March 21, 2008
I HATE MOM! (and the government, too)
My friend and former colleague, Uwe E. Reinhardt, James Madison Professor of Political Economy at the Woodrow Wilson School of Public and International Affairs and the Economics Department of Princeton University, has written the following lovely reflection on the role of the government in the US economy. Its applicability to current discourse in the financial markets throughout the North Atlantic area should be obvious.
Start of Uwe Reinhardt’s guest blog
To provide a proper backdrop for my lecture on “The Government’s Role in the Economy” in Econ 100, I always preface it with the question: “Who in this class has a mother?” In a good year, as many as 25% of the students raise their hand. The rest won’t admit it, because regulating mothers, like regulating government, are the ultimate buzz kills in the human experience.
If enterprising children are out in the yard, researching how hard a snowball can be before breaking a window, who usually kills that experiment? Mom, of course. When, after attending a rock concert, a fully mature 15-year old wants to stay overnight at the Waldorf Astoria with her boyfriend or his girlfriend, who usually kills that enterprising initiative? Mom, of course. Why evolution has not done away with these enterprise-stifling-and-human-development-arresting Moms is an intriguing question. Perhaps they have survived because, when teenagers get into trouble, mothers usually are the source of instant succor. Click on http://www.youtube.com/watch?v=x1fVfcv3vHc, there to see a rugged, All-American teenager accidentally breaking his fish tank with his bar bells and promptly emitting the universal, primeval teenage scream “Mom! Mom!” That is typical for teenagers.
What mothers are to teenagers, government is to the adults who run the private sector of our economy. While teenagers chafe under Mom’s regulations, these free enterprisers sit in their offices, clubs or golf carts, wringing their hands over the mindless regulations issued by politicians and government bureaucrats who “cannot walk and chew gum at the same time.” Yet, like troubled teenagers seeking succor from Mom, when the going gets tough, these same free enterprisers frequently run to the government for instant succor.
Watch, for example, as our investment bankers on Wall Street, a.k.a. Masters of the Universe, now run to our government for help, after the mess they have made of their companies, of our economy and, indeed of global finance. One can cloak what they did in technical jargon such as “under-pricing risk.” One can even write sycophantic apologias on their behalf, as did New York Times columnist David Brooks when he opined that the current calamity on Wall Street is just a byproduct of “financial innovation.” The fact is that what happened on Wall Street was much less innovative than reckless and ill advised (in the vernacular, “stupid.”)
The bankers’ new, new thing was persuading investors around the world (and ultimately themselves) that if dodgy mortgages –technically known as sub prime mortgages –were packaged and repacked several times over, the risk inherent in them would somehow miraculously evaporate. By skillfully marketing that belief, it was possible to suck sheiks in Dubai and town governments as far away as Narvik, Norway into financing millions of dodgy home mortgages in the U.S., extended to borrowers unlikely to make the mortgage payments on them over the longer run.
The foundation of this game was a set of incentives that would have been judged misaligned by any freshman in economics. The dodgy loans were originated by brokers who did not care about the borrowers’ credit worthiness because they were paid commissions simply on bringing the deals to local banks, which then made the loans. The local banks did not care about the borrowers’ credit worthiness either, because they immediately sold the right to the monthly mortgage payments at a profit to the big banks on Wall Street. The latter bought these receivables sight unseen, usually without checking the credit standing of the original mortgagees, because they made their profits by bundling tens of thousands of these dodgy mortgages to resell them the world over as “collateralized debt obligations” (CDOs),” which are rights to the giant but inherently uncertain cash flows from the dodgy mortgages.
In the end, the banks even booked huge profits on repackaging their original CDOs into yet other bundles of CDOs, which were then peddled around the world as well. Evidently believing themselves that thus manure could be made to smell like roses, so to speak, the big banks invested hundreds of billions of their own shareholders’ dollars in these miracle bundles, usually with borrowed funds.
Eventually news penetrated even Wall Street that millions of the dodgy mom-and-pop mortgages would be likely to default unless government came to the rescue. Once that became obvious, the CDOs directly or indirectly based on these mortgages plummeted in value, driving many heavily indebted investors in them to the brink of bankruptcy, among them some of the big banks. And thus we now hear from Wall Street the primeval scream “Mom! Mom!” – with ”Mom” being dutifully played by former Princeton colleague Ben Bernanke of the Fed and, ultimately, the U.S. taxpayer.
Alas, it is a safe bet that a year or so after the federal “Mom” will have brought succor to these swash-buckling free-enterprisers, they once again will sit in their offices, clubs and golf carts, cursing the government and its “mindless regulation.” And therein lies the essential difference between teenagers and the adults on Wall Street. Eventually teenagers learn to appreciate their Moms.
