I’m not sure this will do anything useful. Pretty much all of the contracts that are done by offshore entities are actually registered in either London or New York. People register companies off-shore mainly for tax reasons and secondarily for privacy results, but very few contracts are actually registered off-shore.

One reason is that you want things to be opaque if you are registering a company, but if you want to enforce a contract, you want things to be extremely transparent.

4. Restrict sales and trading of derivatives to public futures exchanges where contracts are registered, records of large positions are kept and prices published under regulated capital-adequacy provisions.

Really tough to do considering that most sales and trading of non-derivatives are done over the counter.

5. Banks should not be allowed by regulators to supervise their own risk profile with “risk control” software, which can generate dangerous macroeconomic effects by failing to anticipate political and credit risk as well as random events.

Actually this works quite well if the bank regulator really is about to look at the internals of the software. If you have a regulator like the Fed that is willing to look at the software, mandate scenarios to be run, and then looks very skeptically at the results, it works really well.

If you have a regulator that just turns a blind eye like the SEC, then you have a problem.

Also, risk software doesn’t try to anticipate events. What you do with it is to use the software to crash test different scenarios.

This is precisely what I’m worried about with respect to China. The problem with inflation is that once it is entrenched, you completely destroy the financial system and any ability to save, which is what has happened in Latin America and Russia. China and India have many differences but the one similarity is sensible inflation rates.

In the Chinese situation you have two lobbies, the “inflation hawks” in the People’s Bank of China and the “inflation doves” in the local officials, and the fighting between these two lobbies keeps Chinese policy in balance. Victor Shih has written a very brilliant book about the dynamic, but for reasons that I can’t quite understand, he considers it a bad thing that needs to be changed.

One thing about Chinese policy is that so much of the economy is dependent on savings that it is impossible for there to be massive inflation without the government being overthrown.

I think it was pretty clear from your writings that you were deeply concerned about the state of affairs, so I wouldn’t feel too badly. It’s not as though anyone looking for comfort would’ve found it in your stuff- quite the opposite. And I do understand your preference to keep your commentary in areas of your own expertise, largely by way of my vice for not doing so. Having said that, your instincts and insight are quite good, so perhaps the vice is yours. As to 1998, we’ll have to agree to disagree. My reading of things tells me the bailout, i.e. inflate, and regulate approach has problems (although I personally have benefited from it, at least this time around). It’s better than bailout and not regulate approach, but with significant drawbacks of its own. Norman Gall’s articulation of that argument is far better than my own, so I’ll link you to it. Plenty to chew on in there from this:

…it [the argument for an aggressive ZIRP/quant easing approach] revives the old idea, familiar to us in Latin America, that a little inflation is a good thing. The trouble with this idea, which some economists incorporated into development theory in the 1950s and 1960s, is that inflation creates powerful vested interests and institutional mechanisms of its own and, once unleashed, is very hard to control…

…An overdue retrenchment has stopped a worldwide expansion and proliferation of financial assets bred on a scale and duration never before seen. This retrenchment has left financial businesses with large amounts of excess capacity pending readjustment of asset values, impacting other forms of economic activity. Readjustment must work its way through the system. Fortunately, we are not dealing with a synchronized collapse of asset values in all major countries as in the Great Depression [or at least we weren't when this was written circa LTCM]. However, as Japan’s recent experience shows us, failure to allow markets to adjust asset values and shrink balance sheets will only prolong the crisis. A lesson of the Great Depression is that artificial stimuli are of marginal use without deeper economic reorganization.

and his five recommendations were uncannily prescient:

1. Limit short-term lending to a certain percentage, fixed by the BIS, of foreign assets of lending countries and foreign liabilities of borrowing countries, making allowance for normal provision of trade credits.
2. Limit leveraged trading of financial assets by banking institutions.
3. Eliminate offshore financial centers by international agreement, with the United States and Britain taking the lead in refusing to enforce contracts registered in these jurisdictions.
4. Restrict sales and trading of derivatives to public futures exchanges where contracts are registered, records of large positions are kept and prices published under regulated capital-adequacy provisions. Banks and other financial institutions should be required to allocate capital to support derivatives bets, with courts assigning them the same legal status as gambling debts.
5. Banks should not be allowed by regulators to supervise their own risk profile with “risk control” software, which can generate dangerous macroeconomic effects by failing to anticipate political and credit risk as well as random events.

