I don’t think it was EVER a good idea. All it did was put the foxes in charge of security for the henhouse. Undfortunately, it seems to me that they were trusting in the old concept of noblesse oblige and didn’t plan for unparalleled greed. Wish they had been right about that.
My dad is a lifelong libertarian and he insists that corporations can self-govern and that it is the responsibility of citizens to “buyer beware”. This is a tidy illustration of why my beloved father is wrong. At least the old geezer has everything in bonds and money market funds.
That’s big of him to admit it. He was told it’d be a mistake at the time.
I notice a lot of these free market, no regulation types don’t have a problem with government interference when it comes to receiving subsidies and tax breaks from the government.
topic hijack: anyone else mildly irked by all the attn. put on how much McCain instructs his team to spend outfitting his sidekick, the gov? I’ll have to browse some feminist commentary/analysis somewhere….
Ah, yes, Bugs. Have I already mentioned that Barack Obama is Bugs Bunny and John McCain is Elmer Fudd?
Sarah Palin is Yosemite Sam, George W. Bush is Daffy Duck, Hillary Clinton is the Tasmanian Devil (always stirring things up), and Bill Clinton is Foghorn Leghorn.
If I’ve brought this up before, I apologize. I have a mind like a steel sieve.
Jana C.H.
Seattle
Saith Floss Forbes: If you don’t know the tune, sing tenor.
Well. yeah Alex,
a friend sent me this investment advice recently:
If you had purchased $1,000 of Delta Air Lines stock one year ago, you would have $49 left.
With Fannie Mae, you would have $2.50 left of the original $1,000.
With AIG, you would have less than $15 left.
But, if you had purchased $1,000 worth of beer one year ago, drunk all of the beer, then turned in the cans for the aluminum recycling REFUND, you would have $214 cash.
Based on the above, the best current investment advice is to drink heavily and recycle.
What a fantastic video AB! It does remind me of Mo annoying Clarice by not going to vote against Reagan in 1980 though. Let’s hope that particular storyline wasn’t autobiographical!
It’s certainly a dilemma. I’m of the school that firmly believe that whenever a politician opens his/her mouth, they’re lying, even when they’re telling the truth, and it doesn’t matter what party they stand for. But I still get up and vote each election because I had an aunt who was a suffragette pal of Emmeline Pankhurst and it was drummed into me that it was my responsibility to go and vote and maintain the democratic process because the only thing worse than morally/ethically bankrupt politicos was not having the vote at all.
You can’t count on politicians to tell the truth, that’s right, Ian. Even Obama occasionally purposefully portrays his opponent in an unflattering light by misplacing emphasis or exaggerating a policy stance. And campaign promises? They’re worth the paper they’re written on, if that — no matter who’s making them. That’s about as far as I’ll go playing devil’s advocate, though.
What I WILL say is this: Look at their voting records. McCain is all over the place. He votes one way on an issue today and the other way on it tomorrow: whatever way he thinks will get him what he wants. Obama consistently votes the same way on a given issue. It may not be the way you like, but he upholds his stance.
Don’t get me wrong Kelli. ‘Cos while the Democrats have been generally completely spineless over the past 8 years of sheer hell, and are generally pro multi-national corporations, rampant capitalism, etc, at least they try to help those less fortunate as well as the very fortunate. And don’t try and grind the faces of the poor into the dirt gloating while they’re at it.
I’d vote for Obama tomorrow, would I had a vote. Or were American!
I guess this sort of relates to our crumbling economy- I just bought my copy of The Essential Dykes at Garrison Keillor’s bookstore (whee!) and I thought that $25 was an eminently reasonable price to pay for a big, pretty book compiling your life’s work, Alison. Plenty to distract me from my Ph.D prelims!
I loved that video.. so witty and too funny… I especially love the woman with the foul mouth! She was a hoot. And, uhm, she scares me so I am gonna vote… but only because of her.
OK, so I’m getting pretty pissed off with a whole bunch of people, but unfortunately you guys are right in the firing line, because of various comments above. They’re comments that lots of people are making, but I’m going to take it out on you because I’m suffering from free-floating irritation as a result of YouTube suddenly thinking I want to see soccer instead of baseball (though I’m slightly mollified by the number of questions about Ty Cobb I was able to get right in a TV quiz earlier this evening). So anyway…
First, my qualifications: I’m comfortably over-qualified both academically and in terms of career experience to comment on the current financial crisis, and have spent large chunks of the past year writing about it.
Second, my bona fides: I’m affiliated with no organised political party (I’m a Green), and have no political axe to grind. (In fact, Green Party policy is pretty extreme-left on this, but I don’t share the general party position.)
So, now that that’s out of the way, let’s get something absolutely clear: current best theoretical thinking is that crises of the kind we are currently facing are a necessary concomitant of running the kind of banking system we have. Diamond and Dybvig (two important theorists in this area) wrote a paper demonstrating this in 1983 (Journal of Political Economy), and their work has proven quite robust and has withstood careful analysis for the past 25 years. In short, their conclusion is that bank runs are something that must happen from time to time if we are to have banks that provide the kind of demand deposit accounts we all use every day. Their basic approach has been extended and tinkered with by other people, but their main conclusion is still true. Their work does provide a theoretical justification for the kind of governmental intervention that is now being seen in the financial markets, and they certainly explicitly note that governmental provision of some form of bank insurance is a solution to the risk of occasional bank crises. Current best academic thinking in this area would not be that this crisis results from some failure of the mainstream banking model.
Greenspan’s comments are actually more subtle than the widely reported headline above. In particular, he noted that problems arose “because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment.” This is not the same as saying that everything went wrong because of “greed”, or some undefined failure of the existing system. In fact, the whole point of self-regulation is that “greed” (also known as “self-interest”) is part of the “control” aspect of the system.
I’d also better say this to Ian, and presumably to others: the cash that is being injected into the banking system is not a subsidy or a tax break, and it’s certainly not governmental expenditure. What it is (and you can check this with an accountant if you don’t believe me) is a transfer of assets from the “cash” part of the governmental balance sheet to the “long-term securities holdings” part. Although the news channels are talking of governments “spending” money here, that is not what is actually going on. What is going on is an expansion of governmental balance sheets, but that’s not the same thing as expenditure. I should also note that this is not any form of Keynsian stimulus (a fact that should be obvious, but has certainly been misreported on this side of the Atlantic).
I don’t think that anyone can doubt that bankers have made mistakes, particularly in the formal structuring of the various credit portfolio models that they have used over the past five years or so, but I feel the current attempt to tar all bankers with the brush of venality is incorrect. On the question of pay I remain undecided: I’m aware of some people who’ve had their million dollar bonuses, and some of these certainly seemed high to me, but in other cases these million dollar bonuses were paid to people who had made their employers $20 million in profit, so it’s not obvious to me that the bonuses were unmerited. If I had to suggest a group who have failed, I would say that it’s the banks’ risk managers, who are generally not particularly well-paid anyway.
What is very clear is that this crisis is going to spur a huge bout of banking regulation in every economy. This will no doubt please the principal readership of this website, whom I judge to be by and large in favour of more rather than less regulation. Sadly, and without in any way seeking to insult anyone here, it seems to me that the majority of people here form their opinions with very little regard to empirically verifiable approaches, but prefer to build their economic thinking on their political presuppositions. I suppose many people do (though I flatter myself that as an aspie I may be slightly more immune to this tendency than average). Though a case can certainly made for better regulation of financial insitutions, it is not obvious that heavy-handed approaches of the kinds currently advocated by most politicians will prove beneficial, and previous experience over many years tends to suggest the converse.
I’m still working on some kind of estimate of the long-term damage that this crisis will cause, but my current professional opinion (guess!) is approximately this: a recession running over several quarters, followed by a moderate recovery in the broad economy, but with perhaps higher household savings rates than over the past few decades. I am less pessimistic than I was a couple of weeks ago, and believe we will avoid a depression. This much is in line with other commentators, but my key expectation is this: a substantial drop in the long-term growth rates of most major economies, certainly including most of G7, Russia and China, lasting for perhaps 20-30 years. Right now, if I had to guess, I’d say we’re going to lose 1% of economic growth each year for about three decades. This may not seem like a lot, but what it means is this: without this crisis, we could have expected to be rather less than three times better off in 30 years than we are today, but with this crisis can only expect to be about twice as well-off in 30 years as we are today: about 40% of what we might have got, we will not now get. Of this loss, my (currently pretty wild) guess is that about half will be due to increased regulation of banks and other financial institutions. In addition, I expect the economies most affected by this to be the USA and the UK, as these are the ones where growth by innovation rather than by adoption of existing technologies is most important. If I have to pick a “winner” (or at least, a “least unlucky loser”) I pick India, by the same reasoning but at the opposite end of the spectrum.
Sorry if I seem slightly sour in this posting, but I’m getting pretty fed up with people in the media gleefully reporting the crisis as some sort of “failure of capitalism”. It’s not, though I can see that people who don’t have a clear grasp of financial economics might think so. I can fully understand that most people don’t have a background in financial economics, but the extent to which people without some training in this area are misunderstanding things is somewhat shocking.
As a biochemist, it all seems rather simple to me: the economy is a positive feedback mechanism. That means when someone figures out a way to make money, people copy them, and as long as it continues to make money, more and more people will do it, until the whole thing collapses.
The point of regulation is, it prevents the sort of catastrophic collapse that leads to depressions. As a biproduct, it also prevents the spectacular rises that lead to booms. The trick is to find a balance point that enables growth but prevents collapse.
The right wing seems to think that booms are good, and when people are caught in the inevitable collapse, that’s because they were stupid. Even though they don’t believe in evolution, they chalk it up to evolution.
The extreme left tries to prevent anyone from benefiting from growth, so they won’t be motivated to turn it into an unsustainable boom.
While my sympathies are more left than right, ultimately, I’m still looking for that balance point.
