Stability and Feedback
28 Jan 09: Emil BizonSig declines to believe that the ways on which the USS Economic Meltdown was launched were greased by sub-prime slime. My readings do not support that view. Dean Baker of the Center for Economic and Policy Research - www.cepr.net - (not to be confused with the similar sounding Centre for Economic Policy Research - www.cepr.org ,- a British group) has just written a book on the subject titled Plunder and Blunder: The Rise and Fall of The Bubble Economy. In a web item http://www.prospect.org/cs/articles?article=plunder_and_blunder_a_roundtable he states: "The country is suffering the worst downturn since the Great Depression for a simple reason: An $8 trillion housing bubble has collapsed. The leading lights of economics and finance, with a very few exceptions, could not see the largest financial bubble in the history of the world. The result is soaring rates of unemployment and foreclosure, a crippled financial system, and a huge cohort of baby boomers who have seen their home equity and savings vanish and now face retirement almost totally dependent on Social Security and Medicare." He then goes on in essentially the same words I used in the first part of this discussion. Baker has been saying this for many years.From the British CEPR I quote from a paper by Axel Leijonhufvud of the University of Trento: "The world of finance is a multidimensional system. In most dimensions it works in the same way as the market for bread. But in two important dimensions it does not. The general price level is not stabilized by market forces under present arrangements. Neither is the overall level of leverage. Both are unstable and subject to positive feedback processes. Movements of the price level - inflations or deflations - tend to be self- reinforcing. So do movements in leverage. Two consequences follow. The price level must be stabilized by monetary policy. Leverage needs to be constrained by regulation."We know from experience that many disasters can be averted by skilful management and control; the recent example of Captain Sully ditching a loaded passenger plane in the Hudson River is a good example. Unfortunately the occupant of the White House whose responsibility it was to supply the regulation was more of a Captain Queeg.On the issue of bank size and its potential failure, I did not imply that size was bad. However if that reason is going to be invoked to place the taxpayer on the hook for the consequences of such a large financial institution collapsing I think the taxpayer has a right to demand that the size be limited.Otherwise I agree with Sig to a large extent. Kevin Phillips in his hot-off-the-press book Bad Money; Reckless Finance, Failed Politics, And The Global Crisis of American Capitalism tends to view the disaster as an Anglo-Saxon development. We know that the earliest bank failure was the British Northern Rock, if my memory serves me, and it was engaging in similar practices to the USA sub-prime. I do not think this type of stuff was going on in Germany or France, but there were major acquisitions of securitized sub-prime American debt by the French BNP Parisbas and several German and Swiss banks. Evidently anything Made In The USA, sold by one of the five big investment banks and given a triple A rating by Moody's was as good as it gets. The same must be said for our banks and pension funds and companies who wound up with $34 billion of this stuff. We should expect that future purchases of US securities will be done more cautiously.The recovery plan demanded by Obama looks expensive beyond comprehension. It seems it will be financed by more government borrowing if foreign lenders are willing to keep piling up US bonds. Otherwise the speed of the printing presses will be warped up. So rising interest rates and inflation on a major scale appear unavoidable. In our country there is not such a serious reason for fear as the debt will be absorbed by our own financial institutions. Paul Krugman insists that the stimulus should be even larger and does not worry about the debt because he maintains it can quickly be paid back from a newly stimulated and thriving economy. In the recent thriving economies this was not done and servicing the total debt of around $13 trillion is going to absorb a lot of tax revenue. No one is, at this time, questioning the wisdom of the continuing haemorrhaging due to Iraq and Afghanistan and the war machine. I have a feeling that there will be a new focus on Social Security. Since it will require input from the treasury in less than ten years, a defaulting on the bonds nominally held in the SS Trust Fund (a bookkeeping fiction), is rather likely.
