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The USA *after* this financial crisis – part 2, a new economy for America

14 October 2008

As this economic earthquake continues shaking the world, we can only guess at the results.  What effects from this will ripple into the future?  This post considers only what might happen, not if these changes are good or bad for America.

This is speculation about the unknowable, to help us understand the magnitude of these events and open our imaginations to the possibility of extreme outcomes.  This series considers the following ways in which the crisis will have large and long-reaching effects.  (note the links to other chapters in the series)

  1. Political realignment in the US — dominance of the Democratic Party for a generation or more.
  2. Economic structure — a massive increase of government power, a slower growing but more stable economy.
  3. Oil prices and supply — lower prices followed by far higher prices, perhaps government ownership.

This post discusses #2:  the changes to the structure of America’s economy.  There will be a recession, probably a global one.  How will it change America?

  1. A smaller role for the free markets
  2. Greater government control over the economy
  3. Higher taxes
  4. Less reliance on foreign money

The result:  a more stable economy.  It will grow more slowly, and have much less social mobility.  The rich will find this trade-off quite congenial.  Everyone else must accept it.

The changes might be larger than this, but space and time limitations prevent exploring them in this post.  Just to mention one:  an end to disintermediation, a return to when household investments were channeled into financial institutions which in turn allocated long-term capital to the economy.

1.  Less role for the free market

The past two decades have seen one financial crisis after another.  The late 1980’s rise and crash of the US dollar.  The 1987 stock market crash.  The commercial real estate bust in the early 1990’s, the collapse of the S&L industry, and a recession.  The tech bust in 2001, collapse of capital spending, and a recession. 

And now this, the biggest bust since the 1930’s.  Ten years of stock gains vaporized.  Public and private pension funds devastated.  The financial sector crippled, requiring hundreds of billions of dollars of public money to recharge.

I think people will say “enough.”  The risk of relying on free market systems is too great, the resulting volatility more than we can bear.  Whether this is correct or not I leave for God to decide; but the American public must decide relying on our own judgment.  Brad Delong (Professor of Economics, Berkeley) may have anticipated their decision (source):

I don’t believe that after this the price of risk will ever again become a free-market price, just as after the Great Depression the short-term price of liquidity — the short term interest rate — ever became a free-market price. The federal government, in one form or another, is going to be in the business of insuring debt securities against steep declines in value. Securities that are not so insured will simply not be traded. What Fannie Mae did for “conforming” home loans, the Treasury or some other government agency will do for derivative securities. It will offer insurance, charge for that insurance, and supervise and oversee financiers much more strictly.

2.  Greater government control over the economy

This means not just greater regulation of the economy.  The government has taken over some of our leading financial institutions, and will take a piece of many more.  It will not quickly release what it has taken.  Furthermore, the #1 public policy objective of the Democratic Party is to nationalize our health care sector.  The opposition to this has already weakened, and their large majority in the next Congress will make this inevitable.  So aprox another 20% of the US economy will pass into government control.

This may be a tipping point for the delicate public-private balance of the United States, in which the government becomes not just the dominant actor in the American polity, but the controlling one.  After which all other power centers must accommodate themselves to a subservient position, as power centers in France did with respect to the French monarchy during the reign of Louis 14th.

3.  Higher taxes

Consider the cost.  Our massive military spending, our foreign wars, the bailouts of financial institutions, the massive fiscal stimulus, and national heathcare.  How will we pay for this?  The Democratic Party is quite clear on this:  higher taxes on the rich and those with large capital gains (overlapping but not identical groups).

During the New Deal the top marginal tax bracket for individuals went from 20% to 80%.

4.  Less reliance on foreign money

The Latin American debt crisises in the 1980’s.  The 1997-98 collapse of the emerging markets and their severe recessions.  The many country-specific crisises (e.g., Argentina in 2001).  And now, the massive disruption of otherwise health nations by withdrawals of “hot” foreign money after the US and EU financial sector crisis.

The lesson will at last be learned that dependence on liquid flows of foreign capital is perilous.  Either do without, or stick to the recipe of the pre-WWI era.  America was built with foreign capital, but mostly illiquid investments.  It’s difficult for foreigners to repossess and take home railroads, canals, and cattle.  Much of the global financial apparatus exists to “recycle” hot flows of money, and will be rendered unnecessary by this change.

If the current events do not spark this change, eventually the greatest casualty of them all will convince everybody of the folly of relying on flows of mobile cash:  the United States.  Adicted to cheap foreign loans, the withdrawal process will be painful.  Already abandoned by foreign private capital, today we rely on the support of a small number of foreign governments.  In the next year or two will we ask them to loan us trillions of dollars.  The result will might be the Master Settlement of 2009, which will change the shape of the world order.