As long as we’re throwing around qualifications: as a political scientist I have the following to say to the LondonBoys comment: This is exactly the kind of speech that is given on this side of the ocean, basically saying, “you ordinary people just don’t get it”. When people ask, “Why is my tax money being used to help continue paying for huge bonuses in the banking business while due to the financial crisis my factory is starting to lay off people?” they get the answer: “Because it’s good for you in the long run.” And if it really is just changing the balance sheet (in some instances it’s buying stock of banks, in some it’s creating an offshore “rescue company” to take over the risky titles), why is it being used as an argument that now there won’t be enough money to invest in infrastructure or education? Why should people care more about the probability that they might be a little better off in 30 years this way, when in the meantime their private pensions are lost because they were invested in stocks, no one is giving small businesses loans to operate, or they risk unemployment, their children need student loans now and not in 30 years and they don’t have 30 years to pay them back. We’ve got to do better than just say, in the end the crisis is a good thing because in the long run we’ll be better off. If one is favorable of such a system that “needs” such a crisis from time to time, one has to offer something for those at the bottom of the economic system, who suffer from this crisis without any wrongdoing. And not just cover those who profited the most from the good times by justifying their in my opinion unjustifiable high bonuses. No one really can deserve to earn 2 or even 20 million a year.
@Monkee / LondonBoy – it is a treat to “listen” as clever people have a set-to.
Monkee, you write: “Why is [this balance-sheet adjustment] being used as an argument that now there won’t be enough money to invest in infrastructure or education?” From LondonBoy’s stance, might the explanation be that our governmental officials, those charged with pushing the levers of government to approve, or to justify, the balance-sheet adjustments do not themselves understand what their advisors, trained in financial economics, counsel them urgently to do?
Thus our masters in Parliament and the Congress say, “We have spent on this, and we can not spend on other things.” Only the LondonBoys can challenge them.
LondonBoy, you write clearly and deftly. Are you making these arguments in other public fora? Ones attended, perhaps, by more people? The NEW STATESMAN, the GUARDIAN?
@ Londonboy: Actually, I wasn’t talking about the bailout when I mentioned tax breaks and subsidies, although I can understand why you’d have assumed that. I was thinking more of corporate welfare and agricultural subsidies.
Thanks for explaining that viewpoint on the bailout though. I bow to your extensive knowledge Londonboy! Although to me, widening the balance sheet seems like a bit of a sleight of hand. In the end, all governmental liabilities have to be paid by the taxpayer. So while the bailout may not technically be direct ‘spending’, if the government takes on these liabilities and fails to recover the bad debts (as seems very likely), presumably the taxpayer will have to cover it.
Classic neo-liberal, free-market theory as I understand it, when it comes to one of these ‘corrections’, would rather the banks went under without government rescue. Survival of the fittest and all that.
By the way, back in cynical mode, when someone privileged (and I don’t mean you LB) tells me I don’t understand, it’s much more complicated than that, I’ve taken things out of context, etc, and the examples that Monkee gives above, I’ve come to realise that actually I’ve hit the nail on the head, touched a nerve and got things in exactly the right context. (I love mixing metaphors).
I’ll try to answer some of the above comments as best I can:
Dr. Empirical: Whilst the economy does contain some positive feedback mechanisms, it also contains some negative feedback ones. As you (in my view correctly) identify, booms seem to be in large part driven by positive feedback. The model that is most often referred to in this area is one proposed by Allen and Gale (though I can’t remember the date or journal, and don’t have the paper immediately to hand), which creates a model for asset prices in which prices increase above their “fair” price as they are bought on credit rather than with an investor’s own money. They envisage this happening as a result of increased credit availability, which I think is probably what has happened here. However, Allen and Gale ascribe this increased availability of credit to either a reduction in interest rates or an easing of loan terms and conditions, and I don’t think that’s what’s happened here. Rather, I think that we are seeing the result of banks being prepared to view their loan assets as quasi-temporary positions whose credit risk could be laid off in the broader financial markets by securitisation or the use of credit derivatives. In my view the introduction of credit derivatives to the financial system is a one-off “step change”, has never happened before, and will not happen again (something can only be “new” once!). This interpretation is consistent with the Allen and Gale model, but extends it to interpret an easing of loan terms and conditions as including an internal management attitude within the banks.
It is by no means clear that regulation prevents booms or depressions. If anything, the reverse appears to be true in the case of economic slumps: the best modern example is the Japanese “lost decade” of the 1990s, where the collapse of the Japanese economy appears to have been substantially abetted by excessive regulation of the financial markets.
To see why regulation may not always be beneficial, think about what the UK government has said to the major banks here: increase the amount of capital you set aside to support your lending activities. This is a sensible thing to tell banks to do in the short term, as it makes it very clear to depositors that “their bank is safe”, but if this higher capital requirement is enshrined in long-term regulations, the cost to banks of providing credit to their borrowers will increase (because they have to set aside more capital to support each loan they make, and capital isn’t free), so banks will make fewer loans. As banks make fewer loans it becomes more difficult for companies to expand their businesses (by getting a mortgage to pay for a new factory, say, or by getting short-term working capital loans to bridge the period between paying their staff and getting paid by their customers), so companies won’t expand as much. That means that they will employ fewer people, and since the stuff they make will be in shorter supply, their products will be more expensive, so fewer people will be able to afford them. Overall effect: people aren’t as well-off as they would otherwise be, and this has been brought about largely by excessive regulation.
I’m certainly not saying that there should be no regulation, but what I am very concerned about is the likelihood of excessive regulation. What we see, if we look through history, is that large-scale market crashes tend to be followed by periods where financial markets are highly, and perhaps overly, regulated. The heavy regulation of the US financial system after the ’29 crash is a case in point. People’s reaction to a problem is to try to “prevent it from ever happening again”, and they try to do this by passing laws and regulations. Unfortunately, as I note in my earlier posting, if we want to have a banking system with demand deposit accounts (that is, you can go into the bank and get your money out whenever you want it, rather than only when the bank says you can) the risk of bank runs seems to be inevitable.
I would be surprised if anyone on either right or left of the political divide thought seriously that “booms and busts are good”. The difference is that on the non-populist/non-stupid right there is an acceptance that such things do happen and may be part of the price we pay for giving people the freedom to buy or sell things as and when they want. My own view (formed from discussions with them) is that even on the “(non-stupid) extreme right” there is a strong desire to minimise the occurence of booms and the effects of busts, and to mitigate their effects on those least able to cope with difficult economic conditions: the desire is simply to move through a bust as quickly as possible, and with minimal interference in normal free-market functioning, on the grounds that this is the optimal long-term economic strategy. (This is a debatable point, of course, and I don’t believe that it will be determined one way or the other in my lifetime, but it is intellectually quite defensible and philosophically consistent. The converse case is of course that argued by the (non-stupid) left.)
Monkee/Ian: Yes, I am in a sense saying “you ordinary people just don’t get it”, though I hope that I’m at least trying to explain what “it” is, and make a reasonably clear case. When you’re ill you go to a doctor because he’s spent years studying medicine, and when you’re having gas installed you make sure your engineer has passed his CORGI registration. Of course, you ask the doctor why he’s prescribing this or that treatment, and you lurk around the gas engineer getting him to explain what’s going on and what you should do to keep the central-heating running smoothly, but you generally wouldn’t consider just asking a random member of the public to treat your scarletina or connect you to the gas main. And yet pretty much everyone feels themselves qualified to comment on the economy and argue long and loud in favour of their particular positions.
If we were, as Monkee says, simply discussing people being “a little better off in 30 years” I wouldn’t be making this posting. The problem is that it’s not “a little”, because of the compounding effect. As I note in my earlier post, it’s the difference between being (very very roughly) three times as well off in 30 years, rather than twice as well off. That’s a huge difference. (Since I made that posting I’ve been revising my figures, to correct what I now think was for technical reasons an overoptimistic view of long-term growth rates, but the impact of this change is to reinforce the significance of my main point here, not to dilute it.)
The reason why there is a cost to governments making cash injections into banks to stabilise them is because although there is no “expenditure”, governments have to borrow to finance this. This has a cost, but it’s not that of money being spent: the cost is that the interest rate paid by governments on their other borrowings will increase. Suppose you borrow some money from your bank, and immediately put it on deposit at something like the same interest rate: you’ve not actually spent anything, but your assets and liabilities have both increased – you’ve got money on deposit, and a bank loan – so if you want to borrow more money for other expenditure your bank will probably charge you a higher rate of interest. It’s important to note that the way governments are structuring their support of their banks means the chance of loss (though non-zero) is comparatively small, which is, of course, as it should be. Supporting the banks is not cost-free, because governmental borrowing costs will rise. Governments are prepared to pay this cost because by doing so they ensure that banks keep functioning, and so can keep financing economic activity generally (and so keep people in jobs, and ensure that they are actually paid for making things or providing services, by the mechanism outlined above).
I absolutely agree that what we should always do at times like these is protect those most exposed to bad economic conditions, either because they are unable to fend for themselves or because they were unlucky enough to work in the most exposed sectors. I believe that the greatness of our society is judged not by the wealth of the people at the top, but by how our least privileged are doing, both in terms of freedom from want and in terms of freedom of action. This is what makes me in many ways a natural right-winger. (If we had a Peelite party today, I’d join it like a shot!)
Alex K.: I suppose I think this: Whilst there are certainly some politicians in all parties who probably don’t have a clear understanding of what is going on, those who are actually in government almost certainly do (though many of them may have been going through a fairly rapid learning process lately!). In particular, I have been very impressed by the actions of Gordon Brown and Alistair Darling in the UK (who really did everything first and exactly in line with what I feel is best current academic and technical thinking), Angela Merkel of Germany (who had the common sense to put the economic health of her people ahead of some inchoate plan for eventual EU action), and, to some extent, George Bush in the USA. The last of these requires some explaining: whilst I do by and large feel that Bush has been a disaster as president, he has at least followed the suggestions of his moderately sane advisors in handling the banking crisis, rather than giving way to the populists of his own party. By taking a more technocratic position than he normally does, he’s probably helped to stabilise things. I still think that in most things he’s an idiot, but he gets a solid ‘B’ for this one.
The Allen and Gale work seems to be in a paper they wrote in about 2000 and presented at an LSE conference. If anyone wants the exact citation, please let me know and I’ll dig it out. They contributed a chapter to “Asset Price Bubbles” (2003), Hunter et al. (Eds.), publ. MIT Press, but I’m pretty sure there’s a stand-alone paper out there too.
@LondonBoy: “Financial contagion”, J Polit Econ 2000;108:1-33, is the best contender for that reference that I can identify in a quick Google. Is it the real McCoy, the article that you intended?
Thank you for setting out your stall so clearly. I am particularly grateful for the explanation of how increased debt load, even if the money borrowed is not spent and gone, raises the cost of further borrowings, and thereby, I infer, how recent events will impede use of governmental resources for infrastructure projects, schooling, health care, and the like.
