Why were arguments against taking on risk discounted heavily during the boom?
Barry Eichengreen writes exceptionally well:
“THE GREAT Credit Crisis has cast into doubt much of what we thought we knew about economics. We thought that monetary policy had tamed the business cycle. We thought that because changes in central-bank policies had delivered low and stable inflation, the volatility of the pre-1985 years had been consigned to the dustbin of history; they had given way to the quaintly dubbed “Great Moderation.” We thought that financial institutions and markets had come to be self-regulating—that investors could be left largely if not wholly to their own devices. Above all we thought that we had learned how to prevent the kind of financial calamity that struck the world in 1929.
We now know that much of what we thought was true was not. The Great Moderation was an illusion. Monetary policies focusing on low inflation to the exclusion of other considerations (not least excesses in financial markets) can allow dangerous vulnerabilities to build up. Relying on institutional investors to self-regulate is the economic equivalent of letting children decide their own diets. As a result we are now in for an economic and financial downturn that will rival the Great Depression before it is over.”
What went wrong? Eichengreen argues that those who wanted to take big financial risks were biased toward theories that supporting taking big financial risks.
“the problem lay not so much with the poverty of the underlying theory as with selective reading of it—a selective reading shaped by the social milieu. That social milieu encouraged financial decision makers to cherry-pick the theories that supported excessive risk taking”
That seems generally right.
Especially as those who tend to be better at seeing risks than opportunities tend to warn of trouble well before it breaks out, and even if they identify certain underlying vulnerabilities, are unlikely to call every move in the market.
Back in 2004 Nouriel Roubini and I argued that the United States’ large external deficit was a risk to global financial. Dr. Eichengreen, Dr. Rogoff, Dr. Obstfeld, Dr. Frankel, Dr. Wolf and no doubt many others issued similar warnings. Yet as late as August 2007 Dr. Wolf felt compelled to acknowledge that: “A world in which capital flows from poor countries to the world’s richest seems to be more stable, more dynamic and and altogether more satisfactory than that of the 1980s and 1990s …. “*
Cassandras generally supply their critics with plenty of ammunition.
One financial implication of the Roubini/ Setser 2004 argument was to short the dollar, which wasn’t all wrong (until recently). Another was to take on less leverage. Nouriel and I implicitly were arguing against the assumption that a highly imbalanced world would also be a low volatility world. And that wasn’t the right financial bet for 2005, 2006 or the first part of 2007. Those who took on leverage — and bet that the various imbalances in the US and the global economy wouldn’t create any immediate problems — made money. Those who sat the dance out didn’t.
And while I think our general warnings about the risks associated with an imbalanced world were right, some of our specific concerns never panned out. We generally focused financial risk that those who were holding low-yielding dollar assets were taking; and thus the possibility that the rest of the world’s credit line might have limits. Far more people expected the dollar to fall than expected major financial institutions to fall. Dr. Rajan and Dr. Roubini are the honorable exceptions. Few realized that the US household deficit could be financed only if US and European financial intermediaries took on credit risk even as the world’s central banks took on currency risk. The US economy was generating riskier assets while central banks generally still wanted fairly safe assets.
US banks — not foreign central banks — proved to be the weakest link.
In a rising market, acting on a worry that doesn’t pan out is risky; your portfolio underperforms. The higher home prices rose, the more wrong those who warned of the risks at an early stage looked. Those who warned of the risks of a large trade deficit were in a similar position.
Ultimately, though highly leveraged bets on securities backed by homes were more risky in 2006 than in 2004, as the higher valuation of the underlying collateral implied a larger risk that the underlying collateral would fall in value. Financial institutions should have insisted that folks put more down, not less, as home prices rose.
And there was a bit too much faith, especially on the part of the regulators, that securitization had dispersed risk.
I would have expected most financial institutions back then to have run a stress test where the ratio of home prices to income fell back to historic levels. It doesn’t seem, though, that many such tests were run — or if they were, key institutions didn’t act on the results. And we all have paid a price.
Read Eichengreen.
* Fixing Global Finance, p. 111. Emphasis though needs to be placed on the word “seems”; Martin Wolf clearly didn’t believe a world where capital flows uphill was optimal in 2007 — and certainly doesn’t believe such a world is optimal now.
Thanks a lot for the interesting discussion yesterday about current account versus fiscal deficits.Exchange rate policy and fiscal policy are closely interlinked.
I’m hoping that the US Treasury will be seen as sticking to their current announced plan i.e. they will reduce the fiscal deficit going forward and make it more sustainable.
