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Miscellaneous news and thoughts about the financial crisis

16 October 2008

Here are bits and pieces you may find of interest, too small for individual posts.  Somewhat self-congratulatory, which I usually avoid.  But every rule has exceptions.

  1. Debt Deflation, predicted and arrived
  2. The Paulson Plan is dead; long live the Paulson Plan!
  3. I recommend these articles about the geopolitics of the crisis
  4. Why so many posts about the financial crisis?
  5. The master narrative of this down cycle

Also:  by now the importance of this election should be evident to everyone.  The new Administration will make decisions that will re-shape important aspects of America, and echo in history for many decades.  Please get involved — donate time, money if you can.  Do you best to help us collectively make the best decision possible.  The candidates might not be what you would hope for, but the difference between bad and worse is more significant than between good and better.

(1)  Debt Deflation, predicted and arrived

I warned in June that if the Fed did not expand the money supply, rising material and energy prices might spark debt deflation.  Others also saw this (see here for an example).  The Fed didn’t, and now we have debt deflation.  There were other factors in play, but this is is a near-exact parallel with the 1930’s.

  • For several years after the 1929 the Fed worried about inflation, while debt deflation grew.
  • Since the crisis started in December 2006 (with the collapse of the mortgage brokers), the Fed spent 10 months worrying about inflation — while debt deflation grew.

(2)  The Paulson Plan is dead; long live the Paulson Plan!

I warned on 29 Septemberthat the Paulson Plan was irrelevant.  Since then it has mutated into something unintended by either the Treasury Department staffers who wrote it or the Congresscritters who approved it.

Instead of buying “toxic assets” at $50b per month, the government is pumping massive sums ($250b in the first round) directly into financial institutions (loans, by purchases of preferred shares).  On lousy terms compared to what Warren Buffett recently negotiated.  Given to some institutions who do not even want the money.  Probably the result of panic at high levels leading to hasty development and thoughtless execution of programs that are nonsense on stilts.

However inefficient, this might work — helping to restart the nation’s flow of credit.  It’s better than the initial plan, and far better than doing nothing.  But a vast waste of scarce resources; and we do not have unlimited resources with which to fight this crisis.

(3)  I recommend these articles about the geopolitics of the crisis

  1. Liquidating the Empire“, Patrick J. Buchanan, posted at Antiwar.com, 14 October 2008
  2. Is this the end of the American era?“, Paul Kennedy, The Times, 12 October 2008

(4)  Why so many posts about the financial crisis?

Because it is reshaping the world.  Right now, on a scale and at a speed seen only in great wars, revolutions, and major recessions.  Like most world-changing events, the daily news covers it in an inchoherent fashion — often misreporting major events in correctly.

(5)  The master narrative of this down cycle

The master narrative of this down cycle has been the unexpected breaking of links in the financial system.  The mortgage brokers.  Defaults on “prime” mortgages.  The long, deep decline in home prices (“home prices have never declined over a full calendar year since the Great Depression”).  The failure of major banks and brokerage firms.

At each step the expectation of the wise was that the past events were unexpected, and the current event was unexpected, but future events would unfold in a predictable fashion.  That was wrong, and I believe it will continue to be wrong.  What will be the next unexpected link int the system to fail?  I have two guesses:

  1. A rise in rates, very unwelcome during a recession.  Every government is borrowing big; there might not be sufficient global savings to meet demand.
  2. A big decline in GDP.  Perhaps zero growth in global real GDP (a big drop from almost 5% during the past 5 years, perhaps worst since WWII).  Perhaps down 4% in US GDP over a 12 month period sometime between now and the end of 2010 (which would be the 5th worst decline on record, tied with 1933 — nothing like a depression, but the worst downturn since WWII).

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 from the FM site

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

Key posts about the financial crisis

  1. America has changed. Why do so many foreigners see this, but so few Americans?, 1 October 2008
  2. A sitrep on the financial crisis: why has the treatment been so slow, so small?, 8 October 2008
  3. Forecasting the results of this financial crisis – part I, about politics, 13 October 2008
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8 Comments leave one →
  1. Nicholas Weaver permalink
    16 October 2008 12:12 am

    2: The big hope now is that it will stave off the situation until after the election where hopefully there will be a clear winner, with that winner IMMEDIATELY choosing a treasury secretary to start the transition immediately.

    The Paulson Plan 2.0 is far better than 1.0, but still has some big problems that need to be fixed before more money is wasted, problems that an ideologically blinded treasury secretary and a femaized treasury department can’t solve.
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    Fabius Maximus replies: Agreed, but that sequence is far too slow. The President-elect must pick an economic team and put them to work in ASAP. So that after they take office they have a fully developed plan, with multiple options for different scenarios.

    Like

  2. 16 October 2008 12:36 am

    At each step the expectation of the wise was that the past events were unexpected, and the current event was unexpected, but future events would unfold in a predictable fashion.

    Brilliant. At the risk of anthropomorphism, the unfolding economic situation is inside our OODA loop. If it were a one-time event, it could be a “black swan.” But 20 months? Would that be a black bevy?

    This pattern of late and therefore ineffective decision making suggests a systemic problem; look forward to your analysis of its cause. And of its solution.
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    Fabius Maximus replies: Why is this a Black Swan? I list here a few dozen of the hundreds of warnings we recieved that our course was certain to end on the rocks. That we ignore warnings and are astonished at the inevitable does make it a Black Swan event.

    The primary cause is too much debt, as described here, and in pictures here.