© Uwe E. Reinhardt 2008
Uwe has written a lovely piece, as I would expect. The reason teenagers learn to appreciate their Moms is that, in the end, they grow up and become Moms (or at least Dads). But the swash-buckling free-enterprisers one meets in financial markets never grow up. If they did, they would have to do more than just take a 95 per cent pay cut. They would have to admit that much of what they used to do was not just useless, but dangerous. That is asking too much. So what do they do, instead? They insist that the disaster they caused was an unforeseeable accident, as in “Mom, mom, where did that fishtank come from? It got in the way of my bar bells.”
Posted by: Martin Wolf | March 21st, 2008 at 2:54 pm | Report this commentMr. Buieter, OK decent article, but help us understand in economic terms ways in which this crisis might play itself out; an analogy about our mothers simply won’t do. Tell me, will banks pledging faulty mortgage assets to borrow money keep them liquid for the long run and really prevent runs on their assets or potential collapse? What could be the cost to taxpayers in the U.S. and won’t that be equally detrimental to the dollar? Bernanke must have obtained these ideas to lend money to the financial institutions by pledging questionble assets from somewhere, but has it been done in history? As you previously wrote “contagion” is the reason for intervention, and to some degree it may prevent total collapse. However despite our stock markets recent irrational exuberance a bank “borrowing” money to prevent a fire sale on its assets seems like a bit of foreshadowing. It’s assets are still under tremendous pressure. Homes in my part of the U.S. have lost 30% of their value in the past year and a half. Between banks auction of foreclosed homes and homebuilders slashing prices to unload inventory and generate cash, everyone will suffer. How will banks and individuals overcome these devasting blows to their balance sheets?
Posted by: Brent H. | March 21st, 2008 at 4:40 pm | Report this commentHowever this ugly credit squeeze ultimately plays out, dear old “Mom” is finally in a position to flex some muscle & force some adult judgement on her greedy runaway children of Wall Street.
Aside from the usual educational value that never seems to sink in, if there is an upside to this crisis — hard to imagine with all of the pain & suffering yet to occur on Main Streets everywhere — it is that the i-banks and Wall Street now have no choice but to submit to govt oversight & regulation since they’ve opted to draw so quickly & copiously from the govt money fountain.
In the bigger picture, this crisis, along with the problems in Iraq and broader US domestic un-tranquility, signals the end of the “Reagan Revolution,” the idea that government is bad and only gets in the way of progress & innovation. The students of Reaganomics and neo-conservative foreign policy, firmly in control of the machinery of US government for the recent past, have proven to the world that their philosphy of governance is a complete failure in practice.
It is now time for the wise, collective “Mom” of the American people to gently admonish the children to go back to their homework while the adults once again take over and clean up their world wide mess…
Posted by: harvey reid | March 21st, 2008 at 6:07 pm | Report this commentThe piece should end:
“But this Mom, instead of like the Moms of yore, is behaving just like the ones we see on Jerry Springer”.
But after the show ends and their temporary false teeth have fallen out and they return to the trailers - the show has ended.
Don’t you believe that ? Can an appearance on the Jerry Springer show actually change anything ? Or do you know it but don’t want to alarm the peasants ?
-K
Posted by: sk | March 21st, 2008 at 7:05 pm | Report this commentI don’t think any free enterpriser rejects government involvement. For example, at the most basic level they need the government to enforce property rights. Generally, free enterprisers don’t like the government interfering with the market, but the credit crisis stems not only from the underlying concerns about the value of MBS securities, but also from market illiquidity - a market freeze. It is a proper role of government to ensure that markets continue to work without interfering in the results. Is that too fine a distinction?
Posted by: Nick N. | March 21st, 2008 at 7:57 pm | Report this commentI don’t know about you, but my mom would never have sat down next to me at the black jack table. All along, the government increased their economic power through increased tax revenues derived from Wall Street’s profits. Mom got to expand government and buy more guns by tweaking the interest rates accordingly. Mom is now taking a home equity line out to play a couple more hands along with their partner in crime. I hope Mom wins, but the odds are certainly against her in the long-term.
Posted by: Doug Wolkon - Author of The New Game | March 21st, 2008 at 8:00 pm | Report this comment[…] Buiter, who writes lengthy, dense blog posts on finance, has the more entertaining Uwe Reinhardt guest blogging on the similarities between moms and government regulation. The pay-off: Eventually news penetrated […]
Posted by: Davos Newbies » Blog Archive » Running to mom | March 21st, 2008 at 8:45 pm | Report this commentMr. Brent H. is right. My commentary does not explain how we might get out of the mess into which the i-bankers have pushed us.
Here we must distinguish between insolvency and illiquidity.
Insolvency occurs when a firm’s assets are worth less than its liabilities. With asset-to-equity ratios among investment bankers in excess of 30, it can easily happen. Illiquidity means that there is insufficient cash on hand to meet current cash obligations. When that is widely suspected, it can trigger a classic run on the bank. Some investment banks find themselves momentarily illiquid but, if that could be overcome, would remain solvent. Others are basically insolvent, if not yet illiquid. And some are both.
Ben Bernanke of the Fed has been busily working on the liquidity problem. Knowing him as well as I do, he must be holding his nose doing so — especially as he is forced to forget about inflation for the moment.