Especially 2 and 5. He’s written a post-Bear pre-Lehman version, though I’ve yet to read it all. In any case, I’ve taken enough of your time. Thanks for the discussion.

It hasn’t, but I doubt that there are going to be much in way of surprises once the numbers come out.

There is one reason for this sort of secrecy, in that having a financial institution saying “I am getting money from the Fed” can often create a confidence crisis that leaves the institution worse off, which means that institutions don’t go to the Fed for money even when they need to.

WD: Purchase of equity stakes by the Treasury has clearly been quite selective.
This leaves out the guarantee details.
Obviously it’s a selective bailout.

Yes, but anyone in the industry can probably figure out who is getting money and how much. It’s very unlikely that the Fed would choose one investment bank over another investment bank because at this point all of the other investment banks would start screaming. The areas were there is bias would be industry based (i.e. IB’s versus hedge funds, finance versus autos), but those biases are fairly open.

WD: The crisis will result in the dominant cartel consoldiating its control and ownership of American businesses.

That’s not how the US economy and political system works. There is a “power elite” in the United States, but there is quite a bit of infighting within that power elite, and if one group gets too strong, the other groups start ganging up against it.

The way that economic policy is made in the United States isn’t hugely different from the way that it is made in China, largely because China copied key ideas from the United States, namely Glass-Stegall and the Banking Holding Act.

In particular the “financial elites” and “business elites” in the US and China are kept pretty separate from each other, which is very different from the structure that you see in Germany or Japan, where the banks either own the businesses (Germany) or the businesses own the banks (Japan).

Curiously a lot of the structure of US/China has been designed with the express purpose of keeping the business and financial elites separate so that they do not challenge the control of the political elite, whereas in Germany and Japan, a post WWII political vacuum allowed business and financial to gather much more power than they could in either the US or China.

as for the broader point, i still would rather not have had a systemic crisis in 98 just to have avoided the 08 crisis by forcing leverage out of the system in a permanent way. we might have ended up in 08 (or 09 — which is shaping up as really really grim — with global output falls of the kind we haven’t seen in a long time). i do though think that the world lost sight of how close a call 98 was — and stopped worrying about risks.

incidentally (and see Krugman today on economists behaving badly) I was reluctant to articulate my concerns with the assymetric fed policy response in 04/05 (unlike say Roubini) b/c of the deference given to greenspan, and concern that i lacked the stature/ academic credibility to articulate successfully a contrary view. i was/ am more of an expert on bop issues/ capital flows than monetary policy, and the “monetary policy/ asset bubble” issue was the key debate in that field.

good luck holding on to your job too …

I don’t disagree with a). My point was probably more the reverse, that the bail-in of LTCM by moral suasion was appropriate, while the broader bailout was not. More on that in answer to d).

As regards b), the bailout that followed, I don’t doubt that letting the financial markets implode, or even marginally risking this, was not politically feasible. However I assume we are interested in more than just the feasible, but also the optimal, (and while we are likely to be 100% in agreement as to what is most appropriate of what is feasible, i.e. mass bailout and mass regulation, I don’t have confidence those policies will be successful).

One thing I certainly do disagree as regards b) is that it is impossible to perceive a bubble contemporaneously. GMO’s asset allocation guys have quite reasonably quantified a definition- one standard deviation around a sound historical measure of value- subject to regime change- (Tobin’s Q, cyclically adjusted price multiples, median home price to median income, etc.), and in any case, like obscenity, it is somewhat the case that ‘you know it when you see it’. Be that as it may, the fuel for a bubble, wayward underwriting practices, are far less difficult to spot (80’s commercial real estate terms, 90s corporate and investment leverage, this decades residential mortgage and other consumer credit abuses, etc. etc.). So I do not for a second sympathize with the defense that counter-cyclical policy cannot be implemented on the upside. And if I did sympathize, I would also believe that the implication of that assertion is that there can be no counter-cyclical policy full stop, something I am unwilling to fully concede as yet. As you can probably tell, anything remotely sounding like Greenspan rhetoric gets my blood up.

