The tendency in the media and the Congress has been to blame the current depression on "stupid, greedy, and reckless" bankers. I believe that that is a mistake. I know bankers. They are not stupid; most of them are smart, and many of them are brilliant. If they are "greedy," it is largely so in the sense in which most Americans (most anyone, I imagine) could be called "greedy": they like money a lot. I read somewhere recently that bankers (a word I use loosely to cover financiers in general) derive their job satisfaction entirely from their monetary compensation, unlike other workers. But that is wrong. Rich bankers derive satisfaction not only from making a lot of money but also from a sense of outsmarting competitors, and in that respect they are not unlike highly paid athletes; in both cases the money the stars are paid do not merely enhance personal welfare, but also are indicators of relative performance. Money is a scorecard of success. Richard Posner
Rudyard Kipling famously argued, If you can keep your head when all about you are losing theirs....you'll be a man. Of course, it is only in hindsight that one can be sure one is keeping one's head.
Perhaps the Bankers really are Nietzchean Supermen? Perhaps intelligence is no longer manifested by following the wisdom of Daedelus but rather by flying high like Icarus?
Then again, perhaps not.
Richard Posner, whose prose in his new book A Failure of Capitalism: The Crisis of '08 and the Descent into Depression and blog suggests a gifted and learned mind, argues the former position.
Bankers, to him, are akin to athletes richly rewarded to push the envelope- to be reckless.
I agree with the comparison, but will argue that this is NOT a sign of intelligence, but of the ignorance of youth.
When I was a bank options trader in my early 20s I chased profits as ardently I chased women- recklessly and without much thought of consequence. I was Icarus and the fear of falling was obscured by the joy of soaring.
I eventually learned that I could fall.
Our Uber-Bankers have been resistant to this lesson, ably assisted in this regard by the Cult thereof. Otherwise intelligent people cheer our Uber-Bankers on like fans in the stadium.
Mr. Posner claims to know bankers. I wonder if he knows athletes? I wonder if he has really thought through his apology for their actions?
In addition to being a banker, I've been an athlete, albeit one who was never paid. In my youth I played Ice Hockey in front of crowds of 100s and it was quite a rush. While I was never the star player when I played competitively, I know the feeling that comes from a roar of the crowd when scoring a goal or body checking an opponent into the boards. Desire for that feeling drives many athletes to actions a saner man would view as mad.
There is a term for people like this- adrenaline junkies- and while they can excite crowds of on-lookers today in much the same way Gladiators of old excited the Romans, to consider them "smart" or worse, able managers of of a vital social function seems to me a bit strange.
To wit, while we might admire the recklessness of a NASCAR driver, we wouldn't want our cab drivers to follow their lead. While we might admire the nerve of a Chuck Yeager, we don't want our commercial air pilots finding out how fast or how high a 767 can go. Should we equip all seats on commercial airlines with ejector buttons and parachutes? It would certainly extend the obligatory safety instructions- in the event the pilot decides to escape the stratosphere and fails you will be expected to hit the ejector button....please wait to deploy your chute until you are clear of all other passengers.
Banking, and finance in general, despite the efforts of CNBC et. al. is not a spectator sport.
I think the Uber-Bankers Mr. Posner glorifies are not smart, nor, in that regard at least, are those who cheer them on and apologize for their excesses as sports agents apologize for the excesses of the athletes in their "stable." They, like Icarus, don't understand that their function is to ensure a safe flight.
Sadly, they have been piloting the US$ 767 Jumbo Jet. I hope you remembered the safety instructions. The ejector button is the golden one on the right but they're not enough to go around so you might want to beat the rush.
Tuesday, May 19, 2009
Monday, May 18, 2009
Hitting the Niall on the head
Human beings are as good at devising ex post facto explanations for big disasters as they are bad at anticipating those disasters. It is indeed impressive how rapidly the economists who failed to predict this crisis — or predicted the wrong crisis (a dollar crash) — have been able to produce such a satisfying story about its origins. Yes, it was all the fault of deregulation.