In the meantime, the White House (Treasury) and the Congress are likely to work on the solvency issue by pumping subsidies into the mortgage market (disguised as loan guarantees by the FHA). The aim here probably will be not so much to help stricken home owners — the ostensible reason likely to be given for such a move — as compassion for the balance sheets of Wall Street’s bankers, who, we must remember, are major shareholders, so to speak, in the Washington-based businesses called the White House and the Congress. (I may sound cynical here. But I just can’t imagine that a White House that has never shown much compassion for uninsured Americans who go bankrupt over medical bills caused by cancer would have any genuine compassion for low-income homeowners who signed on to dodgy mortgages).
If tax payers can be made to guarantee the mortgage-payment streams of mom-and-pop mortgages, the value of the structured securities based on them is likely to be enhanced even if the lenders had to take a small hair cut on the principal due on the mortgages. On balance, a bail out of homeowners probably would address the solvency problem of the i-banks.
This bailout will cost US taxpayers some money, to be sure, but probably not more and perhaps not even as much as a year’s worth of Iraq, so it is not that big a big deal in the sweep of American things. Since any federal outlay must be financed by borrowing abroad, however,(the net national savings ratio of the US being 0) these added federal outlays may well have a slight negative impact on the value of dollar, but probably not nearly as much as has the loss of confidence abroad in what was once thought to be the great American capitalist model, with virtually omniscient i-bankers at the helm. From being the Masters of the Universe of yore they have morphed into pitiful and pitiable supplicants of sheiks in the Mideast and Communists in China. Mao Dze Dong must be smiling at seeing what he called “capitalist running dogs” repairing now to Beijing, hat in hand.
All told, this too is likely pass somehow. My point in the commentary was that, when the wounds have mended, the swashbuckling free enterprisers who got us into this mess will once again whine that nothing good ever comes from government (I once heard Peter Ueberoth actually say that during an after dinner speech to venture capitalists) — keeping silent only momentarily, when government has to play the shovel brigade once again, cleaning up the do-do left behind by whatever next asset bubble the swashbucklers will concoct. Perhaps it will be credit derivatives or something not yet dreamt about. A good parlor game would be to guess what that next mess will be. It’ll come within the decade.
I can’t disagree with Mr. Nick N. either. Evidently, at this very moment the swashbuckling free enterprisers do, indeed, not reject government involvement in the private sector. On the contrary, they beg for it, as a teenager begs for succor from Mom. As Mr. N. also suggests, however, the free enterprisers normally want to be free to make the very messes that causes government to get involved. Perhaps it is the government’s role to be the shovel brigade behind the private sector — although textbooks in economics never quite put it that way — just like Moms see it as their role to clean up messes left by teenagers.
So it goes.
Posted by: Uwe Reinhardt | March 21st, 2008 at 9:01 pm | Report this commentAlthough it’s easy to see it now, very few people at the time dared question something so innovative and mould breaking. W.S Gilbert had seen it all before when he wrote (as I recall):
If this young man expresses himself in terms too deep for me,
Posted by: Nigel Nicholls | March 21st, 2008 at 9:42 pm | Report this commentThen what a singularly deep young man this deep young man must be.
They mainly thought that the boom in commodities would not end, that there was way enough ressources for china to consume as much as US did.
The end of the story is that we need to recycle a lot more if we want to avoid costly wars on commodities, be it commercial conflict or real wars.
The credit bubble is more an answer from the complex energy, minerals, water and food research.
Posted by: samuel champagne | March 21st, 2008 at 9:49 pm | Report this commentWhen one finds an out of control spoiled brat of a teenager, in my experience, one not uncommonly finds that part of the problem actually comes from the Mom (or indeed Dad.) One familiar pattern is the Mom who scolds and spoils — and in particular, always bails her delinquent offspring out when he or she gets into trouble, and does nothing to curb his or her delusional views of the world. The end result is liable to be that the Mom creates insoluble problems for herself. Because the child has not had to pay the penalty when he or she got into mild trouble, or had its delusions punctured, he or she ends up repeatedly getting into scrapes so serious that the parent simply cannot contemplate the consequences of refusing a bailout. Another familiar element in this scenario is the family friend, or friends, who unavailingly try to warn Mom of the damage she is doing to the child and the rod she is making for her own back before the situation is irreparable.
Part of the beauty of Professor Reinhardt’s most entertaining and illuminating piece, to my mind, is how precisely the role of the Mom who scolds and spoils matches the behaviour of Alan Greenspan since 1996. Having talked of ‘irrational exuberance’, he backed off any serious attempt to do anything about it. He then decided that it was impossible to identify bubbles, as a matter of theory; while confronted by exorbitant values in first the technology sector and then the housing market, he asserted that they were justified by fundamentals. So he both did his best to ensure that his ‘children’ in the markets were cushioned from the effects of their recklessness, and also encouraged them in their illusions.
