Recommended links:
Arnold Kling of EconLog talks with EconTalk host Russ Roberts about the role of credit default swaps and counterparty risks in the current financial mess. The conversation opens with the logistics of credit default swaps and counterparty risks and moves on to their role in the financial collapse. The conversation closes with a discussion of the political economy of pending financial regulation.
It’s an hour long podcast recommended by a reader who writes:
Taleb has called the current credit crisis a “white swan” because it was forseeable (as he noted). I think the true Black Swan is what the government is doing in response to the crisis. In short, they have rewrote the rolls. As Arnold Kling in this podcast notes, who would want to invest in U.S. equities when the Paulson or Bernanke can take it away? Or, the audacity of Bernanke and Pualson to complain that banks are not using the money that the U.S. government has loaned them to make new loans. But why would the banks make loans when the Paulson keeps chanign the rules? And with Obama coming in, and the democrats in control, it will be scary times I fear. The Black Swan is still in front of us not behind.
Those who watch the podcast may wish to turn this into an open thread. What will this new intervention in financial markets ultimately mean? If a new Black Swan comes along, what might it look like?
Tip Jar
I have not listened to the podcast yet, but this brings to mind the main point of a book from the early 90’s “Unlimited Wealth.”
The book pointed out that technical innovation could change things radically, and when different technologies – computers and internal combustion engines for example – things change in still more radical ways. If computer controlled fuel injection had not occurred in the 80’s, then both cars and gasoline would cost a lot more today.
Computer technology, low cost worldwide satellite communications, and the American victory in the Cold War ultimately produced the current credit meltdown.
Computer modeling technology and more detailed weather data as well as even better communications is in the process of producing the Carbon Cap and Trading “industry.” From those same wonderful people who brought you the Mortgage Meltdown. And what happens when the polar ice caps don’t melt but the Carbon Trading industry does?
How many more of these combine-different-parts schemes are out there? That’s the real Black Swan.
One of the insights in the Black Swan is that the concentration of technology, size, international capital flows, consolidation and globalization is that it actually creates more risk through connecting everyone and removing redundancy from the system. So, when one goes down, the inter-connectedness pulls them all down.
The U.S. government takeover of the financial industry actually appears to further this centralization, with all the risk that further consolidation and removal of redundancy creates.
Separately, in this podcast, and after seeing the new AIG bailout plan, I fear that the policy response might be far worse than the cause. One of the things that they discuss in this podcast is the replacement of the “rule of law” and the “rule of the market” with the “rule of the man,” i.e. Ben Bernanke and Hank Paulson. We are in uncharted waters and Bernanke and Paulson don’t even know it. The U.S. government takes over the financial sector and pumps money into banks and then asks why banks are not loaning? This is hypocritical as Paulson & co keeps changing the rules. What business will make loans in an uncertain environment like that? Who would buy U.S. securities in an environment where you don’t know what the regulators are going to do next? That’s the growing policy response risk.
Usually companies in distress file bankruptcy and re-organize under court supervision or give it up and liquidate. The Feds have decided that the institutions threatened are so big that the massive losses from either type of bankruptcy are too painful for the economy and shareholders. So they’ve decided to prop them up until the economy turns around. This is an effort to build confidence – there is tons of capital out there, but no one wants to take risks. The more that major institutions fail the less confident we are that the end of the pain is near.
My personal political instinct is that the government shouldn’t get involved, let unhealthy companies fail, the market will work things out. It will be a painful but necessary lesson. But maybe sometimes the problem is so big it requires a massive mobilization that only a unified effort (in this case, “massive deficit spending by the taxpayers”) can assure success. In many ways, it’s like a unified war effort, only instead of a competent military running the show, it’s a legion of bureaucrats and a novice executive.
In my dark moments I feel that this won’t end until it can’t go down any further.
This whole mess is due to a series of decisions made by people who thought they were smart, but were foolish and shortsighted. The antidote for fools is that they lose what they have. What is happening is that the fools with deep pockets are giving money to the other fools so they can continue being fools.
Paulson should give money to the banks so they can lend it to GM and Ford.