One understands that granted loans, once transformed into a “derivative” or “securitised”, are cut free from close observation of the debtor by the lender. (I think of my maternal uncle’s banker father-in-law, who made his Iowa farm loan decisions on the basis of how good the land looked and how well the farmer tended it. A lot of road time was involved, driving back and forth between the quarter-sections and seeing where, say, standing water meant that the tiles weren’t running, that the collateral was in poorer condition. No doubt his wife, by paying close attention to conversations in the church porch, gathered valuable data as well. That’s where you find out that such-and-such a farmer is drinking again…) SInce interest rates DID drop, and loan terms WERE eased, at the same time as “securitisation” took place, to separate out contributions of those three elements may prove difficult. No doubt the research is ramping up as I type.
Let’s agree that we have all lived more wealthily in part due to recently greater availability of credit. WERE we indeed wealthier? Or were we all buying on the never-never and hoping that the repo man would never track us down? Is wealth better defined, in a nation, as high house prices or as a TGV network?
Let’s also agree that financial markets need regulation, and that the only question is – how much? The Goldilocks dilemma – too hot, too cold, or just right? No one wants “excessive” regulation, or for that matter “inadequate” regulation. Pro bono, contra malum – a universal banner! – but what concrete steps seem likely to be enough and yet not too much? What advice would you tender to politicians? (I have noted your tip to invest in India.) Extending that query, and reflecting that under the present regulatory regimen, investment decisions in Britain have yielded high house prices and no TGV network – if laying new railway lines indeed results in greater long-term growth than do house-price rises, how have governmental policies led to lower-growth outcomes, and what room for change in those policies do you see in the aftermath of this “crunch”?
Re: Bush – We should all feel lucky when the proper hand gets into so important a sock puppet, particularly when the record suggests that exactly the wrong hand will be inside the sock. But it is the puppeteer, not the puppet, who deserves the solid B.
It’s unlikely that I’ve set out my comments and queries so clearly as you did, so thanks for bearing with my incapacities.
Wow! I checked in during the smartie hour of the blog…. Thanks for the enlightening posts, guys. Much appreciated.
London Boy, you never answered if you write for a public forum – do you? I’d be interested in reading it.
Thank you,
Jennette
P.S. And thanks to anyone out there who came to Lee’s in Minneapolis on Saturday the 18th for Baracktoberfest. It was a big success and we raised a nice chunk of change of the Obama campaign.
LB, there are about a bajillion things I’d like to ask or comment on re your posts on this topic. I’ll try to keep it relatively short.
Using your example, if I took out a bank loan and immediately deposited the money in a savings account, over time I’d get killed on the interest rate spread. Why do you think the government will come anywhere near break even on the rescue? Obviously there are all kinds of differences. Your analogy was not intended to be exact. But if anything the differences work against the government. E.g. if I borrow money and put it in a savings account I’m at least guaranteed to get my principal back. By contrast, at least some of the government’s new assets are guaranteed to go bust, and the rest are in such bad shape that they’re at least temporarily illiquid — which is why the gov’t is buying them.
Even if you can convince me that the exchange of assets for debt is economically neutral, there are political ramifications. It’s not politically tenable for the USA to keep running debt at it’s current level. (Whether this reflects sound economics or not is politically irrelevant.) Government services are going to get cut, and as a result of the rescue they will get cut further than they otherwise would have. And internationally, the further in debt we are, the more leverage our creditors have over us. When we have been creditors (eg through the World Bank) we have shown no hesitation to dictate policy to debtor governments. What would happen to us if e.g. the Chinese decided that a certain policy decision on our part would force them, regretfully, to sell all the Treasury debt they hold? What would that do to our government’s ability to function? That won’t happen tomorrow. Tomorrow it won’t be to their benefit to drive our interest rates through the roof (and the value of their Treasuries through the floor). But some day it might be, and the deeper in debt we are, the more leverage they’ll have when that day comes.
Bringing this back a little bit to Alison’s original point, Alan Greenspan is not just a technocrat. He has had a busy sideline as a pundit supporting deregulation and “free markets”. His admission of error in his punditry is a serious matter, regardless of what you think of monetary policy during his tenure. Finally, on the technocratic level, I don’t see how anyone can take that twenty year excuse seriously. Even an amateur like me knew that the twenty year stock market boom that ended in 2000 was historically exceptional. One could have argued that it represented a fundamental change that would extend into the future — one would of course have turned out to be wrong — but to take this as fact, if indeed that’s what happened, is just economic malpractice.
Relatively short, believe it or not. Mostly comments, but my question — as to why you think the gov’t will break even on the assets it has acquired/will acquire — is not just rhetorical.
Thanks so much LondonBoy and Andrew B for both bringing up some really good points. It’s great to get the “insider’s” viewpoint and also a critical examination.
I’m only a layman, so bow to your knowledge LB. But I do think it’s impossible to separate economics from politics. I’m sure we agree that it’s not more or excessive regulation that’s needed, but efficient and effective regulation. I do think there’s a line between self-interest and plain ol’ greed which has been passed.
LondonBoy, thanks so much for the clear explanation. I’ve been wondering where the bailout money came from. Also, I know it was more or less an aside, but I’m glad you mentioned the risk managers, on the same lines, how much resposibility can we lay at the door of the credit rating agencies? It strikes me that if Moody’s and S&P had provided more realistic ratings back down the line, a lot of this mess could have been avoided.
Wow, I never imagined I’d find such an intelligent conversation about the economy here. LondonBoy, your explanation of the balance sheet shift of governmental assets was concise and cogent. I’ll use it myself. Thanks much! What I want to know is why, if Alan G can say he’s sorry, why can’t Jake and Donna Carpenter (Burton’s Snowboards)? http://www.7dvt.com/2008burton-critics-rally-companys-headquarters [Sorry if this counts as blognapping.]
How the mighty have fallen! I can remember growing up in the 60’s, back when economists were treated like rock stars or astronauts. My sister and I read every word we could on economist John Kenneth Galbraith’s adventures as President Kennedy’s ambassador to India. Now, look at them. An economist on CNN last week said that we will now see if we have a “deep, nasty recession, or something worse.” OR SOMETHING WORSE???
Deep, nasty recession or something worse? Now about a deep, nasty depression with droughts, floods, rising sea levels, food shortages, and all the other concomitants of climate change? Oh, and more nuclear weapons.
Hey, how ’bout those Mariners?
Jana C.H.
Seattle
Saith Arthur Pinero: Where there is tea, there is hope.
Something worse? Like US soldiers raiding Syria from Iraq and killing civilians? Will Darth Cheney achieve his goal of WWIII before 20 January? Talk about brinkmanship.
Tasteless joke of the week from UK TV: “Will Obama win in a landslide, or will the CIA think of another ingenious way in which to kill him?”
Holy Jeezum, LondonBoy. Thanks for that exceptionally lucid economics lesson. Um…I’m now officially intimidated by the prospect of commenting on my own blog.
LondonBoy, for all your presumed qualifications, your acquaintance with *actual* banks must be very slight if you think their risk management officers has any authority and are in a position to fail. You note yourself that they are not well-paid but you don’t seem to grasp the implication: in a merchant bank, you are what you are paid, not what your business card says. In reality, like all quants they serve decorative, i.e., regulatory or PR purposes and have very little clout. Their role is to make what the traders and management wish to do and would do anyway look acceptable; if they tried to really manage the risk, they’d receive a reminder (in the form of a pink slip) of who’s really in charge.
With the election a few days away, maybe you could whip up a one-size-fits-all single panel? Like Mo, unconscious. I think either way that’ll cover her likely reaction.
I have to admit that I find it amazing how strongly people don’t want unpleasant issues brought up. That Obama and family have been receiving Secret Service protection since 2007 is hardly unexpected. ALL the candidates of the major parties receive such protection.
The notion that a few bad apples could, yes indeed, have a monumental effect by looking the other way at the right time (which is the point I take away from Ian’s comment) is neither woo-woo conspiracy or tasteless. It may not be presented as tactfully as possible, but what does tact have to do with it?
Was I alone in seeing how the Democrats’ “tact” cost them two elections (possibly three)? I now see that there are voting irregularities showing up. Again. These are serious problems. I’m sorry if a couple people are goodness gwacious me wupset, but I wish a lot more people were wupset eight years ago when the “Dynastic Dipstick” (as Mo calls him in one strip) got into office. Or four years ago. The Dems have consistently stunned me — stunned, stunned, stunned — with their gosh darn civility and ineffectualness. Eight years and the machines are still suspect? That’s like thinking your accountant is swiping money and firing the cleaning crew.
It stops being “civility” after a while and becomes being a victim.
We’re now at the last point in the trail everyone. If McCain and Palin win the election (straightup or by deceit) that’s the Supreme Court for the next three decades. The justices who are going to be retiring (one of them is 84!) or dying in the next four (or, god help me no, eight) years, are probably three or four of the liberal siders. You can say good-bye to Roe v. Wade and a woman’s right to privacy. You can say good-bye to the Constitution’s pesky Bill of Rights, except (wink) the good-ol’ Second Amendment. Schools, libraries? Evolution?
My point? A tasteless joke? Perhaps. Raising a point: that there is a racist, hate-filled element in America, and that element should be confronted and dealt with, and not with gosh-shucks “Impeachment is off the table” sorts of “compromise”? That’s part of it, too. And sitting there fingers-in-ears la-la-la-ing and going “if we don’t say it, it won’t happen” won’t work anymore. (It never did.)
I’ve never seen such greed and rapaciousness as I’ve seen in the last eight years. The Constitution flushed down the toilet to keep us “safe” from terrorists. We’re all taking off our shoes in the airports. Why not just have us all toss salt over our shoulders? It would be as effective.
I’m sorry to rant like this, but I’m really fed up with how many people still have “company manners.” We’re really well past the point of “oh, let’s all process for half an hour and really, really, really make sure everything is super OK with everyone.” Some see a tasteless comment. I see a kernel of truth. And perhaps tasteless is necessary at this point.
In my opinion … (Please don’t beat me with a pillowcase full of door knobs.)
Well, I wondered if I was going too far when I posted it. I interpreted the comments (which were made on a news/current affairs comedy quiz/satire show by Paul Merton) as a riff on conspiracy theories. Without wanting to dig myself in deeper or offend anyone, we all know that inspirational leaders who’ve changed (or threatened to change) the status quo have not had a long life expectancy in the United States and not everyone believes the lone gunman/madman theory. Thanks to the CIA and those right-wing factions the USA has supported over the past 50 years, quite a few inspirational leaders abroad have ended up shot as well. So people in other countries are a little less careful of the sensibilities of the US public I suppose.