Among the friends who tried to warn were the Tobin family, whose paterfamilias is dead but has left behind some highly articulate descendants, notably Andrew Smithers; and also the Minsky family, whose paterfamilias is likewise dead, but has left behind a thriving household at the Levy Institute. The Tobins warned Mom — as family friends often do — that her child had become completely delusional. Insofar as capitalism was a competitive system, values of assets could not deviate radically from their replacement costs — and anyone who told you different was a fantasist. Meanwhile, the Minskies pointed out that delusional children are the natural products of having it too easy for too long — the natural end result is that the child either borrows with no realistic hope of repaying or lends with no realistic hope of return.
Of course, the question that was raised by the arguments of these family friends was essentially that of how serious was the trouble into which the child was likely to get. In particular, the argument that central banks should target asset price inflation as well as consumer price inflation is essentially about the balance of risks. But here it would seem the contribution of another family member is — as so often — crucial. As I understand it, the thrust of Ben Bernanke’s Friedmanite reading of the Great Crash and its aftermath is that the policy tools — and specifically monetary policy tools — available to the Fed in 1929 were quite adequate to prevent the bursting of the Twenties asset bubble having catastrophic economic consequences. If one accepts this argument, and believes that it holds valid lessons for the present, the case for targeting asset prices, even if this means a sacrifice of growth, loses traction.
As someone who lacks the economic expertise to judge these arguments with any authority, I am waiting with interest — if some trepidation — to see whether Bernanke’s success in managing the collapse of the housing bubble vindicates his readings of interwar economic history. What does however worry me — to revert to the family analogy — is that although one can find patterns, the differences between different family crises are so great that reliable lessons on how to handle specific situations are often hard to come by. Similarly, policy prescriptions based upon a small sample of financial crises, and inherently unverifiable counterfactual claims, may turn out very misleading.
Posted by: David Habakkuk | March 22nd, 2008 at 10:56 am | Report this commentThe deadly worm in this apple-pie is of course incentive payments. What gave the Banks the idea that incentivising their employees was a Good Idea? Why the free-market neo-classical economists of course. Labour market economists!!!Now there’s another immature bunch: They cling to the belief that rational employees are only ever motivated by greed (or self-interest as they prefer to call it.)? Hence payment by results; hence gross over-selling; hence passing the problems on until later or to someone else.
How about a simple rule for financial operatives: Flat-rate salaries, no incentive bonuses? (No, it won’t happen; bosses to lazy to manage)
Posted by: Conall | March 22nd, 2008 at 12:52 pm | Report this commentAnyone who has worked for the gov’t has surely noticed that the biggest deriders of gov’t make for the worst/most exploitative employees.
I have come to realize that their rants have little to do with concern for efficient governance and everything to do with rationalizing their ability to cheat the taxpayer.
Posted by: HH | March 22nd, 2008 at 1:25 pm | Report this commentWillem & Uwe, Thank you for telling the truth.
Posted by: groucho | March 22nd, 2008 at 1:29 pm | Report this commentIf there is ever a master class in how to present inconvenient truths, Uwe Reinhardt should give it. I shall never be able to recall my economist colleagues in government preaching the virtues of non-regulation without hearing the earnest tones of inexperienced parents talking about how the children need to make their own mistakes.
In practice, these elaborate, rich national households employ tutors and governesses to keep the kids out of the parents hair. After a get-together in Switzerland (a country dear to all good governesses), the central banks devised and pretty well sold to the kids a new book of rules (called Basel II) which makes the big kids responsible for their own risk models, subject only to over-sight by the central banks. A kicker in this is that it gives the central banks the power in future to say, about any type of assets that may look likely to pose a systematic problem, that the governess will think about withdrawing privileges from any kid whose model rates the risk too lightly. That may save quite a few future fish-tanks; provided the governesses do not go back to being fixed in their old ways.
Posted by: David Heigham | March 22nd, 2008 at 5:21 pm | Report this commentThe fundamental flaw in Mr. Buiter’s argument is that he assumes that, by virtue of being elected or appointed to government, one becomes a rational, mature “parental” figure capable of guiding the market
Although it’s not easy to claim to be a free-market capitalist right now, I’ll go ahead and make that claim. It’s about time we cast aside these fears of another Great Depression and just let the market unwind these positions. Sure, the result may be painful, but sooner or later, the government’s current attempt at bailing out the markets will just sow the seeds of the next crisis, the same way that the S&L bailout set the stage for the 1990s tech boom, and the LTCM bailout set the stage for the subprime crisis.
What makes government bureaucrats any more able to regulate an economy? Didn’t the USSR try that? Won’t China’s economy eventually collapse under its own weight? Would these i-bankers have been able to “innovate” so much if we didn’t have the government creating such a huge market for securitizations in the first place (what are Fannie Mae and Freddie Mac other than government attempts to “innovate”)?