Derek
Herbert Hoover and and FDR were compulsive fiddlers with the economy. Their fiddling prolonged the Depression from a year or two to twelve years. This is already happening, again. Bailouts, regulatory changes, tax increases threatened, threats to seize 401Ks and other pension funds, the refusal to allow some failing companies to go bankrupt while pursuing successful companies with anti-trust actions, and the imminent collapse of social security and medicare are all game changers that so confuse investors that they will all pull their money out and turn it into gold bars to be stored under their mattress or in the garden. If Obama continues the economic meddling it will only make things worse. The US was fooled once before by a charismatic meddler, back in the Great Depression, and it’s possible we could be fooled again. It’s a sure bet that he will be blaming “conservative” George W. Bush for everything that goes wrong for four-eight more years, and longer if he repeals the 22nd Amendment and manages to win.
This whole mess is due to a series of decisions made by corrupt politicians and their lackey appointees in the GSE’s and regulatory agencies
peoplewho thought they were smart, but were asfoolish and shortsighted as they were greedy.There, fixed that for you.
Bravo, Beaglescout! As I posted elsewhere, unemployment reached 25% everywhere in 1932.
By Dec of 1941, (afteralmost 9 years of New Dealing), the national average remained at 14%. However, the favorites of the New Deal were still at 20% plus while those “neglected”
were at not more than 6% to 8%.
Lesson learned? Be damned sure that the socialists don’t like you. You will survive
in much better shape than those whom they “assist”.
I live in Las Vegas, I don’t think casinos are high on the Obamaroids list. I am from the West Texas oil patch. I know the home folks are not in line for largesse. Looks like both my areas will be okay. Don’t know about Wall Street, the auto industry, “renewable” energy etc. Fact is, I think they are screwed.
I like what P. J. O’Rourke says:
Anyway, it’s no use blaming Wall Street. Blaming Wall Street for being greedy is like scolding defensive linemen for being big and aggressive. The people on Wall Street never claimed to be public servants. They took no oath of office. They’re in it for the money. We pay them to be in it for the money. We don’t want our retirement accounts to get a 2 percent return. (Although that sounds pretty good at the moment.)
What will destroy our country and us is not the financial crisis but the fact that liberals think the free market is some kind of sect or cult, which conservatives have asked Americans to take on faith. That’s not what the free market is. The free market is just a measurement, a device to tell us what people are willing to pay for any given thing at any given moment. The free market is a bathroom scale. You may hate what you see when you step on the scale. “Jeeze, 230 pounds!” But you can’t pass a law making yourself weigh 185. Liberals think you can. And voters–all the voters, right up to the tippy-top corner office of Goldman Sachs–think so too.
http://www.weeklystandard.com/Content/Public/Articles/000/000/015/791jsebl.asp?pg=2
I think if you asked most people what they thought caused our economic woes they would say greed. And this greed ran wild because of a lack of government oversight and regulation. I believe the reason why they think this is so is because, in our political climate, that’s the narrative that’s being allowed to pass for the truth. Or, at least, that view is not plainly rebutted. I think that’s why so many people voted for Obama, who is seen as the right person to take over and exercise the needed corrective governmental authority to crack down on all this supposed wild-west free-wheeling greed run amok. So, right from the beginning, dishonesty has been a real hindrance.
Though it might be interesting, you don’t have to understand all the complexities of derivatives and credit default swaps and stuff in order to appreciate that the trigger of the meltdown was the government’s interference in the housing market in the first place. It worked like this: 1. Advance your policy to increase home ownership among a population traditionally shut out of the home ownership market. 2. Make credit easy and cheap, then watch dramatic appreciation of real estate and consequent big bubble. 3. Continue this policy and even increase it and expand it for years and years. 4. Feel very proud of yourself over all the good you’re doing. 5. End up with a huge load of unbelievably shaky mortgage backed securities. 6. Let this rotten stuff permeate its way through the financial system. 7. Watch the house of cards collapse. 8. Blame the resulting mess on the Republicans and elect Obama.
Kling and Roberts say they’d much rather be seeing the problem approached in a Hayekian manner instead of more centralization, but the chances of that happening would be, well… THAT would be a black swan occurence for sure!
RWE:
VW had computer controlled FI in the 70′s!
Australian Islamist Boxer KO’s Opponent– Starts Riot (Video)
Fascinating and frightening podcast. What interested me most was that these were two extremely bright economics Ph.D.s who had to admit that 1)they had very limited understanding of what was going on, 2) that the current interventions appeared ad hoc and not supported by current economic theory (which suggests supporting prices rather than recapitalizing financial institutions), and 3) that this failure occurred in the part of the economy (housing)that was most clearly the object of industrial policy. Yet we’re trying to solve the problem with increased government intervention in the economy.