On the issue of credit expansion, according to the latest g19, outstanding consumer credit is around $2.5 trillion, o/s mortgage credit is around $11 trillion in the L268 table(I got to know about that table from Paul Swartz), and the US GDP is around $14 trillion from the BIPA tables. I don’t see how or why this can be considered as excessive credit load on the household sector. Remember 35% of US homes are still owned outright – i.e. there’s no mortgage on them. During the boom, 5% of all mortgages were a combination of ARM and sub-prime, and there were loans on 65% of the 128 million homes in the US.
There are always individuals who borrow excessively, but as a system credit expansion wasn’t unsustainable.
The massive shift in forex reserves away from the dollar, followed by the typical phony Peak Oil Shock, then the crude price crash beginning end June 2008 – plus the massive unneccessary interventions by the FDIC in WaMu, Wachovia, etc and the engineered collapse of Lehman Brothers – all show that the credit panic was deliberately triggered, as usual, to keep the dollar hegemony going.
Sorry I made a mistake – the real problem was perhaps the o/s CDS worth at least around $43 trillion – a massive part of which became due, and an avalanche of collateral calls – that threatened a situation where all the major banks owed too much to settle the CDS. Left to the market, since there was actually no collateral to provide – all major banks would have had to file bankruptcy, and the FDIC settle ALL the deposits – which wouldn’t have been possible.
Sorry about the error – but it looks to me that the problem is still there. While base money supply has expanded at least $2 trillion – banks are shoring up their balance sheets – and refusing to lend even to creditworthy borrowers. A Massive amount of CDS is still outstanding, collateral calls are still hanging overhead like the proverbial Damocles sword.
Unless defaults stop – banks won’t be confident to lend again – and stopping the defaults involves more employment generation – which requires some credit flow.
Hmm … we should quite happy that somehow the deleveraging isn’t much worse than it was in October 2008. I think the main thing to focus on is solving the curious problem of the credit-default swaps, rather than the o/s loans of ordinary borrowers with their friendly neighbourhood bank managers.
“The Great Moderation was an illusion.” It truly was, yet is the illusion beginning to re-ignite??? And if moderation should be in, is great risk making a great return?
Here in NY, the weather has been gorgeous and a strong sense of Spring is in the air. It was not long ago that the winter cocktail parties people were holding back moderately, and more importantly concerned about the economy, global well being, and the focus became more on moral and less on wealth accumulation.
Past forward to this prior weekend, and we’re on a penthouse (in the west village) of 28 year old homeowner who works at Morgan. In the crowd is the who’s who of Yale, Princeton, Harvard and half the others who graduated with a degree in Arts yet ended up in the 6 or 7 figure camp of Goldman, Barclays or Citi.
Guys from 26-33 are in the audience and the topic of this weeks discussion were who’s getting what house in the Hamptons, one guy whispers “bonuses won’t be bad, we got in a on a summer share July-August weekends, 18K” To my left another one of the sweet girls from Morgan Stanley, a Princeton graduate shouts “did you see my new Hermes bag” Oh my god, isn’t that like 4K whispers a third”. Finally another guy from Columbia who works at Citi joins and says, “dinner at the waverly” a few hours later a table of 6 and a tab of $1797 is placed on the counter”.
Making the social rounds I find it amazing just how quickly my closest friends are beginning to believe we’re moving back to life pre Fall-2007. It’s without question that a twit of arrogance, or could it be ignorance has found it’s way back into the air. Regardless of how bad things get, or how much new risk is taken
Although the U.S. may have entered a severe recession it seemed awfully shallow, at least to those who work at the most prestigious banks, and attended the most prestigious universities.
All of these people are my close and dear friends, yet I cautiously sit back and take it all in. I hope that the fertilizer boosting our Green Shoots reflects their view.
If there were a severe recession, all i can is it surely hasn’t been witnessed by those attending last weeks cocktail parties. Then again, it’s hard for me to truly celebrate, because what if we’re all wrong? And what if it’s far from over?
Leave it to one of my 29 year old friends who just purchased a 2 BR on Central Park South with his bonus “by August no need for the blackberry, things will be just fine, we’ll be right back in the hamptons”…
Let’s hope he’s right!
A system predicated upon capital gains as opposed to cash flows and incomes (convenient as not on the CB s radar screen).
Central banks money supply growth averaging 10 Pct a year when nominal growth in western Europe was averaging 2 Pct
Liquidities feeding credit, credit feeding future bad debts. Leverage and more leverage on the same existing assets (LBO funds selling assets to other LBO funds)
No major technical inovation, no major population growth.
Economic agregates,BOP,GDP components and dependencies not being questioned.
A Social peace,a political recognition, central banks populated by members of the human specy.
“US banks — not foreign central banks — proved to be the weakest link.”
I believe that people need to back up a step in the chain of payments. It is actually the lower and middle class that proved to be the weakest link because of negative real earnings growth.
The banking crisis is only a symptom.
IMO, the “Great Moderation” was nothing more than attempting to use more debt to stabilize and grow an economy.