Would there have been a credit expansion if we had a hard currency and no fractional reserve banking? Isn’t much of this “innovation” merely an attempt to stretch fractional reserve banking to its limits? Greenspan himself encouraged all this “innovation” while heading what is arguably the government’s biggest intrusion into the financial markets. It seems that “Mom” is always out there bailing everyone out based on some misguided notion of “too [insert adjective here] to fail.” Somewhere along the way, someone corrupted the concept of capitalism to mean privatization of upside and socialization of the downside. All that “Mom” is doing right now is encouraging more of the latter. Was “Mom” out there discouraging any of the subprime lending? Not as long as it was inflating home ownership percentages. Something tells me that in 5 or 10 years, we’ll be hearing complaints from “Mom” again that it is too difficult for the underprivileged to afford a house, and that lenders had better start making cheap credit available to them again. The cycle will repeat itself.
Posted by: KPO\'M | March 22nd, 2008 at 9:21 pm | Report this commentIs there any point that the “Washington-based businesses called the White house and the Congress” also become insolvent? Why do we assume that they will be able to bail us out? Aren’t they the largest debtors in the world? If the government’s borrowers are going bankrupt, then why do we so ignorantly assume that they will avoid a similar fate? Is Hank Paulson not just a Wall Street banker hired to eat and sleep at the White House?
At what point does Mother Nature play a role in all of this - cycling out the huge inefficiencies in our land and labor based Capitalistic model. Is there any possibility that Economic Capitalism is not here to stay and we will see its evolution to Economic Pluralism in the very near future?
Economic Pluralism is based on the infinite utility value of air, water & light and human innovation (entrepreneurial in nature); as opposed to Economic Capitalism which is based on the scarce utility value of land and labor TIME. The science of Economic Capitalism is based on getting more and more utility value out of less and less natural resources as land rent and labor wages grow proportionately until they run out of scarce land to feed, clothe and shelter the labor, naturally forcing an economic cycle.
In a more competitive Pluralistic Economy, Mini-stock markets reign over Monopolistic Stock Markets allowing for true investment diversification of geography, labor and industry; naturally stabilizing otherwise inflationary rent and wage expense increases, and inevitably producing secured dividends consistent with Leon Walrus’ “Desired Cash Balance” in his Final Equilibrium model.
Mom knows best when to cut the umbilical cord, and in the end, renewable energy (“Earned” Energy as opposed to “Borrowed” Energy) securities naturally become the new Treasuries. Mom’s all over the world start to teach their children to own their own energy based on their survival-of-the-fittest instincts; rather than government “Treasuries”, which become as valued as the paper their written on.
Posted by: Doug Wolkon - Author of The New Game | March 22nd, 2008 at 10:14 pm | Report this commentAs though any mature adult could watch the antics of politicians and listen to their rhetoric and believe them to be anything other than children.
And let’s all ignore the role of government in this bubble, while we’re at it. How the government anointed ratings firms stamped AAA ratings on bonds that never deserved it.
Or, how the government, Republicans and Democrats alike, pushed banks and other lenders to loosen their standards so the poor could ‘qualify’ for home loans.
Or, how the Fed lowered the short term interest rates to absurdly low rates as SIV’s pumped short-term cash into long-term bonds. And then raised the rates and popped the bubble.
But no, it’s all the market’s fault. Of course it is, like the children they are you can’t expect politicians and bureaucrats to accept responsibility.
And with their typical political spin we’re told lenders need to be regulated to keep them from making unprofitable loans to people who can’t pay them back.
Yawn.
Posted by: Marcus | March 22nd, 2008 at 11:52 pm | Report this commentMarcus,
I beg your pardon?
‘Government anointed rating firms’ - You mean licensed as competent in a ‘market’ proven to be full of dodgy operators who will pedal companies to their cients whilst privately dismissing those companies as trash.
‘how the government, republican and democrat alike pushed banks and other lenders to loosen their standards…’ - As if the titans of commerce were unable to push back in the new globalised world where the market is king and government’s influence is inexorably on the wane. Doubtless your book shelves are full of tomes that will remind you of that ‘fact’ central to the creed of the radical free-marketeer.
Your apparent point that the poor helpless bankers were arm twisted by bullying politicians into participating in their crazed and dangerous social engineering programs is wrong on so many levels.
The current generation of financial sector leaders believes it has the right to privatise all profit and nationalise all risk, building a house of cards that government must prop up in order to prevent wider social and economic unravelling. Greater regulation and transparency of loans instruments have to be the results of this bank engineered debacle.
Posted by: Andrew Bramley | March 23rd, 2008 at 10:57 am | Report this comment“Greater regulation and transparency of loans instruments have to be the results of this bank engineered debacle.”
Andrew, the civilian market could perform it’s coordination to a much higher degree if the bureaucrats would leave the markets to run themselves.
Most countries are running a dual economy. One for the state(military, state holdings and basic infrastructure) and one for the civilian/household sector. An argument can be made for the apparatchik to be involved in the state’s industries but certainly not in the household sectors.