Thus, it seems likely that no one really knows how deep the water is in this debacle. Ouch.
http://derivativedribble.wordpress.com/2008/11/08/a-conceptual-framework-for-analyzing-systemic-risk/
Karen: Yes, you have it right, except add: 7A. Realize belatedly that when you pushed those policies that also encouraged and enabled people who were not “needy” to buy two or three or seven houses as short term investments and then say “Hey, it ain’t our fault; how was we to know…”
Doug: The “Computer Controlled Fuel Injection” of the 70′s VW engines employed ONE transistor.
Sorry for going OT but I found a minor house keeping issue that may need attention.
The “older posts” link (or whatever it is called) has been missing from the bottom of the main Belmont Club page for some days now.
Just an FYI.
We now return you to your regularly scheduled erudite discussion … already in progress.
A helpful thing to remember here is that banks have considerably scaled back their loans and not too many trash loans are being handed out any more. The banks themselves are slimming down their debts to assets ratios from +30 to 1 to the traditional 12 to 1.
It cannot be be emphasized enough. This is Massively deflationary.
At the same time the federal government as well as countries around the world are injecting massive amounts of money into the system.
It cannot be emphasized enough. This is massively inflationary.
So what happens when you have a massively inflationary rock come up against a massively inflationary hard place?
Beats me. Time will tell.
But I think it was vision of the deflationary spiral caused by the banks credit contraction that motivated the central bankers to inject money into the system.
The great power of the US is a function of private return on capital–which far exceeds the rest of the world. However, government return on capital likely is in line with the rest of the world’s governments return on capital–which is to say–not much.
My WAG as to why the reason the fed is not telling where they are spending their money is that part of it is going to compensate foreign banks who bought junk US mortgages that were marked GRADE A.
People don’t want to buy chinese vegetables with pesticides in them or chinese anything that have pollutants in them, or chinese toys that are going to harm kids because they are shoddily made…
Its not likely that the USA will be held to another standard vs a vis financial products.
Junk means Junk. Grade A Means Grade A.
Truth in labeling.
So the fed is likely paying off a lot of foreign banks that got the democratic trash mortgages when they thought they were buying Grade A.
It also seems to me that we have a rather widespread denial of what really can be done
to smooth things out.
Typified by Freddie and Fannie portfolios, income still exceeds outgo by a considerable margin. Therefore, obligations can too be met
by one means or the other. (As regulars know, I favor revenue bonds but that is not the ONLY thing that could be done.)
However, using total cash flow to solve problems requires using original principal(as well as interest) to meet obligations. Which means in turn that paper losses occur and principal has to be rebuilt after the crisis is over.
The emotional reaction to that prospect is to
refuse to meet obligations, thereby creating
more and more obligations which wipe out principal alltogether and leave nothing but additional obligations behind.
Precisely the kind of non-thinking that made
for the Great Depression back when. It is this kind of attitude, not the actual problems to be solved, that is causing me concern.
As US Gov’t spending creates deficits that soar into the stratosphere in an effort to prop up the economy, at what point does The Market decide US Gov’t securities are too risky and refuse to buy them? If that happens, then what? Just print money like Zimbabwe? What else could happen?
The one thing about the U.S. Dollar that makes it different from other assets is that its value is always relative to other currencies. Even if the Fed is pumping out greenbacks like pennies it may still be a better value today than say the Euro or the Yen if more commercial interests believe that Brussels and Tokyo are likely to do something even more destructive.
What is most distrubing about the current crisis is that it went from practically unnoticed to global nuclear with a few weeks. Although Wall Street is the convenient and visible whipping boy I think history will show that social engineering of the credit markets is the root cause of the problem. Wall Street could not have securitized bad mortgages without the enthusiastic backing of Fannie/Freddie, which for years were the corporate playground and cash machine of Washington insiders.
I would like to see people like Gorelick, Raines and Emmanual put on the rack and made to disgorge the millions they personally took out of Fannie/Freddie. They’re more likely to end up in Obama’s administration with everybody asking why there is no confidence in government.
