H/T Atmoz for the title of this posting.
The NY Times points to an audio production of an outsider’s asking stupid questions about finance. It promises to be very interesting.
I thought I’d capture my opinions about what I’ll call the wtf, by which I mean the current financial/political situation, before listening to that report.
My background, as regular readers know, is a PhD in climatology and a long standing interest in the processes of policy and collective decision making under complexity. So of course the present clstrfk fascinates me.
My opinion is informed by an undergrad class in economics in the 70s taught by a Keynesian, occasional and spotty reading in the area since, and fundamnetal doubt regarding some axioms of economic thought, especially that growth in measurable financial transactions is a useful measure of public well-being. The last keeps me very separate from Keynesians like Krugman to whom I am otherwise closest. It puts me closest to a small camp of anti-growth economists, but they also seem wrong to me on technical grounds I won’t get into here. I make no claim to being an expert; I merely doubt that there is much expertise at all.
For instance, here is Kalinda Stevenson, Ph.D., financial adviser, life coach stating “However, the bank cannot loan out all of its deposits. If you deposit $1,000 in the bank, the bank loans most, but not all, of your $1,000 to other customers.” As I will explain briefly below, this seems obvious enough but it is completely wrong. Anyone believing this falsehood will find it impossible to understand wtf, their eyes will glaze over, they will sigh, and they will go with their “gut” which will steer them wrong. OK, her PhD turns out to be in protestant theology, so I’ll put my Ph.D. up against hers as a basis for thinking about economics any day, but she doesn’t stress this at all and happily poses as an expert on money. Her implied perspectives in the latter article should fascinate those who don’t understand the “conservative”, “red state mentality”. But I digress.
Anyway, here’s my own first attempt to explain wtf before shuffling off to my day job this morning.
First of all, the intrinsic worth of a dollar is obviously zero; a dollar is simply a measure of how much purchasing power everybody agrees you have. The fact that it’s disconnected from gold is pretty secondary. The practical uses of gold are real enough, but the value of gold is also pretty much dominated by convention and not by actual utility. The number of dollars in the world (I use the term loosely to include all fungible currencies here) is not the total of printed and minted currency; the existence of printed and minted currency is a bit anachronistic. Most dollars are digital. So what prevents the bank from “lending” more of these bits than they actually have?
Well, in fact, nothing. More to the point, banks are encouraged to do exactly that. Lending money you don’t have is the prerogative of a bank. Banks are the institutions which are licensed to lend money they don’t actually have! This is the keystone of the whole situation. Currency comes form the mint, but money comes from the bank. Anyone with a license to lend money they don’t have is a bank, any bank is licensed to lend money they don’t have.
The crucial aspect is the multiplier, the ratio of how much they lend to how much they have.
What controls the multiplier? Could a bank abuse this and create infinite amounts of money? Well, in the past this would cause a run on the bank. Everyone with any real money on deposit would “pull it out”, ultimately turning it into currency, stuffing their mattresses, and buying up ammunition. (This is of course rather silly, because even the stuff in your mattress is ultimately imaginary.) The amount of actual cash on hand at the bank would become negative, the ratio would become infinite, and the bank would find itself unable to get currency and would “collapse”, leaving remaining deposits worthless. Something like this happened in 1929 if I understand correctly.
To prevent this, we have a federal reserve bank, whose function is primarily to insure the first $100K of any deposit at any bank. (Does bank consolidation limit the amount of money you can insure?) In order to insure this, the “Fed” is empowered to regulate the banks, including setting the limits on the multiplier.
This worked out brilliantly for a long time, almost 80 years in the American context; lots of “growth” happened, much of it actually corresponding to well-being. Some of us have been worried that this would eventually blow up, since many types of “growth” aren’t actually improvements. Indeed, people have of late become tired, angry, stressed and shallow. This certainly feeds into our other problems. Growth addiction prevented the substitution of long-term sustainable energy supplies for short term ever-burgeoning fossil fuel consumption, and this finally provided the trigger for the wtf.
In my view, though, the wtf occurring now is decades early with respect to resource limits. Normally we could have worked through the petroleum shortfall using the genuine creativity and competence that capitalism unleashes. This ought to have been a glitch. The Kunstler scenarios never rang true for me. If we are going to be reduced to an Argentine-class collapse anytime soon, (and it looks all too likely that we are) it will be a mistake to attribute it to resource limits. Eventually those will bite, but this is too early.
Anyway, this central role of the Fed means that the libertarian “government-out-of-the-economy” advocates are thus fundamentally either ignorant or dishonest. The entire structure of modern capitalism is entirely based not only on regulatory powers but also on deliberate manipulation on the part of governmental entities. The idea that regulation could go away and everything would continue to work out is simply at odds with reality.
And this idea, the idea that markets need no regulation, the idea that modern markets even exist in the absence of regulation, not oil, not housing, not outsourcing, is the root of the problem.
After decades of republicanism, interrupted only by a brief interlude of Clintonesque “market-friendly” democratism that is not substantially different in this regard, the boundaries between banking and non-banking enterprises blurred. Because banking is so profitable compared to, you know, actual work, anyone who could get in on this something-for-nothing business looked for ways to do so. The availability of vast computing power contributed. Many brilliant people who might have been doing useful work involving derivatives and integrals were diverted to parasitical efforts involving derivatives and options. Essentially these “products” were bets on bets about bets on bets. These products essentially replicated the banks ability to manufacture money without being subject to regulation.