For other perspectives on this

The End Of American Capitalism?“, Anthony Faiola, Washington Post, 10 October 2008 — Excerpt:

The worst financial crisis since the Great Depression is claiming another casualty: American-style capitalism. … Given that the United States has held itself up as a global economic model, the change could shift the balance of how governments around the globe conduct free enterprise. Over the past three decades, the United States led the crusade to persuade much of the world, especially developing countries, to lift the heavy hand of government from finance and industry.

But the hands-off brand of capitalism in the United States is now being blamed for the easy credit that sickened the housing market and allowed a freewheeling Wall Street to create a pool of toxic investments that has infected the global financial system. Heavy intervention by the government, critics say, is further robbing Washington of the moral authority to spread the gospel of laissez-faire capitalism.

The Commodities Market Bubble: Money Manager Capitalism and the Financialization of Commodities“, L. Randall Wray, Levy Institute, October 2008 — Abstract:

Money manager capitalism—characterized by highly leveraged funds seeking maximum returns in an environment that systematically underprices risk — has resulted in a series of boom-and-bust cycles in equities, real estate, and commodities. Because subsequent cycles have been increasingly damaging to the broader economy, we are now at the point where we are experiencing the most severe financial crisis since the Great Depression. Hasty interventions (bailouts) by Congress, the Treasury, and the Federal Reserve are attempting to keep the financial industry solvent, in the belief that government inaction would result in a prolonged recession. \

In this new public policy brief, Senior Scholar L. Randall Wray shows how money manager capitalism (financialization) has destabilized one asset class after another. He concludes that policymakers must fundamentally change the structure of our economic system, break the cycle of booms and busts, and reduce the influence of managed money—as well as prevent the next speculative boom in yet another asset class.

Afterword

If you are new to this site, please glance at the archives below.  You may find answers to your questions in these, such as the causes of the present crisis.  I have been writing about these events for several years; since November 2007 on this site.  As you will see explained in these posts, the magnitude of the events now happening is beyond what most Americans have — or can — imagine.

Please share your comments by posting below.  Please make them brief (250 words max), civil, and relevant to this post.  Or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).

For more information about these things

What can we do to fight this crisis?  See A solution to our financial crisis.

To read other articles about these things, see the FM reference page on the right side menu bar.  Of esp interest these days:

A few posts about America – how can we reform it?

  1. Forecast: Death of the American Constitution, 4 July 2006
  2. Diagnosing the Eagle, Chapter III – reclaiming the Constitution, 3 January 2008
  3. A report card for the Republic: are we still capable of self-government?, 3 July 2008
  4. Americans, now a subservient people (listen to the Founders sigh in disappointment), 20 July 2008
  5. de Tocqueville warns us not to become weak and servile, 21 July 2008
  6. A soft despotism for America?, 22 July 2008
  7. The American spirit speaks: “Baa, Baa, Baa”, 5 August 2008
  8. We’re Americans, hear us yell: “baa, baa, baa”, 6 August 2008
  9. Obama describes the first step to America’s renewal, 8 August 2008
  10. Let’s look at America in the mirror, the first step to reform, 14 August 2008
  11. Fixing America: elections, revolt, or passivity?, 16 August 2008
  12. Fixing American: taking responsibility is the first step, 17 August 2008
  13. Fixing America: solutions — elections, revolt, passivity, 18 August 2008
  14. The intelligentsia takes easy steps to abandoning America, 19 August 2008
  15. Another step away from our Constitutional system, with applause, 19 September 2008
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21 Comments leave one →
  1. Nicholas Weaver permalink
    14 October 2008 4:01 am

    I actually think the rich and the hyperrich will have a divergent experience:

    The well to do ($150K+/year household income) and the conventional rich ($250K+/year household income) will benefit from a more ordered stability.

    The financially-derived rich and hyper-rich, however, are probably going to suffer, esp if Obama wins, as the price of the federal backstop on the financial markets will undoubtedly include some hits on “excessive” compensation, especially attempts to tie compensation to the LONG term health of the company: which not only cuts the compensation but limits somewhat the ability of “heads I win, tales you lose” bets in the effect on compensation.

    At the same time, the financially-derived rich and hyper-rich are going to be the ones most hurt by the more realistic pricing of risk. Risk in loans for credit cards, car loans, CONFORMING mortgages, small business loans, etc, were not underpriced. Risk was underpriced really only in the financial market (including the commercial paper and interbank lending), and in a direct conduit with securitization, in the non-conforming mortgage market.