“So what happens when you have a massively inflationary rock come up against a massively inflationary hard place?”
Stagflation, as in Carter era.
I wouldn’t know a credit default swap or counterparty risk if it introduced itself and gave me its bio.
At my level of knowledge, you watch what people do, not what they say.
So when I hear Rush Limbaugh and others predict that Obama’s policies will destroy our economy, I ask, “So where is Rush putting his money?”
The first week of this crisis, I moved what was left of my savings into Treasury Bonds to wait until things were clearer. I do understand fear and confusion.
Peter Boston writes:
“I would like to see people like Gorelick, Raines and Emmanual put on the rack and made to disgorge the millions they personally took out of Fannie/Freddie.”
Yes, that is an end devoutly to be wished.
But let’s remember, also, that Wrichard suggested poems and plays are an appropriate response.
Black swan. White swan. As your 401(k) takes flight in a southerly direction, take a moment to consider these swans (“Coole” has two syllables):
W.B. Yeats (1865–1939). “The Wild Swans at Coole” (1919)
THE TREES are in their autumn beauty,
The woodland paths are dry,
Under the October twilight the water
Mirrors a still sky;
Upon the brimming water among the stones
Are nine and fifty swans.
The nineteenth Autumn has come upon me
Since I first made my count;
I saw, before I had well finished,
All suddenly mount
And scatter wheeling in great broken rings
Upon their clamorous wings.
I have looked upon those brilliant creatures,
And now my heart is sore.
All’s changed since I, hearing at twilight,
The first time on this shore,
The bell-beat of their wings above my head,
Trod with a lighter tread.
Unwearied still, lover by lover,
They paddle in the cold,
Companionable streams or climb the air;
Their hearts have not grown old;
Passion or conquest, wander where they will,
Attend upon them still.
But now they drift on the still water
Mysterious, beautiful;
Among what rushes will they build,
By what lake’s edge or pool
Delight men’s eyes, when I awake some day
To find they have flown away?
I know a number of the top macro economists in the US. They did not write anything about the hedging scam and the implications of the massive leveraging. At least one praised the Greenspan Fed and the “creative” new financial instruments.
Economics is NOT a science. I believe that the Fed and Treasury are going to make the mess worse.
One aspect of all the machinations in the markets and in Wachington politics that scares the pajamas off me is the fact that the Washington insiders continue to use the same morons as their “go to” people in these situations.
Consider this – President-Elect Obama is apparently seriously considering Jamie Gorelick as a candidate for Attorney General. This is the same person who created the wall between the FBI and the CIA in the 1990s (while in the Clinton Administration) that prevented our own anti-terrorist experts from “connecting the dots”. Following that, Ms. Gorelick was named to the 9/11 Commission investigating the government’s role in detecting terrorist events. Whenever given the opportunity, she prevented the Commission from examining any of the Clinton-era connections to the 9/11 conspiracy.
Where does she go from there? To Fannie/Freddy, from which she apparently extracted over $14million of pay and bonuses. when the Auditors started to get too close, she jumped ship and went to work as a Washington lawyer/lobbyist.
And then? She shows up as defense counsel for Duke University in Lacrosse team (alleged) rape incident lawsuits. The respondent briefs that her “team” has prepared are nearly unbeelievable as to fundamental misunderstandings of the law, of the specifics of the case, and of the actions of the University Administration. She’s probably going to lose a good-sized chunk of Duke’s endowment if she isn’t careful.
Or maybe she’s just wating for the next Washington-insider deal to come down the pike. Why not become Attorney General? Then she could excuse all of her unfortunate screw-ups by jumping ship ahead of the ultimate recriminations again.
when does the revolving door stop?
Nick Danger has it about right – it’s all backwards.
I’m not completely in the camp, but I’m within spitting distance of it so I’ll go ahead and drive home the point of the last two points (plus a few others) since somebody has to do it.
The real gap that seems to be emerging is not black-white, Dem-Repub, but “elites” vs Americans of the Palin stripe.
“Revolving doors” do not make for the cross-pollination required to reverse trend lines. But then look at what happened when Clinton tried to crack open the gates of privilege with his appointments from the back-bench.
Condemn it as Luddite-lite, but that “dismal tide” darkens the event horizon for the next decade.
This too shall pass – maybe – but trust has been badly compromised.