Eventually, the debt destabilized the economy when there was too much of it.
It is true that many investors made money in momentum trades of 2005-2007. That does not mean that the skeptical prophets like Nouriel or the late Dr. Kurt Richebächer were wrong at timing the bubble.
The collateral damage is still being counted. A decade of borrowed liquidity is unwinding, bringing Americans to their senses. But I wonder whether the Obama policymakers know how to handle the consequences of money printing at the Fed.
Will we see another borrowed liquidity bubble created in other assets?
I’d also recommend his The European Economy since 1945. On page 78 ref. the 1949 devaluations: “This reluctance (to devalue) was informed by the prevailing “elasticity pessimism”, the contemporary name for the belief that even large exchange-rate changes could have only small effects.” Plus ca change….
Naysayers are extremely irritating guests at the weekend house party, especially if ‘everyone’ is getting rich.
It’s more human psychology than anything.
Apologize for deviating to yesterday’s topic but after hours and hours of ponderous reasoning I’ve concluded that there’s no way the US Treasury can go bankrupt in the immediate foreseeable future. Now I’m moving to the ‘green shoots’ camp – but only after the standard Election Tamasha gets over in India.
There’s a huge section of the population in China and many other countries that’s dependent on exports to the US for employment. So the China T-Bond buys are assured depending on the volume of US imports. There’s a shortfall based on UST’s borrowing plans, and there’re rebels – who will be doused with QE water cannons.
In any case China can complain about QE and file their speeches on the record,but they can’t afford to have many more millions of jobless people – already there’re at least 20 million unemployed in China by official estimates.
So the US Treasury will be able to implement its ongoing plans with its borrowings and Fed QE. Now you see the green shoots of recovery.
The problem has been put off for now, but sooner or later it will re surface. I expect China will appreciate the RMB against USd and depreciate the RMB against EUR and other major reserve currencies.
But the existing system can’t break down till such time a massive re structuring of China’s export destinations actually happens on the ground.
Except to predict a financial crisis in 2004 was premature. There was no financial crisis then. In fact it was three to four years later. I’m sure you’ve heard of a stopped clock?
But even then was the crisis first of all because of the China/US relationship? Certainly China’s purchase of US treasuries brought the US interest rate down creating the conditions for the sub-prime bubble etc. but alone it would not have created the crash.
What did that was the loosening of lending standards, the mystifyingly complex securisation of that lending and finally the combination of all that with the hike in raw materials prices up to the summer of 2008 and the decision of Paulson to allow Lehmans to collapse.
That turned a crisis into a calamity.
But we shouldn’t lose site of the bigger picture. The Chinese continue to buy US treasuries, that now enables the US to keep interest rates low, that very significantly ameliorates the scale of the crisis now, deep as it is, and will create the conditions for an upswing.
That’s why I personally think Roubinis assertions of a L shaped Japanese stagnation, albeit somewhat trimmed more recently, are wide of the mark.
what’s interesting to me is that the ‘great moderation’ was created using financial instruments and not real productive activity.
in the end, then, if enough people are using financial instruments as insurance, isn’t the system bound to get unstable? leverage is just a set of somewhat illiquid commitments made on future production…
The over indebtness of the USA and to a certain extent of some European countries and Japan (domestic debt} is no longer a worrying trend but a de facto problem. The resolution through money supply is an expedient and not a cure.
The green shots can only be :
The aknowledgement of the situation and remedies… a long field
One problem was that institutional structure of American finance. Basically in most firms, getting into “risk management” was a career death sentence. There were some exceptions and you can tell which firms were the exceptions by which ones managed to survive.
There was also “over-deregulation.” Put simply, compensation was based on return, and you boost return by increasing risk, and without any internal controls to reduce risk, you need external controls, and those weren’t there.
Nemehiah: The collateral damage is still being counted. A decade of borrowed liquidity is unwinding, bringing Americans to their senses. But I wonder whether the Obama policymakers know how to handle the consequences of money printing at the Fed. Will we see another borrowed liquidity bubble created in other assets?
Absolutely. The history of market economies since the industrial revolution has been one of boom-bust cycles, and this bust will lead to another boom which will lead to another bust which will lead to another boom.
One big problem was that the “Great Moderation” was accompanied by the idea that we had hit the “end of history.” That we had reached the end of all economic turmoil. This isn’t true because the history of markets is the history of people moving between greed and fear. I expect that when we get out of this, we’ll have one or two years of sanity, before people start going crazy with credit again. The crucial period will be late 2009/early 2010, because you will have about a year to put in new regulations before people stop caring.
The other thing about finance is that last quarter has actually been a pretty decent one for the banks. People are refinancing, and the difference between wholesale and retail interest rates, and large scale refinancing means quite a bit of income for the banks. One consequence is that there weren’t too many layoffs at the end of Q1.