    Without the access to super-cheap money (eg, LIBOR at Treasuries + .5%, rather than Treasuries + 4.5%), they lose the ability to use leverage to create much larger bets (and bets which are combined with “heads I win, tales you lose” comensation regigms), significantly limiting their effectiveness.

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  2. mclaren permalink
    14 October 2008 7:21 am

    What worries me is Nassim Nicholas Taleb’s contention that in the peculiar statistical realm of “extremistan” (which he claims characterizes financial markets), risk cannot be accurately modeled.

    “Globalization creates interlocking fragility, while reducing volatility and giving the appearance of stability. In other words it creates devastating Black Swans. We have never lived before under the threat of a global collapse. Financial Institutions have been merging into a smaller number of very large banks. Almost all banks are interrelated. So the financial ecology is swelling into gigantic, incestuous, bureaucratic banks – when one fails, they all fall. The increased concentration among banks seems to have the effect of making financial crisis less likely, but when they happen they are more global in scale and hit us very hard. We have moved from a diversified ecology of small banks, with varied lending policies, to a more homogeneous framework of firms that all resemble one another. True, we now have fewer failures, but when they occur ….I shiver at the thought.” [Nassim Taleb, The Black Swan, 2006]

    Even with extreme government control of financial markets, can we eliminate boom and bust cycles from the global economy? 19th century economists like Mill accepted these kinds of cycles as part of the basic financial fabric. Increasing amounts of post-1930 government regulation don’t seem to have alleviated the boom-and-bust cycles. Humans, being ingenious, seem to find ever subtler ways of leveraging assets and destabilizing the financial system. I wonder if trying to get rid of boom-and-bust cycles entirely isn’t an ignis fatuus, like trying to get rid of corruption in politics…?

    Also — what’s your take on globalization? Will it grind to a halt? Continue in modified form? Or go into hyperdrive?

    I ask because Niall Ferguson wrote a provocative and prescient article “Sinking Globalization” in which he predicted the crack-up of globalization due to a monteary crisis, as occurred at the start of WW I in 1914 (and I quote — a remarkable passage from 4 years ago!):

    Today, no one can be sure how stable the international monetary system is, but one thing is certain: it is no more stable than the system that preceded World War I. Although gold is no longer the basis of the monetary system, there are pegged exchange rates, just as there were in 1914. In Europe, there is a monetary union–essentially a deutsche mark zone. In eastern Asia, there is a dollar standard. Both systems, however, are based on fiat currencies. Unlike before 1914, the core central banks in New York and Frankfurt determine the volume of currency produced, and they do so on the basis of an opaque mixture of rules and discretion.

    “Sinking Globalization,” Foreign Affairs, 2004.

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  3. seneca permalink
    14 October 2008 2:27 pm

    David Brooks makes exactly the same argument in the NY Times this morning (“Big Government Ahead“). I hope you don’t mind the company.

    I find it odd to consider health care as primarily an economic activity, although it certainly costs a lot. How many of us think of ourselves as “consumers” of healthcare, and doctors as entrepreneurs in a market where profit is the main motive?

    Some people believe health care, or health, is a natural human right, like liberty and happiness. I at least think it’s something the community provides to its members as part of the social compact, like water and power, and protection of property. So public regulation and public support of it seems natural, not threatening, as you imply in warning against a coming “nationalization”.
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    Fabius Maximus replies: Should all essential services be part of the government? Production and distribution of food, power, water, sewage, medical care, financial services, transportation, protection, education (pirmary thru advanced)? What’s left? Entertainment, consumer services, mining, and industry, a few other odds and ends. We’re moving toward such a state.

    In a state like this not only is the government by far the most powerful decisions, allocating most of society’s resources, a large fraction of the society’s decision-making will be done by the government — be politicized. Talent will be channeled into the government, since the big rewards will be there. And there will be big rewards — one way or another — for those at the top of the machinery controlling so much of society.

    I doubt our Constitutional regime can withstand the added stress of operating a system so unlike the Founders design. The concept of liberty loses most of its force in a state where power is so concentrated in one “node.” For more about this see the articles in “America – how can we reform it?“.

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  4. 14 October 2008 3:22 pm

    The Democratic Party is quite clear on this: higher taxes on the rich and those with large capital gains (overlapping but not identical groups).