I suppose really, tasteless or not, it’s a black comedy comment (in the sense of of finding humour in very dark subjects, like gallows or hospital humour). In this case humour is being used as a survival response in order to cope with the possibility of very bad things happening. “Many a true word is spake in jest”, etc, etc.
(When I wrote the above I felt a bit as if I was saying, “Here granny, let me show you just how to suck those eggs, you’re not doing it right”. But I thought it might explain why I’m less shocked by it than others).
Ginjiont: I’m probably not going to make it. Just bad timing. The good news is that I won’t make it because my softball team ended up 4th in the state and that extended the season by 3 weeks.
As for the Obama joke, I personally believe if he is killed we will be in a civil war like we have never seen before and the economy will be the last thing people will be worried about.
Zoinks! I’m amazed people had the stamina to read my last post, let alone respond to it. I’ll try to make this brief (though I may not succeed!) …
Alison: sorry for posting so much, but it’s such a fascinating topic. I don’t mean to be intimidating, and I’m sorry if anyone thinks I am. This is a good faith effort to discuss a complicated subject.
Olivier: actually, I’ve been in the financial industry for many years, initially as an FRN trader, then as a swaps trader, then as a generalised quant, then as a risk manager. All of these positions were with large international banks at degrees of seniority consonant with my experience. For the last decade I’ve run a specialist risk management outfit that provides outsourced services and consultancy to banks and hedge funds over three continents. Our speciality (eek!) is the credit markets, and I’m intimately familiar with the problems there. As a former risk manager (specialising in credit derivatives) for a household name global bank, I know the “political” problems that such people face. You’re quite right when you say that many of these people and departments are regarded by traders as “just there for show”, but I would like, if I may, to draw a distinction between the teams (typically middle-/back-office) who spend their days preparing risk reports (VAR, stress-tests, etc.), and the small number of real risk managers in the main reporting hierarchy that runs up to board level. Certainly, the first of these two groups has no real influence, but the second either does, or should have. I think that it was this second group to which I was alluding. The problem is that at some banks the position of “risk manager” for a dealing room has served as either a stopping-off place for the ambitious executive who is already seeking his next promotion, or as a place to put an elderly trader out to grass. These people tend to treat the job as of less significance than appropriate. Risk managers should be proactive, have the temperament to push their point of view, and should regard their job as a worthwhile contribution to their institution’s long-term stability in its own right. In my view, where this has not been done is where risk managers have failed.
Andrew B.: why do I think the governments will break even on their new assets in the banking sector? Actually, I don’t guarantee that they will. I suspect they’ll actually make a profit, which is appropriate as they’re taking the risk that they might lose their money. I can’t cover every country, so let me just outline part of the situation in the USA, to give you an idea. The US government is buying preference shares in banks that will pay the equivalent of 5% per year for 5 years, then 9% per year thereafter. The banks have to pay the dividends (interest) on these preference shares before they pay any dividends to their ordinary shareholders (that’s why they’re called “preference shares”, because the government gets preferential treatment). Now, if I look at the borrowing costs for the US government today (you can see these by looking at the Fed’s website) I can see that for the government to borrow money for 5 years would cost about 3% per year, and for the government to borrow money for 30 years would cost about 4.5% per year. The banks can buy back the preference shares from the government any time after 3 years, and it’s a pretty good bet that they will try to do so as soon as they can, so as to show that they’re strong enough to stand on their own feet, so all the government has to do is estimate how long it will be before the banks decide to repay, and borrow accordingly. If they think it’s about 5 years, the government will make a profit of 2% ( = 5% – 3% ) for 5 years, which is $5 billion a year in profit for the government (if the full $250 billion available to the banks is used). If they think it’s about 30 years before the banks repay, the government will make a profit of 0.5% ( = 5% – 4.5% ) for 5 years, then 4.5% ( = 9% – 4.5% ) for the next 25 years; this would be $1.25 billion per year for 5 years, then $11.25 billion per year for a further 25 years. Of course, these are just rough example figures, but give a reasonable estimate of what’s going on. My own expectation is that the true figure will lie somewhere between these two extremes, probably at the lower end of the range. The government gets this profit because it is taking the risk that some of the banks may go broke and the government’s investment may be lost. The Fed and the Treasury have probably decided the exact rates on the preference shares on the basis of their expectations for future bank failure probabilities, and then added a margin of error just in case. (They may also have indulged in a certain amount of “punitive” caution, just to teach the banks a lesson, but without seeing their detailed estimates of expected bank failure and preference share repayment rates I couldn’t say.) There’s other stuff going on in the various rescue packages around the world, but the underlying philosophy is likely to be the same everywhere: charge the banks a sufficiently high rate on the government-supplied capital that the government makes a profit, or at least breaks even.
Alex K.: as for the best regulatory steps that governments might take that would help avoid a repeat of the current crisis, without over-regulating, I would suggest the following: (1) require that all mathematical models used in pricing and risk assessment of complex instruments be driven by input parameters that are actually market-observable, or derivable from market prices on a “historical” rather than “implied” basis (this is a fairly technical point, but options traders may see what I’m getting at: what I want to ensure is that everything that a bank does can be accurately described in terms of actions and instruments that are actually being traded in the real world); (2) introduce tax and banking capital requirements legislation that encourages the transfer of over-the-counter complex derivatives to special-purpose regulated clearing houses, which can be overseen and adequately capitalised, because by doing this we can reduce the risk of contagion where a failure at one bank may damage its counterparties; and (3) for banks above a certain size, find some way to “privilege” the risk management function (so that it becomes something like the Supreme Court: well-paid, able to choose its own targets, and protected from attack if it decides to do something that pisses off the (bank) Executive(s)). There’s a whole lot more that might be done, but these are ideas that I’d like to see discussed seriously, because they are relatively low cost, don’t excessively interfere with interal bank activities, don’t require whole rafts of governmental oversight, and seem likely to help. I’d also like to see a general review of how banks optimise their credit portfolios, but such a review should be open-ended and should serve more to discover new thinking in this area than to immediately bring forward legislation.
As for the Allen and Gale paper, it’s called “Bubbles and Crises”, and was in the Economic Journal (2000). The paper is available in .pdf format from Franklin Allen’s website: http://finance.wharton.upenn.edu/~allenf/download/Vita/bubble2.pdf
If you’ve got a bit of background in the area you should find it a reasonably easy read, but it does involve a bit of college-level maths.
Jennette: sadly, I don’t write for any public forum, except for my friends here. I do professional commentary on aspects of the financial markets and risk management, but the price is set at my normal consultancy rate. I’d love to be a financial journalist, but I’ve never really thought about how I’d start. I’m toying with the idea of a blog, but the time commitment would be so high that it’s hard to see how to justify it. Thanks for the vote of confidence, though… 🙂
BTW, yaay Phillies, though I will be watching more of the Rays in future: Iwamura is just so hot! LOL
Ian, I wasn’t offended by the joke, and I say that as someone who’s been developing an ulcer over the last week just thinking about something happening to Obama. I took the joke as simply a swipe at the CIA – no more, no less.
Ksbel6 – another time, then. And congrats on your team!
LondonBoy, thanks for the response. Can you suggest a good free or relatively inexpensive, paper or online source for the kind of detailed information about political/economic issues that your response includes? I find it’s very easy to get sound bites about the bailout but very hard to learn interest rates, periods, and other specific terms.
Regarding your response, two things. I understand you weren’t and aren’t offering guarantees. Neither am I. And you are assuming that the government is a rationally self-interested actor, which is not a safe assumption. It’s not supposed to be self-interested, for starters. And the phenomenon of regulatory capture shows that its conception of public interest, i.e. how it should deviate from self-interest, is not always a democratic one.
Hey Ginjoint, that’s basically how I saw it too! I keep reading that the polls are getting closer and the gap between the candidates narrowing! Thank goodness in about 48 hours all this will be over one way or the other.
Andrew B.: Although it may not cite specific technical papers, a very good place to start would be by reading the Economist, which is published globally. It covers a wide range of economic and financial thinking, of course, but it also covers pretty much all the major political stories from around the world. Although its editorial policy tends to be of the free-market (“sensible”) right its endorsements for president include Obama (2008), Kerry (2004) and Clinton (1992), and it is by no means tied to a particular party or candidate. It is periodically banned in places where criticism of the local regime is frowned on (China, Iran, Singapore, etc.), but it tends to be un-banned after a few years because it is very good at its job: reporting facts and explaining them. It is particularly strong in its coverage of the financial markets and in its regular special sections, which appear every two to three issues and cover a wide range of topics in considerable depth (more than enough for the interested lay reader). It is published weekly, but it is almost impossible to read it all before the next one comes out. Different people adopt different strategies in reading: my approach is to read stories that look interesting in the Asian section, all of the US and UK sections, as much of the European section as I can manage without getting indigestion, all of Finance and Economics, and, if I have time, the Arts and Science section. I tend to save the editorials till last, though if there’s one that looks interesting I’ll read it first. Unless it looks exciting I tend to skip the Middle East & Africa section, though its coverage of sub-saharan Africa is extremely good, particularly southern Africa. The “must read” sections for me are the one-page quasi-editorials “Lexington” (on US politics) and “Bagehot” (on UK politics), which are often ruthless in their treatment of their subjects.
63 Responses to “oopsy”
Fail.
i’d go so far as to say: EPIC FAIL.
(smacks own head, V-8 style)
NICE.
Thank-you, Captain Obvious!
No kidding, eh?
“Bad Reporter” hit it a couple weeks back, with a news story about Greenspan texting a friend while the economy crashed.
Well, it was a good idea at the time…
Sort of like sending arms to Saddam Hussain.
I don’t think it was EVER a good idea. All it did was put the foxes in charge of security for the henhouse. Undfortunately, it seems to me that they were trusting in the old concept of noblesse oblige and didn’t plan for unparalleled greed. Wish they had been right about that.
My dad is a lifelong libertarian and he insists that corporations can self-govern and that it is the responsibility of citizens to “buyer beware”. This is a tidy illustration of why my beloved father is wrong. At least the old geezer has everything in bonds and money market funds.
That’s big of him to admit it. He was told it’d be a mistake at the time.
I notice a lot of these free market, no regulation types don’t have a problem with government interference when it comes to receiving subsidies and tax breaks from the government.
Gee, YA THINK???