AstroPlace: Although the U.S. may have entered a severe recession it seemed awfully shallow, at least to those who work at the most prestigious banks, and attended the most prestigious universities.
I think it has a lot to do with the fact that the people you mention are late-20-somethings with no kids. If you are a late-20 something with no family obligations, then recessions aren’t quite as scary, since if things go bad, it doesn’t hurt you that much, but if things go good, you have lots of disposable income.
q: what’s interesting to me is that the ‘great moderation’ was created using financial instruments and not real productive activity.
I don’t think this is true. There are two major sources of productive activity over the last 10 years.
1) technology and the internet
2) growth of China and India
There have been spectacular sources of wealth created over the last ten years. The good news is that these two sources of wealth are not one time events.
I don’t think that the world has had any problems with wealth production. Lots of problems with wealth distribution, but no problems with wealth production.
Uneased with the the financial industry and results;
Few figures may help to explain:
The pretax gains of five banks only when booking at fair value the price of their bonds 19.2 billion usd (to be read the worse the financial situation the better the profits)courtesy of zero hedge
http://4.bp.blogspot.com/_FM71j6-VkNE/Se-YJDOeJJI/AAAAAAAACF0/PHsC17sNXWE/s1600-h/FVO+banks.jpg
As a consequence before celebrating a downfall profits of 37 Pct only for the SP 500 constituents it may be useful to restate profits in the banking industry, as healthy as it is it will repay its bonds in full isn it?
bill j: china and other central bnaks have more or less stopped buying long-term treasuries, so they are — in my view — playing a smaller role keeping int. rates low than in the past. to be sure, if the inflows into t-bills stopped, there would need to be a broader adjustment that would likely imply higher rates (or an even lower current account deficit). but right now the main factors keeping rates low are the global downturn and the prospect of fed buying, not foreign central bank demand. at this stage in the cycle, in other words, rates should be low.
incidentally, i heard a lot about stopped clocks, especially when i worked for dr. roubini. it is no longer even all that creative a put down.
there is something a bit strange about banks paying bonuses out of accounting profits derived from a higher probability that they will default on their bonds. on the other hand, if bank bonds recover, that will be a drag on profits for some time.
Another issue that doesn’t get mentioned nearly as much as the ones in this topic and comments is that whenever our observations of what is going on around us seems unfavorable, we change the statistics methodology to prove the obvious to be incorrect.
Bill Gross was on CNBC yesterday and mentioned that the changes in computing the inflation rate under the Greenspan Fed in the 90s resulted in inflation being understated by 1% and therefore real GDP is overstated by 1%. This also allows the Fed to be terrified of deflation much more often than necessary. So over the long term, we had excess liquidity and credit finally creating a credit crunch, debt deflation and the Great R. We don’t have any economic theory for that, even tho that is probably the biggest dynamic that occurred during the Roaring 20s and Great D 30s.
Bill was also quite bearish on the outlook for the T-bond market.
@astorplace: apparently your friends are not affected by the huge amount of tree pollen in the air in nyc now. myself i have been the unfashionable one, breaking into violent sneezing fits on the subway.
@twofish: i was misstating a bit, but it was the _moderation_ that was derived through financial instruments, not the productivity.
my thought is that this moderation was caused by the use of debt derivatives and cash stockpiles which were meant to serve as insurance. the process of deriving somewhat liquid insurance-level promises (some with long duration) from underlying productive assets is inherently risky and that risk was swept under the rug.
how would you, say, “save” for retirement for two hundred million people, just in the US? you might need a present value of a hundred trillion dollars or more to fund this, and this will have to be backed by present productive assets, meaning that they will be deeply in hock and the instruments themselves will need a high liquidity premium. add to this the currency stockpiles in asia, etc.
i believe i am not being sufficiently coherent in my explanation, but when i wonder how we can have long term insurance-type promises in the private financial system without huge amounts of debt (included hoarded governnment debt), i am baffled.
[...] Were Arguments Against Taking on Risk Discounted Heavily During the Boom? (CFR) Brad Setser from the Council on Foreign Relations reviews economist Barry Eichengreen’s [...]
bsetser: there is something a bit strange about banks paying bonuses out of accounting profits derived from a higher probability that they will default on their bonds. on the other hand, if bank bonds recover, that will be a drag on profits for some time.
More stupid in hindsight than strange. A lot of management thinking in the 2000’s was that companies needed to make the incentives of the employees match shareholders, so a lot of effort was made into bonus plans which encouraged employees that took actions that boosted profits and increased share prices.
One can boost profits by leveraging and decreasing capital, but this was considered a good thing. Cash reserves in 2000’s management thinking were a sign of incompetence.