    Well, Sen. Obama was also quite clear in one of his ‘great’ speeches — how he could no more disown Rev. Wright after 20 years than he could his own grandmother.
    Which lasted only until Rev. Wright went to a National Press conference and repeated his same, anti-whitey, anti-American blacks are victims and only victims spiel … and Obama disowned him.

    While I fear the coming concentration of power, I’m pretty sure when tax bills come due there will have been included plenty of loopholes to keep the actual taxes paid almost competetive with lower tax regimes in Europe and the world.

    Funny how the lies, er, likely broken promises of the Dems is actually somewhat comforting in a resigned sort of way.

    And the Big Bailout/ crisis provides an easy excuse for breaking any ‘(read my lips?) tax the rich (till they squeal)’ promises.

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  5. Nicholas Weaver permalink
    14 October 2008 3:29 pm

    I actually hope that the banking system will be reprivatised over the next 5 years, but in return for the government backstop, is forced to be far more transparent.

    EG: ANY financial instrument worth a notional $10M or more involving a public company or subsidiary or controlled interest of a public company (eg, SIVs) must be published (this way, we would have seen the CDS chaining etc).

    And regulation for banks and insurance companies which describes BEHAVIOR which brings the companies under the regulatory framework, rather then the simple opt-in in the current system.

    And I think that is what will happen, as that is how similar crises have played out in the past.
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    Fabius Maximus replies: There have been no financial events in modern financial history (since WWI) of this scale, with global near-failure (hence bailout) of so many of the largest financial institutions. I suggest not drawing too strongly on historical precedents. Nor is this cycle over; wer may still be in the early innings.

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  6. seneca permalink
    14 October 2008 3:58 pm

    “Fabius Maximus replies: Should all essential services be part of the government? Production and distribution of food, power, water, sewage, medical care, financial services, transportation, protection, education (pirmary thru advanced)? What’s left? Entertainment, consumer services, mining, and industry, a few other odds and ends. We’re moving toward such a state.”

    Look at this list carefully: food production is already under the control of megabusiness. Is that desirable? Power in Californi was recently under the control of Enron. State government was complicit. Was that good? Water is provided by private entities carefully regulated and publically accountable, though subject to ordinary lobbying by special interests. Seems imperfect but ok. Education is already controlled by distant state governments — a dismal condition, which local communities should fight to correct. In other words, your list is a mixed bag, somewhat incoherent. And the threat of government takeover is mitigated by budgetary realities. Government services, at all levels, and including essential ones like police and fire, may actually decline in the recessionary economy. There will be lots of opportunities for revival of local self-government.
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    Fabius Maximus replies: I do not understand your point. Are you saying these should be agencies of Heaven? Corruption and error are inevitable occurances in any system run by mortals.

    My point was far more simple: concentration of power. Now we have competing power centers, which allows room — or at least potential — for freedom between them. That is the essence of our current system, not just division of powers between state and federal, between the 3 branches, but in society as a whole.

    You seem to advocate concentrating power into one entity, and you believe will still provide the benefits of our system: a high degree of individual freedom, a government more-or-less responsive to the people, and a high degree of social mobility. I consider this unrealistic in the extreme, with little basis in history.

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  7. houswife permalink
    14 October 2008 4:47 pm

    The German Government (right-left coalition, second economic power behind the US) put two sweeteners for the people in the bailout plan(13.october.08):

    1. The Financial industry will be obliged to look for a good return on saving accounts.(Saving preferred to big capital).

    2.Managers may not be paid over 300.000$ a year, with bonus, severance payments not allowed at all.

    Implies, big losses coming in the bail-out.

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  8. Nicholas Weaver permalink
    14 October 2008 4:53 pm

    There have, however, been regional crises with the same theme: notably Sweeden and Japan.

    In fact, one of the big worries from DeLong is the type of stock the Treasury is purchasing as being one which can create the “zombie bank” situation of Japan, where you had “insolvent but not dead” institutions who’s incentive becomes one to keep/extend “zombie loans” in the hopes of getting back to solvency because acknowledging the losses would mean the bank is no longer solvent.

    High level background reading on Sweden:
    The Zombie problem in Japan:

    So in the past 15 years, we’ve had two nation-scale banking collapses fueled by speculative land/market bubbles, one in Japan and one in Sweden.
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    Fabius Maximus replies: Both apt analogies. Sweden’s handling of the situation is widely considered a model for us to follow, Japan’s a model to avoid.

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  9. Nicholas Weaver permalink
    14 October 2008 7:40 pm

    The concern about zombie banks is starting to grow: Brad DeLong, Felix Salmon, and Brad Setzer are all concerned that by being nonvoting shares yet a senior equity infusion, this can only encourage any bad banks to “double down”: keep the bad debt on the books rather than write it down, and make risky-loans with the government infusion.