There are just three problems with this story. First, deregulation began quite a while ago (the Depository Institutions Deregulation and Monetary Control Act was passed in 1980). If deregulation is to blame for the recession that began in December 2007, presumably it should also get some of the credit for the intervening growth. Second, the much greater financial regulation of the 1970s failed to prevent the United States from suffering not only double-digit inflation in that decade but also a recession (between 1973 and 1975) every bit as severe and protracted as the one we’re in now. Third, the continental Europeans — who supposedly have much better-regulated financial sectors than the United States — have even worse problems in their banking sector than we do. Niall Ferguson
I envy Niall Ferguson's command of the facts of history. Reading his books or essays, leavened with historical yeast, reminds me of the limits of my own sense of history.
Yet, for some odd reason, despite the, apparently, appropriate leavening, the "bread" of his arguments never seems to rise, for me. Jumping to a new metaphor, his arguments are like cloth from a weaver with the strongest, most vivid and varied thread, but a broken loom.
The loom on which a storyteller weaves his fact-threads into cloth is his perceived experience. If his experience-loom comports with the reader's the story seems to come alive. If not, the story will prove inaccessible to the reader.
Similarly, arguments in essays require a shared loom of premises, else they too fall short.
To accept Mr. Ferguson's argument the deregulation was NOT the problem, we would have to accept that policy changes 29 years ago alternatively have no impact on today's events or have a negative impact which must be balanced by the intervening good. We would also have to accept that the depths of the current event have been plumbed, else the comparison with the 70s might, in the future, obviate his argument.
In the arena of history, the view that the Treaty of Versailles's punitive imposition of reparations on Germany led, in part, to the rise of Hitler and WWII is reasonably well accepted. Should we, a la Ferguson, deny that a policy choice decades prior can have no effect on today's events, or that the intervening good- no war and a France rebuilt on Germany's dollar (or mark)- negated the flaws in the Treaty?
Has the fraud and theft of Mr. Madoff been negated by the years of income he did provide his investors, or the fact that his choice to "go Ponzi" occurred decades ago?
To me, though, the most egregious error in Ferguson's reasoning is his ridicule of the dollar crashers and sense that the depths of the current crisis have been plumbed.
Reality, it seems to me, has yet to fully unfold on this crisis. When it does, in the event that, as I suspect, the US$ loses it's place as global reserve currency the wisdom of retaining the old (or similar) regulations on finance will become evident.
Borrowing a phrase from his essay, for reasons to do with human psychology, regulations of certain activities has proven effective. These regulations are often capable of significant improvement, but their absence....well, when this story ends we'll find out the true cost of their absence.
There are just three problems with this story. First, deregulation began quite a while ago (the Depository Institutions Deregulation and Monetary Control Act was passed in 1980). If deregulation is to blame for the recession that began in December 2007, presumably it should also get some of the credit for the intervening growth. Second, the much greater financial regulation of the 1970s failed to prevent the United States from suffering not only double-digit inflation in that decade but also a recession (between 1973 and 1975) every bit as severe and protracted as the one we’re in now. Third, the continental Europeans — who supposedly have much better-regulated financial sectors than the United States — have even worse problems in their banking sector than we do. Niall Ferguson
I envy Niall Ferguson's command of the facts of history. Reading his books or essays, leavened with historical yeast, reminds me of the limits of my own sense of history.
Yet, for some odd reason, despite the, apparently, appropriate leavening, the "bread" of his arguments never seems to rise, for me. Jumping to a new metaphor, his arguments are like cloth from a weaver with the strongest, most vivid and varied thread, but a broken loom.
The loom on which a storyteller weaves his fact-threads into cloth is his perceived experience. If his experience-loom comports with the reader's the story seems to come alive. If not, the story will prove inaccessible to the reader.
Similarly, arguments in essays require a shared loom of premises, else they too fall short.
To accept Mr. Ferguson's argument the deregulation was NOT the problem, we would have to accept that policy changes 29 years ago alternatively have no impact on today's events or have a negative impact which must be balanced by the intervening good. We would also have to accept that the depths of the current event have been plumbed, else the comparison with the 70s might, in the future, obviate his argument.
In the arena of history, the view that the Treaty of Versailles's punitive imposition of reparations on Germany led, in part, to the rise of Hitler and WWII is reasonably well accepted. Should we, a la Ferguson, deny that a policy choice decades prior can have no effect on today's events, or that the intervening good- no war and a France rebuilt on Germany's dollar (or mark)- negated the flaws in the Treaty?