The idea that people should be encouraged to take actions that maximizes profits sounds reasonable, almost obvious, but there is a downside, in that risk and reward are correlated, and you end up boosting profits by increasing risk, which you cannot bear since you have no cash reserves.
Also one big problem is that if you don’t reward people for making profits, then what is the metric for deciding how much someone should be paid.
The incentives in Chinese companies are different. Chinese companies have incentives to maximize cash reserves, since more more cash you have in the bank, the more ways you can find to pay yourself a bigger salary. Profit comes into it, because having large profits means higher bank balances.
This means that the SOE’s avoided the crisis, but there are other problems with this system (which is how US companies operated in the 1960’s). The big one is that you can argue that it encourages inefficiency. However, we are discovering that inefficiency may not be such a bad thing at times.
Brad, if I may, there are two levels of responses to a groupthink problem:
1. We know the contours of sensible response in terms of regulation to prevent recurrence. (As a note, Obama speaks to this in the NYT upcoming magazine, that while it isn’t necessary to separate investment banking, it is necessary to regulate. He noted that buyers of AIG business lines had no idea what the company was doing, which speaks to a point about using AAA ratings inappropriately.)
2. We have no mechanism to understand or mitigate groupthink other than calls from you, Dr. Roubini et al that occur in a context which all but guarantees the warnings will be ignored. Collective madness recurs too often in too many forms to be anything other than fundamental. (Read any of the stories about the hysteria in Africa over witches? Another form of groupthink hysteria.)
If you remember the 80’s, all those S&L’s and many banks jumped into the madness of real estate lending because the other guys were making so much money and they didn’t want to be left behind – and didn’t want to lose their “best” people, didn’t want to make less, etc. After London’s Big Bang of 1980, a wave of consolidation madness swept through: get big, spend lots to get big, to hire more and more. I could list dozens of similar examples from business and even more from the rest of life, but why bother when there’s the famous catchphrase (and book), The Madness of Crowds.
So as much as we wish, one underlying issue is that we get caught up in the madness of crowds and that will not go away. Behavioral economics can help but that raises another issue, that we use the term “economics” in many ways. It’s in general use. It refers to a profession. It is a blanket word. An economist is what? We could name how many specialties or perspectives?
Another fundamental issue is that economics has tremendous and complex tools but lacks real basic understandings in key areas. Physics is similar; in many areas, we know how things work but not why. (The most well known examples are light and gravity.) We can describe a business cycle but we argue about why it occurs and which model is appropriate – and that directly goes to the entire idea that people actually believed in such an idiotic thing as macro moderation.
I’ve taken too much space, but in close, I find it ironic that we’re so good at some things but so bad at others, that we can develop extraordinarily complex models and deeply layered understandings and yet can’t figure out the fundamental why’s on which these things rest. All our models are built on sand, which brings to mind the old Jewish saying, “Man plans and God laughs.”*
*From Psalms 33:10.
q: my thought is that this moderation was caused by the use of debt derivatives and cash stockpiles which were meant to serve as insurance.
I don’t think that it was. You can move money back and forth, but ultimately you can’t have a two decades long boom without something driving wealth creation, and if you compare computers today with computers in 1980, it’s obvious what one factor is.
Also, computers played a part in the derivatives mess. You just couldn’t create large amounts of derivatives without cheap computing power.
q: i believe i am not being sufficiently coherent in my explanation, but when i wonder how we can have long term insurance-type promises in the private financial system without huge amounts of debt (included hoarded governnment debt), i am baffled.
It depends on what you are promising. A well run investment bank is like a well run casino. Money goes in, money goes out, the house takes a cut. So you look at all of the bets that people are making and then match the bets, so that when someone wins, someone else loses, and you take a cut.
If you want more stability and less risk, that is fine, but you have to sell that risk to someone.
2fish:A well run investment bank is like a well run casino.
Not so. My brother runs a casino and he would be outraged at being compared to a business as sleazy as investment banking.
A few key differences:
1) People willingly come to the casino to play. My brother does not think he is “too big to fail”. If his casino goes down he can’t hold a gun to the heads of depositors, the government, and the world economy.
2) Casinos do not use leverage. Lehman borrowed in overnight repo markets at near zero interest to fund 30:1 leverage. AIG sold CDS not backed by anywhere near enough cash reserves. The banks bought CDS insurance on the off chance that housing prices could down and defaults go up(from 1%) after the biggest boom in history. So this is the foundation of the financial system. Casinos use cash.
3)Half the casino profits go to State and Local governments, not the other way around. The standard joke in the casino biz is “in the good old days, the mafia only skimmed 8%”.
Just a few differences, not a comprehensive list, I’m sure.