Take that, Joe the Plumber!
topic hijack: anyone else mildly irked by all the attn. put on how much McCain instructs his team to spend outfitting his sidekick, the gov? I’ll have to browse some feminist commentary/analysis somewhere….
OK, now back to Greenspan.
I sent this story to a colleague at work today with the subject line: “From the ‘No Sh*t, Sherlock!’ department.”
😛 As Bugs would say: Whatta maroon.
Ah, yes, Bugs. Have I already mentioned that Barack Obama is Bugs Bunny and John McCain is Elmer Fudd?
Sarah Palin is Yosemite Sam, George W. Bush is Daffy Duck, Hillary Clinton is the Tasmanian Devil (always stirring things up), and Bill Clinton is Foghorn Leghorn.
If I’ve brought this up before, I apologize. I have a mind like a steel sieve.
Jana C.H.
Seattle
Saith Floss Forbes: If you don’t know the tune, sing tenor.
Erm, they HAVE regulated themselves.
A toddler, or a drunk, or an unsupervised market will overbalance and topple. Darwinian, that, but self-regulatory.
Interesting that of the three, the drunk does her-/himself the least damage during a crash, being so loosey-goosey.
Learning point: Booze is a better investment than the stock market.
Well. yeah Alex,
a friend sent me this investment advice recently:
If you had purchased $1,000 of Delta Air Lines stock one year ago, you would have $49 left.
With Fannie Mae, you would have $2.50 left of the original $1,000.
With AIG, you would have less than $15 left.
But, if you had purchased $1,000 worth of beer one year ago, drunk all of the beer, then turned in the cans for the aluminum recycling REFUND, you would have $214 cash.
Based on the above, the best current investment advice is to drink heavily and recycle.
@Aunt Soozie: That settles it – two different lines of reasoning, same conclusion. It must be true, eh?
Now all we need are another 49,999,998 French(wo)men… and we can’t be wrong. Hit it, Sophie!
In my head I can hear Walter from Dunham’s stand up routines…
“Dumbass!”
Hey, have you guys seen this? If you know anyone who might not bother to vote, it’s a great motivational tool.
After a long and crappy Friday… THAT made me laugh. thanks Alison!
What a fantastic video AB! It does remind me of Mo annoying Clarice by not going to vote against Reagan in 1980 though. Let’s hope that particular storyline wasn’t autobiographical!
It’s certainly a dilemma. I’m of the school that firmly believe that whenever a politician opens his/her mouth, they’re lying, even when they’re telling the truth, and it doesn’t matter what party they stand for. But I still get up and vote each election because I had an aunt who was a suffragette pal of Emmeline Pankhurst and it was drummed into me that it was my responsibility to go and vote and maintain the democratic process because the only thing worse than morally/ethically bankrupt politicos was not having the vote at all.
You can’t count on politicians to tell the truth, that’s right, Ian. Even Obama occasionally purposefully portrays his opponent in an unflattering light by misplacing emphasis or exaggerating a policy stance. And campaign promises? They’re worth the paper they’re written on, if that — no matter who’s making them. That’s about as far as I’ll go playing devil’s advocate, though.
What I WILL say is this: Look at their voting records. McCain is all over the place. He votes one way on an issue today and the other way on it tomorrow: whatever way he thinks will get him what he wants. Obama consistently votes the same way on a given issue. It may not be the way you like, but he upholds his stance.
Don’t get me wrong Kelli. ‘Cos while the Democrats have been generally completely spineless over the past 8 years of sheer hell, and are generally pro multi-national corporations, rampant capitalism, etc, at least they try to help those less fortunate as well as the very fortunate. And don’t try and grind the faces of the poor into the dirt gloating while they’re at it.
I’d vote for Obama tomorrow, would I had a vote. Or were American!
Love the go vote vid! Until the end, I was thinking, wow, Alison has some big skills when it comes to putting together videos!
I guess this sort of relates to our crumbling economy- I just bought my copy of The Essential Dykes at Garrison Keillor’s bookstore (whee!) and I thought that $25 was an eminently reasonable price to pay for a big, pretty book compiling your life’s work, Alison. Plenty to distract me from my Ph.D prelims!
I loved that video.. so witty and too funny… I especially love the woman with the foul mouth! She was a hoot. And, uhm, she scares me so I am gonna vote… but only because of her.
OK, so I’m getting pretty pissed off with a whole bunch of people, but unfortunately you guys are right in the firing line, because of various comments above. They’re comments that lots of people are making, but I’m going to take it out on you because I’m suffering from free-floating irritation as a result of YouTube suddenly thinking I want to see soccer instead of baseball (though I’m slightly mollified by the number of questions about Ty Cobb I was able to get right in a TV quiz earlier this evening). So anyway…
First, my qualifications: I’m comfortably over-qualified both academically and in terms of career experience to comment on the current financial crisis, and have spent large chunks of the past year writing about it.
Second, my bona fides: I’m affiliated with no organised political party (I’m a Green), and have no political axe to grind. (In fact, Green Party policy is pretty extreme-left on this, but I don’t share the general party position.)
So, now that that’s out of the way, let’s get something absolutely clear: current best theoretical thinking is that crises of the kind we are currently facing are a necessary concomitant of running the kind of banking system we have. Diamond and Dybvig (two important theorists in this area) wrote a paper demonstrating this in 1983 (Journal of Political Economy), and their work has proven quite robust and has withstood careful analysis for the past 25 years. In short, their conclusion is that bank runs are something that must happen from time to time if we are to have banks that provide the kind of demand deposit accounts we all use every day. Their basic approach has been extended and tinkered with by other people, but their main conclusion is still true. Their work does provide a theoretical justification for the kind of governmental intervention that is now being seen in the financial markets, and they certainly explicitly note that governmental provision of some form of bank insurance is a solution to the risk of occasional bank crises. Current best academic thinking in this area would not be that this crisis results from some failure of the mainstream banking model.
Greenspan’s comments are actually more subtle than the widely reported headline above. In particular, he noted that problems arose “because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment.” This is not the same as saying that everything went wrong because of “greed”, or some undefined failure of the existing system. In fact, the whole point of self-regulation is that “greed” (also known as “self-interest”) is part of the “control” aspect of the system.
I’d also better say this to Ian, and presumably to others: the cash that is being injected into the banking system is not a subsidy or a tax break, and it’s certainly not governmental expenditure. What it is (and you can check this with an accountant if you don’t believe me) is a transfer of assets from the “cash” part of the governmental balance sheet to the “long-term securities holdings” part. Although the news channels are talking of governments “spending” money here, that is not what is actually going on. What is going on is an expansion of governmental balance sheets, but that’s not the same thing as expenditure. I should also note that this is not any form of Keynsian stimulus (a fact that should be obvious, but has certainly been misreported on this side of the Atlantic).
I don’t think that anyone can doubt that bankers have made mistakes, particularly in the formal structuring of the various credit portfolio models that they have used over the past five years or so, but I feel the current attempt to tar all bankers with the brush of venality is incorrect. On the question of pay I remain undecided: I’m aware of some people who’ve had their million dollar bonuses, and some of these certainly seemed high to me, but in other cases these million dollar bonuses were paid to people who had made their employers $20 million in profit, so it’s not obvious to me that the bonuses were unmerited. If I had to suggest a group who have failed, I would say that it’s the banks’ risk managers, who are generally not particularly well-paid anyway.
What is very clear is that this crisis is going to spur a huge bout of banking regulation in every economy. This will no doubt please the principal readership of this website, whom I judge to be by and large in favour of more rather than less regulation. Sadly, and without in any way seeking to insult anyone here, it seems to me that the majority of people here form their opinions with very little regard to empirically verifiable approaches, but prefer to build their economic thinking on their political presuppositions. I suppose many people do (though I flatter myself that as an aspie I may be slightly more immune to this tendency than average). Though a case can certainly made for better regulation of financial insitutions, it is not obvious that heavy-handed approaches of the kinds currently advocated by most politicians will prove beneficial, and previous experience over many years tends to suggest the converse.
I’m still working on some kind of estimate of the long-term damage that this crisis will cause, but my current professional opinion (guess!) is approximately this: a recession running over several quarters, followed by a moderate recovery in the broad economy, but with perhaps higher household savings rates than over the past few decades. I am less pessimistic than I was a couple of weeks ago, and believe we will avoid a depression. This much is in line with other commentators, but my key expectation is this: a substantial drop in the long-term growth rates of most major economies, certainly including most of G7, Russia and China, lasting for perhaps 20-30 years. Right now, if I had to guess, I’d say we’re going to lose 1% of economic growth each year for about three decades. This may not seem like a lot, but what it means is this: without this crisis, we could have expected to be rather less than three times better off in 30 years than we are today, but with this crisis can only expect to be about twice as well-off in 30 years as we are today: about 40% of what we might have got, we will not now get. Of this loss, my (currently pretty wild) guess is that about half will be due to increased regulation of banks and other financial institutions. In addition, I expect the economies most affected by this to be the USA and the UK, as these are the ones where growth by innovation rather than by adoption of existing technologies is most important. If I have to pick a “winner” (or at least, a “least unlucky loser”) I pick India, by the same reasoning but at the opposite end of the spectrum.
Sorry if I seem slightly sour in this posting, but I’m getting pretty fed up with people in the media gleefully reporting the crisis as some sort of “failure of capitalism”. It’s not, though I can see that people who don’t have a clear grasp of financial economics might think so. I can fully understand that most people don’t have a background in financial economics, but the extent to which people without some training in this area are misunderstanding things is somewhat shocking.
Gosh, that looks so long! Sorry, but I had to get it off my chest!
As a biochemist, it all seems rather simple to me: the economy is a positive feedback mechanism. That means when someone figures out a way to make money, people copy them, and as long as it continues to make money, more and more people will do it, until the whole thing collapses.
The point of regulation is, it prevents the sort of catastrophic collapse that leads to depressions. As a biproduct, it also prevents the spectacular rises that lead to booms. The trick is to find a balance point that enables growth but prevents collapse.
The right wing seems to think that booms are good, and when people are caught in the inevitable collapse, that’s because they were stupid. Even though they don’t believe in evolution, they chalk it up to evolution.
The extreme left tries to prevent anyone from benefiting from growth, so they won’t be motivated to turn it into an unsustainable boom.
While my sympathies are more left than right, ultimately, I’m still looking for that balance point.