    This, if it happens, could string things out further.

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  10. Erasmus permalink
    14 October 2008 8:40 pm

    There is a huge, important difference between govt regulation and control. The current Democratic health care initiatives are nowhere near being a government-run or single-payer system ( which works very well in those countries which, not co-incidentally, also have the best health care like France & Italy). What most others have is a hybrid form that includes legislation that guarantees universal coverage and yet allows for private sector competition in providing insurance, medicine and technology. A truly govt-run system would take the profit factor out of all of these three areas. This is not being done anywhere, as far as I know, (though perhaps China and Russia?).

    What we have been fostering the past fifty years or so is Ike’s (in)famous military-industrial(-congressional) complex, or matrix wherein large ‘special interests’ have become adept at gaming the political and other cultural infrastructure of developed countries to promote their agendas which protect large-scale so-called ‘corporate’ endeavours. There is nothing being floated right now that even remotely questions, let alone challenges, this underlying paradigm.

    If all goes well, they will have saved the current system and all that is required is the same sort of regulatory oversight that exists in the stock and futures markets so that these sort of massive levels of derivative-based speculation doesn’t happen in the dark. It is the dark that made them dangerous, and that dark was due simply to the lack of sensible, efficient regulation which is the proper domain of government to provide through legislation. There is no reason to suppose this won’t be coming next. Indeed, Paulson announced yesterday that clearly this had to happen as soon as the immediate crisis was solved.

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  11. Erasmus permalink
    14 October 2008 8:47 pm

    PS. Cuba for sure has authentic state-sponsored healthcare. And by all accounts it is some of the best in the world especially given their per capita rankings. America’s – which is by far the most expensive – scored rather low on most lists. If America moved more towards Canada’s model – which is still highly corrupted by corporate price fixing and ‘standards’ controls (they are about to make natural supplements illegal unless they control them!) – it surely couldn’t be all that bad. Americans won’t wait for anything so they’ll work around that. The British have figured it out and they are an uber-capitalist country.

    So there is no need to swing from extreme projections about ‘free markets’ (which never truly exist as such in reality since they depend upon regulation which is always manipulated on some level for their existence) and ‘total state controlled’ models (which depend on no less manipulation and usually are controlled by the same sort of oligarchical bigwigs who virtually control the free market ones!
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    Fabius Maximus replies: Before labeling it “among the best in the world” I would like to see an analysis by some reputable outside agency (there may be such, it is not my field). Despite much praise for the Soviet Union’s economic management, it was revealed to be a highly armed 3rd world state when opened for inspection after its collapse.

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  12. 14 October 2008 10:52 pm

    When you suggested “dis intermediation”, I wasn’t really getting the point, until I read your link by Wray. Intermediation is “Middle manning”. You’re saying reign in the middlemen, especially the high level financial middlemen aka Fund Managers of various sorts. I agree. As those in control of our capital become ever more insulated and disconnected from our physical reality, we get ever more “Tulip bulbed” by their decisions. Healthy capitalism allocates resources efficiently only when capitalists, the people in charge of money, have some clue of how wealth is actually produced. Our current intermediaries are demonstrably terrible at allocating capital and determining risk. These guys are homogeneously the product of our Ivy League schools. You question the credentials of Sarah Palin. Would she, or people more like her, do worse?
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    Fabius Maximus replies: That was poorly phrased on my part, a difficult to understand double negative. “Intermediation” was the usual method of financial management in the US until after 1982. Individuals placed their savings in banks and insurance companies, who invested the money. Any losses are the problem of the finanical institution.

    Disintermediation means people directly investing, so that they directly own the gains or losses. This might work if people were locked into their investments, forced to become long-term investors. But the system (for many and complex reasons) offered the illustion of liquidity to investors, allowing them to be short-term investors — providers of “hot money.”

    This was a illusion, as people cannot collectively buy and sell in response to systemic events. Who will take the other side? This system is inherently unstable, and I doubt will last through this cycle. It also has other flaws, such as being both extremely expensive and inefficient.

