression has become common that would have been unthinkable in the 1980s: “IBG, YBG”— “I’ll be gone, you’ll be gone.” In other words, long-term consequences (likely damage) don’t matter; all that counts is this year’s kill. And if it’s big enough, you will never need to work again.

This attitude is predatory. And it has become widespread. A former Deutsche Bank employee, Deepak Moorjani, wrote:

When speaking about the banking sector, many people mention a “subprime crisis” or a “financial crisis” as if recent write-downs and losses are caused by external events. Where some see coincidence, I see consequence. At Deutsche Bank, I consider our poor results to be a “management debacle,” a natural outcome of unfettered risk-taking, poor incentive structures and the lack of a system of checks and balances.

In my opinion, we took too much risk, failed to manage this risk and broke too many laws and regulations. … [T]he system of incentives encourages people to take risks. I have seen honest, high-integrity people lose themselves in this cowboy culture, because more risk-taking generally means better pay. Bizarrely, this risk comes with virtually no liability, and this system of O.P.M. (Other People’s Money) insures that the firm absorbs any losses from bad trades.

And remember, in the Brave New World of OPM, management has every reason to be in on the game. Their bonuses are a function of the profitability of the businesses that report to them. And now that the consequences are evident, it is easy to rationalize the behavior: Everyone else was operating the same way, there was money to be made, you were just providing what the “market” wanted.

A second change has been in how members of the industry see themselves. Most I ran across were proud to be members of respected firms (the reaction when offering your card was quick confirmation), but no one labored under the delusion that finance was an elevated calling. It was a necessary function, the plumbing of a capitalist economy. If there was anything to congratulate yourself for, it was having discovered and gotten into a field that offered outsized rewards, thanks to regulatory and scale-based barriers to entry. The same M&A banker who jeopardized her health in her successful pursuit of partnership once commented dismissively, “It’s indoor work.” A successful institutional salesman said he had never run into more mediocre overpaid people than on Wall Street.

Thirty years of conservative extolling of the virtues of “free markets” seems to have contributed to the banking sector’s inflated ego. Even though the securities markets are far from “free” (they are regulated to varying degrees), the mythology has taken hold that players in finance allocate capital to its best uses—a role of vital importance to society—and therefore deserve to be more richly compensated than everyone else. Such rationales became necessary as growth in capital markets pay greatly outstripped that of other forms of indoor work.

But this flattering self-image is inaccurate. It’s the end investors that are making the capital allocation decisions; the brokers and bankers are facilitators and an information hub. And, unfortunately, as we’ve seen with auction rate securities and dodgy collateralized debt obligations sold to hapless investors as far away as Norway and Australia, the sellers were sometimes less than forthcoming about the quality of the wares they were peddling.

Nevertheless, one sees bankers and brokers, who concede that much of the anger directed at fancy finance is “very well deserved” nevertheless take DeSantis-like exception to their specialty being spattered in the mud-slinging. From the blogger Epicurean DealMaker:

And, in twenty years of offering M&A and financial advice to corporate clients, I have yet to meet someone who has intentionally pushed a “bad” M&A idea to a client, either. Sure, I’ve been in pitches where a banker has proposed silly, ill-thought-out, or downright stupid M&A ideas to a client, but those instances are either unintentional—in which case the client throws the banker out of his office and said banker usually gets fired in the next round of layoffs—or intentionally designed to provoke a deeper and more productive dialogue with the client.

One wonders, has the Epicure ever actually worked on the sell side? There, the banker’s role is to elicit the best possible price. And, trust me, plenty of crappy businesses get peddled. That’s precisely when a broker adds most value, in monetizing a garbage barge, and I saw tons of them when representing one of the preferred dumping grounds, the hapless Japanese. Ah, but of course! They aren’t your client; it’s perfectly OK if the guy on the other side of the table is a stuffee.

Yet to prove his point that the critics have gone overboard, the Epicure wraps himself and his colleagues in a mantle of “we’re good guys in our sector.” What is troubling is that his black-and-white portrait doesn’t appear to be a rhetorical device; he seems to believe it.

Later he writes:

Would the esteemed economist from the New York Times care to explain to me exactly how the finance industry was able to unilaterally increase demand for its services while drastically expanding its operating margins? Maybe I don’t remember my entry-level Economics so good, but that strikes me as a somewhat dubious proposition. And yet, that is exactly the conclusion an inattentive or ill-informed reader would draw from Mr. Krugman’s tendentious screed: regulate those nasty bankers, before they force our country to lever up and make them filthy rich again!

The anger is as telling as the logic, or lack thereof. The Epicure never addresses the inconvenient truth that lay at the heart of all those arguments for stricter regulation: that the rising asset values that fueled the securities industry boom in turn were the result of ever-increasing borrowings. Private sector debt to GDP rose gradually in the 1980s, more steeply in the 1990s, and went near hyperbolic from 1999 onward.

In modern economies, we don’t let banking systems that lend money on a reckless scale go bust, as much as that would be a useful cautionary practice. We socialize the losses. Those who weren’t perps fail to acknowledge that they benefited from the wanton risk-taking nevertheless. In the case of the Epicurean Dealmaker, how can he not recognize that transaction prices were pushed up enormously by the easy access to cheap deal funding? And that his fees, set as a percentage of the deal price, were higher as a result? Many of the cheap loans that funded transactions and pushed M&A prices into the stratosphere were in collateralized loan obligations. The big lenders and investment banks hadn’t unloaded them when the crisis hit, so they are part of the losses that taxpayers are now eating.

That’s why the great unwashed public is furious. They may lack the sophistication to grasp the arcana of the financial crisis, but they sense that the explanations for the costs they are bearing are insufficient; they see that a lot more people were feeding at the trough, directly or indirectly, than the poster children served up for public ridicule. And they’re right.

So the whining, the petulance, the defensiveness, the distorted reasoning, signifies something much deeper and more troubling.

Finance has lost sight of its role.

Banking and capital markets have become important to advanced economies, but also they represent a charge on the productive economy, just like lawyers and national defense. Ironically, the Japanese understood this well, and were still unable to prevent a turbo charged borrowing binge that left their economy a mess. They recognized that letting banks be very profitable comes at the expense of industry. And indeed, until the global financial crisis, while Japan’s domestic economy remained mired in deflation, its export sector was still robust. When our crisis broke out, Japanese policy makers were uncharacteristically blunt and warned the US that the mistake they had made was not cleaning up their banking sector quickly. We are repeating their error for the very same reason: financial firms have great political clout.

Or, as John Maynard Keynes put it, “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill done.”

Yet the people at the heart of this system, even with the wreckage they created all around them, still fail to acknowledge that the rich pay of recent years was the product of a debt binge. It wasn’t just the makers of the pernicious securities who benefited; all boats in the finance industry rose with the surge of borrowing. Trying to defend the status quo ante shows a willful, self-serving blindness to the proper place of financial markets in a healthy economy.