The reason the state always bailout the bankers is very simple. It is the banking systems job to BUY/SELL the govt debt. A failed banking system would force the Treasury to be a market maker directly with the CB. (the 3 card monte game would be exposed)
Bailouts are the breeding ground of not only moral hazard but are the seed kernel for the tragedy of the commons fiascos that we are currently witnessing.(global warming, rising lifetime shelter expenses per household, etc.)
At the least, policymakers should follow Martin’s maxim of “leaning against the wind”. Which seems to be the current ECB and BIS motto as well. Greenspan’s(and company) wall st/pro-cyclical game with taxpayer bailout is clearly a failed policy.
Posted by: groucho | March 23rd, 2008 at 12:53 pm | Report this commentWhich “Sheiks [sic] in Dubai” bought the sub-prime toxic waste? Last I checked few banks in the Middle East (and none in Dubai) were affected by this episode.
While it would be more comfortable to believe that everyone was blind-sided by this problem, the uncomfortable fact is that the sub-prime fall-out has mainly affected those institutions that thought they had the monopoly on good risk management, those that were stuck with high growth budgets in low growth economies and those that believed their own hype.
Posted by: Ian | March 23rd, 2008 at 1:23 pm | Report this commentAndrew,
Ask yourself, why today does anyone gives a flying hoot about the ratings from S&P and Moody’s? Because the SEC requires them too. The SEC obligates money markets and other funds to hold only NRSRO rated bonds and licensing requirements have effectively limited that to S&P and Moody’s. They are incumbent companies protected by government regulations.
Those regulations make for a lack of diversification in the market.
What’s wrong on so many levels and is, in fact, laughable is Buiter’s mindless yet romantic notion that somehow only mature, honorable adults are attracted to government.
The 1997 Tax Relief Act, the 2003 American Dream Downpayment Initiative, deductibility of mortgage interest, the money pumped into the market through Fannie Mae the list goes on and on. The government was actively complicit in this bubble through out its entirety.
Posted by: Marcus | March 23rd, 2008 at 4:26 pm | Report this commentThe following comment is from Brian Davey. It focuses on ways of solving the current financial crisis.
Current discussions about the banking and financial crisis are circling round and round the dilemma of what is called “moral hazard” - if the banks are bailed out then will they re-create the same crisis? So should they be regulated more? Various participants in this discussion either accept or reject the idea that banks and a wider network of financial institutions should be bailed out and either accept or reject the necessary complement to that idea - that these banks and other financial institutions will need to be regulated more tightly - or at least have accept more state intervention in their operation.
Posted by: Willem Buiter | March 26th, 2008 at 11:51 pm | Report this commentWhat this entire discourse fails to acknowledge is that the complexity of the financial markets arose to a large degree as a way of financial institutions finding their way around regulations. Thus, if it is the complexity of the market that has made it opaque and unmanageable, then a proposal to do more of the same - pump in more liquidity to bail the financial institutions out and have more regulation - is more of the same and will make the situation worse not better.
Various proposals, like those of Martin Wolf, who opines in the Financial Times that bankers’ income should be tied to their long term achievements and not to short run gains, would be up against the same problem. I would like to see Mr Wolf draw up the terms of such a scheme without financiers experiencing it at some future point as a bureaucratic constraint that smart city lawyers would be hired to “innovate” their way round and get paid a high sum to do so. It will merely add a further level of complexity on the Jenga Tower of world finance.
This way of thinking about finance is stuck on the horns of a dilemma. Is there a way out? I don’t think so. Sometimes things are as bad as they seem and cannot be fixed. Behind the “Minsky cycle” of alternating financial euphoria and market panic there is a bigger cycle , let us call it a complexity cycle, in which, at the present time, decreasing returns to increased complexity has reached a point that can only lead to collapse of the financial system. (And then, we must hope, a simpler but functioning system). The marginal productivity of further financial complexity is now negative. “Marginal productivity” here means additional benefit with a further step of a process like financial innovation.
What on earth do I mean by these obscure jargon words?
In 1988 an archeologist called Joseph Tainter wrote a book called ‘The Collapse of Complex Societies’ which is still in print, the fourteenth printing being in 2005, because it appears to have lost none of its relevance. The central thesis of the book is that societies collapse because, as they try to solve their problems, they do so by investing more and more in complex socio-political organisation. What then happens is that the additional benefits arsing in this process are less and less, while the costs go up and up. This is described in the jargon of economics - the marginal productivity of investing in complexity declines and at some point becomes negative. When it becomes negative further complexity makes things worse not better.
Those who are aware of the collapse of the Western Roman Empire probably immediately think of the barbarian invasions as its ’cause’. However, Tainter would describe these invasions as “stress surges”. Apart from wars and invasions, other ’stress surges’ would be things like disease pandemics (the plague), and climatic change producing crop failure. In the financial world a stress surge happens, for example, when it is discovered that too much finance has been lent out and a chain or domino effect of bankrupticies is threatened.