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  13. hsarvell permalink
    15 October 2008 5:01 pm

    We need to get the politicians out of the financial system, I say free banking is the answer, no more central banks and national currencies, they only fail all the time anyway. For the first time we have the technology to make it happen, free flow of information will take care of the old problem of asymmetrical information and automatic, electronic trade takes care of the previous high costs and headaches of clearing. From this standpoint what you outline above is the absolute worst thing that can happen. I do agree about the health care though, no amount of tech can remedy the problem of asymmetrical information with regards to health insurance. The US should study what is happening in Singapore when it comes to health care, that will serve you well.
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    Fabius Maximus replies: Always interesting to see Libertarians surface in these discussions, as if provides an opportunity to reference one of the greatest web posts — ever! “If Wishes Were Horses, Beggars Would Ride — A Pony!“, John & Belle Have a Blog, 6 March 2004. The definitive reply to Libertarian dreams, when they intrude into serious discussions.

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  14. Nicholas Weaver permalink
    15 October 2008 5:42 pm

    hsarvell: That attitude doesn’t work: That was the theory behind the almost complete absence of regulation of the CDS market, and of the big-5 investment banks. That was also the theory behind the pre-federal reserve days, and look at all the bank panics throughout US history in the pre-Federal reserve days.

    And I don’t think there is any amount of mandated transparency that can both enable trust and enable a profitable bank, even with computers. The bank-like institution will always claim that some parts of the information are proprietary, and as long as there is lack of transparency, you can’t have the libertarian trust model.

    As long as there is potential for deception, the libertarian regulation model can be summed up easily: Melamine in the milk.

    We had the similar thing happen: melamine on the bank balance sheet.

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  15. Erasmus permalink
    15 October 2008 11:37 pm

    #13: to put together the first CDS derivatives a few years ago it took a Cray Supercomputer 48 hours. Which is why Buffet says – amongst many others – that they are not understandable. They are not. Nor is it possible to calculate what is out there to be unwound.

    Good old stock options from ancient Black-Scholes models are scary enough. When the general markets decline over 10% fairly rapidly, normally counter-balanced positions on the part of the market-makers suddenly balloon out of control with about 10 million in underlying option cost mushrooming into hundreds. For every 10% decline there are about 50 billion in naked, institutional option losses that must be covered.

    What is going on with the uber-derivatives which are not in any way regulated and in any case largely not quantifiable (except by those with Cray supercomputers!) is unknown but the same in principle except cubed or more.

    This is not a ‘free market’ issue the way it is being discussed, nor will open access to information alone be a solution. What is needed – as is always the case in ANY political system – is a sane combination of openness and rules. It is always so in any endeavor or discipline. We do not need Nation-State controlled systems but we do need national rules that can be monitored and enforced.

    The biggest danger is that we continue with corporate sector dominance of the legislature which is essentially gaming the system in their favor and creating an ipso-facto fascist condition albeit the government in question is not the one portrayed on television as such.
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    Fabius Maximus replies: Absurd. The problem with derivatives is that they operate in an unregulated framework. Forcing them to move from unstandardized contracts traded over-the-counter to a central exchange (operating under proper regulation) will eliminate the problem. This would have happened years ago if we had sentient regulators. The transition might be painful, but not necessarily so if managed properly.

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  16. Nicholas Weaver permalink
    16 October 2008 3:14 pm

    Derivitives are also easy to understand ON THEIR OWN: Its a bet between two parties about an economic event, with one party paying in money continuously and the other party paying out if the event happens under the duration of the contract. Simple. Easy-peasy.

    They were originally designed as an insurance policy: you could use a derivitive to hedge the failure of a bond (a CDS), indexes, or other “bad events”.

    The problem arrises from two factors: They are zero-sum-game instruments (so for every winner there must be an equal loser. And when you consider expenses, they become a negative-sum game) and they were often chained to create chains of counterparty risk.

    EG, you’re a hedge fund with $100M. You sell, for $10M a year over 5 years, a $1B CDS. Now as long as your bet is fine, its all good. But if it goes wrong, you have insufficient backstop to pay off. OOPS.

    OK, lets go the other way. You BUY, for $10M a year over 5 years, a $1B CDS. Now the company in question has become riskiier, so you sell for $20M a year over 5 years a $1B CDS. Now you keep getting $10M a year income and hey, no risk either way. But suppose your counterparty is like you: They can’t pay off, so you can’t pay off. ANd you can get cascading chains of failure, and this is also why the notional amount of outstanding CDSs is more than the notional amount of debt being protected.

    Now because this is a concern, nobody trusts anybody else, because the strenghth of your counterparties in any transaction now depend on the strength of their counterparies which depends on the strength of their counterparties and so-on. And this is, in many ways, why banks don’t trust each other anymore.

    Now if derivitive transactions were centrally exchanged and regulated, such chains would become visible and would also be less likely to be created.