I am not so sure that arguments were discounted. I think the players involved were just willing to play “the greater fool game’ and hot potato. How else can one overlook the complete lack of due diligence re the credit default swaps. I could teach a hamster that insurance is only as good as the ability to pay a claim.
At its heart, once a system turns to ‘money making money’, is there any place for rationality?
To quote Bank of Canada chief Mark Carney:
“The financial system should be the servant of the real economy. As one of my international colleagues recently remarked, “it is time the banks stopped swanning around like the Queen of England and resumed their traditional role as handmaidens to industry.” It is apparent that an era of self-absorbed finance that viewed itself as the apex of economic activity led to widespread misallocation of capital.”
Most of those differences that you mention are largely because the government does a much better job regulating casinos than investment banks.
This one just isn’t true:
2) Casinos do not use leverage
Most of the big Las Vegas and Atlantic City casinos are hotel and resort companies that do use leverage as they borrow on the capital markets and hedge funds to fund their operations.
2) Casinos use cash.
Which they get from Wall Street through bond issues and stock purchases. The two are related because Nevada and the Las Vegas area are getting hit really hard by the drop in real estate, which causes casinos to lose money, and then this hits their investors.
see
http://www.google.com/finance?q=AMEX:RIV
Personally, I don’t really see the attraction of casino gaming. The really big games in Las Vegas aren’t the thousand dollar stuff at the tables but rather then billion dollar stuff involving the hotels and resorts.
2fish:
True lots of things happen at corporate level. Casinos are expensive to build and that is where most stock and bond money goes. Too much everyone is finding out now.
But at individual casino/hotel level, the GMs are expected to run the biz cash flow positive plus covering corporate overhead charges. If that doesn’t happen for short periods of time, corporate would fund the shortfall, but that is combined with serious cost control. Also, “bonus” is not a word anyone uses if they wish to hang on to their job.
There was a risk-valuation problem at the origin of the crisis, which comes directly from lack of adequate model of the subject matter. All models current models assume that the global economy is some kind of sea of random interactions. We have brilliant descriptions of the individual economies, and almost nothing for the whole lot.
For instance, take the IMF’s updates of the 2009 growth forecasts. The average forecast correction (between the October 2008 and April 2009 updates of the 2009 GDP growth forecasts) was higher than the average growth of the past 20 years. Even a quick analysis shows how meaningless the results are.
If you do not have a credible model for the system, you will misjudge the systemic risk. That is exactly what happened. The debate about the global imbalances that the this post points at was impossible to decide given the uncertainty of the implied global economy models.
The inevitable fact that one side of the debate ended up to be right in their forecast, does not actually mean that their models were right.
Follow the money! while the masses are being offered the illusion of green shoo the money of TARP is being channeled to XYZ, and the talk of 90% bonus tax caps have vanished, and AIG has become Americas Intelligent Group for the scheme that created multi-millionaires out of thin air the last 5 years. How’d we rally ? Did we create an illusion? the quick edits to paper over AIG by fixing mark to market-basically because AIG couldn’t cover further losses.
Meanwhile America is bloated in debt. not billions-BUT trillions as the markets shoot higher and higher.
The peasants will follow Cramer. BUY BUY BUY while the insiders whisper BYE BYE BYE.
Fair point, it was never that original and apols for being a bit strong.
Just to add I don’t think the idea of the great moderation was wrong. There was a great moderation from the early 1990s until around 2008. That’s a pretty long period of moderation given the prediliction of the capitalist system to enter crisis. There clearly isn’t one now.
But I personally don’t believe that the preconditions for that moderation have suddenly disappeared. The opening of the world market to the former “Communist” states was the driver for the IT revolution, and the restoration of profit rates world wide.
I don’t think the dynamic impetus that that added to world capitalism has exhausted itself, notwithstanding the present difficulties.
That’s why I think the most likely thing to happen next is a rapid climb out of the crisis, if not quite as rapid as the dive into it.
2fish, I believe Cedric’s point was not that casinos aren’t built with leverage but that the games themselves, the operations of a casino from the point of view of the House, aren’t anything like the use of the word “casino” as applied to gambling in investments. The House uses strict odds, down to each machine, each table, over small periods of time so its income stream is predictable given a specific level of activity. The use of the word “casino” applied to investment banking means what players do in a casino, not running a casino. The development of real estate and the financing of the casino business is like any other.
The following quote appeared in our American Thinker commentary this morning:
“Competent economists realized that imbalanced trade was taking the world economy toward disaster. Nouriel Roubini and Brad Setser have long been predicting the financial crisis that the world is now going through. They knew that the American consumer could not continue to pile up debt. And Richard Duncan predicted the same in his 2003 book (which he revised in 2005), The Dollar Crisis: Causes Consequences and Cures. In fact, Duncan even warned that the global imbalances would cause a great depression that would be the biggest economic story of the 21st century.”