Worse, it bespeaks a dangerous, destructive ideology that has somehow managed to live on, zombie-like, through the crisis. The idea that the needs of the financial sector trump those of the productive sector isn’t just specious; as the crisis so vividly demonstrated, it’s outright dangerous. But its strange persistence as an article of faith among our leadership class, both in government and the media, has yielded inertia and fecklessness where there should be energy and resolve. It seems that before we can confront the challenge of mending our broken financial system, a battle of ideology must be waged and won. And the hour is getting late.

A Tale of Two Economies and The Myth of Recovery: Thoughts Before the State of the Union Address

Jan 26, 2010

Michel Hudson frames the current situation with the US national economy in his most recent essay, The Myth of Recovery, in a way that is strikingly different from the conventional view.

Sometimes we become locked into a model of thinking that leads us to engage in repeated errors, because of a flaw in the model, and not in the actual detailed decisions that lead us to those errors.

I think it is worth reading, and herein is a protracted excerpt from it. It cuts to the heart of what we have said, that there will be no sustained recovery until the real wage increases. The outsized financial sector is strangling the real recovery by diverting resources to itself, and taxing whatever is provided to the real economy.

Mike Hudson takes a more Keynesian approach than I would because of his background and training. That is a legitimate difference. My personal approach would begin with a reform and reshaping of the financial system first and foremost, and a recognition that the current structure of global trade is a game that is rigged against the American working class.

There are two economies – and the extractive FIRE sector dominates the “real” economy

When listening to the State of the Union speech, one should ask just which economy Obama means when he talks about recovery. Most wage earners and taxpayers will think of the “real” economy of production and consumption. But Obama believes that this “Economy #1” is dependent on that of Wall Street. His major campaign contributors and “wealth creators” in the FIRE sector – Economy #2, wrapped around the “real” Economy #1.

Economy #2 is the “balance sheet” economy of property and debt. The wealthiest 10 per cent lend out their savings to become debts owed by the bottom 90 per cent. A rising share of gains are made in extractive ways, by charging rent and interest, by financial speculation (“capital gains”), and by shifting taxes off itself onto the “real” Economy #1.

John Edwards talked about “the two economies,” but never explained what he meant operationally. Back in the 1960s when Michael Harrington wrote The Other America, the term meant affluent vs. poor America. For 19th-century novelists such as Charles Dickens and Benjamin Disraeli, it referred to property owners vs. renters. Today, it is finance vs. debtors. Any discussion of economic polarization between rich and poor must focus on the deepening indebtedness of most families, companies, real estate, cities and states to an emerging financial oligarchy.

Financial oligarchy is antithetical to democracy. That is what the political fight in Washington is all about today. The Corporate Democrats are trying to get democratically elected to bring about oligarchy. I hope that this is a political oxymoron, but I worry about how many people buy into the idea that “wealth creation” requires debt creation. While wealth gushes upward through the Wall Street financial siphon, trickle-down economic ideology fuels a Bubble Economy via debt-leveraged asset-price inflation.

The role of public spending – and hence budget deficits – no longer means taxing citizens to spend on improving their well-being within Economy #1. Since the 2008 financial meltdown the enormous rise in national debt has resulted from the reimbursing of Wall Street for its bad gambles on derivatives, collateralized debt obligations and credit default swaps that had little to do with the “real” economy. They could have been wiped out without bringing down the economy. That was an idle threat. A.I.G.’s swap insurance department could have collapsed (it was largely in London anyway) while keeping its normal insurance activities unscathed. But the government paid off the financial sector’s bad speculative debts by taking them onto the public balance sheet.

The economy is best viewed as the FIRE sector wrapped around the production and consumption core, extracting financial and rent charges that are not technologically or economically necessary costs.

Say’s Law of markets, taught to every economics student, states that workers and their employers use their wages and profits to buy what they produce (consumer goods and capital goods). Profits are earned by employing labor to produce goods and services to sell at a markup. (M – C – M’ to the initiated.)

The financial and property sector is wrapped around this core, siphoning off revenue from this circular flow. This FIRE sector is extractive. Its revenue takes the form of what classical economists called “economic rent,” a broad category that includes interest, monopoly super-profits (price gouging) and land rent, as well as “capital” gains. (These are mainly land-price gains and stock-market gains, not gains from industrial capital as such.) Economic rent and capital gains are income without a corresponding necessary cost of production (M – M’ to the initiated).

Banks have lent increasingly to buy up these rentier rights to extract interest, and less and less to promote industrial capital formation. Wealth creation” FIRE-style consists most easily of privatizing the public domain and erecting tollbooths to charge access fees for basic necessities such as health insurance, land sites, home ownership, the communication spectrum (cable and phone rights), patent medicine, water and electricity, and other public utilities, including the use of convenient money (credit cards), or the credit needed to get by. This kind of wealth is not what Adam Smith described in The Wealth of Nations. It is a form of overhead, not a means of production. The revenue it extracts is a zero-sum economic activity, meaning that one party’s gain (that of Wall Street usually) is another’s loss.

Debt deflation resulting from a distorted “financialized” economy

The problem that Obama faces is one that he cannot voice politically without offending his political constituency. The Bubble Economy has left families, companies, real estate and government so heavily indebted that they must use current income to pay banks and bondholders. The U.S. economy is in a debt deflation. The debt service they pay is not available for spending on goods and services. This is why sales are falling, shops are closing down and employment continues to be cut back.

Banks evidently do not believe that the debt problem can be solved. That is why they have taken the $13 trillion in bailout money and run – paying it out in bonuses, or buying other banks and foreign affiliates. They see the domestic economy as being all loaned up. The game is over. Why would they make yet more loans against real estate already in negative equity, with mortgage debt in excess of the market price that can be recovered? Banks are not writing more “equity lines of credit” against homes or making second mortgages in today’s market, so consumers cannot use rising mortgage debt to fuel their spending.

Banks also are cutting back their credit card limits. They are “earning their way out of debt,” making up for the bad gambles they have taken with depositor funds, by raising interest rates, penalties and fees, by borrowing low-interest credit from the Federal Reserve and investing it abroad – preferably in currencies rising against the dollar. This is what Japan did in the “carry trade.” It kept the yen’s exchange rate down, and it is lowering the dollar’s exchange rate today. This threatens to raise prices for imports, on which domestic consumer prices are based. So easy credit for Wall Street means a cost squeeze for consumers.

The President needs a better set of advisors. But Wall Street has obtained veto power over just who they should be. Control over the President’s ear time has been part of the financial sector’s takeover of government. Wall Street has threatened that the stock market will plunge if oligarch-friendly Fed Chairman Bernanke is not reappointed. Obama insists on keeping him on board, in the belief that what’s good for Wall Street is good for the economy at large.