On c) I don’t disagree with what you’ve written, though again, I don’t see that these uninterrupted expansions punctuated by crises that lead to still greater crises are likely to be redeemed by virtue of the former. More on this in d). And I do think Fannie and Freddie were entirely critical ingredients on delivering us to the doorstep of oblivion, but in no way is that opinion consistent with some of the politically expedient but factually laughable spin that has been spawned to affix the blame for this crisis to ‘government’ and ‘Democrats’, (this also means I don’t think the Community Reinvestment Act has anything to do with subprime, in fact I’m pretty confident on that point, nor really do Freddie and Fannie, though they have some). No, my opinion stems from the fact that these guys were effectively spending federal tax dollars all along without anything like Congressional oversight or approval, (there is of course a regulator, but this is not the same thing), to bailout the plutocrats that were getting obscenely wealthy speculating in securities (of course, not expressly to that end, but what difference does it make?).

Why were they critical elements in the brewing of this crisis? Because, as we have seen vividly illustrated by the recent crisis, it takes more than buying treasuries with freshly minted reserves to resuscitate markets- it takes backstop bids by risk takers. When the market became risk averse in bouts of crisis, situations that can quickly spiral out of control into panics that are both self-fulfilling and self-sustaining. For 15 years, in these circumstances, Freddie and Fannie would come in- en mass relative to the then scale of trading volume in the mortgage and credit markets- and be that backstop where private functionaries couldn’t (as they weren’t real money investors and were up to their ears) or wouldn’t (as they lost confidence). All that happened during that time is that the financial house of cards they were instrumental in building became too much larger than the GSE’s ability to swamp them (though I agree with you that their activity during the latest crisis has kept us afloat, as I noted in my first post). As something I read recently went, institutions like Fannie and Freddie, (and Deutche and Fortis etc. etc.) went from being too big to fail, to being too big to save. It simply isn’t easy for a country to organize a bail-out for an institution whose assets are close on 100% of GDP or greater in the case of Fortis, (or much greater in the case of the Icelandic banks).

Which after too many words brings me to d). You asked how far I would’ve gone in 98, with respect to letting all hell break loose. Now, don’t get me wrong, I don’t underestimate the scale of the fallout from permitting emerging market defaults or permitting runs on the B/Ds (although my recollection was that the IMF did bail-out Russia, at least to some extent). In fact, I think the fallout from the S&L crisis alone, which was blunted substantially by the burgeoning bubbles in Wall Street finance, (noted I believe in the literature by comparison with Japan and with the wrong lessons learned), could have been dramatic, but obviously wasn’t.

However, the answer to your question is nothing short of all the way. And I will tell you why: because problems grow exponentially with time. I am in my mid-thirties now, with a nearly 15 year career in finance, that now seems moot. That human capital is patently wasted, and it is conceivable I will not be particularly useful to society again for some time. I may not even ever again be able to fully apply the fruits of my education (I’m still employed but let’s say with less than full confidence, and the point is academic- the industry will shrink massively). Now, of course, that will have been true in 1998, but the industry has mushroomed from there, and not just on Wall Street.

Moreover, here we are 20 years into a credit bubble, by which time generations of adults have never known what a sustainable US/global economy would look like. That cannot be a good thing. What exists now begins to resemble a museum exhibit, or Fatapur Sikri; a snapshot of a world in terminal decline. There are five million ways to spend money and a massive swath of the workforce dependent on wealthy consumers, and financing them, yet very little in the way of a workforce that build tradable goods, let alone one whose productivity justifies its relative consumption. And of course there is the mirror image of this in the surplus nations. The scale of those real costs over 20 some odd years has become near on inconceivable, and scary. And I simply don’t believe in a social rate of time preference that remotely justifies putting off these adjustments at the cost that procrastination bears.