Tainter is at pains to argue that ’stress surges’ do not in and of themselves provide the reasons why complex societies collapse - one typically finds that in the decades or centuries before the collapse ’stress surges’ of equal, or even greater magnitude, have occurred and the society has withstood them. What is important is to understand why the final stress surge, the one that brings down a society, does not produce the necessary robust coping response which the society had displayed in earlier crises. In his analysis it is because the society is managed in too complex a way.
In my view this provides a useful way of looking at the current financial crisis. Clearly there have been here lots of financial “stress surges” in economic history. However, the growing panic in the current situation arises from the realisation that this crisis is different because it is taking places against the backdrop of a waves of complex globalised financial innovations which are now showing themselves to be fatally flawed.
In its original meaning “credit” is derived from the Latin and means to believe or to trust and arose in relationships in which lender and borrower knew each other. The banks manager took a direct interest in the management of the finances of debtors. A wave of financial innovations put paid to all of that. At the end of decades of computerised telecommunications it apparently became possible to do finance in a completely depersonalised way through securitisation and the securities, bundles of financial obligations, could be sliced and diced and traded anywhere in the world. In this kind of financial environment safety came, apparently, in yet more clever innovation - a whole series of arrangements whereby one group would sell reassurance in through the credit ratings that they gave to products or through insurance against default - i.e. but the fancy word “insurance” here was really accepting payment in a bet that things would not go wrong.
These de-personal arrangements were then made between market traders at screens who neither knew or cared about the people who were ultimately carrying the debt. They merely wanted fees to spread their innovatory rubbish across the whole world through the magic of the internet. The local personal knowledge had disappeared. Now that this entire pack of cards is collapsing the financiers are in terror and running round in circles wanting the state, that means everyone else, to bail them out, and reluctantly talking about accepting more regulation. What Tainter would call a stress surge has hit the complex structure and it is falling like a pack of cards….. …..or more accurately it is falling in slow motion because there is total uncertainty how big market losses are, or will be.
In the triumphalism of market economics prices can and should be able to tell you everything that you could possibly want to know. That means that the assets of the banks should be, in the jargon, “marked to market” - it should be possible to know what they would bring, in cash, if sold. The idea perfectly expresses the ideology and mind set of the economic thinking that produced securitisation and de-personalised debt relations. Before this new world debt relations were typically managed, long-term, in a relationship where the lender had some trust that they would get paid back because they knew what the lenders financial situation was and in any case they had some flexibility about waiting for payment.
This kind of relationship banking is the sort of model for Captain Mainwaring in the comedy series “Dad’s Army” - pompous perhaps, but having an intimate knowledge of local bank customers and borrowers like the butcher, the undertaker and so on. This was not at all the kind of banking based on making calculations about the known probability that one can turn the debt owed by strangers on another continent into a specific quantity of cash in a liquid market at specific point in time provided by calculations on a computer screen because a rating agency had said so and because it was insured with a credit default arrangement.
When debt is created in relationships where borrower and lender know each other and each other’s situation this is to a degree manageable as long as economic conditions are expansionary. (Which they are unlikely to continue to be after oil peak). However, where debt is packaged as IOUs between strangers and spread across the entire world it is quite impossible to sustain once doubt is thrown up as to whether the borrower will pay up or not - accounting has to be done on quantified performance criteria and administered by specialist deparments. The added complexity here has proved incapable to debt management simply because it has no way of working with debts that are not brought to market and, indeed, if they are brough to market for sale the value of the financial assets would thereby be dragged down.
What we have, in consquence is that the banks and financial institutions have quite literally “dis-credited” themselves. Their financial innovations took place at a level of centralisation and globalisation that added complexity but on deeper inspection was a relinquishment of the basis on which borrower debtor relationships are possible in any economy.
Money was earned on fees and bonuses in which the more people you got into debt in the here and now the more your short term bonuses - and these debts were then sold on to others. The bank managers regarded finance as a mere technical operation and did not even recognise that they had innovated away the very basis of their operations by abolishing the trust relationship.
This is not something that can be put back together again - like Humpty Dumpty the great fall of the banks is a terminal process. More regulation would make it worse. What regulation involves, after all, is greater complexity. Complex regulations rarely make things safer because what they add is yet complication - and fraud and sharp dealing is typically hidden in the thickets of complications and red tape. Things become so complicated that an information gap opens up in which those in the know are frequently able to prey on those with less knowledge. (Information assymetry can include poisonous dangerous interrelationship between falling ethics and rising amounts of red tape).
All of this means that we will have to put the monetary system back together again, in a much more simple form and it is difficult to see the existing bankers playing much of a role with us. It is difficult to believe that the local relationship banking relationships or that trust could be re-created and the clock rolled back.
The trust in the financial system is plummeting and so it should. Not long ago a Professor of Organisational Ethics at the Cass Business School, Roger Steare, undertook integrity tests on more than 700 financial services executives in several major firms and came to the conclusion that “There is a systemic deficit in ethical values within the banking industry. This will not change by hanging a few people out to dry,” says Professor Steare. The results of these tests indicate that as a group, they score lower than average in honesty, loyalty and self-discipline, he said. He compared traders to “mercenary hired guns”, who regularly switch firms to maximise earnings. http://news.bbc.co.uk/1/hi/business/7207563.stm .