    And derivitives CAN be profitable. Berkshire/Hathaway has a fair amount of oustanding CDSs that they sold (insurance on $4.7B of bonds, which they have already collected a premium of 3.2B in premiums, as well as some LONG term (15-20 year) S&P 500 derivitives.

    But Buffet is VERY VERY VERY clear to point out that “We hold the cash from the premium, there is no counterparty risk”. It is this chaining that makes derivitives so destructive.
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    Fabius Maximus replies: This issue is all so overheated, IMO just a way to avoid thinking about the serious challenges ahead. Subprime served as a similar whipping boy in the early stages of this cycle, then housing price declines, now “derivitives.”

    Options and futures are derivatives, properly run on centralized exchanges for many decades. Interest rate swaps and credit default swaps will also be standardized and moved into this framework. Ten years from now the only mention of this in texts will be the failure of regulators in the post-WWII era to do this from the beginning — as yet another example their incompetence.

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  17. Erasmus permalink
    16 October 2008 10:17 pm

    Fabius, you are not quite right here about options, for example, which are clearly regulated and efficiently so. The issue is that there are certain aspects of them that are either misunderstood or, in the case of options, ignored, namely that if the moves deviate too much from the norm (about 10% in the indexes within 2 weeks or so), then the market makers end up taking huge hits and have to get into the liquidation game which exaggerates the current move (up or down) and then creates further momentum/volatility.

    With the CDS’s, my understanding is that what is hard to understand is not that there are two parties but that in most cases the underlying premise of the contract – especially with variegated ‘tranches’ of mortgage securities – is almost impossible to calculate; furthermore, if the computer algorithm declared combinations with x% of Y-grade ‘junk’ as AAA, institutions could use such CDS’s as collateral for yet more. The number of derivatives on derivatives in this essentially unregulated market is literally unknown, but they are all hugely leveraged.

    Fabius, when you say ‘absurd….the problem is lack of regulation’, that is PRECISELY what I was arguing! Along with the caveat that since many of the underlying instruments require massive calculations to evaluate, clearly there is something fundamentally out of whack with their premise.

    I also think you are wrong to discount their importance. 90% of what is going on right now has little to do with economic fundamentals and mainly to do with huge ‘margin calls’ essentially forcing massive liquidations.

    Without the CDS overhand, the rate of foreclosures in the US the past two years, with previous methods of bundled insurance, would have been painful but fine and only effected the mortgage banking sector, not the entire world financial order. The fact that there might be an ongoing 2-5 trillion dollar ‘margin call’ is precisely what has precipitated and continues to drive the current calamity.

    In short, it is not about housing per se, but the leveraged bets made upon it. Not the same thing at all.

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  18. Erasmus permalink
    16 October 2008 10:23 pm

    To give just a flavor of how the relatively simple stock options market is often misunderstood in terms of underlying broad systemic risk, take a gander at this interview with Smithers from an article in Barrons many years ago since when that market has expanded greatly, especially with new index options in vastly greater volume than was the case at the time of their prescient analysis.

    The CDS and MBS instruments are geometrically more dangerous and I suspect that around 80% of the current volatility in the credit and stock markets is due to unwinding of those positions not strategic or other considerations.

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  19. OldSkeptic permalink
    17 October 2008 8:41 am

    Erasmus “Good old stock options from ancient Black-Scholes models are scary enough”. They are actually scarier, because S-B is wrong and risk is significantly understated (by orders of magnitude). I did a paper back (in 03 or 04), part of which was debunking S-B.

    It took me less than 1 hour of work to prove it was wrong, nice maths + incorrect asssumptions = rubbish, dangerous rubbish. All the ‘financial engineering’ and ‘credit scoring’ models suffer from the same sort of faults.

    Why did they continue? Group think, poor statistical understading (quite a lot by the academic statisticians as well), easy money, great ‘profits’, etc etc. One guy I talked to after I delivered my paper said that I was right, but his company used S-B “because everyone else does and it’s more than my job’s worth to fight it”.

    Underestimated risk + excessive leverage = doom. Add unregulated markets, e.g. the whole CD market comprised people passing emails to each other, basically taking bets on themselves and others.

    The closest anology I can think of is getting a 100 million dollar loan on your $200,000 house and going to Vegas, plus a lot of side bets with the local numbers guy, playing internet poker as well, betting on the horses, betting how someone else does on the horses and betting on how long it takes two flies to get to the ceiling. Only one end for that sort of lifestyle.

    For the techies amongst you: I have never come across a ‘normal’ distribution in my entire working life using real data. Any model built on that assumption is going to be wrong.
    .
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    Fabius Maximus replies: I strongly agree on all points! The incorrect assumption of normal distributions my have created more (and more serious) bad calculations than any other statistical error.