18 Jan 09: Sig Carlsen
I think that Emil’s letter does not deserve to go unanswered because, while in my opinion he is by and large correct in his summary of what went so disastrously wrong, perhaps a few more errors also occurred along the way. And therefore they may also be worth mentioning. Before doing so, let me at least suggest to Emil that the disaster did not exclusively originate in the US, but most assuredly also in the UK, and with respect to banking , also in Germany among other places. And while a source of the disaster was undoubtedly the housing bubble in the US, it was only one of the many causes, albeit a very important one, and by the way not only confined to the US. Finally, I also permit myself to disagree with the (at least) implied assertion that some future rule ought to exist against a bank becoming so large that it cannot be permitted to fail. Surely size alone is not bad in and of itself, as the experience of Canada would suggest. A handful of large chartered national banks have almost certainly brought more stability to Canada than the thousands of US banks have done in that country.
I spoke of other causes above. Briefly, let me suggest that the repeal of the Glass-Steigal Act in 1999, which in turn permitted a virtually unregulated parallel banking system to arise was clearly another terrible policy mistake. This new banking system was a crucial enabler of the disaster to come. The emergence of new mathematical business schools, sprouting forth financial alchemists creating among other things the default credit swab derivatives, cdo’s containing in many cases exclusively such derivatives, and other like unfathomable instruments totaling well over the annual value of all the economies of the world were other causes. But we could go on, for example, from the 1970’s onward did any academics write about the essential need for responsible and accountable corporate governance? If they did it was certainly well hidden, with the result that no intellectual basis was created either for courts of first instance let alone appellate courts to create much needed rules of the road so that neither senior executives or their supposedly supervising boards of directors (artfully selected by the very executives to be supervised) could be held accountable, with the result that large scale “legal” theft of huge sums to the detriment of the true owners (stockholders) regularly occurred. And was this lack of writing in turn caused just by ignorance, or was it not more probably provoked by a fear of offending large contributors from alumni associations regularly filling the coffers of university endowment funds? If that doesn’t grab you, how about a built in fatal systemic weakness in enforcement authorities like the SEC and the Federal Reserve? There is no rule that prohibits regulators of the various oversight agencies from quickly joining on lovely financial terms the very organizations that they were sworn to keep on the straight and narrow, with the inevitable result that an irresistible temptation was created to “overlook” or bury inappropriate conduct by the supervised. The system of surveillance was effectively rotten ab inito.
One could go on, but the causes of this disaster are many, and you may be sure that innumerable books and papers will come forth purporting to explain the whole sorry mess. And it is obviously important for the future, I would submit, not only to look at the technical proximate causes of the disaster but also to drill a little deeper, particularly into ourselves. For at the bottom of all this sorry business lies the frailties of Man, and therefore economic disasters are bound to recur somewhat regularly. The road of hell is not only paved with good intentions but also with bad ones. Lest you remain unconvinced, have a look on your bookshelves. Those of you who have kept your text books from the College will probably find a copy of Paul A. Samuelson entitled “Economics”, and on the inside you will no doubt find your surname followed by your initials and your College number. I venture that few if any of us ever read the Introduction. It is instructive because the author reminds the reader of what we all experienced once and perhaps several times. “Look to your right and look to your left and one of you won’t be here next year”. And Samuelson said that it is also the same for the Economy. The author noted that if the future should be like the past then: “There is a strong probability that one (of the three of you), at some period in his life, will be hard hit by a depression or he may have in his lifetime savings wiped out by price inflation.”
One may suppose that one lesson (apart from a revised and effective oversight and regulatory regime, and essential systemic changes) that will be learned is that it is much better in the long run not to pretend that we can abolish regular recessions by for example unduly manipulate monetary remedies such as the rediscount interest rate. Rather we should willingly go back to accepting little recessions, and also to take heed of former Fed Chairman Chester Martin’s admonition that it was his job to take the punch bowl away just as the party was getting going. Of course another effective remedy may be to change human nature itself, and then only put men of good character and education in charge of the shop. But isn’t that asking a little too much of our natures turning endlessly around in our mass democracies based on universal suffrage? Sig
(Canadian banks are not really 'Big' by world standards and they operate, thankfully' under more restrictive regulation than US banks. Ed)
STABILITY AND FEEDBACK
In my degree year at McGill I was taught a course with a title something like Automatic Control and Feedback. The prof was a recent arrival from the UK named GL d’Ombrain; he was an excellent instructor and the subject was new and quite absorbing. In my working career, such as it was, I had some opportunities to apply some of this theory to various industrial processes.