As long as we’re throwing around qualifications: as a political scientist I have the following to say to the LondonBoys comment: This is exactly the kind of speech that is given on this side of the ocean, basically saying, “you ordinary people just don’t get it”. When people ask, “Why is my tax money being used to help continue paying for huge bonuses in the banking business while due to the financial crisis my factory is starting to lay off people?” they get the answer: “Because it’s good for you in the long run.” And if it really is just changing the balance sheet (in some instances it’s buying stock of banks, in some it’s creating an offshore “rescue company” to take over the risky titles), why is it being used as an argument that now there won’t be enough money to invest in infrastructure or education? Why should people care more about the probability that they might be a little better off in 30 years this way, when in the meantime their private pensions are lost because they were invested in stocks, no one is giving small businesses loans to operate, or they risk unemployment, their children need student loans now and not in 30 years and they don’t have 30 years to pay them back. We’ve got to do better than just say, in the end the crisis is a good thing because in the long run we’ll be better off. If one is favorable of such a system that “needs” such a crisis from time to time, one has to offer something for those at the bottom of the economic system, who suffer from this crisis without any wrongdoing. And not just cover those who profited the most from the good times by justifying their in my opinion unjustifiable high bonuses. No one really can deserve to earn 2 or even 20 million a year.
@Monkee / LondonBoy – it is a treat to “listen” as clever people have a set-to.
Monkee, you write: “Why is [this balance-sheet adjustment] being used as an argument that now there won’t be enough money to invest in infrastructure or education?” From LondonBoy’s stance, might the explanation be that our governmental officials, those charged with pushing the levers of government to approve, or to justify, the balance-sheet adjustments do not themselves understand what their advisors, trained in financial economics, counsel them urgently to do?
Thus our masters in Parliament and the Congress say, “We have spent on this, and we can not spend on other things.” Only the LondonBoys can challenge them.
LondonBoy, you write clearly and deftly. Are you making these arguments in other public fora? Ones attended, perhaps, by more people? The NEW STATESMAN, the GUARDIAN?
@ Londonboy: Actually, I wasn’t talking about the bailout when I mentioned tax breaks and subsidies, although I can understand why you’d have assumed that. I was thinking more of corporate welfare and agricultural subsidies.
Thanks for explaining that viewpoint on the bailout though. I bow to your extensive knowledge Londonboy! Although to me, widening the balance sheet seems like a bit of a sleight of hand. In the end, all governmental liabilities have to be paid by the taxpayer. So while the bailout may not technically be direct ‘spending’, if the government takes on these liabilities and fails to recover the bad debts (as seems very likely), presumably the taxpayer will have to cover it.
Classic neo-liberal, free-market theory as I understand it, when it comes to one of these ‘corrections’, would rather the banks went under without government rescue. Survival of the fittest and all that.
By the way, back in cynical mode, when someone privileged (and I don’t mean you LB) tells me I don’t understand, it’s much more complicated than that, I’ve taken things out of context, etc, and the examples that Monkee gives above, I’ve come to realise that actually I’ve hit the nail on the head, touched a nerve and got things in exactly the right context. (I love mixing metaphors).
I’ll try to answer some of the above comments as best I can:
Dr. Empirical: Whilst the economy does contain some positive feedback mechanisms, it also contains some negative feedback ones. As you (in my view correctly) identify, booms seem to be in large part driven by positive feedback. The model that is most often referred to in this area is one proposed by Allen and Gale (though I can’t remember the date or journal, and don’t have the paper immediately to hand), which creates a model for asset prices in which prices increase above their “fair” price as they are bought on credit rather than with an investor’s own money. They envisage this happening as a result of increased credit availability, which I think is probably what has happened here. However, Allen and Gale ascribe this increased availability of credit to either a reduction in interest rates or an easing of loan terms and conditions, and I don’t think that’s what’s happened here. Rather, I think that we are seeing the result of banks being prepared to view their loan assets as quasi-temporary positions whose credit risk could be laid off in the broader financial markets by securitisation or the use of credit derivatives. In my view the introduction of credit derivatives to the financial system is a one-off “step change”, has never happened before, and will not happen again (something can only be “new” once!). This interpretation is consistent with the Allen and Gale model, but extends it to interpret an easing of loan terms and conditions as including an internal management attitude within the banks.
It is by no means clear that regulation prevents booms or depressions. If anything, the reverse appears to be true in the case of economic slumps: the best modern example is the Japanese “lost decade” of the 1990s, where the collapse of the Japanese economy appears to have been substantially abetted by excessive regulation of the financial markets.
To see why regulation may not always be beneficial, think about what the UK government has said to the major banks here: increase the amount of capital you set aside to support your lending activities. This is a sensible thing to tell banks to do in the short term, as it makes it very clear to depositors that “their bank is safe”, but if this higher capital requirement is enshrined in long-term regulations, the cost to banks of providing credit to their borrowers will increase (because they have to set aside more capital to support each loan they make, and capital isn’t free), so banks will make fewer loans. As banks make fewer loans it becomes more difficult for companies to expand their businesses (by getting a mortgage to pay for a new factory, say, or by getting short-term working capital loans to bridge the period between paying their staff and getting paid by their customers), so companies won’t expand as much. That means that they will employ fewer people, and since the stuff they make will be in shorter supply, their products will be more expensive, so fewer people will be able to afford them. Overall effect: people aren’t as well-off as they would otherwise be, and this has been brought about largely by excessive regulation.
I’m certainly not saying that there should be no regulation, but what I am very concerned about is the likelihood of excessive regulation. What we see, if we look through history, is that large-scale market crashes tend to be followed by periods where financial markets are highly, and perhaps overly, regulated. The heavy regulation of the US financial system after the ’29 crash is a case in point. People’s reaction to a problem is to try to “prevent it from ever happening again”, and they try to do this by passing laws and regulations. Unfortunately, as I note in my earlier posting, if we want to have a banking system with demand deposit accounts (that is, you can go into the bank and get your money out whenever you want it, rather than only when the bank says you can) the risk of bank runs seems to be inevitable.
I would be surprised if anyone on either right or left of the political divide thought seriously that “booms and busts are good”. The difference is that on the non-populist/non-stupid right there is an acceptance that such things do happen and may be part of the price we pay for giving people the freedom to buy or sell things as and when they want. My own view (formed from discussions with them) is that even on the “(non-stupid) extreme right” there is a strong desire to minimise the occurence of booms and the effects of busts, and to mitigate their effects on those least able to cope with difficult economic conditions: the desire is simply to move through a bust as quickly as possible, and with minimal interference in normal free-market functioning, on the grounds that this is the optimal long-term economic strategy. (This is a debatable point, of course, and I don’t believe that it will be determined one way or the other in my lifetime, but it is intellectually quite defensible and philosophically consistent. The converse case is of course that argued by the (non-stupid) left.)
Monkee/Ian: Yes, I am in a sense saying “you ordinary people just don’t get it”, though I hope that I’m at least trying to explain what “it” is, and make a reasonably clear case. When you’re ill you go to a doctor because he’s spent years studying medicine, and when you’re having gas installed you make sure your engineer has passed his CORGI registration. Of course, you ask the doctor why he’s prescribing this or that treatment, and you lurk around the gas engineer getting him to explain what’s going on and what you should do to keep the central-heating running smoothly, but you generally wouldn’t consider just asking a random member of the public to treat your scarletina or connect you to the gas main. And yet pretty much everyone feels themselves qualified to comment on the economy and argue long and loud in favour of their particular positions.
If we were, as Monkee says, simply discussing people being “a little better off in 30 years” I wouldn’t be making this posting. The problem is that it’s not “a little”, because of the compounding effect. As I note in my earlier post, it’s the difference between being (very very roughly) three times as well off in 30 years, rather than twice as well off. That’s a huge difference. (Since I made that posting I’ve been revising my figures, to correct what I now think was for technical reasons an overoptimistic view of long-term growth rates, but the impact of this change is to reinforce the significance of my main point here, not to dilute it.)
The reason why there is a cost to governments making cash injections into banks to stabilise them is because although there is no “expenditure”, governments have to borrow to finance this. This has a cost, but it’s not that of money being spent: the cost is that the interest rate paid by governments on their other borrowings will increase. Suppose you borrow some money from your bank, and immediately put it on deposit at something like the same interest rate: you’ve not actually spent anything, but your assets and liabilities have both increased – you’ve got money on deposit, and a bank loan – so if you want to borrow more money for other expenditure your bank will probably charge you a higher rate of interest. It’s important to note that the way governments are structuring their support of their banks means the chance of loss (though non-zero) is comparatively small, which is, of course, as it should be. Supporting the banks is not cost-free, because governmental borrowing costs will rise. Governments are prepared to pay this cost because by doing so they ensure that banks keep functioning, and so can keep financing economic activity generally (and so keep people in jobs, and ensure that they are actually paid for making things or providing services, by the mechanism outlined above).
I absolutely agree that what we should always do at times like these is protect those most exposed to bad economic conditions, either because they are unable to fend for themselves or because they were unlucky enough to work in the most exposed sectors. I believe that the greatness of our society is judged not by the wealth of the people at the top, but by how our least privileged are doing, both in terms of freedom from want and in terms of freedom of action. This is what makes me in many ways a natural right-winger. (If we had a Peelite party today, I’d join it like a shot!)
Alex K.: I suppose I think this: Whilst there are certainly some politicians in all parties who probably don’t have a clear understanding of what is going on, those who are actually in government almost certainly do (though many of them may have been going through a fairly rapid learning process lately!). In particular, I have been very impressed by the actions of Gordon Brown and Alistair Darling in the UK (who really did everything first and exactly in line with what I feel is best current academic and technical thinking), Angela Merkel of Germany (who had the common sense to put the economic health of her people ahead of some inchoate plan for eventual EU action), and, to some extent, George Bush in the USA. The last of these requires some explaining: whilst I do by and large feel that Bush has been a disaster as president, he has at least followed the suggestions of his moderately sane advisors in handling the banking crisis, rather than giving way to the populists of his own party. By taking a more technocratic position than he normally does, he’s probably helped to stabilise things. I still think that in most things he’s an idiot, but he gets a solid ‘B’ for this one.
Sorry for another grotesquely long post.
The Allen and Gale work seems to be in a paper they wrote in about 2000 and presented at an LSE conference. If anyone wants the exact citation, please let me know and I’ll dig it out. They contributed a chapter to “Asset Price Bubbles” (2003), Hunter et al. (Eds.), publ. MIT Press, but I’m pretty sure there’s a stand-alone paper out there too.
@LondonBoy: “Financial contagion”, J Polit Econ 2000;108:1-33, is the best contender for that reference that I can identify in a quick Google. Is it the real McCoy, the article that you intended?