Does that mean a crash is necessary to remedy the situation? I certainly think it’s possible. Dramatic circumstances are required to change people’s behavior. I would argue that the political will to regulate a booming marketplace in 1999 had as much chance politically as letting these companies to their own devices- and failure- perhaps less so. It is simply very difficult to get people to believe something when their wallet depends on their not understanding, and many people’s did for some time.

So that’s where I come out, and sorry for the length. On a related, but unrelated note, this is an absolutely brilliant column in case you missed it. This by the same author is good too…

Majorajam — interesting comment/ thanks for digging up the BIS study. A few points in response:

a) If I am right and LTCM’s failure would have been followed by a set of measures to stabilize the b/ds/ bigger rate cuts/ more freddie and fannie securitization (the whole shebang) then I am not sure that letting LTCM fail would in the end have disciplined the b/ds and systemically important institutions. The key question is whether their creditors would have become less willing to lend them money, and on that I am not sure. Or rather I suspect that getting that outcome would have taken more than letting LTCM fail.

b) I agree that the assymetric policy response to financial excess (no restraints on the way up b/c there is no way of knowing what is a bubble/ all hands on deck to limit the fallout if things go wrong) is a problem. And I fully support efforts to use regulatory policy to reign in excesses. I don’t think it is credible to assume that the government will allow big institutions to fail, and I think that has to be reflected in how we regulate said institutions. market discipline won’t work in that context. I think that is one of many things that we have learned.

c) I agree that Freddie and Fannie have been used as tools of countercyclical policy (or at least as tools to try to limit downturns). that was long seen as one of the strengths of the US system: if the banks were in trouble, capital market players could step in and vice versa. It just turned out this time that the banks had become capital market players/ there was no healthy balance sheet left in the system …

that said, Freddie and Fannie were reigned in a bit in 04, 05 and 06 as a result of the accounting scandals and thus were scaling back during much of the housing boom (i.e. they weren’t fueling the boom). they started up again in 06/ 07 if memory serves. And then in late 07/ the first part of 08 they grew their balance sheet like gangbusters in an attempt to offset the fall in private securitization/ keep credit to the households flowing. That was one reason why there wasn’t a sharper downturn in late 08/ early 08. It also though seems to have only deferred a bigger crisis.

d) i am curious how far you would have gone in 98 in terms of not bailing out the speculative community.

speculative bets on russia ($10-20b or so, ballpark, in direct foreign exposure GKOs if memory serves plus a decent amount exposure — say $30-50b in exposure to Russia’s longer-term $ bonds/ soviet era $ loans) clearly were not bailed out. that wasn’t enough.

LTCM wasn’t bailed out with federal $. Though there was an effort to coordinate creditors (reasonably in my view/ no risk was assumed by the feds) and macro policy was loosened to try to avoid a broader slump (arguably set a bad precedent, as macro policy wasn’t tightened in the face of the speculative excesses of the post-Mexico EM/ US stock boom but was loosened as insurance against a bust)

But what about Brazil? Should it have gotten bailed out then? Absent a big chunk of IMF and G-10 support, a disorderly exit from its $ peg that produced Asian style distress in its banks and firms (meaning losses for all those who lent to them) was possible, and the government’s finances were a bit shaky so losses on speculative bets on brazil were also possible. Would you have stopped at LTCM or also let Brazil go down?

And if LTCM’s failure had say led to big trouble at one of the broker-dealers (say LEH — which was a smaller firm at the time), would you have bailed it out or let it fail?

And if it fails, what would you have done if there was a broader run on all the b/ds a la 08/ a full withdrawal of all credit to all EMs?

My argument was that it is hard to draw the line in practice. Runs are real – and can be disruptive. THat is why i am in the end willing to risk moral hazard with some intervention on the condition that the associated risk is offset by regulation.

In retrospect the biggest failure — apart from not recognizing a housing bubble and trying to limit the financial system’s exposure to it whether by more monetary tightening or tighter regulation — was a failure to recognize that a lot of big players in the financial system were not borrowing on the basis of their own financial strength but rather borrowing on the basis of the assumption that they were too big to fail, and as a result the large profits made possible in good times by high levels of leverage ultimately should have belonged to the taxpayer who was backstopping the risk/ allowing the leverage …