Summary: Much of the analysis of this great crisis — now clearly the worst since the 1930’s — focuses on minute, even trivial, aspects of the problem. This is natural, as its sweep and magnitude dwarf anything seen during our lifetimes (for most of us, at least). It has affected almost every business, kind of investment, nation — and before the end will probably affect almost every person (except those in the least developed nations).
The simple narrative for a crisis is that which came first must cause what follows. This seems plausible, since post hoc ergo propter hoc is the default reasoning mode of the human mind. Consider dropping colored grains of sand to form a pile. Eventually one will collapse the pile, perhaps a green grain. Is this then a green grain problem? Apparently so to many people.
First this was a subprime mortgage crisis. Then a securitized mortgage crisis. Then a housing crisis. Then a derivative crisis. The crisis drags us forward to an expanding array of problems, with many experts’ eyes fixed backwards on the past. Understandable, as looking forward is quite alarming.
Causes of this crisis
A thing long expected takes the form of the unexpected when at last it comes.
— Mark Twain
These financial shocks are byproducts of deeper trends, in my opinion. The world has begun a process of regime change, as the foundations of the post-WWII geopolitical order decay. Here are some of the major trends forging a new world. Each of these has played a role in bringing us to this point; some will play an even bigger role forcing events during the next few years.
(a) The transition from a bipolar (or unipolar) world to a multi-polar world.
(b) Entering the transition period to peak oil, as global oil production peaked (not necessarily the peak) in 2005. Since then biofuels have provided most of the growth in liquid fuel consumption. Rapid GDP growth (almost 5%) required high prices to match ex ante demand with flattish liquid fuel production.
(c) The replacement of the US dollar as the reserve currency (by what we do not yet know), after 30 years of foreign borrowing — 30 years of increasing current account deficits.
(d) The exhaustion from overuse of monetary and fiscal policy. Persistently too-low interest rates yielding serial investment bubbles. The long decline to near zero of the marginal elasticity of GDP with respect to debt. For more about this see Death of the post-WWII geopolitical regime – death by debt.
(e) Structural weakness: Funding long-term businesses with “hot” (aka liquid) capital, from the disintermediation of household savings. Money shifted from vehicles where institutions bear the risk (insurance, annuities, CD’s, etc) to direct participation (owning stocks and bonds either directly or through mutual funds). See this post for an explanation.
(f) The Thomas Kuhn-type paradigm crisis in Keynesian economics, by which the world economies have been steered for fifty years. The aggregate debt level of an economy is not a significant variable; attempts to integrate into orthodox theory by radical Keynesians (e.g., Hyman Minsky) were unsuccessful. Sometime after 2000 we reached and broke though the edge of the “operating envelope” of Keynesian theory. We ran like Wile E. Coyote off the cliff and beyond — a few exhilarating years — and now we fall.
Black Swans
How comforting to think that these were Black Swan events! (from Wikipedia):
As formulated by Nassim Nicholas Taleb in his 2007 book The Black Swan … The term black swan comes from the ancient Western conception that ‘All swans are white’. In that context, a black swan was a metaphor for something that could not exist. The 17th Century discovery of black swans in Australia metamorphosed the term to connote that the perceived impossibility actually came to pass. Taleb notes that John Stuart Mill first used the black swan narrative to discuss falsification.
This relieves us of responsibility. Unfortunately, none of these were “black swan” events. All were widely predicted by experts for decades (see here for 2 dozen examples from major institutions and experts). These warnings were made early, allowing us sufficient time to act and prevent this crisis. The world is a large and ponderous vessel, which took generations for its internal weakness to finally capsize it. The failure of the boat to immediate capsize following the warnings was seen as proof that they were false.
This is not a new phenomenon. People’s impatience and short-sightedness are commonplaces in history.
On September 23 his fleet hove in sight, and all came safely to anchor in Pevensey Bay. There was no opposition to the landing. The local fyrd had been called out this year four times already to watch the coast, and having, in true English style, come to the conclusion that the danger was past because it had not yet arrived had gone back to their homes.