Thank you for setting out your stall so clearly. I am particularly grateful for the explanation of how increased debt load, even if the money borrowed is not spent and gone, raises the cost of further borrowings, and thereby, I infer, how recent events will impede use of governmental resources for infrastructure projects, schooling, health care, and the like.
One understands that granted loans, once transformed into a “derivative” or “securitised”, are cut free from close observation of the debtor by the lender. (I think of my maternal uncle’s banker father-in-law, who made his Iowa farm loan decisions on the basis of how good the land looked and how well the farmer tended it. A lot of road time was involved, driving back and forth between the quarter-sections and seeing where, say, standing water meant that the tiles weren’t running, that the collateral was in poorer condition. No doubt his wife, by paying close attention to conversations in the church porch, gathered valuable data as well. That’s where you find out that such-and-such a farmer is drinking again…) SInce interest rates DID drop, and loan terms WERE eased, at the same time as “securitisation” took place, to separate out contributions of those three elements may prove difficult. No doubt the research is ramping up as I type.
Let’s agree that we have all lived more wealthily in part due to recently greater availability of credit. WERE we indeed wealthier? Or were we all buying on the never-never and hoping that the repo man would never track us down? Is wealth better defined, in a nation, as high house prices or as a TGV network?
Let’s also agree that financial markets need regulation, and that the only question is – how much? The Goldilocks dilemma – too hot, too cold, or just right? No one wants “excessive” regulation, or for that matter “inadequate” regulation. Pro bono, contra malum – a universal banner! – but what concrete steps seem likely to be enough and yet not too much? What advice would you tender to politicians? (I have noted your tip to invest in India.) Extending that query, and reflecting that under the present regulatory regimen, investment decisions in Britain have yielded high house prices and no TGV network – if laying new railway lines indeed results in greater long-term growth than do house-price rises, how have governmental policies led to lower-growth outcomes, and what room for change in those policies do you see in the aftermath of this “crunch”?
Re: Bush – We should all feel lucky when the proper hand gets into so important a sock puppet, particularly when the record suggests that exactly the wrong hand will be inside the sock. But it is the puppeteer, not the puppet, who deserves the solid B.
It’s unlikely that I’ve set out my comments and queries so clearly as you did, so thanks for bearing with my incapacities.
Wow! I checked in during the smartie hour of the blog…. Thanks for the enlightening posts, guys. Much appreciated.
London Boy, you never answered if you write for a public forum – do you? I’d be interested in reading it.
Thank you,
Jennette
P.S. And thanks to anyone out there who came to Lee’s in Minneapolis on Saturday the 18th for Baracktoberfest. It was a big success and we raised a nice chunk of change of the Obama campaign.
LB, there are about a bajillion things I’d like to ask or comment on re your posts on this topic. I’ll try to keep it relatively short.
Using your example, if I took out a bank loan and immediately deposited the money in a savings account, over time I’d get killed on the interest rate spread. Why do you think the government will come anywhere near break even on the rescue? Obviously there are all kinds of differences. Your analogy was not intended to be exact. But if anything the differences work against the government. E.g. if I borrow money and put it in a savings account I’m at least guaranteed to get my principal back. By contrast, at least some of the government’s new assets are guaranteed to go bust, and the rest are in such bad shape that they’re at least temporarily illiquid — which is why the gov’t is buying them.
Even if you can convince me that the exchange of assets for debt is economically neutral, there are political ramifications. It’s not politically tenable for the USA to keep running debt at it’s current level. (Whether this reflects sound economics or not is politically irrelevant.) Government services are going to get cut, and as a result of the rescue they will get cut further than they otherwise would have. And internationally, the further in debt we are, the more leverage our creditors have over us. When we have been creditors (eg through the World Bank) we have shown no hesitation to dictate policy to debtor governments. What would happen to us if e.g. the Chinese decided that a certain policy decision on our part would force them, regretfully, to sell all the Treasury debt they hold? What would that do to our government’s ability to function? That won’t happen tomorrow. Tomorrow it won’t be to their benefit to drive our interest rates through the roof (and the value of their Treasuries through the floor). But some day it might be, and the deeper in debt we are, the more leverage they’ll have when that day comes.
Bringing this back a little bit to Alison’s original point, Alan Greenspan is not just a technocrat. He has had a busy sideline as a pundit supporting deregulation and “free markets”. His admission of error in his punditry is a serious matter, regardless of what you think of monetary policy during his tenure. Finally, on the technocratic level, I don’t see how anyone can take that twenty year excuse seriously. Even an amateur like me knew that the twenty year stock market boom that ended in 2000 was historically exceptional. One could have argued that it represented a fundamental change that would extend into the future — one would of course have turned out to be wrong — but to take this as fact, if indeed that’s what happened, is just economic malpractice.
Relatively short, believe it or not. Mostly comments, but my question — as to why you think the gov’t will break even on the assets it has acquired/will acquire — is not just rhetorical.
Thanks so much LondonBoy and Andrew B for both bringing up some really good points. It’s great to get the “insider’s” viewpoint and also a critical examination.
I’m only a layman, so bow to your knowledge LB. But I do think it’s impossible to separate economics from politics. I’m sure we agree that it’s not more or excessive regulation that’s needed, but efficient and effective regulation. I do think there’s a line between self-interest and plain ol’ greed which has been passed.
LondonBoy, thanks so much for the clear explanation. I’ve been wondering where the bailout money came from. Also, I know it was more or less an aside, but I’m glad you mentioned the risk managers, on the same lines, how much resposibility can we lay at the door of the credit rating agencies? It strikes me that if Moody’s and S&P had provided more realistic ratings back down the line, a lot of this mess could have been avoided.
How ’bout those Phillies?
Wow, I never imagined I’d find such an intelligent conversation about the economy here. LondonBoy, your explanation of the balance sheet shift of governmental assets was concise and cogent. I’ll use it myself. Thanks much! What I want to know is why, if Alan G can say he’s sorry, why can’t Jake and Donna Carpenter (Burton’s Snowboards)? http://www.7dvt.com/2008burton-critics-rally-companys-headquarters [Sorry if this counts as blognapping.]
http://mine.icanhascheezburger.com/view.aspx?ciid=2382779
How the mighty have fallen! I can remember growing up in the 60’s, back when economists were treated like rock stars or astronauts. My sister and I read every word we could on economist John Kenneth Galbraith’s adventures as President Kennedy’s ambassador to India. Now, look at them. An economist on CNN last week said that we will now see if we have a “deep, nasty recession, or something worse.” OR SOMETHING WORSE???
Deep, nasty recession or something worse? Now about a deep, nasty depression with droughts, floods, rising sea levels, food shortages, and all the other concomitants of climate change? Oh, and more nuclear weapons.
Hey, how ’bout those Mariners?
Jana C.H.
Seattle
Saith Arthur Pinero: Where there is tea, there is hope.
Something worse? Like US soldiers raiding Syria from Iraq and killing civilians? Will Darth Cheney achieve his goal of WWIII before 20 January? Talk about brinkmanship.
Tasteless joke of the week from UK TV: “Will Obama win in a landslide, or will the CIA think of another ingenious way in which to kill him?”
Holy Jeezum, LondonBoy. Thanks for that exceptionally lucid economics lesson. Um…I’m now officially intimidated by the prospect of commenting on my own blog.
Ian,
Could you do us a favor and leave your tasteless joke of the week on your side of the Atlantic?
Not so funny.
I agree with Louise,especially in light of today’s news re: the 2 white racists’ ultimate goal of assassinating Obama.
Well, I apologise if I’ve offended anyone. I hadn’t heard about today’s news Feminista.
Thanks for the apology, Ian.
The racist patterns in the US are fierce. The Obama family has had Secret Service protection since May 2007 because of threats against him.
LondonBoy, for all your presumed qualifications, your acquaintance with *actual* banks must be very slight if you think their risk management officers has any authority and are in a position to fail. You note yourself that they are not well-paid but you don’t seem to grasp the implication: in a merchant bank, you are what you are paid, not what your business card says. In reality, like all quants they serve decorative, i.e., regulatory or PR purposes and have very little clout. Their role is to make what the traders and management wish to do and would do anyway look acceptable; if they tried to really manage the risk, they’d receive a reminder (in the form of a pink slip) of who’s really in charge.
Alison!
With the election a few days away, maybe you could whip up a one-size-fits-all single panel? Like Mo, unconscious. I think either way that’ll cover her likely reaction.
As to Ian’s “tasteless joke.” In my opinion …
I have to admit that I find it amazing how strongly people don’t want unpleasant issues brought up. That Obama and family have been receiving Secret Service protection since 2007 is hardly unexpected. ALL the candidates of the major parties receive such protection.
The notion that a few bad apples could, yes indeed, have a monumental effect by looking the other way at the right time (which is the point I take away from Ian’s comment) is neither woo-woo conspiracy or tasteless. It may not be presented as tactfully as possible, but what does tact have to do with it?
Was I alone in seeing how the Democrats’ “tact” cost them two elections (possibly three)? I now see that there are voting irregularities showing up. Again. These are serious problems. I’m sorry if a couple people are goodness gwacious me wupset, but I wish a lot more people were wupset eight years ago when the “Dynastic Dipstick” (as Mo calls him in one strip) got into office. Or four years ago. The Dems have consistently stunned me — stunned, stunned, stunned — with their gosh darn civility and ineffectualness. Eight years and the machines are still suspect? That’s like thinking your accountant is swiping money and firing the cleaning crew.
It stops being “civility” after a while and becomes being a victim.
We’re now at the last point in the trail everyone. If McCain and Palin win the election (straightup or by deceit) that’s the Supreme Court for the next three decades. The justices who are going to be retiring (one of them is 84!) or dying in the next four (or, god help me no, eight) years, are probably three or four of the liberal siders. You can say good-bye to Roe v. Wade and a woman’s right to privacy. You can say good-bye to the Constitution’s pesky Bill of Rights, except (wink) the good-ol’ Second Amendment. Schools, libraries? Evolution?
My point? A tasteless joke? Perhaps. Raising a point: that there is a racist, hate-filled element in America, and that element should be confronted and dealt with, and not with gosh-shucks “Impeachment is off the table” sorts of “compromise”? That’s part of it, too. And sitting there fingers-in-ears la-la-la-ing and going “if we don’t say it, it won’t happen” won’t work anymore. (It never did.)