Has the fraud and theft of Mr. Madoff been negated by the years of income he did provide his investors, or the fact that his choice to "go Ponzi" occurred decades ago?
To me, though, the most egregious error in Ferguson's reasoning is his ridicule of the dollar crashers and sense that the depths of the current crisis have been plumbed.
Reality, it seems to me, has yet to fully unfold on this crisis. When it does, in the event that, as I suspect, the US$ loses it's place as global reserve currency the wisdom of retaining the old (or similar) regulations on finance will become evident.
Borrowing a phrase from his essay, for reasons to do with human psychology, regulations of certain activities has proven effective. These regulations are often capable of significant improvement, but their absence....well, when this story ends we'll find out the true cost of their absence.
Friday, May 15, 2009
You can't get a little bit "fiat"
As you likely know, the administration is proposing to lend $100bn to the IMF, as part of that organization’s increase in resources following the G20 summit. Peter Orszag, head of OMB, argued that there was zero probability of this money being lost, so $100bn should be “scored” for budget purposes as $0bn – which is how this kind of transaction has been handled in the past. As the IMF likes to say, it is “the lender of last resort, but the first to be repaid.”
After considerable back and forth, the scoring issue was referred to the CBO. The CBO has reportedly decided there is a 5 percent probability of default by the IMF. This is an extraordinarily important statement. Most informed people just assume that the risk of IMF default is zero, because that would essentially constitute a complete breakdown of the global economy and payments system. But nothing is zero probability, particularly in a world of massive financial panics, incipient protectionism, and improvised global governance. Baseline Scenario
Another day, another example of monetary confusion.
To what do I refer? I'm (once again) noticing the apparently widespread view that "credit risk" only occurs in the event of default- a view that seems to me a "residual monetary image" from the days of fixed exchange rates to specie.
When money was defined as a fixed amount of Gold or Silver, "credit risk" could be conflated with the risk of default- either you got your specie (or equivalent) or you didn't.
However, we haven't had such a link to specie for decades. The value of fiat money fluctuates, which is both the blessing and curse of that policy. The risk of, say, a default by the US Treasury, which was a concern of France before the link to Gold was severed, is now almost nil because the only obligation is to pay US$s, which the Fed can print.
In other words, the risk of default inherent in a fixed specie exchange system has been replaced- at least for countries that can issue debt in their own currency- by the risk of devaluation.
There isn't, as the old saying goes, any free lunch. To borrow a concept from physics, risk, like matter and energy (combined), is never created nor destroyed, it just changes form.
It seems to me this residual monetary image- the view that money, specifically the US$, is a thing unto itself and not merely a share of output divided by the stock thereof- is the last bit of foundation holding the house of cards together.
Human conception is a curious thing. I can remember quite a few instances when I was sure I knew something only to later find out I did not. I didn't, for various reasons, take in all the consequences. I thought, to use another old adage, one could get a little bit pregnant- an adage that has lost some of its punch with the availability of abortions.
One also can't get a little bit fiat. Either there is a fixed exchange to specie or there isn't. The most pressing risk in funding the IMF is not whether they will be repaid in US$s, on which I agree with the CBO's assessment, but what those US$s will buy when repaid.
After considerable back and forth, the scoring issue was referred to the CBO. The CBO has reportedly decided there is a 5 percent probability of default by the IMF. This is an extraordinarily important statement. Most informed people just assume that the risk of IMF default is zero, because that would essentially constitute a complete breakdown of the global economy and payments system. But nothing is zero probability, particularly in a world of massive financial panics, incipient protectionism, and improvised global governance. Baseline Scenario
Another day, another example of monetary confusion.
To what do I refer? I'm (once again) noticing the apparently widespread view that "credit risk" only occurs in the event of default- a view that seems to me a "residual monetary image" from the days of fixed exchange rates to specie.
When money was defined as a fixed amount of Gold or Silver, "credit risk" could be conflated with the risk of default- either you got your specie (or equivalent) or you didn't.