The “Great Moderation” would have worked if policy makers had added “balanced trade” to their goals, as Keynes urged. In another paragraph in my American Thinker commentary (quoted just above) I wrote:
“During WW II John Maynard Keynes, tried to set up an international system that would have kept trade in balance. But instead we got the IMF, World Bank and the WTO. Keynes’ system was based upon balanced trade, not free trade. He understood that a world system which permitted mercantilism was not sustainable. He would require that trade surplus countries take down their trade barriers and stimulate their economies and would let trade deficit countries limit their imports and subsidize their exports. Maybe it’s not yet too late to adopt Keynes’ proposal.”
Twofish’s post said:”
Twofish responds:
q: what’s interesting to me is that the ‘great moderation’ was created using financial instruments and not real productive activity.
I don’t think this is true. There are two major sources of productive activity over the last 10 years.
1) technology and the internet
2) growth of China and India
There have been spectacular sources of wealth created over the last ten years. The good news is that these two sources of wealth are not one time events.
I don’t think that the world has had any problems with wealth production. Lots of problems with wealth distribution, but no problems with wealth production.”
About twofish’s point, I would say the major sources of productivity were:
1) technology and the internet
2) CHEAP LABOR from china and india
Both of those “produced” price deflation (cost of goods and services went down).
About q’s point, the fed then wanted and allowed debt (future demand) to keep price deflation from occurring. What they most needed was CONSUMER DEBT, and imo they suckered the lower and middle class into it. The producers of the debt needed someway to be sure they would get paid back (or at least mostly paid back) so they bought insurance on the debt. The insurance people didn’t realize that the lower and middle class were in that bad of shape, and the debt defaults “overpowered” the insurance.
About twofish’s point, negative real earnings growth for most people and too much debt led to income/wealth inequality and asset prices being too high based on income.
The real questions are should the fed use debt (future demand) to keep price deflation from occurring, and if they do, does that lead to wealth/income inequality and asset prices being too high if most of the goods market is oversupplied and if most of the labor market oversupplied.
Howard Richman said: “Competent economists realized that imbalanced trade was taking the world economy toward disaster. Nouriel Roubini and Brad Setser have long been predicting the financial crisis that the world is now going through. They knew that the American consumer could not continue to pile up debt.”
Well and imo, the fed believed the American consumer could. The idea was to “trick” the American consumer into working more hours (whether more hours at a first job, get a second job, or retire later) but NOT getting a real wage increase because the fed, and greenspan in particular, are still living in their supply constrained 1970’s world.
Two Much Fed,
I don’t know how productivity is measured, but I don’t think that cheaper = more productive. Only if it Western labour markets were constrained by having workers do jobs that they were ill suited for and their ‘liberation’ allowed them to work in a more productive field.
NB. I wish Huxley would have provided as eloquent definition of ‘productivity’ as he did capital.
jonathan: The House uses strict odds, down to each machine, each table, over small periods of time so its income stream is predictable given a specific level of activity.
Which is what investment banks *should* be doing, and which well run investment banks actually did do. Running a derivatives operation is exactly like running a sports book. You set odds, but you don’t make the bets yourself.
The reason that I made the investment bank analogy is that if the casino owners start taking bets within the casino or expect to make money themselves from the slots, then something is very, very wrong.
jonathan: The use of the word “casino” applied to investment banking means what players do in a casino, not running a casino.
No. The word “casino” applied to investment banking means running a casino. Someone takes a bet, someone takes a counter-bet, if you’ve done your job right as a banker, then these two cancel out, and you end up making money regardless if house prices or stocks go up or down.
Hedge funds, insurance companies, and private individuals should be the bettors.
Where investment banking seriously went wrong is when people starting taking bets themselves in casinos that they run. The most important thing about being a bookie is not to think that you know more than your bettors.
Fed: About twofish’s point, negative real earnings growth for most people and too much debt led to income/wealth inequality and asset prices being too high based on income.
Personally, I think it was because of the Bush tax cuts. Incomes were rising across the board in the 1990’s, but just stopped cold after 2000.
Glen M said: “I don’t know how productivity is measured, but I don’t think that cheaper = more productive.”
That is a good question. Here is an example. If it takes 2 workers at $25 per hour to make something in the USA ($50 total) and it takes 5 workers at $2 per hour in china ($10 total), who is more productive?
Twofish’s post said: “Fed: About twofish’s point, negative real earnings growth for most people and too much debt led to income/wealth inequality and asset prices being too high based on income.
Personally, I think it was because of the Bush tax cuts. Incomes were rising across the board in the 1990’s, but just stopped cold after 2000.”