But what’s good for the banks is a larger market for their credit – more debt for the families and companies that are their customers, higher fees and penalties, no truth-in-lending laws, harsher bankruptcy terms, and further deregulation and bailouts.

This is the program that Bernanke has advised Washington to follow. Wall Street hopes that he will be kept on board. Bernanke’s advice has helped bolster that of Tim Geithner at Treasury and Larry Summers as chief advisor to convince Pres. Obama that “recovery” requires more credit.

Going down this road will make the debt overhead heavier, raising the cost of living and doing business. So we must beware of the President using the term “recovery” in his State of the Union speech to mean a recovery of debt and giving more money to Wall Street Jobs cannot revive without consumers having more to spend. And consumer demand (a hateful, jargon word, because only Wall Street and the Pentagon’s military-industrial complex really make demands) cannot be revived without reducing the debt burden. Bankers are refusing to write down mortgages and other debts to reflect the ability to pay. That act of economic realism would mean taking a loss on their bad debts. So they have asked the government to lend new buyers enough credit to re-inflate housing prices. This is the aim of the housing subsidy to new homebuyers. It leaves more revenue to be capitalized into higher mortgage loans to support prices for real estate fallen into negative equity.

The pretense is that this is subsidizing the middle class, but homebuyers are only the intermediaries for government credit (debt to be paid off by taxpayers) to mortgage bankers. Nearly 90 per cent of new home mortgages are being funded or guaranteed by the FHA, Fannie Mae and Freddie Mac – all providing a concealed subsidy to Wall Street.

Obama’s most dangerous belief is in the myth that the economy needs the financial sector to lead its recovery by providing credit. Every economy needs a means of payment, which is why Wall Street has been able to threaten to wreck the economy if the government does not give in to its demands. But the monetary function should not be confused with predatory lending and casino gambling, not to mention Wall Street’s use of bailout funds on lobbying efforts to spread its gospel.

Deficit reduction

It seems absurd for politicians to worry that running a deficit from health care or Social Security can cause serious economic problems, after having given away $13 trillion to Wall Street and a blank check to the Pentagon. The “stimulus package” was only about 5 per cent of this amount. But Obama has announced that he intends on Tuesday to close the barn door by proposing a bipartisan Senate Budget Commission to recommend how to limit future deficits – now that Congress is unwilling to give away any more money to Wall Street.

Republican approval would set the stage for Wednesday’s State of the Union message promising to press for “fiscal responsibility,” as if a lower deficit will help recovery. I suspect that Republicans will have little interest in joining. They see the aim as being to co-opt their criticism of Democratic spending plans. But in view of the rising and well-subsidized efforts of Harold Ford and his fellow Corporate Democrats, the actual “bipartisan” aim seems to be to provide political cover for cutting spending on labor and on social services. Obama already has sent up trial balloons about needing to address the Social Security and Medicare deficits, as if they should not be financed out of the general budget by taxpayers including the higher brackets (presently exempted from FICA paycheck withholding).

Traditionally, running deficits is supposed to help pull economies out of recession. But today, spending money on public services is deemed “bad,” because it may be “inflationary” – that is, threatening to raise wages. Talk of cutting deficits thus is class-war talk – on behalf of the FIRE sector.

The economy needs deficit spending to avoid unemployment and poverty, to increase social spending to deal with the present economic shrinkage, and to maintain their capital infrastructure. The federal government also needs to increase revenue sharing with states forced to slash their budgets in response to falling tax revenue and rising unemployment insurance.

But the deficits that the Bush-Obama administration have run are nothing like the familiar old Keynesian-style deficits to help the economy recover. Running up public debt to pay Wall Street in the hope that much of this credit will be lent out to inflate asset prices is deemed good. This belief will form the context for Wednesday’s State of the Union speech. So we are brought back to the idea of economic recovery and just what is to be recovered.

Financial lobbyists are hoping to get the government to fill the gap in domestic demand below full-employment levels by providing bank credit. When governments spend money to help increase economic activity, this does not help the banks sell more interest bearing debt. Wall Street’s golden age occurred under Bill Clinton, whose budget surplus was more than offset by an explosion of commercial bank lending.

The pro-financial mass media reiterate that deficits are inflationary and bankrupt economies. The reality is that Keynesian-style deficits raise wage levels relative to the price of property (the cost of obtaining housing, and of buying stocks and bonds to yield a retirement income). The aim of running a “Wall Street deficit” is just the reverse: It is to re-inflate property prices relative to wages.

A generation of financial “ideological engineering” has told people to welcome asset-price inflation (the Bubble Economy). People became accustomed to imagine that they were getting richer when the price of their homes rose. The problem is that real estate is worth what banks will lend – and mortgage loans are a form of debt, which needs to be repaid.

The Banking Oligarchy Must Be Restrained For a Recovery to Be Sustained

Brilliant article really, in its simplicity.

Despite Obama's recent brave words, the US is lagging the world recognition that because of systemic distortions in the financial system the banks are in fact exercising a tax on the real economy that is impeding global recovery. As recently noted in London's Financial Times regarding the structural imbalances in the financial system:

" long as they are not addressed, the banks will make profits – or more accurately, extract rents – out of all proportion to any contribution they make to the wider economy."
The US is going in absolutely the wrong direction, lessening competition and strenghtening the grip of a financial oligarchy through its policy of focusing relief efforts on a small group of Too Big To Fail Banks, at the expense of the broad economy. Despite assurances to the contrary, this is the policy being administered by Washington.

This institutionalization of distortion was easier to understand under the Bush Administration with Treasury Secretary Hank Paulson guiding policy, and the Clinton Administration under banking insider Robert Rubin. But why this sort of response from the new reform government? The answer most likely is centered on three men: Larry Summers, Tim Geithner, and Ben Bernanke. None of the three has practical experience in business. All three are creatures of the banking system, and are heavily indebted to the status quo.

The first practical step for Obama would be to dismiss Summers and Geithner, and if he is wise, the person or persons who recommended them. He also should encourage the Congress to investigate the bank bailouts in general, and tie this to Bernanke's reappointment to the Chairmanship and the movement to audit the Fed.

The most recent scandal regarding the collusion between the government and the Fed to mask the backdoor bailouts to a few big banks via AIG should be proof enough that the Fed has no intentions of acting honestly and openly, and is far exceeding its mandates in its aggressive expanding its balance sheet and the selective monetization of private debts.

There are disturbing indications that the US is using a few of its large banks as elements of its policy to achieve certain objectives in the world markets. Such collusion between the corporate and the government sectors is the prelude to fascism.