However, we haven't had such a link to specie for decades. The value of fiat money fluctuates, which is both the blessing and curse of that policy. The risk of, say, a default by the US Treasury, which was a concern of France before the link to Gold was severed, is now almost nil because the only obligation is to pay US$s, which the Fed can print.
In other words, the risk of default inherent in a fixed specie exchange system has been replaced- at least for countries that can issue debt in their own currency- by the risk of devaluation.
There isn't, as the old saying goes, any free lunch. To borrow a concept from physics, risk, like matter and energy (combined), is never created nor destroyed, it just changes form.
It seems to me this residual monetary image- the view that money, specifically the US$, is a thing unto itself and not merely a share of output divided by the stock thereof- is the last bit of foundation holding the house of cards together.
Human conception is a curious thing. I can remember quite a few instances when I was sure I knew something only to later find out I did not. I didn't, for various reasons, take in all the consequences. I thought, to use another old adage, one could get a little bit pregnant- an adage that has lost some of its punch with the availability of abortions.
One also can't get a little bit fiat. Either there is a fixed exchange to specie or there isn't. The most pressing risk in funding the IMF is not whether they will be repaid in US$s, on which I agree with the CBO's assessment, but what those US$s will buy when repaid.
Tuesday, May 12, 2009
When Interests Collide
I followed the rules as I always have. Stephen Friedman, on his purchase and previous holdings in GS
2500 years ago Euripides observed, Whom the Gods would destroy, they first make mad. Having risen beyond the confines of the rules of men, big finance, forgetting that the rules of true finance and economics apply to all, will fall by their own hand.
The case of Stephen Friedman, who, while owning a stake in GS, chaired the NY Fed Board which approved their application to become a bank holding company and thus have access to government bail out funds- a shift denied to Lehman Brothers- is a perfect example of the "rules don't apply to me" perspective.
This perspective doesn't end with Mr. Friedman. Fed Vice Chairman Donald Kohn, according to the WSJ, The Fed's logic was that the conflict wasn't created by any action of Mr. Friedman, the financial system was in crisis, and the New York Fed needed a new president if Timothy Geithner became Treasury Secretary. So Fed officials say Mr. Kohn concluded that the benefit from the continuity of keeping Mr. Friedman outweighed the conflict of interest.
The virtues of continuity outweighed the conflict of interest, eh? In other words, maintaining the status quo- a policy which doesn't seem to comport with creative destruction- is more important than the judgment clouding effects of a large monetary stake in the outcome of a bureaucratic decision.
On the topic of the virtues of continuity, the big banks appeared to pass their "stress tests" with satisfactory grades, although they'll need to raise some extra capital because the rest of the economy isn't pulling its weight. I wonder if the policy of maintaining the status quo in finance, or even more mundane issues like a large financial stake in the outcome, might have influenced that assessment.
To wit, according to the Fed Report: At the end of 2008, the 19 BHCs held $1.5 trillion of securities, more than one‐half of which were Treasury, agencies, or sovereign securities, or high‐grade municipal debt, and so are subject to no or limited credit risk. This is, I sense we are to assume, a good thing. If there was any credit risk in sovereign securities (including Treasuries), agencies, or hi-grade munis the BHCs would have to raise a couple $100B more in capital. We'll leave aside the obviously silly concern that there actually is credit risk in such securities. No government has ever defaulted or devalued nor has mortgage debt ever led to a loss.
Right?
The other thorny issue of such an assessment- marking to market securities which few apparently hazard to value- was easily ignored with these words: The adherence of SCAP to current practices is important because the majority of assets at most of the BHCs participating in the SCAP are loans that are booked on an accrual basis. As a result of the loss recognition framework for assets in the accrual loan book, the results of this exercise are not comparable with those that would evaluate such assets on a mark‐to‐market basis.
In other words, if we marked these loan books to market the BHCs would need to substantially raise capital levels, far beyond those recommended by the Fed. The virtues of continuity must be great indeed- outweighing the concerns of sovereign credit risk and virtues of marking to market- all in one report, mind you.
I wonder if our foreign creditors are aware of continuity's great virtues. Given recent talk about changing the global financial architecture, I suspect they aren't, mainly because the virtues are not universal.
Sometimes interests collide.