IMO, it was because the labor market became oversupplied in the USA. In the 1990’s we were losing some jobs to outsourcing, but new ones were created because of computers, cell phones, and the internet. When the nasdaq went down in 2000, more jobs went overseas and some others just went away. Add in permanent WTO entry for china, and even more jobs went overseas. Nothing really replaced those lost jobs (well the real estate and debt jobs did not really replace those lost overseas).
The research that gave rise to the phrase ‘the great moderation’ was based on post-war U.S. recessions and so suffered from a dearth of observations of the type relevant for today’s malaise. All that fancy statistical work looks a little stupid in light of events. I think the phenomenon will still prove correct, though the explanation will shift from ‘luck’ and ‘enlightened monetary policy’ more towards the change in the structure of the economy (the move towards services that eviscerates the old accelerator-multiplier phenomenon.) This presumes, however, that existing international imbalances are curtailed and not expanded.
As for ignoring risks, the pay structure encouraged this behavior – why worry about a ten-year failure event, or even a five-year failure event, if by doing so you can earn in one year a bonus that exceeds a lifetime’s worth of normal annual salaries?
Very good article at American Enterprise Institute by John Makin: Can China continue to grow?
To Qingdao: Personally, I think that the article is just wrong. If the investment was being directed at export industries, then there would be a long term problem, but as far as anyone can tell, it isn’t. In particular, much of the new lending is going to capital-intensive state-owned enterprise whereas most of the export industries were labor-intensive private enterprises, that aren’t likely to see much money from the stimulus package.
Also the growth boom wasn’t only driven by exports, although exports played a large role. It was mostly domestic investment. One reason that China had an export boom is that export industries are one way that non-state enterprises can find financing, since they could get overseas credit.
Also, I think that people are quickly forgetting that during the boom, export industries were considered a good thing by people that believed that private enterprises are inherently good, and state-owned enterprises are inherently bad.
Personally, I think that AEI is ending up with rather incoherent policy suggestions, because the different parts of their world view are colliding with each other and with reality. In particular, I think that they are trying rather unsuccessfully to salvage the idea that the ideal economic system involves markets with minimal government intervention. The trouble is that it’s very hard to figure out how to apply that principle to the current situation.
Too Much Fed: IMO, it was because the labor market became oversupplied in the USA. In the 1990’s we were losing some jobs to outsourcing, but new ones were created because of computers, cell phones, and the internet. When the nasdaq went down in 2000, more jobs went overseas and some others just went away. Add in permanent WTO entry for china, and even more jobs went overseas.
I don’t think that the labor market is oversupplied. If you had education and connections, then the 2000’s were a great time for you.
The big problem wasn’t that jobs went overseas, it was that low-skilled jobs went overseas, and without expensive government programs to increase access to education and reduce the impact of social connections, then you have more social inequity. If you had an MBA from Harvard, then the 2000 decade was wonderful since globalization gave you tons of opportunities. If you are a high school drop-out, then you are pretty doomed by the economic system of the 2000 decade.
twofish, I think these partial quotes are correct. I don’t know that.
“BEN BERNANKE, FEDERAL RESERVE CHAIRMAN: Simply producing more engineers and scientists may not be the answer because the labor market for those workers will simply reflect lower wages or, perhaps, greater unemployment for those — for those workers.”
“… says 40 percent of the engineers at Duke end up not going into engineering because the salaries aren’t there when they graduate. They go into investment banking.”
More partial quotes:
“There is no shortage of students studying for careers in Math and Science. There is a shortage of jobs. That’s the simply bottom line finding of a new study from the Urban Institute.
The study shows that between 1985 and 2000 435,000 U.S. citizens and permanent residents a year graduated with Bachelors, Masters, and Doctoral degrees in Science and Engineering. That’s three times the number of jobs in Science and Engineering added per year, 150,000 during that time.
Separately Michael Teitelbaum at the Alfred P. Sloan Foundation told Congress last week that neither he nor a separate study by the RAND Corporation can find any evidence of worker shortages. These studies are not anomalies.
VIVEK WADHWA, HARVARD UNIVERSITY: Bottom line is that all of our research at Duke and now at Harvard shows the same thing. That there is no shortage of engineers; there’s no shortage of scientists. Companies aren’t going abroad because of skills. They’re going abroad because it’s cheaper.”
“As a result, Wadhwa says that more than half of the engineering graduate students at Duke don’t pursue engineering as a career and there is another indicator that the market is anything but short of scientists and engineers.”
“Wages in the science and engineering fields over the last five years when adjusted for inflation have been basically flat.”
“… that’s the Urban Institute, the Alfred P. Sloan (ph) Foundation, Duke, Harvard, the RAND Corporation. Studies done independently of each other, different researches, different funding, all reaching the same basic conclusion that there is no worker shortage.”
“… those companies either off-shore the work or as you mentioned at the top, demand more H-1B visas and then pay those workers less”
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