Description of William the Conqueror’s arrival, from History of the English Speaking People by Winston S. Churchill. Bold emphasis added.
Alternative theories
We are at the stage where the full magnitude of these events has not yet become apparent, even to many experts. Hence the nonsense flooding the media, attributing these great events to the most trivial of causes. Here is a wonderful example (hat tip to Zenpundit):
“Top Theorists Examine Rippling Economic Turbulence“, the PBS Online Newshour, 21 October 2008 — “As the financial sector shifts, so does the reach of the jolt to economic structures around the world. Economist Nassim Nicholas Taleb and his mentor, mathematician Benoit Mandelbrot, speak with Paul Solman about chain reactions and predicting the financial crisis.”
Much of this is correct, of course. As in “Mandelbrot’s key insight came in the ’60s with a study of cotton price surges and plunges, suggesting the world moves in fits and starts, especially the human world.” This is a commonly seen pattern, in both history and the physical sciences (e.g., punctuated equilibrium in evolutionary biology).
But much of this is “inside baseball”, concentrating on the details of the financial system while ignoring the great changes in the real world — driven by forces far larger than the dynamics of our banking system.
Some of this is just wrong. Myopia can afflict even the greatest experts.
NASSIM NICHOLAS TALEB: Let me tell you why it’s not like before. Look at what’s happening. The world is getting so fragile that a small shortage of oil — small — can lead to the price going from $25 to $150.
PAUL SOLMAN: A barrel.
NASSIM NICHOLAS TALEB: A barrel. A small excess demand in an agricultural product can lead to an explosion in price.
The world “wanted” liquid fuel growth of aprox 2% per year in 2003 – 2007. It got 1.4% per year — 30% less. Almost zero since 2005. (source of oil production #s: BP Energy Review). That is an ex ante shortage of roughly 2 million barrels per day, given oil’s low price elasticity of demand. Sufficient to drive oil prices up quite a bit; hardly a small shortage. this post for details.
This is not academic quibbling about the causes of our crisis. After first aid is successful we must begin serious treatment for our global economic and probably even geopolitical systems. At that point correct diagnosis becomes essential for a cure, and to prevent it reoccurring.
Update: Taleb recants
Taleb admits that the current meltdown is not a black swan: “Taleb’s `Black Swan’ Investors Post Gains as Markets Take Dive“, Bloomberg, 14 October 2008 — Excerpt:
As a trader turned philosopher, Taleb has railed against Wall Street risk managers who attempt to predict market movements. Even so, Taleb said he saw the banking crisis coming. ‘The financial ecology is swelling into gigantic, incestuous, bureaucratic banks — when one fails, they all fall,” Taleb wrote in The Black Swan: The Impact of the Highly Improbable,’ which was published in 2007. “The government-sponsored institution Fannie Mae, when I look at its risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup.'”
Taleb said the current crisis is a ‘White Swan”, not a Black Swan, because it was something bound to happen. ‘I was expecting the crisis, I was worried about it,” Taleb said. ‘I put my neck and money on the line seeking protection from it.”
Afterword
If you are new to this site, please glance at the archives below. You may find answers to your questions in these.
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:
- about the Financial crisis – what’s happening? how will this end?.
- about The End of the Post-WWII Geopolitical Regime.
- A solution to our financial crisis
Previous situation reports about the crisis:
- The US economy at Defcon 2, 11 March 2008 — Where are we in the downcycle? What might the world look like when it ends?
- The most important story in this week’s newspapers, 22 May 2008 — How solvent is the US government?
- Another warning from our leaders, which we will ignore, 4 June 2008 — An extraordinarily clear warning from a senior officer of the Federal Reserve.
- High priority report: a geopolitical sitrep on the financial crisis, 15 September 2008
- A new sitrep, as we move into phase 3 of the financial crisis, 19 September 2008
- A sitrep on the financial crisis: why has the treatment been so slow, so small?, 8 October 2008
The (b) peak oil transition period is crucially important for reminding folks that, in the transition, there is no long term (transition) price. Both $50 and $150/bbl are likely prices, and we might well see them a few times.