Thus there is a certain amount of karma in the fact that we are getting nearer and nearer to the point where the financial system slips into Professor Avi Persaud calls a “liquidity black hole” . Usually if the price of something falls there are less sellers and more buyers appear so that the market comes back into equlibrium. However, if we are talking about financial assets then, in a “liquidity black hole” the very opposite happens. As the price of financial assets fall their holders get in a panic and sell them lest the price falls even further - so there are more sellers - and, correspondingly, buyers become more and more reluctant to enter the market. The losers in a liquidity black hole are the people who sell last.
If the banking and financial system does collapse in this way - and it is not impossible - this not mean that nothing can be done. But it does mean that we will have to start again with a radically different and much simpler approach to finance. In this simple approach to finance we need to recognise that the money system is a social institution that we all depend upon for exchange transactions and so it should be managed in the interests of everyone.
When one wants to manage things for the common good, rather than for private gain, one establishes trusts to manage them. In the case of a money system trust the trustees would be given a legal duty to manage the money system in the interest of all equally. If they failed to work within those legal rules they could be challenged in the courts. That would mean that if there is money to be created that it should be distributed to everyone equally. This is an important principle.
A key aspect of money creation is seignorage - someone gets the benefits of the initial creation of money and do not have to sell anything or work to receive the purchasing power. Banks get the seignorage when they create debt money and they create too much for everyone’s interests and then have to be rescued. They should lose this right. We should all share the seignorage. A money creation trust responsible to us all would distribute any more money directly to us all equally.
This, I may say, would be more socially just than dropping money from helicopters over the financial districts. (’Dropping money from helicopters’ is the metaphor used frequently by economists to describe getting money to people to spend in order to prevent an economy falling into a depression or recession). Some people may think that money should be created by the state and spent into circulation.
However we have seen in recent years that the state is in the hands of the financiers, the energy barons and the military-security and armaments apparatus and have dis-credited themselves too. While the increased complexity is key to explaining the current banking crisis it is not the whole story. Another part of the story is the abuse of debt finance by the governments to fund their military and other adventures.
A winner of the Nobel prize for economics, Joseph Stiglitz working with Linda Bilmes has been working out the math on the cost of US (and UK) military adventures and comes to the conclusion that these could be as much as $3trillion in the long term - $25,000 for every household in the US. In a $13 trillion economy this is a huge sum. The huge military expenditures of the US have only been possible because the US government has been able to abuse the financial power of the US government. This has inflated the government deficit which has been borrowed by flooding the world with dollars. In the UK our own government is looking to spend over £3 billion this year which does not help the already strained finances here either. Stiglitz and Bilmes see a direct connection between the credit crisis and the enormour bill for the Iraq war. http://www.washingtonpost.com/wp-dyn/content/article/2008/03/07/AR2008030702846.html.
The idea of giving back to the state and away from banks the ability to create money therefore lacks credi(t)ability. Governments have told us for years that monetary policy is too important to be controlled directly by the government itself and handed this over to bankers. Now the bankers have shown they cannot be trusted and are dis-credited too. So does this mean it should be handed back to the state? Hardly - the principle of independence of the monetary authorities from the state is a good one - but to prevent money creation being a lawless and chaotic process a social organisation must be created with responsibility to somewhere to manage the money system in the interests of all.
There is no other alternative then but to make this a trustee system whose terms of reference - can be defended in the courts. The crisis of the money system is a crisis of trust of the banks. We are told continually in the newspapers that the banks do not trust each other having sold each other financial junk. So why should citizen’s trust the banks? And if we cannot trust them then how much more appropriate can you get than to re-establish the money system than by running it by a Trust with a duty to manage money in the interests of everyone? How will we get there?
We cannot expect the existing powers-that-be to bring such a system into existence, at least not at the moment. At some point there will be a need for a comprehensive reform package of the type described here but it will take time and effort to build a political movement for it.
In the meantime the gradual breakdown of the financial system, as its nears the edge of the liquidity black hole, will mean that responsible citizens are likely to have but to try to improvise their own currency and exchange systems to bridge a period of turbulence and chaos - if possible with the support of local authorities. The precedent for doing this can be found elsewhere - e.g. the provincial currencies of Argentina in the banking crisis there of a few years ago. At one time these created nearly 16% of Argentinias money supply. Thus a popular movement to help people re-create vital local exchange relationships in desperate times will help to create the expertise, the networks and the mass understanding for the re-establishment of a new simpler national financial system to be run in the interests of all.
[…] of writing by Uwe Reinhardt. In some ways it is a a sequel to his earlier piece on this blog “I hate mom (and the government too)”, but it also stands very well on its own. This article was first published in The Daily […]
Posted by: FT.com | Willem Buiter’s Maverecon | Bankers and Patriots | June 20th, 2008 at 9:51 pm | Report this comment