    As for operational risk, perhaps the best discussion of this is in “Personal observations on the reliability of the Shuttle” by Richard P. Feynman. I highly recommend reading it.

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  20. OldSkeptic permalink
    17 October 2008 9:35 am

    Fm I have to disagree with one point of your projecttion (though I basically agree with the others), to wit:

    “The result: a more stable economy. It will grow more slowly, and have much less social mobility. The rich will find this trade-off quite congenial. Everyone else must accept it.”

    Social mobility. Here’s the rub, the US and UK models produces LOWER social mobility than the “Northern European model”. The US has always been low and the UK dropped after it took on their varient of the US model (called TINA, there is no alternative).

    See here for a range of studies into this. Google “social mobility measures” as well.

    Some of this is a real no-brainer, the greater the economic inequality in a society the lower the social mobility . Basically because there is less resources for the lower classes (money, health, education, etc) to give them the tools and opportunities to move up (and out compete existing idiots who were born into it). Plus the big boys put in all sorts of barriers to the upstarts to make sure their offspring succeed.

    I also speculate that de-industrialisation has contributed to this, as many ‘ladder’ jobs have disappeared. Take the example of the bright poor, very poor actually, working class kid, with free education who studied physics and got into the middle class (me actually). That route has largely disappeared in many Anglo countries (UK, US, Australia, etc).

    Social mobility is essential for a viable soceity as it turns over the middle/upper clases and the elite, otherwise they just ossify and since they control the society it also ossifies.
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    Fabius Maximus replies: I agree with all this, but it is off-topic. My point was simple: all other things being equal, the changes I describe will decrease social mobility in the US. Do you disagree?

    Like

  21. OldSkeptic permalink
    20 October 2008 9:34 am

    FM unfortunately I cannot disagree.

    The current ‘plan(s)’ as they stand will do little to rebuild economies (not just the US’s), infrastructure (human and capital), etc. The danger, as flagged by many, is an L shaped recession, crumbing infrastructure, huge social costs (unemployment, etc) and a ‘locking in’ of the current inequalities.

    To simplify, to solve the US’s trade deficit issues (essential to start to sort out the destabilising impact on capital and financial flows) there are a few ways, but one is to drop the standard of living for a very large number of people low enough to cut demand. In simple terms that would be about 25%(ish) of the US population thrown on the scrap heap and a lot of the rest with sharply lower living standards, with the ‘national security’ apparatus keeping everyone in line. A generation, or more, in debt peonage? It has happened before in many places, no reason to expect the US (or the UK and quite few other places) are immune.

    The worry I have is history. Any country that has a reasonable sized middle class and then stuffed them has gone under and had a revolution (both in good and unfortunately bad ways). The reason again is simple, the middle classes run everything. The elite may give the orders, the middle classes carry them out, they have the actual hands on the levers, plus to ability and skills to organise. When they lose their houses, watch the values of their houses and superannuation crumble and watch their wages crumble …. then interesting times as they say. Even Hitler was wary of the middle classes, pandering to them right up until late in WW2, lest they get too restive.

    In the US in the 30’s would the US system survived without Roosevelt (he at least supplied hope, though his actual economic achievments were more limited)? There were documented plans to overthrow the Govt (one of which was famously blown).

    Trouble is when we move in this extreme an area, even normally very low probability events become far more possible. Succession by a State (California is my long shot bet)? Who knows. My gut feel, for what it is worth, is that the social fabric of the US is nowadays far more fragile than many people think (the UK Govt definately thinks its fabric is shallow judging by its desperate attempts to turn itself into the greatest police and survellence State since East Germany, the boys in WW2 should just have surrendered and saved all the effort*). The US polls on social attitudes and confidence in the State are .. well interesting. There is nothing more corrosive to a society than a long standing, deep resentment and anger that, like a volcano builds and builds until…

    Tipping points, even more huge bonuses to the bailed out bank executives, Obama being as much a dud as Australia’s Dudd, heavy handed police impacting middle class people, etc. People are funny, a single event can crystalise years of resentment and anger and then they explode.

    * WW2, Battle of Britain. “Well boys I want you to go up there against overwhelming odds and die so we can create a State where everything you do, say, read or listen to is watched. Where a even local council can put bugs into your house and follow you. Where the police can order you to not go out, or stop you leaving your house except when we allow you. Where you can be locked up, basically forever for reading something we don’t want you to read.”.

    “Sod off, I’m going to the pub, tell the Germans they can have the place”.

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