(This is also true, and scary, about ‘climate change’ — higher variability is more costly, whether it’s really warming or, increasingly likely, cyclical cooling.)
(c) is not yet fully correct. The ‘euro’ was the most likely replacement currency, but it is going thru even more volatility now; there will be few ‘replacement’ costs until it is clear that it will be replaced. If there is a drift of oil exporters and China to increase their euro, or some other non-dollar reserves, that won’t provide much evidence of this point. Quantifing this would be good: if China reduces its USD reserves by 10% in a year, this becomes significant but not yet replacement. If the reduction is greater than 50% (or when the accumlated total is 50% of their max?), then I’d agree that this replacement shock is happening.
Arguing about the USD vs Euro as primary reserve currency is an excellent example of financial ‘crying wolf’. It has been predicted repeatedly (we have been warned!), and has repeatedly not yet happened. Insofar as the usual ‘cure’ is some form of increased protectionism, to reduce the current account deficit, I am far more worried about and in opposition to such a cure than to claim this trend is a problem to be solved.
But my main point is that warnings need to have some time limit to be taken seriously, because only with a time limit can they be falsified, and the relevance for taking action is time related. Specifically, I’m fairly certain that there will be no signficant replacement of USD in the next 12 months, altho over the longer term I expect to see a an ever increasing % of national reserves in non-USD. I wouldn’t say this confirms the replacement trend / current account deficit trend of (c).
The world needs better warning mechanisms, and ways of knowing which warnings are worth taking action on, and which ones not. The ‘global warming’ hysteria, as it might well be called in history if we really have cooling, will be a blow against science / the UN / and rationality.
Greenspan’s famous Dec ’96 “irrational exuberance”, was too soon.
The Economist’s 2003(?) US Housing Bubble was too soon.
Warnings that are too soon create too much noise and thus disguise the important signals.
I don’t yet believe (d) The long decline to near zero of the marginal elasticity of GDP with respect to debt., and especially don’t believe that good targets of fiscal stimulation will fail — but this is a wonderfully interesting, and original(?) tho gloomy, idea to contemplate. Thanks.
In considering an attempt to falsify this idea, would you agree that if the US escapes 2009-2010 with no more than a 3% drop in GDP, because of successful fiscal/ monetary/ global policy, that the marginal elasticity is not yet so close to zero?
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Fabius Maximus replies: What is your definition of “too soon”? Policy changes of the magnitude to change major national trends take years to acomplish — and years more to have effect. Your two examples were both probably too late, not too soon.
(d) has been remarked upon by many economists since first noticed in the mid-1980’s by Maria Fiorini Ramirez (One of our top economists). It was of limited effectiveness in the 2002 recession; at 5:1 it is not a practical solution for a medium-large recession. It is certainly even lower now.
Growth of Credit market debt growth per dollar of GDP growth.
1950’s $1.77
1960’s $1.53
1970’s $1.69
1980’s $2.92
1990’s $3.15
circa 2004: $4.95
“The world needs better warning mechanisms”
Perhaps. I wonder if better data collection would help much. First, as I describe in this post, our inability to see the warnings results from limitations in economic theory — not “mechanisms.” Second, as I will discuss in a future post, our cultural optimism makes forecasts of doom a serious career risk. Prof Roubini was extraordinarily correct about this cycle (as he was about the 1997-98 emerging market event). So they call him “Dr. Doom” (not a compliment) say this about him: (from The Times of 26 October):
“Given such cataclysmic talk, some experts fear his new-found influence may be a bad thing in such troubled times. One senior Wall Street figure said: ‘He is clearly very bright and thoughtful when he is not shooting from the hip.’ He said he found some of Roubini’s comments ‘slapdash and silly’. ‘Sometimes the rigour of his analysis seems to be missing,’ he said.