We should keep in mind that financial crisis was indeed created during both Democratic and Republican administrations, and that simply replacing the Democrats with traditional opponents is unlikely to achieve genuine change.

Change is what is required. But while the foul stench of corruption hangs over the political process in Washington, where Big Money readily buys influence and control over legislation and regulation, there will be no significant changes, and no economic recovery. Recovery will be in appearance only.

Financial Times
How the big banks rigged the market

By Philip Stephens
18 January 2010

When Lloyd Blankfein met politicians in London a little while ago he brushed aside warnings that investment banks faced higher taxes if they ignored the rising public outcry about multibillion-dollar bonus pools. The Goldman chief executive seemed to believe governments would not dare.
That misjudgment – a measure of the breathtaking hubris that, even after all that has happened, continues to separate bankers from just about everyone else – may explain Goldman’s response to the British government’s decision to apply a 50 per cent tax to this year’s payouts

In the description of Whitehall insiders, Goldman executives reacted with anger and aggression. The threat was that the bank would scale back its business in London. For a moment it seemed Gordon Brown’s administration might wobble. In the event, Goldman’s lobbying failed to persuade it to soften the impact of the tax.

Britain, of course, is not alone. France has imposed its own bonus tax. Barack Obama’s administration has just announced a levy to recover an estimated $90bn (£55bn, €63bn) over 10 years. The centre-right government in Sweden has gone further by introducing a permanent “stability levy” to discourage excessive risk-taking.

It is a measure of how far the political debate has shifted against the financial plutocrats that George Osborne, the Tory shadow chancellor, has applauded the Swedish plan. If the Tories win the coming general election, they would support a worldwide levy along similar lines. It is “unacceptable”, Mr Osborne remarked the other day, for the banks to be paying big bonuses rather than building resilience against future crises.

So far, so encouraging. But the process cannot end here. Irritating as it may be to Mr Blankfein, a one-off bonus tax is not going to change anything in the medium to long term. Levies such as that in Sweden mark a recognition that the profits and remuneration policies of the banks are more than a fleeting problem. But forcing bankers to strengthen balance sheets with money they would rather put in their own pockets addresses only part of the problem.

The next stage must be scrutiny of the structural distortions that allow these institutions to rack up such huge profits. Broadly speaking, the leading players in at least three areas of investment banking – wholesale markets, underwriting and mergers and acquisitions – have been operating natural oligopolies.

Their profits have been in significant part a reflection of the absence of robust competition. There are different reasons for this in the different areas of business – what economists call asymmetries in some and market dominance in others. But as long as they are not addressed, the banks will make profits – or more accurately, extract rents – out of all proportion to any contribution they make to the wider economy.

Read the rest of this article here.

The Financial Crisis Inquiry Commission Ready For A Breakthrough

The Baseline Scenario


The person who has the best chance of saving the Republican Party is Barak Obama. The president campaigned on change. He clearly stated that he was not going to allow big business to own and run Washington. If the health care proposal that is moving through congress is his version of change, the citizens of this great country are going to realize what he meant was “chump change”.

When he and his fellow democrats said more competition is needed in the health insurance industry, what did they do? They came up with the idea of a public option. The essence of the option was to create a not-for-profit health insurance company run by the federal government. They refused to tackle the oligopolistic prone health insurance industry. One of the pillars that made this country and its citizens the most prosperous in the world is the free market system called capitalism. Capitalism is under attack from within the business community and our government refuses to do anything about it.

With Barak Obama’s refusal to bring about the change he promised by weakening the strangle hold oligopolistic industries have on our “free markets” he is giving the republicans the opportunity to rise from their terminal illness. The citizen is losing his right to access the free market and it is being taken away from them because the oligopolies have bought our politicians including Barak Obama.

Adam Smith when he discussed “rational self interest” and competitive markets in his book Wealth of Nations, envisioned many consumers buying goods and services from many producers with everyone looking out for their self-interest. By keeping markets “free”, producers pursue their rational self-interest and this best meets the needs of the consumers and the citizens of our country, who are also looking out for their self-interest. Under this system, what is in the producers self interest is to provide the best product possible to the consumer, while striving to be a low cost producer for their niche. If they do not, they will perish.

This consolidation of markets began in the late 1960’s early 1970’s in the auto industry when three giant corporations and one union transformed it from a free market to an industry that was controlled by these entities. As this transformation was occurring, the auto company’s and auto union’s self-interest became separated from what the consumer wanted and/or needed. Competition between the companies broke down and this gave an opening for foreign competition to enter our markets and the beginning of the end of the American auto industry as we knew it.

Other industries saw what was happening in the auto industry and saw that government was not objecting so naturally they followed the same path with little concern on any ones part that we were losing our free market system to a more centralized market system of oligopolies. As a result, we now have major markets where the producing entities self-interest is not always in line with the self-interest of the consumer. What is in the self-interest of the entities in these industries is to keep the oligopoly alive. Thus, this was the creation of special interests and lobbyists.

These oligopolies have bought the protection of our representatives in Washington and state capitals. I am baffled by the fact that corporations and unions cannot vote in this country, however they are allowed to buy votes with their contributions.

We lost track of a key ingredient that Adam Smith identified as necessary in order for “rational self interest” to work. There must be many producers. In too many industries, the number of producers has shrunk and the ones remaining have gotten “too big to fail”. This is true in the auto industry, the banking industry, Wall Street, health care and will soon be true in the computer software industry.

In the end, the republicans may be thanking Barak Obama for providing them a bailout package called the free market.

Financial markets are mostly unproductive

January 4, 2010 | billy blog

Today I was reading some academic articles on the implications of budget deficits. In general, the amount of effort that goes into these articles doesn’t match the quality of the argument. They all have predictable formats – some proposition, then invoke neo-classical assumptions, do some mathematics (mostly second-rate in quality), then make a conclusion that was given anyway by the structure of the exercise. As a consequence there is no information content at all in these articles. Just gymnastic exercises. However, one article I read presented a new slant on the case against government spending. It also resonated with my reaction to the release of a major report on executive salaries in Australia today, which quashed hopes that shareholders would have more say in disciplining the companies they own. The debate generalises and points to the conclusion that financial markets are mostly unproductive and have conned us into thinking otherwise.

The Productivity Commission released its report into Executive Remuneration in Australia today (January 4, 2009) and already it looks like they are recommending a soft-line on what our Prime Minister had described as the “obscene executive salary” problem.

For non-Australian readers, the Productivity Commission used to be the Tariffs Board then the Industries Assistance Commission and describes itself as:

The Productivity Commission is the Australian Government’s independent research and advisory body on a range of economic, social and environmental issues affecting the welfare of Australians. Its role, expressed simply, is to help governments make better policies in the long term interest of the Australian community.