The disappearance of TARP transparency – just one signal.
wrt to Boston #20, banks were eventually forced by the Feds to join in the trash mortgage business or lose business.
Cold Comfort indeed that all of the most malicious actors are returned to serve our country.
(as in the Twilight Zone:
“To Serve Man“)
I can’t think of a better candidate in 4 years than Bobby Jindal.
(if the Pubs *ever* return to the WH, …which depends entirely on how many tens of millions of illegals are given the right to vote)
Confirmed It Looks Like Obama Just Got Away With Largest Election Donations Fraud in History
Bush “Justice” (lawlessness) has been a disaster for this country, along with his refusal (except for token efforts of late) to enforce any aspect of immigration law.
Change for America…
The Politico reported that Obama will not have to worry about his election donations scandal.
There will be no investigation:
The Federal Election Commission is unlikely to conduct a potentially embarrassing audit of how Barack Obama raised and spent his presidential campaign’s record-shattering windfall, despite allegations of questionable donations and accounting that had the McCain campaign crying foul.
However, John McCain will be audited since he took federal funding as he and Obama both agreed to back in the spring.
Doug, re your “all the most malicious actors are returned to serve our country” is reason enough to wonder how anyone can hope for a Jindal (or other sane actors) to come to the rescue in just 4 years when a Jamie Gorelick and her kind has been allowed to wreak destruction scot-free for a decade or more. The coming Obama administration, plus Congress, plus millions more voters for them, will not only make things worse, they will centralize everything so densely, it will become a massive black hole impossible to escape. We know the mindset, the beliefs, the worldview of those coming to power and character is destiny. I fear a future of famine and freezing in the dark. Tell me (anybody) some good reasons why I’m just getting hysterical.
Karen,
It’ll be Paradise!
(of a sort)
Dystopian Paradise
Maybe I should add: I agree that, when a governmental system is designed in such a way that whichever particular personalities occupy whatever particular slots of power, the system can stay on-course even in bumpy waters. The problem is, that system has been so successfully chipped away at by the bad actors for so long now… Maybe we are the ones who are simply living in the past, acting as if the past is still present.
Agreed.
Moody’s issued a warning in January of this year:
In its report on the country’s so-called “sovereign debt rating,” Moody’s says the world’s largest creditor risks losing its triple-A rating within the decade, if it doesn’t get control of its entitlement programs.
Those would be the same agencies that rated the repackaged mortgaged-backed securities that became a household name in September of this year.
The difference with a distinction is getting serious versus hysterical.
Difficult not to feel a bit Moody.
Or a bit Standard and Poor.
slade, the Moody’s thing is a riot – I recall S&P did something similar.
Let’s review – US debt is denominated in dollars. The US can print dollars. The likelihood of a US default is zero. QED.
What Moody’s and S&P can do is inject FUD, and worse, into the bond market. The appetite for US Treasuries is critical to our fiscal health. The Treasury market could collapse, the dollar could erode, etc – but the idea that you won’t be paid back your par dollars on your long bond is ludicrous.
Moody’s and S&P are worried about being called to account for the MBS/CDO ratings fiasco.
What they doing with the “sovereign ratings” saber rattling is saying, in effect: nice Treasury market you have there. Be a shame if something happened to it.
Pure gangsterism.
So the avenue of entry for various “agents” was the credit agencies.
Well then.
Famine and hysteria it is.
Let’s review – US debt is denominated in dollars. The US can print dollars. The likelihood of a US default is zero. QED. – lewy14
I assume you’re being curmudgeonly, which is OK.
But it’s a worthy point – the long-term view obscured by the dramatic upheavals within a two-month period that cut 40% from the portfolios of pending retirees (Roubini still believes another 20-25% to go).
This “episode” – as I have been saying – is deeper and longer – regardless of what you call it, which means short-term concerns/hysteria subsume long-term confidence/hubris (?). Systemic failures across the boards.
Listening to analysts, short-term horizons have become longer (5-10 years) and long-term horizons have become longer (10-20 years).
$20 trillion is needed from energy companies to keep up with demand over the next 20 years. – Steve Forbes
Still a lot of skepticism over the short-term and long-term value/objective of the TARP. AS you said, not to worry, the US Treasury Sec can always go to Congress and smile nice.
One caveat to watch is the media hype.