“{Anirvan Banerji, economist with the New York-based Economic Cycle Research Institute} still has problems with Roubini’s prescient IMF speech. ‘He has been very accurate in terms of what would happen,’ he said. But Roubini was predicting an ‘imminent’ recession by the start of 2007 and he was wrong. ‘He hurt his credibility by being so pessimistic long before it was appropriate.’”
It occurs to me that we don’t have to worry about the last four of the six reasons you list for a global economic change in the works. Theories (f) are discredited by events, and mechanisms (d) and (e) are abandoned when they don’t work or aren’t applicable. These seem to be already happening, as we speak. (c) is a predicted outcome which we can’t do anything about.
(a) and (b) are the two factors which bear thinking about, since we have the possibility of actively changing our economic and political policies to adapt to them. To use a metaphorr, considering all the factors you mention as a landslide, the first two are the only ones on which we can get a foothold to resist being swept away.
On the other hand, there’s a real danger that policy makers and economic drivers won’t admit any of these changes, and by pursuing old tactics (like military control of resources like oil) will turn a gradual change into a cataclysm.
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Fabius Maximus replies: Probably I would disagree with this if I understood what you are saying.
(c) Is a danger for which we should prepare, as the transition might be painful. Loss of reserve currency status for the pound was one of the reasons for the UK’s poor economic performance between 1918 and 1980.
(d) To say we can “abandon” fiscal and monetary policy seems an odd thing to say. What would we replace them with?
(e) To say we can “abandon” disintermediation — one of the foundational principals of our financial system — makes it sound like tossing away a chewed-out stick of gum.
(f) One of the primary lessons Thomas Kuhn extracts from history is that key theories (paradigms) are not falsified — only replaced. The reason is simple: we cannot function in science or public policy without a theoretical basis (which runs the Orientation and Decision steps in the OODA loop). To believe otherwise is like saying VISTA does not work, so I’ll run my computer without an operating system.
I think one key element in this discussion is the idea that money is energy. It is a discrete concrete form of human thought, which is itself energy. Being energy, it is no different than light, heat and other forms of electromagnetic radiation and is governed by the same laws. The money we make comes from the labor we put forth. Heat is work as they say in Thermodynamics. The financial problems we have been living thru are nothing more than the 1st and 2nd laws of Thermodynamics in action. The dot.com bubble, the housing bubble, the commodities bubble are akin to a boiler bursting from being overheated. This is why we put controls on boilers to keep them from blowing up. We did the same to the financial boys, but there seems to be a strong anarchist tendency among many of them. They don’t want controls. They forget the sins of the past and doom all us to repeat history one more time.
One place the money is energy metaphor breaks down is that unlike energy money can be created or destroyed. Important to remember.
I’ll try again. (d) and (e) are mechanics of the current economy, which have been discredited in practice and can’t be used again for the foreseeable future. (f) is the theory of the current economy whose envelope you say has been broken through. (a), (b) and (c) are coming realities which we can adapt to, if political leaders are wise enough to recognize that the old game is over.
Taleb concurs that the current meltdown is not entirely a black swan: “Taleb’s `Black Swan’ Investors Post Gains as Markets Take Dive“, Bloomberg, 14 October 2008 — Excerpt:
“As a trader turned philosopher, Taleb has railed against Wall Street risk managers who attempt to predict market movements. Even so, Taleb said he saw the banking crisis coming. ‘The financial ecology is swelling into gigantic, incestuous, bureaucratic banks — when one fails, they all fall,” Taleb wrote in The Black Swan: The Impact of the Highly Improbable,’ which was published in 2007. ‘The government-sponsored institution Fannie Mae, when I look at its risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup.”
Taleb said the current crisis is a ‘White Swan”, not a Black Swan, because it was something bound to happen. ‘I was expecting the crisis, I was worried about it,” Taleb said. ‘I put my neck and money on the line seeking protection from it.”
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Fabius Maximus replies: Thanks for posting this! I found it odd that Taleb appeared to ignore the decades of warnings about the trends leading to this crisis.