As its name implies, the Commission’s focus is on ways of achieving a more productive economy – the key to higher living standards. As an advisory body, its influence depends on the power of its arguments and the efficacy of its public processes.

You learn from its history that is was formed in 1998 by the previous conservative government who rationalised three related government bodies into the one unit. It typically comes up with neo-liberal policy prescriptions with reflect its mainstream economics approach. Its previous findings have spawned deregulation in many industries and sectors and supports privatisation and out-sourcing of public activity at the expense of employment. It has never answered the critique that its concern about the damage of so-called “microeconomic inefficiencies” are out of all proportion to the losses its imposes via unemployment.

Anyway, it seems to have dropped that charter in this report.

The motivation for the Enquiry was the:

Strong growth in executive remuneration from the 1990s to 2007, and instances of large payments despite poor company performance, have fuelled community concerns that executive remuneration is out of control.

They note (see Overview) that “some past trend and specific pay outcomes appear inconsistent with an efficient executive labour market, and possibly weakened company performance” and that “some termination payments look excessive and could indicate compliant boards”.

However they say that “the way forward is not to by-pass the central role of boards. Capping pay or introducing a binding shareholder vote on it would be impractical and costly” and instead say that “the corporate governance framework should be strengthened”.

Initially, the draft report had recommended a “two strikes and you’re out” proposal which would have forced company directors to stand for re-election if executive pay deals were twice rejected by 25 per cent of the shareholders.

The Productivity Commission claimed that “company representatives, as well as advisers to companies and institutional shareholders, considered that the second strike would have significant downside risks” which they listed as:

- conflate the advisory signal on remuneration with the prospect of spilling the board, thereby deterring some investors from expressing dissatisfaction with the remuneration report

- lead boards to take the line of least resistance and adopt generic (‘vanilla’) pay practices likely to be acceptable to proxy advisers and others, rather than seek to devise innovative pay structures that better met the specific needs of the company

- lead to some directors choosing not to recontest their positions if forced to present themselves for re-election over perceived failures on remuneration

- provide a ready vehicle for shareholders to pursue objectives or agendas unrelated to remuneration

The main claim was that a minority of shareholders could force a board spill. However, if you believe any of this is more than special pleading then you will believe anything. But the Commission bowed to the pressure and finally settled on a recommended change to the Corporations Act 2001 to read that if there are “more than 50 per cent of eligible votes cast, the board would be required to give notice that such an extraordinary general meeting will be held within 90 days.”

The business lobby, who are never happy unless they are receiving public handouts with no reciprocation required, are still angered with these conditions and claimed this “would turn remuneration into a stalking horse for other issues” (Source)

The Commission also reject any notion of a “binding shareholder vote on executive pay … [as being] … impractical and costly.” They also rejected the trade union request for a salary cap on CEO and non-CEO pay.

So we will not expect to many reforms which will empower shareholders to discipline what the directors of the companies that the shareholders own do with their capital.

As an aside, I did some analysis to see how executive salaries had tracked relative to growth in share valuations of the major companies and also relative to average weekly earnings. The following graph is indicative as the data issues are fairly difficult. It shows the from the evolution of CEO pay in Australia, Average Weekly (Total) Earnings (AWE) and the S&P/ASX200 share price index from 1988-89 to 2008-09.

The CEO pay data came from Kryger (1999) from 1988 to 1998 and then from the Productivity Commission Appendix B for 2003-04 to 2008-09. I then just filled in the gap via linear interpolation which will not be that inaccurate. The S&P/ASX200 index and Average Weekly (Total) Earnings (AWE) comes from the Reserve Bank database.

I then converted the series into index number form for comparison with base year 1988-89 = 100. The graph is self-explanatory. The rapid growth in CEO pay begins just after the previous conservative government took over and started deregulating the labour market making it harder for workers to access pay rises.

My conclusion: there is a problem. The Productivity Commission report has dodged the issue. Bad luck Australia.


Anyway, all this was an aside – a sort of mental connection – with some other things I have read today. One particular paper I found interesting (in its audacity) was arguing that deficits are “good” because they will discipline government spending more than if a balanced budget was pursued.

In the Hoover Digest (Number 3, 2008), an article When Deficits Make Sense appears written by one Dino Falaschetti, who lists his affiliation as a Hoover fellow in addition to his university post in Florida.

You can see the full working paper at his SSRN archive – Deficits do Matter: They can Improve Government Quality.

The Hoover Institution at Stanford University was set up by former US President Herbert Hoover, who dithered while the US went south in the early years of the Great Depression. The Institution’s mission statement reads that:

… The principles of individual, economic, and political freedom; private enterprise; and representative government were fundamental to the vision of the Institution’s founder. By collecting knowledge, generating ideas, and disseminating both, the Institution seeks to secure and safeguard peace, improve the human condition, and limit government intrusion into the lives of individuals.

So it is a free market biased organisation whose fellows include known conservatives economists like Robert Barro, Gary Becker, John Taylor, Thomas Sargent to name a few.

Falaschetti’s main proposition is that while all sides of politics think the federal “government borrows too much” it doesn’t necessarily follow that the government should try to balance its budget. He says that “balanced budget spending can actually facilitate unproductive tax transfers”.

He claims that:

Indeed, while the invisible hand of markets pushes for win-win bargains, the visible hand of government favors a plurality of voters at the expense of others.

The conclusion is that “running deficits appears to be more solution than problem”. You may be wondering what his line of argument is going to be given this is a conservative institute advocating budget deficits over balanced budgets.

Falaschetti’s second main proposition is that:

Because voting “markets” tend to take from those without a voice, tax-financed spending often channels resources to politically attractive (though not always productive) uses. Financial markets, on the other hand, reward making more than taking. Having to fund deficits can thus replace political manoeuvring with market discipline.

First, it is clear that he doesn’t understand the way the modern monetary system operates in the sense that taxes do not finance government spending. The pork-barrelling in politics however, does involve “tax” and “spending” bribes because national governments choose to mislead the electorate either intentionally or through ignorance about the true nature of their currency monopoly.

Second, his concept of productivity is very narrow – apparently the dictates of the financial markets determine what is best for society. So it is better to “fund” government spending by selling debt because as you will see he thinks this invokes “market discipline” which is a superior form of discipline according to this argument than that which is exercised via the ballot box.

We might ask why bother with elections? Why not just let Wall Street and its regional derivatives (pun not intended) nominate the government of the day in each nation and give us all “win-win” public spending outcomes? I know – you will say that effectively that is what happens anyway. Probably true.

But Falaschetti thinks that financial markets know best how to use resources:

… financial markets, despite recent credit channel difficulties, discipline public spending better than voting markets do. A “bridge to nowhere,” such as the multimillion-dollar span recently proposed in Alaska, would have a hard time attracting financial capital on a cost-benefit basis. But voting markets can forge ahead anyway, spreading the tax costs of unproductive projects widely while concentrating the benefits onto politically attractive constituencies. By more transparently distinguishing between political redistributions and sound public investment, running deficits can improve government quality.