Remember the science fiction story about so many volumes of cross references and indexes that the actual information got lost? “Ms fnd n a lbry” it was called… It’s sort of like what has happened. There were so many bets and bets about bets that they amounted to a huge financial structure dwarfing the real economy on which they were perched. And now the whole structure is tipping over.
For years, rewards went to people making elaborate bets far more than to people doing real work. (Even our heroes at Google and Apple are fundamentally in advertising and fashion, though to be sure they have done more real work than most beneficiaries of the current period!) This fed the building boom, feeding the real estate boom, feeding into many of the bets that suddenly went sour at the first provocation.
Of course, there’s also a lot of resources lost to literally blowing things up these days too. But I don’t think the awful tragic waste of the Iraq escapade is crucial.
My idea of what happened is that the bets about bets about bets became so huge as to so dominate; that their consequent effect is essentially to undermine the whole concept of money. More money changed hands in the phantom economy every day (if I recall correctly) than was transmitted in real transactions in a year. The bets on bets came to dominate finances. So at the first significant setback to the real economy that all these bets were magnifying, multiplier effects started cascading up the betting chain, and now they are set to cascade back down.
Because the system was unregulated, it became too risk-tolerant and brittle. At the first provocation (peak oil is not peak energy, folks) rather than adjusting it started to crack.
The $700 bn can be looked at as an effort to grout the cracks. Will it work? I don’t know. Is it a good idea? Well, since the money is sort of an imaginary quantity anyway, and if we don’t risk it, it will become sort of worthless anyway, I figure, yeah, it’s better than instability.
For once, I have a little bit of sympathy with the extreme republicans. They say that a core tenet of capitalism is letting failures fail. Maybe we ought to take them up on it and see where that leaves us. One thing is certain; rich people would lose more than poor people would. There’s a certain rough justice in that. The outcome though would be a huge leveller, something I think the hard core Republicans (representing mostly relatively rich people in relatively poor regions) would not care for.
I also think the liberal impulse is easy to understand. This looks like the middle class bailing out the rich!
The thing is, it’s all paper. If the value of the paper goes away, the middle class is even more thoroughly screwed. So they really have got us over a barrel. I am not smart enough about these things to have much to say about the details, but I am smart enough to understand the political calculus of it. Pelosi is right to insist that the Democrats not be saddled with the blame; I have no issue with that. I think we should try to keep the existing mechanisms wheezing along as best we can rather than trying to reinvent them from scratch, though. So I don’t know what should be done, but it seems to me like it’s not nothing.
In the end, though, it’s the market libertarians’ incapacity to see that the system we have set up is an elaborate artifact, not a fact of nature, that is at the root of the problem. We are now in a position that the whole of capitalism needs to be reconsidered and largely reinvented, and it’s hard to see who is on the scene to do the thinking.
In the short run I think we need to try to flex rather than breaking the whole thing in one swoop, though there is a strong argument for getting the collapse over with based on the plausible idea that any bailout won’t work anyway. The way I see it, if things are that bad it hardly matters what we do though. It’s hard to understate the risk associated with total breakage, so that’s why I’m for at least trying to patch it together.
It’s interesting that it’s the deregulators in congress who caused the problem and thus created the risk of collapse seem to be the ones trying hardest to finish the job…
Interesting times, either way.
Update: Unsurprisingly, the Texas delegation has been particularly unenthusiastic about the bailout, this despite the extent to which Phil Gramm, former Texas senator, was a crucial player in inflating the bubble in the first place. Did you expect a population that keeps electing Ron Paul to be very enthusiastic about this thing? What’s perhaps a bit surprising, though, is that the eight members from Arizona, evenly split between the major parties, were unanimously in opposition, despite the urging of their own Senator McCain.
Update: James Galbraith:
Despite the common use of language, the capital cost of this bill does not involve “taxpayer dollars.” It authorizes a financial transaction, exchanging good debt (U.S. Treasury bills and bonds) for bad debt (the “troubled assets”). Many of those troubled assets will continue to earn income for some time, perhaps a long time. The U.S. Treasury commits itself to paying the interest on the debts it issues. The net fiscal cost — which is also the net fiscal stimulus — of this bill is the difference between those two revenue streams. Given the very low rate of interest presently prevailing on Treasury bills, this is likely to be somewhere between $20 billion per year and zero from the beginning, even if the Treasury were to issue all $700 billion in new debt at once. It is a mistake, in short, to count the capital cost as a “cost to the taxpayer.”
This is not the war in Iraq. In the longer run, of course the Treasury will incur capital losses on the assets it acquires. The entire purpose of the bill is to overpay for bad assets, so as to give financial institutions a chance to recapitalize themselves.
Update: Tom Friedman is apocalyptic.
Update: In the comments, David Benson agrees with me that the newfound availability of vast computing power is a component of the financial fiasco. But HPC Wire (the newsletter of the high performance computing community) takes exactly the opposite perspective!
“Why didn’t the sophisticated, computerized pricing models that Wall Street firms use to predict returns and risk for complex derivatives save them from the sub-prime mortgage mess? The short answer is: Fund and portfolio managers rarely use them.” Crosman goes on to reveal some problems with the algorithms themselves, noting that “some models for analyzing mortgage-backed securities don’t include house prices, which are a fairly important piece of the puzzle.” In other cases, the models were simplified for the sake of expediency. One quant noted that “[t]raders will like a light model because they don’t need heavy routines that will take forever to run on their machines.”
Update: Krugman not only is apocalyptic, he uses the word “apocalyptic”.