Robert Skidelsky, in his introductory chapter in “John Maynard Keynes: The Economist as Savior:1920-1937,” stated that
“the simple message of Keynes’s economics seems to be that when a society’s self-goveerning mechanisms break down, it needs more government from the center. This is the managerial response to the breakdown of values…the manager manipulates social relations in the interests of stability.”
But if the new state managers themselves, (i.e.the central bankers and the government bureaucrats)also believe in the same cultural values that got the financial sector into their meltdown (the goal of unlimited power and wealth no matter what the societal consequences) then our collective future seems dim indeed.
The deeper issue is moral regeneration and how this is to take place independent of the failed market and the failed state.
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Fabius Maximus replies: Your summary of Keynes is powerful and appropriate! Here is another, in a similar vein (bold emphasis added):
…………. From “The General Theory of Employment, Interest, and Money” (1936), Chapter 12 – The State of Long-term Expectation.
However, I think “failed market and State” is a bit of an exaggeration, unless you can point to a system that has not had periods of similar stress.
The current unfolding series of events is more like a complex, probabilistic “perfect storm” than either a single cause “whodunnit” or an unimaginable “black swan.” If you study the available “coming events” predictions made by economists in the 2003-2007 period, you will find that more than 20% identified excess global credit expansion as the most significant destabilizing phenomenon and severe credit contraction as the most likely outcome within 5 years.
The sources of the explosion of household, business, and government credit creation are many and most can be traced back at least to the early 1980’s, with several going back all the way to the late 1930’s. No one doubts that credit expansion creates wealth and leads to GDP growth; while it is not the only way to boost an economy, it has become the dominant way to produce growth in mature economies during the last 25 years (e.g., not only has aggregate debt in the U.S. become 350% of GDP, the financial industry has become over 40% of the business sector – until the recent crash).
Setting aside Keynsian, Friedmanian, Minskyian biases, it will be interesting to watch the process unfold from here as the world’s governments send their credit factories into overtime to attempt to prevent the developing private sector credit contraction. Those who are worried about the attempt failing, and the onset of a deflationary depression have good arguments, as do those who are worried about the possibility that the attempt will succeed and the hyper-credit-funded rebound will lead to hyperinflation. In the complex, probabilistic real world, this panic-driven manipulation of credit markets just might get us both these outcomes.
Re: Twain and Taleb
A fragment from the pre-Socratic “Weeping Philosopher” of ancient Ionia, Heraclitus, can be translated as: “Unless you expect the unexpected you will never find truth, for it is hard to discover and hard to attain.” {source}
FM, your “Growth of Credit market debt growth per dollar of GDP growth.” is measuring the US GDP, but your own site is often claiming a global perspective — there’s been a huge growth in global GDP that has been influenced by that US credit market debt. Interesting table, but possibly showing two trends, 1) the reduced effectiveness (d) and 2) the transfer of GDP growth from the US to non-US.
As is becoming clear in Europe, exposed to Emerging Markets, whose share prices are nose-diving, if America sneezes the world catches a cold.
I’m now thinking of two ways to test tires. One way is to see if a test pair lasts 50 000 miles. Another way is to test them until they fail. I’d personally rather have had my brand’s tires tested until they fail, and know that some very high percentage fail long after the guarantee.
Test pilots in aircraft often die.
The Big Banks (I love to hate) have been testing to failure, because of the socialization of the risk. From the S&L bailout, Chrysler bailout (#1), LTCM bailout (because of derivatives!), to now. I don’t remember any bailouts from the dot.com bubble pop.
When Greenspan warned about irrational exuberance in Dec 96, he should have used the Fed’s power thru Reg T (just learned about) to increase margin requirements from 50%. Besides interest rate, a tool for money, the Fed needs a credit risk tool that it uses. It has the power to change the margin requirements. It hasn’t been adjusting these requirements. It should. As much, and perhaps more so, than the bigger and more blunt interest rate tool. There may be other tools it has but hasn’t used — there are likely to be more tools coming.
The downturn goal should be the soft landings we’ve been having in the past 25 years (since ’82).