So you get the drift. “Bridges to nowhere” would not be funded if financial markets were the arbiters. This is the usual argument made about public allocations – that the pattern of spending would not resemble that made by profit maximising capitalists who have to answer to their shareholders.

By the way, the accountability to shareholders is why I tied the Productivity Commission report and this article together.

He talks about “credit channel difficulties” as they were just a hiccup – an aside that hasn’t altered anything much. He seems to forget that the current global economic crisis began as a financial crisis driven by irrational greed and dishonest behaviour within the financial markets. The record of these markets in determining what is a “productive” investment is now highly questionable.

Is Falaschetti really telling us that the $billions that are tied up in collateralised debt obligations and the $US30 trillion outstanding credit default swaps are exemplars of “productive” allocations of capital?

How many people have lost their life savings as a result of the financial markets folly?

How many people in less developed countries have starved from the increased poverty that the financial crisis has imposed on their countries?

In this context, I was reminded of the speech Adair Turner, Chairman of the UK Financial Services Authority gave to a dinner at The Mansion House, London on September 22, 2009. He said:

This was the worst crisis for 70 years … a new Great Depression – was only averted by quite exceptional policy measures. Despite these measures major economic harm has occurred. Hundreds of thousands of British people are newly unemployed; tens of thousands have lost houses to repossession; and British citizens will be burdened for many years … because of an economic crisis whose origins lay in the financial system, a crisis cooked up in trading rooms where not just a few but many people earned annual bonuses equal to a lifetime’s earnings of some of those now suffering the consequences. We cannot go back to business as usual and accept the risk that a similar crisis occurs again in ten or 20 years’ time … while the financial services industry performs many economically vital functions, and will continue to play a large and important role in London’s economy, some financial activities which proliferated over the last ten years were ’socially useless’, and some parts of the system were swollen beyond their optimal size.

He also quoted the Chairman of the British Bankers’ Association who said:

… in recent years, banks have chased short-term profits by introducing complex products of no real use to humanity.

Financial markets are, in the most part, unproductive and produce very little of any value to the broader community. That is at the best of times. But the recent crisis has demonstrated that when they over-extend they have lethal consequences for the real economy.

People and nations now suffering unemployment, poverty, and, in some cases, starvation, had nothing to do with the development of all the shady products that the geniuses on Wall Street invented and pushed often fraudulently, onto ignorant investors.

Further, if private cost-benefit is to be the arbiter of where activity is best focused then a significant number of projects that obviously generate social wealth would never be funded. Society would be much worse off as a consequence. I can think of countless examples where the private markets would never have provided a socially-beneficial activity or resource.

In other words, there is a serious flaw in the proposition that financial markets are the best judges of social costs and benefits. Even mainstream microeconomics textbook have sections (if you can find them) on the divergence between social and private calculations and the need for non-market interventions to resolve the differences.

Falaschetti doesn’t consider government redistributive efforts to be beneficial to the economy. He says that economies prosper “when governance institutions reward productive efforts, and suffer when individuals instead seek redistributive rents”. So the implication is that public education and public health that promotes quality human capital formation in poor areas when it otherwise would not occur are not productive?

He also claims that redistributive policies (where governments provide benefits from its spending to specific groups to garner political support) are bad enough but then “politically attractive tax-and-transfer projects tend to shrink economic opportunities” because they “encourage individuals to lobby to be members of favored groups”.

So financial markets apparently do not lobby for specially-pleaded advantages? I wonder how he explains the bailouts that have occurred with the limited oversight by the US and other governments and the clear evidence that public money has been used by the players in the financial markets to reward those whose criminality and imprudence caused the whole crisis in the first place.

Falaschetti claims that to “maximize the benefits of public spending” there has to be a “funding mechanism that discourages inefficient” spending. In this context he says that :

Voters in corporations “that is, shareholders” readily agree to run deficits, in part because debt capital offers important advantages in governing a firm’s management. Likewise, government bondholders put their money where their mouths are and thus help rein in unproductive tax redistributions. Financial markets can give us a better idea of the appropriate scope of government activity and encourage a less wasteful employment of public resources once that scope is set.

He thinks the within-generational transfers implied by tax favourtism is more of a problem than the debt transferring resources from future generations to the present” because “debt also embodies a number of self-policing mechanisms, whereas taxes create relatively little discipline on how governments spend resources”.

The first of the alleged self-policing mechanisms are:

By selling off bonds when creditworthiness deteriorates, financial markets continually monitor the potential for public spending to decrease the government’s repayment ability.

I laughed at this point. While there is no risk of solvency of a national government defaulting on obligations denominated in its own currency in a modern monetary economy with flexible exchange rates the point being made here is different to his primary justification.

Notwithstanding the obvious reality that sovereign governments have no solvency risk, the financial markets do waste their time talking about sovereign default risks and the credit rating agencies make money by conditioning (fuelling) this conversation. It is a glaring example of bright minds filling up their days with unproductive activity.

If you do some research and talk to people in financial markets you will come to the conclusion that the concept of creditworthiness of sovereign debt is quite different from a neo-classical assessment of whether a particular dollar of public spending is productive.

You might like to read this Fitch sovereign rating methodology particularly the “Checklist of Sovereign Rating Criteria”.

If you examine that list you will see that an assessment of “creditworthiness” however misguided that is in the case of a sovereign government that issues its own currency is rather removed from the process that Falaschetti envisages.

It is true that bond prices will fall and yields rise if the “financial markets” are spooked by the credit ratings. But this is in no way a reflection of a cost-benefit analysis performed by the bond traders on whether the dollars being spent are “productive” or not. The bond investors are just wanting a safe return.

Finally, Falaschetti concludes that:

Economists have long debated whether deficits boost consumption during economic downturns or instead make their way into savings. Deficits do matter, but perhaps less for fiscal stimulus and more for disciplining public spending. To attract funding through debt markets, spending proposals must reasonably promise to strengthen society’s repayment ability. Moreover, debt markets continually evaluate the price at which government obligations are traded and thus transparently report on the credibility of such promises. Running deficits, not balancing budgets, can productively constrain governments by raising the price on unproductive spending while readily supporting public projects that strengthen economic performance.

So he really wants less spending and taxes overall. But his conception that bond markets are continually judging projects on their capacity to “strengthen society’s repayment ability” is far-fetched.

It is difficult to conceive of how we would ever measure “society’s repayment ability” anyway? Further, even if we guess at what he means, one wonders what the “repayment ability” might be of the billions of USD that have been spent in Afghanistan killing and maiming?