I’ve never seen such greed and rapaciousness as I’ve seen in the last eight years. The Constitution flushed down the toilet to keep us “safe” from terrorists. We’re all taking off our shoes in the airports. Why not just have us all toss salt over our shoulders? It would be as effective.
I’m sorry to rant like this, but I’m really fed up with how many people still have “company manners.” We’re really well past the point of “oh, let’s all process for half an hour and really, really, really make sure everything is super OK with everyone.” Some see a tasteless comment. I see a kernel of truth. And perhaps tasteless is necessary at this point.
In my opinion … (Please don’t beat me with a pillowcase full of door knobs.)
Well, I wondered if I was going too far when I posted it. I interpreted the comments (which were made on a news/current affairs comedy quiz/satire show by Paul Merton) as a riff on conspiracy theories. Without wanting to dig myself in deeper or offend anyone, we all know that inspirational leaders who’ve changed (or threatened to change) the status quo have not had a long life expectancy in the United States and not everyone believes the lone gunman/madman theory. Thanks to the CIA and those right-wing factions the USA has supported over the past 50 years, quite a few inspirational leaders abroad have ended up shot as well. So people in other countries are a little less careful of the sensibilities of the US public I suppose.
I suppose really, tasteless or not, it’s a black comedy comment (in the sense of of finding humour in very dark subjects, like gallows or hospital humour). In this case humour is being used as a survival response in order to cope with the possibility of very bad things happening. “Many a true word is spake in jest”, etc, etc.
(When I wrote the above I felt a bit as if I was saying, “Here granny, let me show you just how to suck those eggs, you’re not doing it right”. But I thought it might explain why I’m less shocked by it than others).
@Alex the Bold:
Mo, I’ve missed you!
Ginjiont: I’m probably not going to make it. Just bad timing. The good news is that I won’t make it because my softball team ended up 4th in the state and that extended the season by 3 weeks.
As for the Obama joke, I personally believe if he is killed we will be in a civil war like we have never seen before and the economy will be the last thing people will be worried about.
Zoinks! I’m amazed people had the stamina to read my last post, let alone respond to it. I’ll try to make this brief (though I may not succeed!) …
Alison: sorry for posting so much, but it’s such a fascinating topic. I don’t mean to be intimidating, and I’m sorry if anyone thinks I am. This is a good faith effort to discuss a complicated subject.
Olivier: actually, I’ve been in the financial industry for many years, initially as an FRN trader, then as a swaps trader, then as a generalised quant, then as a risk manager. All of these positions were with large international banks at degrees of seniority consonant with my experience. For the last decade I’ve run a specialist risk management outfit that provides outsourced services and consultancy to banks and hedge funds over three continents. Our speciality (eek!) is the credit markets, and I’m intimately familiar with the problems there. As a former risk manager (specialising in credit derivatives) for a household name global bank, I know the “political” problems that such people face. You’re quite right when you say that many of these people and departments are regarded by traders as “just there for show”, but I would like, if I may, to draw a distinction between the teams (typically middle-/back-office) who spend their days preparing risk reports (VAR, stress-tests, etc.), and the small number of real risk managers in the main reporting hierarchy that runs up to board level. Certainly, the first of these two groups has no real influence, but the second either does, or should have. I think that it was this second group to which I was alluding. The problem is that at some banks the position of “risk manager” for a dealing room has served as either a stopping-off place for the ambitious executive who is already seeking his next promotion, or as a place to put an elderly trader out to grass. These people tend to treat the job as of less significance than appropriate. Risk managers should be proactive, have the temperament to push their point of view, and should regard their job as a worthwhile contribution to their institution’s long-term stability in its own right. In my view, where this has not been done is where risk managers have failed.
Andrew B.: why do I think the governments will break even on their new assets in the banking sector? Actually, I don’t guarantee that they will. I suspect they’ll actually make a profit, which is appropriate as they’re taking the risk that they might lose their money. I can’t cover every country, so let me just outline part of the situation in the USA, to give you an idea. The US government is buying preference shares in banks that will pay the equivalent of 5% per year for 5 years, then 9% per year thereafter. The banks have to pay the dividends (interest) on these preference shares before they pay any dividends to their ordinary shareholders (that’s why they’re called “preference shares”, because the government gets preferential treatment). Now, if I look at the borrowing costs for the US government today (you can see these by looking at the Fed’s website) I can see that for the government to borrow money for 5 years would cost about 3% per year, and for the government to borrow money for 30 years would cost about 4.5% per year. The banks can buy back the preference shares from the government any time after 3 years, and it’s a pretty good bet that they will try to do so as soon as they can, so as to show that they’re strong enough to stand on their own feet, so all the government has to do is estimate how long it will be before the banks decide to repay, and borrow accordingly. If they think it’s about 5 years, the government will make a profit of 2% ( = 5% – 3% ) for 5 years, which is $5 billion a year in profit for the government (if the full $250 billion available to the banks is used). If they think it’s about 30 years before the banks repay, the government will make a profit of 0.5% ( = 5% – 4.5% ) for 5 years, then 4.5% ( = 9% – 4.5% ) for the next 25 years; this would be $1.25 billion per year for 5 years, then $11.25 billion per year for a further 25 years. Of course, these are just rough example figures, but give a reasonable estimate of what’s going on. My own expectation is that the true figure will lie somewhere between these two extremes, probably at the lower end of the range. The government gets this profit because it is taking the risk that some of the banks may go broke and the government’s investment may be lost. The Fed and the Treasury have probably decided the exact rates on the preference shares on the basis of their expectations for future bank failure probabilities, and then added a margin of error just in case. (They may also have indulged in a certain amount of “punitive” caution, just to teach the banks a lesson, but without seeing their detailed estimates of expected bank failure and preference share repayment rates I couldn’t say.) There’s other stuff going on in the various rescue packages around the world, but the underlying philosophy is likely to be the same everywhere: charge the banks a sufficiently high rate on the government-supplied capital that the government makes a profit, or at least breaks even.
Alex K.: as for the best regulatory steps that governments might take that would help avoid a repeat of the current crisis, without over-regulating, I would suggest the following: (1) require that all mathematical models used in pricing and risk assessment of complex instruments be driven by input parameters that are actually market-observable, or derivable from market prices on a “historical” rather than “implied” basis (this is a fairly technical point, but options traders may see what I’m getting at: what I want to ensure is that everything that a bank does can be accurately described in terms of actions and instruments that are actually being traded in the real world); (2) introduce tax and banking capital requirements legislation that encourages the transfer of over-the-counter complex derivatives to special-purpose regulated clearing houses, which can be overseen and adequately capitalised, because by doing this we can reduce the risk of contagion where a failure at one bank may damage its counterparties; and (3) for banks above a certain size, find some way to “privilege” the risk management function (so that it becomes something like the Supreme Court: well-paid, able to choose its own targets, and protected from attack if it decides to do something that pisses off the (bank) Executive(s)). There’s a whole lot more that might be done, but these are ideas that I’d like to see discussed seriously, because they are relatively low cost, don’t excessively interfere with interal bank activities, don’t require whole rafts of governmental oversight, and seem likely to help. I’d also like to see a general review of how banks optimise their credit portfolios, but such a review should be open-ended and should serve more to discover new thinking in this area than to immediately bring forward legislation.
As for the Allen and Gale paper, it’s called “Bubbles and Crises”, and was in the Economic Journal (2000). The paper is available in .pdf format from Franklin Allen’s website:
http://finance.wharton.upenn.edu/~allenf/download/Vita/bubble2.pdf
If you’ve got a bit of background in the area you should find it a reasonably easy read, but it does involve a bit of college-level maths.
Jennette: sadly, I don’t write for any public forum, except for my friends here. I do professional commentary on aspects of the financial markets and risk management, but the price is set at my normal consultancy rate. I’d love to be a financial journalist, but I’ve never really thought about how I’d start. I’m toying with the idea of a blog, but the time commitment would be so high that it’s hard to see how to justify it. Thanks for the vote of confidence, though… 🙂
BTW, yaay Phillies, though I will be watching more of the Rays in future: Iwamura is just so hot! LOL
Ian, I wasn’t offended by the joke, and I say that as someone who’s been developing an ulcer over the last week just thinking about something happening to Obama. I took the joke as simply a swipe at the CIA – no more, no less.
Ksbel6 – another time, then. And congrats on your team!
LondonBoy, thanks for the response. Can you suggest a good free or relatively inexpensive, paper or online source for the kind of detailed information about political/economic issues that your response includes? I find it’s very easy to get sound bites about the bailout but very hard to learn interest rates, periods, and other specific terms.
Regarding your response, two things. I understand you weren’t and aren’t offering guarantees. Neither am I. And you are assuming that the government is a rationally self-interested actor, which is not a safe assumption. It’s not supposed to be self-interested, for starters. And the phenomenon of regulatory capture shows that its conception of public interest, i.e. how it should deviate from self-interest, is not always a democratic one.
Hey Ginjoint, that’s basically how I saw it too! I keep reading that the polls are getting closer and the gap between the candidates narrowing! Thank goodness in about 48 hours all this will be over one way or the other.
Andrew B.: Although it may not cite specific technical papers, a very good place to start would be by reading the Economist, which is published globally. It covers a wide range of economic and financial thinking, of course, but it also covers pretty much all the major political stories from around the world. Although its editorial policy tends to be of the free-market (“sensible”) right its endorsements for president include Obama (2008), Kerry (2004) and Clinton (1992), and it is by no means tied to a particular party or candidate. It is periodically banned in places where criticism of the local regime is frowned on (China, Iran, Singapore, etc.), but it tends to be un-banned after a few years because it is very good at its job: reporting facts and explaining them. It is particularly strong in its coverage of the financial markets and in its regular special sections, which appear every two to three issues and cover a wide range of topics in considerable depth (more than enough for the interested lay reader). It is published weekly, but it is almost impossible to read it all before the next one comes out. Different people adopt different strategies in reading: my approach is to read stories that look interesting in the Asian section, all of the US and UK sections, as much of the European section as I can manage without getting indigestion, all of Finance and Economics, and, if I have time, the Arts and Science section. I tend to save the editorials till last, though if there’s one that looks interesting I’ll read it first. Unless it looks exciting I tend to skip the Middle East & Africa section, though its coverage of sub-saharan Africa is extremely good, particularly southern Africa. The “must read” sections for me are the one-page quasi-editorials “Lexington” (on US politics) and “Bagehot” (on UK politics), which are often ruthless in their treatment of their subjects.