    To go one step deeper, this is a Thomas Kuhn-type paradigm crisis in economics. Aggregate debt levels are not considered a significant factor in Keynesian economics, so the massive rise in debt was not a concern of mainstream economists. “Austrian School” economists warned this was unwise, but they are a irrelevant minority in the profession. Some mainstream economists gave warnings, such as Maria Fiorini Ramirez in the mid-1980’s — but were ignored.

    If we go deeper, there are reasons why we fecklessly accumulated so much debt. Weaknesses in our society, our patterns of thought. This downturn will fix some of these — an education for American, but an expensive one.

    Like

  3. Nicholas Weaver permalink
    16 October 2008 1:53 am

    Fabius: Thats exactly what I mean but did not express. The president-elect MUST, on Nov 5th, appoint a shadow treasury and immediately move them into the treasury building and effectively take-over policy, if only to ease the transition and hopefully fix the gross disfunction in the department.

    Like

  4. FxConde permalink
    16 October 2008 3:28 am

    What if none of these solutions come to pass? I may be showing a lack of faith in our illustrious political class but the slow response and the lack of any change in message from the presidential candidates does not increase my confidence. They will go through the usual solutions using the cover of the press finding that nothing works. This is pure speculation but it will be very similar FDR’s solutions which set a floor but that was about it. I really believe we lack the leadership at this moment in time.

    Your reference to austrian economist as “irrelevant minority in the profession.” may be true but does it make them incorrect? We are going to need a melding of Austrian and Keynesian economics. Keynesian theory was used as an excuse for running unlimited government debt. He would not of approved.
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    Fabius Maximus replies: Remember that I just describe what is. Of course being an “irrelevant minority” does make them wrong. Newton sometimes found his classroom empty, so I have heard.

    As for the need for a fusion of the two schools, I said exactly the same thing here.

    “What if none of these solutions come to pass?”

    There are many examples in history of such things. They usually end very badly.

    Like

  5. alan calhoun permalink
    16 October 2008 4:26 am

    “…a melding of Austrian and Keynesian economics”

    Just the thought of such intellectual depravity would make poor old Mises spin in his grave.

    Like

  6. 16 October 2008 10:35 am

    Fab,

    Your question can be read two ways. If you’re asking “Is it a ‘black swan’ event?”, let me answer that by quoting Fabius Maximus:

    The master narrative of this down cycle has been the unexpected breaking of links in the financial system. … At each step the expectation of the wise was that the past events were unexpected, and the current event was unexpected

    If you’re asking why it was unexpected, that’s the same question I asked. There were warnings, and not just from irrelevant economists and obscure bloggers. BusinessWeek, for example, had a cover story a couple of years ago entitled “How Toxic is Your Mortgage?”

    Wasn’t it Dick Cheney who pointed out that Caspar Weinberger proved that debt didn’t matter?
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    Fabius Maximus replies: Great point! These are two different perspectives here. In today’s post I attempt to explain this more clearly.

    Like

  7. 16 October 2008 2:25 pm

    How about China deciding to socialize IP — meaning no longer any enforcement of copyright (monopoly) laws? Prosecution only for fraud, not for copying. Imagine all the digital entertainment available to all for the (extremely low) cost of download; as well as programs. Perhaps this is wishful thinking on my part.

    Maybe a more (Henry George) land value tax, perhaps even progressive, to tamp down real estate bubbles.

    Replacement of the mortgage interest deduction with a flat rate (35%?) tax credit for house buying, even for those who do not itemize. (Perhaps with a lifetime limit? Perhaps spread over a maximum of two houses?)

    FM, I’m almost certain your #1 won’t happen — the central bank printing presses mean there is enough ‘money’, or else it can be printed.

    #2 Is the big fear, more feared than expected, and the whole sale of the bailout, etc, is to reduce this GDP drop. And most folks’ support for future increased fiscal spending will also be to avoid such a big GDP drop. I strongly suspect this now-current fear will help to avoid the GDP drop.

    I’d guess the fear that many experts say should be ignored, inflation, would be a more likely candidate for an ‘unexpected’ event. But as the trillions in paper assets disappear, and recession reduces demand for commodities and prices … I would indeed be surprised to see much inflation next year.

    Close to the election will be the unwinding of Lehman Brothers huge CDS stuff, Oct 21. Your often linked RGE has a fine note on it: RGE note. Perhaps you’d care to guess? My own guess is over $250bn — much of it recently sold and bought by those who are close to Paulson, and are planning on getting a big windfall by the bailout.
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    Fabius Maximus replies: Debt deflation is happening now, and has almost trashed the financial system. Only the massive expansion of the money supply has offset its effects. See this paper for an explanation of debt deflation.

    Inflation is a danger during the eventual recovery. The Fed will find it difficult to withdraw all that money without aborting the recovery. This assumes, of course, that we do not fall into a long deflationary cycle as did Japan in the 1990’s. Forecasts about this cycle can only be tentative.

    The Lehman CDS story is just inside baseball. Probably a footnote in the history books. Folks seize on these things IMO because they are tangible stories, while the future remains lost in the fog.

    The important threats are not things like this — in the headlines, and hence getting attention from the government — but those not yet visible. Like a 4% decline in US GDP — or 1% in world GDP — that are far outside the consensus, and against which no preparations are made.

    Like

Trackbacks

  1. “What Barack Obama Needs to Know About Tim Geithner, the AIG Fiasco and Citigroup” « Fabius Maximus

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