Perhaps, the bond markets who line up without fail to buy US government debt have worked out that the US government is part of the heroin trade centred around that part of the world?

Further, rising bond yields typically will rise when there is a diversification of investment opportunities available in a growing economy. So bonds become relatively less attractive because private assets offer higher returns and the higher risk is discounted in the growth environment.

There is no coherence in the statement that variations in bond yields provide an index of the public spending capacity to increase society’s repayment ability, whatever that term actually means.

That is enough for today.

Selected Comments
  1. BritishBankers says:

    Monday, January 4, 2010 at 23:47

    British Bankers’ Association here. Interesting article. We offer a quick clarification if we may.

    Lord Turner did use a quote from our chairman, Stephen Green, to support his view that some of the City’s trading activity was “socially useless”. But Turner failed to set out the context of Stephen’s comments:

    “At our best, what we do allows businesses to supply products and services that customers need; allows individuals to own homes and cars; to save for a rainy day and for retirement; and to protect themselves and their businesses against the unpredictable. If we care about human freedom and human well-being, we cannot do without these functions.

    “But at their worst, financial markets can be engines of destructive excess. In recent years, banks have chased short term profits by introducing complex products of no real use to humanity. It is clear that very many innovations introduced by the financial markets have been socially useful, and indeed are critical to economic and social development to our prosperity, in short.

    “But it is equally clear that some parts of our industry had become overblown, and that certain products and services failed the tests of usefulness, suitability and transparency.

    “If we are to regain the position of trust and confidence that is a fundamentally important mark of social and economic health, the financial industry will need to learn the lessons of a crisis that has shocked and frightened the world.”

  2. scepticus says:

    Tuesday, January 5, 2010 at 0:57

    Hi bill,

    Couldn’t agree more with this:

    “But his conception that bond markets are continually judging projects on their capacity to “strengthen society’s repayment ability” is far-fetched.”

    On this matter, I have a related question. Assuming a government followed your prescriptions and simply spent without issuing bonds, and balanced that with liquidity removal via taxation and possibly via paying interest on reserves, then we can say this government has no need to issue long bonds.

    Because the government does not need to issue long bonds, does it not follow that they can then control the entire yield curve by simply issuing sufficient bonds of of mid and long maturity such that the combination of supply and demand of these securities achieves a given target 25 year rate?

  3. pebird says:

    Tuesday, January 5, 2010 at 1:16

    The only positive I take from the extraordinary pay levels of executives is that there must be a tight supply of unethical actors in the executive labor market.

    Also, how commentators can get away with statements about government-funded “bridges to nowhere” while ignoring much larger privately-funded debacles like Dubai World and think that they have any credibility is beyond me.

    It is interesting that different tactics are being used to “argue” against increased government spend – the pressure on the US to avoid a 2nd stimulus is going to be the sideshow of Q1 2010.

    We need a prediction contest – my bet is that there the US Congress will pass a 2nd stimulus of relatively small amount and deferred release schedule.

  4. Ramanan says:

    Tuesday, January 5, 2010 at 2:59


    Good point about the yield curve. The government can “set the yield curve”. One may raise objection and dismiss the claim because data shows that the overnight rates fluctuate around the overnight rate target but that is because of lack of proper understanding and use of insufficient tools. The CB can just announce the price of each Treasury security and be willing to buy/sell it at that price. With the CB paying interest (=target) on reserves, – the excess reserves if any – will earn the overnight rate. The CB should also set the discount window – the rate at which it lends to banks – at the target rate. This way, the whole yield curve can be made “exogenous”.

    Of course this does not serve any public purpose, so might as well stop issuing Treasuries or have maximum maturity ~ 3 months.

  5. scepticus says:

    Tuesday, January 5, 2010 at 3:46

    ramanan, without any guidance from the CB as to the long term risk free rate, how do you imagine the private sector would price a 25 year mortgage?

  6. bill says:

    Tuesday, January 5, 2010 at 5:29

    Dear Scepticus

    Poor dears … they would have to develop their own low risk asset to replace the public (corporate welfare) bond!

    best wishes

  7. scepticus says:

    Tuesday, January 5, 2010 at 5:57

    Bill, ins’t that exactly what they were trying to do with the shadown banking sector.

    You know, create informationally insensitive debt (akin to a deposit account) by taking lodsa mortgages and packaging them up in an opaque fixed income asset which is more or less interchangable with another opaque fixedincome asset (while the music is playing)? And then they use that as collateral for repos in the shadow banking sector. That is, I post MBS collateral with X nominal value and you give me access to 0.95X wholesale funding which I then use to source more loans and make more MBS?

    That way the wholesaler gets a place to deposit very large sums of money with the repo collateral acting as deposit insurance.

    is it wise to leave all this to the private sector without any kind of benchmark for the more risk averse to cleave to?

  8. bill says:

    Tuesday, January 5, 2010 at 6:17

    Dear scepticus

    Yes, securitised mortgages were a possible contender for a low-risk privately created asset. The problem was that they were corrupted by the con-artists and used to create other derivative assets which were useless.

    If you also regulate most of the financial sector out of business and require banks have to hold all their own loans they will soon work out what a 25-year mortgage is worth – the level of demand will tell them.

    best wishes

  9. Scott Fullwiler says:

    Tuesday, January 5, 2010 at 6:31

    Hi Scepticus

    This is essentially already done in swap markets, and there were a number of articles suggesting these could/would rather seemlessly become the new benchmarks back in 2000 when everyone erroneously thought the US would run surpluses large enough over the next 10 years to pay off the national debt. As an aside, Randy, Bill, Warren, and others in our “camp” were writing at the same time that it would never happen given the implications for the private sector financial balance.


  10. scepticus says:

    Tuesday, January 5, 2010 at 7:24

    Hi scott, do you have links to some of those writings you’re talknig about? Would love to read them.


  11. Scott Fullwiler says:

    Tuesday, January 5, 2010 at 12:35

    The one I can recall off the top of my head is here: . See the papers/comments related to session 4.


  12. c smith says:

    Wednesday, January 6, 2010 at 6:10

    You said:

    It is true that bond prices will fall and yields rise if the “financial markets” are spooked by the credit ratings. But this is in no way a reflection of a cost-benefit analysis performed by the bond traders on whether the dollars being spent are “productive” or not. The bond investors are just wanting a safe return.

    Other than cases of war financing where the immediate survival of the regime is in question, you are correct that bond investors generally DON’T care what the money is spent on. However, if the spending is rising fast enough that the prospective financing capabilities of the sovereign come into question, OR the prospect of monetization by the central bank arises, bond investors will revolt. This process is less an analysis of the productivity of current spending than an analysis of the capacity for future spending. BOTH the productivity of current spending and the willingness of government to accelerate future spending on projects the bond market deems unproductive figure in the calculation however. In this way the bond market is more coal mine canary than ongoing arbiter of efficiency.