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Fabius Maximus replies — I find these kinds of narratives about economics of little interest, however popular they might be. I see little grounding here in theory or economic history; this is more like one of Kipling’s “Just so stories”, like How the Camel Got His Hump.
I do not understand your first paragraph. Your (2) makes no sense to me.
Also, US credit market growth has boosted global gdp growth, but most analysts say that this effect is not as large as commonly supposed. For example, China’s growth is largely domestic-driven — not export driven. As usual for early stage economies. Almost every study on the subject confirms this; here are two of the latest:
* “How Dependent is the Chinese Economy on Exports and in What Sense has its Growth been Export-led?“, Dong He and Wenlang Zhang, Hong Kong Monetary, 14 October 2008)
* “China’s Economic Rise—Fact and Fiction“, Albert Keidel, Carnegie Endowment for International Peace, July 2008
IMO people who expect another mild recession, like 1991 and 2001, are dreaming. Those were made possible by “Easy Al Greenspan’s” massive credit creation. That is no longer possible. For quite a while recessions will return to their normal behavior.
* role, rebalancing the excesses built up during expansions,
* frequency, aprox 15-20% of the cycle’s length, and
* lenght and severity — 1991 and 2001 were the lightest of the post-WWII era.
Peak oil is linked to our (world’s) transportation economy. All practical engine designs for vehicular use are internal combustion types and these require liquid fuel. Heat engines can use solid fuel, and direct combustion of bio-mass makes good sense given the current supplies of such material. The problem then is one of technical achievement in weight reduction and cost performance of such engines. Kondratiev cycle theory posits exactly this type of bottle-necking of capitalist societies. If such engines are demonstrated the whole world will, dare I say, capitalize on it in a major way, thus providing a logical and attractive home for money. Don’t worry about bankers fighting over money, that’s a symptom, worry about a demonstration of this technology showing up…soon.
c,d,e,f are so interrelated as to be essentially the same point.
b is hypothetical in that there have not been serious supply issues yet.
a is a long-term trend, extremely important, possibly the cause of the crisis but that needs to be fleshed out.
Personally I think it goes something like this: America’s ascendance in the post-industrial-revolution world because of being there for the taking by displaced immigrant overcrowded European occupiers took wing; however, about a century ago it decided to base its financial house on a usury-funded monetary system.
Along with significant expansion in productivity and population, a pervasive attitude emerged, that of expecting things to always be geometrically bigger and better, a sort of hyper-optimism that gradually turned into a very greedy form of ignorance. This gluttony, if you will, further (r)oiled the wheels of the credit-based financial system until its goals gradually became the leading determinant of economic development. Since it is a derivative function depending upon an underlying ‘real’ economy, just like the sea-shell mania of 4000 BC or the tulip craze in Holland more recently, or like winged Icarus, it spiralled too far from underlying reality and was doomed to evaporate.
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Fabius Maximus replies: I doubt you can find many people who consider c, d, e, and f to be the same point. At some high degree of abstraction that might be true, but it is probably impossible to communicate this to another person. You may attempt to do this (elsewhere); I would be interested to see the result.
(b) is not hypothetical, as oil production peaked in 2005 (+/- a tiny fraction), while the global economy continued to grow at 5%/year. To reconcile demand and supply, price had to skyrocket (in order to “destroy” ex ante demand). If the global oil supply was not peaking (i.e., began the long period of peaking), supply would have increased. Prices have crashed this year — along with many other indicators of global economic activity — but not due to supply growth.
Theres a lot of root causes to the current financial crisis mentioned, but how come no one has mentioned the funding of war and maintaining troops in Afghanistan and Iraq never gets mentioned?
In my view a lot of money could have gone to that effort and somehow caused the defence mechanism in the US financial crisis t fail. Just a comment for the experts to rebut.
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Fabius Maximus replies: Nobody has mentioned the wars because they do not have an obvious relationship to the economic processes now at work. Not every bad thing in recent American history is a cause of this problem.