This theory applies to any dynamic system which has measurable and real inputs and outputs. The current financial system disasters originating in the US are most certainly amenable to such inspection.
As we all know, the source of this catastrophe was the housing bubble. This followed the smaller but equally severe dotcom bubble a few years earlier. The tulip bulb bubble in Europe several hundred years ago is another example.
In the US, housing is a major factor in the economy. About seventy percent of the GDP is due to consumer spending and of this, almost one half is directly spent on housing so one can approximate that housing accounts for about one third of that nation’s economy. In such a context one should expect that the dynamics of the industry would be monitored as closely as the temperature of the nitro-glycerin reactor mentioned in End of Empire, the one that took Mottsy Dupont’s life, for example.
We know the long-term trend in housing prices, both in the US and here, is not far different from the inflation rate. In Alberta, from about 1980 to 2000 it may have been less. When prices over there started to rise early in the decade someone amongst the best brains of the nation- Allan Greenspan, Lawrence Summers, Henry Paulson, John Snow, Robert Rubin, Phil Gramm- might have seen the rapid run-up as having an endpoint which was not especially attractive. This was a textbook case of positive feedback. The output was changing in response to itself, in the same direction- upwards. The reaction from the tall foreheads was to observe and talk about irrational exuberance and the tendency for free markets to self-regulate! So there was, as Peter Schiff describes it “ a no-doc, no money down, negative amortization, interest only, adjustable rate jumbo mortgage” regime for years.
Of course there were a few dissenters like Nobel laureates Joe Stiglitz and Paul Krugman and reputable economists like Lawrence Kotlikoff, Dean Baker, Mark Weisbrot. Bill Bonner and Addison Wiggins wrote Empire of Debt-The Rise of an Epic Financial Crisis in 2005 and its predictions are eerily accurate. These commentators received no recognition from the mainline media or Congress. Kotlikoff wrote a trenchant paper a few years ago. I emailed him a suggestion that he redo it in simple sentences and put a copy on each congressman’s desk. He wrote back that he and others had done that but “there are no grown-ups down there.” I then asked if he foresaw a repeat of 1929 and he answered “1929 but far worse.”
The positive feedback was apparent and the means to overcome it were readily available. For two years Greenspan kept interest rates at one percent to prevent a recession following 911. This tool could have readily reduced the wild speculation and irresponsible lending. John Snow, Treasury Secretary stated that a housing bubble could not occur because “houses are not like stocks, pork bellies, or gold, and are therefore not prone to bubbles.”
The resale of the sub prime mortgages was facilitated by false ratings by the credit rating agencies, which were in a highly visible conflict of interest. As well, although insurance on the securitized mortgages could not be obtained from regulated insurance companies, the equivalent- credit default swaps- were sold openly by investment banks with the full knowledge of the overseers. So insurance is regulated and monitored but when given a different name it becomes yet another financial instrument and part of the normal free market system. We now know that credit default swaps helped to bring down several investment banks.
There is now a fear amongst consumers and this also has undesirable positive feedback. This fear is reducing consumption since most expect prices to come down. And prices will drop and more businesses fail.
It is also reported that there are as many adjustable rate mortgages as the sub prime volume just seen – about a trillion dollars-coming due next year and 2010 and many of these will be defaulting. So there is the real expectation that house prices will have to decline very significantly once again and the industry is, therefore, a long way from recovering. Positive feedback is at work here also.
All of the recovery projects require enormous amounts of additional state debt. Because, unlike the case during WWII when some domestic savings were available to fund the war, most of the borrowings for these programs must be placed beyond the borders of the US. When the dollar starts to weaken, positive feedback will again become a force to drive it down to a point of collapse. Interest rates and commodity prices will have to rise quickly. Ultimately, prices will also rise and inflation will take over the economy with disastrous effects on pensions, Social Security, and fuel prices.
The bailout of the big banks was deemed necessary because “they were too big to be allowed to fail.” Somehow no one questions why they were allowed to grow to this size if the taxpayer would have to prop them up when trouble arrived.
We are definitely in interesting times.
26 December 2008