  13. joebhed says:

    Thursday, January 7, 2010 at 7:52

    ummmm, regarding the financialization of the economy and the need “to strengthen society’s repayment ability” , have you read Steven Lachance’s “How Debt Money Goes Broke”?
    And would you care to comment on this fractured debtor-creditor relationship.

[Jan 5, 2010] Limiting the destruction brought by irrational exuberance in a one-party state

By Edward Harrison of Credit Writedowns

As a writer, Matt Taibbi is a lot more vitriolic than I am. He curses, makes some pretty over-the-top personal attacks, and divines a policymaker’s intent where I don’t think he can. But, this goes mostly to style.  Substantively speaking, he has a lot to say and we should take notice. 

I wanted to highlight a piece he wrote yesterday called Fannie, Freddie, and the New Red and Blue. The crux of his argument is this: The partisan rhetoric is on full display in the dust-up over the unlimited liabilities coming from Fannie and Freddie thrust upon taxpayers on Christmas Eve. This rhetoric is not just beside the point, it is specifically designed to obscure the point, namely that both Democrats and Republicans, private industry and the government are culpable in the shambles our economic system has become.

Taibbi says:

Over the Christmas holiday a nasty thing happened: Tim Geithner’s Treasury Department decided to lift the cap on aid to the Government-Sponsored Entities, Fannie Mae and Freddie Mac, apparently in response to Obama administration fears that the two agencies would become insolvent. The cap was raised from $200 billion on each and government backstopping of the mortgage market will apparently now extend into infinity for at least three years, through 2012.

recent history of the GSEs and uncovering some disturbing new facts…

Sometimes I’m amazed at the speed with which highly provocative information like this GSE business can be converted into distracting propaganda in this country…

What worries me is that we’re… starting to see fault lines develop, where one side blames the government while another side blames Wall Street for the messes of the last two decades…

Everyone was involved in the mortgage scam. At the lender level the deceptions were myriad; liar’s loans, fraudulent income documentation, negative amortization loans, HELOCs, etc. The rush to get as many loans written as possible and then get those hot potatoes moved to the next sucker in the line was furious and extended from coast to coast, sinking one lender after another in Ponzoid debt and indictments….

Everyone had a hand in the bubble, from the congressmen who killed regulatory initiatives to the regulators who snoozed at the wheel to the GSEs to the Fed to the banks to the ratings agencies to the lenders. I don’t think it’s really controversial to say that, but it does seem like there’s an argument brewing about what that across-the-board complicity means.

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. Incumbent politicians and policymakers retain power by looking the other way and allowing special interests an unfair profit advantage. Usually, this goes to excess. Irrational exuberance takes over and losses ensue – losses which are not borne by the economic actors but taxpayers. That is how it always happens, but in this case it happened on a grander scale. And both Democrats and Republicans were complicit.

The question is: what can be done?  Can we really spot this kind of ‘irrational exuberance” when it permeates the entirety of the social fabric? Barring another Great Depression, I don’t think any one President or one party is going to be the agent of change – Barack Obama has demonstrated this quite effectively. Both major political parties have too much at stake in the status quo. So, if the question goes to the whole Red/Blue partisan back and forth, Taibbi is right that this is a side-show. We effectively have a one-party system when it comes to investment in the present economic, power, and wealth structure.

But, the question also goes to Greenspan’s argument about not spotting bubbles, but cleaning up after the mess. Greenspan feels the Fed’s job is not to regulate and not to target asset prices as a bubble forms. Rather, the Greenspan view has the Fed acting asymmetrically by raising rates slowly so as not to cut off a boom, but cutting them quickly to forestall depression – something I see as hopelessly blinkered and outright dangerous.  Greenspan, in his ideological fervor, is presenting an extreme form of an argument that has some basic merit.

Mark Thoma presents a much more sensible argument based on this same we-can’t-stop-bubbles view. In reviewing Bernanke’s recent defense of Fed policy, Thoma says the following (emphasis added):

there is blame to be placed, plenty of it, but I don’t think it should be concentrated as much as it is on Bernanke and the Fed (Greenspan may be a different story, but he was also going along with the majority of the profession, or at least the powerful voices in the profession at that time). The blame is on the entire profession, and those who study the structure of the banking industry and regulation in particular. Many of the economists who are the most critical today were among those supporting deregulation (or they said little or nothing about it).

Finally, as I’ve noted before, I have come to the same conclusion that Krugman states today, that the most important thing we can do is to reduce the effects that bubbles have when they pop. We may never be able to prevent all bubbles or other problems in the financial sector, but we can do a better job of making sure that the effects of these problems are minimized. I’d start with limiting leverage ratios, the 30 or more to 1 we saw prior to the crisis is much too high and dangerous to unwind when problems hit, and I’d also restrict the other side of that coin and increase capital requirements. The system was far too fragile before the crisis, and that’s something that we need to fix.

The key in what Thoma says – and what connects it to Taibbi’s polemic is that the blame for this bubble and collapse is widely dispersed. That should give you pause as to whether any specific policy remedies are going to prevent a recurrence of the same in future. 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.

So, Greenspan, Bernanke, and Thoma are asking the right question. Where I disagree most with Greenspan and agree most with Thoma is in the remedy. In making a remedy one has to first diagnose the problem, prioritize goals of remedial action and affect a decent plan of implementation.

I lean heavily toward the third view, but see a lot of merit in the first.  My bias is toward a relatively free market buttressed with adequate rules as a regulatory framework and sufficient regulation of those rules.  Clearly, existing rules on bank size as percentage of the deposit base and leverage would need to be enforced. But, I don’t see a need to create more rules. That would just retard growth and wouldn’t alleviate the problem of irrational exuberance. Certainly, bringing all financial agents (money market funds, insurance companies, derivatives and hedge funds) under a comprehensive regulatory umbrella is a priority but this can be done in a way that is consistent with the existing structure.  Why burden the system with a system risk regulator as another layer of oversight? Better to just hive off the essential bits into a tightly regulated oasis, de-coupled from the rest as Volcker suggests.

One last note, this time on Bernanke’s views.  I was struck by how much Bernanke tried to ‘defend’ Fed policy. His was not an objective assessment of a disinterested party in why we got to where we are and what we can do to fix it. It was a defense of his institution and his own role in it.  No good can come of such an analysis.

Update 2100ET: A reader chastised me for not being more explicit about the Geithner proposal’s loopholes. Just to be clear about choice number two, the regulation-heavy one, 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. When Byron Wien predicts that regulation will be industry friendly, that’s what he means. Also note his discovery of Barack Obama by early 2007 from this post. Obama had strong Wall Street ties from the start.


Fannie, Freddie, and the New Red and Blue – Matt Taibbi

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