To wit, theft is virtuous for the thief but not for he from whom the goods were stolen. The owner's interests are not aligned with the thief's. Nor, it seems to me, are our foreign creditors' interests aligned with our BHCs'.
Continuity is only in the interests of those within the system in question in the event that different, more efficient modes of thought and action cannot be implemented for less than the cost of maintaining that continuity- a view which seems to have escaped the men at the Fed.
Perhaps the Financial Powers That Be have, as is the wont of those who use econo-metric models, gotten confused by recent history. In the early 90s, during the last reliquification of Big Finance- remember the job-less recovery- Japan was in the role China plays today. If Japan had a Army, instead of a US military base on Okinawa, they too might have called for changes to the global financial architecture.
China, unlike Japan, has an Army. Like Japan, China sees the virtues of trading internationally in one's own currency. Unlike Japan, whose talk of "internationalizing" the Yen never came to much, China is internationalizing the RMB.
Returning to the early 90s experience, the resolution had 3 main facets: 1) raise capital 2) use the capital to take non-performing assets off bank balance sheets 3) maintain a large spread between short and long rates for an extended period of time to raise bank profits. In my view, global economic growth during that period was sluggish, in part, because the banks increased the "vig."
I suspect a similar strategy is in play in the sense that the BHCs will need a wide spread for an extended period of time. Thus the key question arises. Will our foreign creditors, who might (or might not) be willing to purchase an equity stake, also agree to pay the increased "vig" in the form of a wider than normal spread, to use US$s?
Side note: Would we be willing to sell an equity stake big enough to make a difference, can sufficient capital be raised without loss of control?
Perhaps, but only if the Fed is right about the lack of credit risk in Treasury Securities. If inflation returns, as I suspect it will, the cost benefit analysis of continuity in the global financial system changes radically.
At some point the cost of a devaluation would exceed that of creating a new system, although the cost of creating a new system increases dramatically if a war is required to "align everyone's interests."
I truly hope the powers that be can manage this mess, for it seems to me a collision of interests is imminent. The more success China has in RMB based international trade, the less willing they will be to use US$s and thus the longer will recovery take. In a sense, expansion of US$ use in the 90s dug the BHCs out of a hole. A decline in US$ use while trying to dig out of a much deeper hole seems to me a desperate situation.
2500 years ago Euripides observed, Whom the Gods would destroy, they first make mad. Having risen beyond the confines of the rules of men, big finance, forgetting that the rules of true finance and economics apply to all, will fall by their own hand.
The case of Stephen Friedman, who, while owning a stake in GS, chaired the NY Fed Board which approved their application to become a bank holding company and thus have access to government bail out funds- a shift denied to Lehman Brothers- is a perfect example of the "rules don't apply to me" perspective.
This perspective doesn't end with Mr. Friedman. Fed Vice Chairman Donald Kohn, according to the WSJ, The Fed's logic was that the conflict wasn't created by any action of Mr. Friedman, the financial system was in crisis, and the New York Fed needed a new president if Timothy Geithner became Treasury Secretary. So Fed officials say Mr. Kohn concluded that the benefit from the continuity of keeping Mr. Friedman outweighed the conflict of interest.
The virtues of continuity outweighed the conflict of interest, eh? In other words, maintaining the status quo- a policy which doesn't seem to comport with creative destruction- is more important than the judgment clouding effects of a large monetary stake in the outcome of a bureaucratic decision.
On the topic of the virtues of continuity, the big banks appeared to pass their "stress tests" with satisfactory grades, although they'll need to raise some extra capital because the rest of the economy isn't pulling its weight. I wonder if the policy of maintaining the status quo in finance, or even more mundane issues like a large financial stake in the outcome, might have influenced that assessment.
To wit, according to the Fed Report: At the end of 2008, the 19 BHCs held $1.5 trillion of securities, more than one‐half of which were Treasury, agencies, or sovereign securities, or high‐grade municipal debt, and so are subject to no or limited credit risk. This is, I sense we are to assume, a good thing. If there was any credit risk in sovereign securities (including Treasuries), agencies, or hi-grade munis the BHCs would have to raise a couple $100B more in capital. We'll leave aside the obviously silly concern that there actually is credit risk in such securities. No government has ever defaulted or devalued nor has mortgage debt ever led to a loss.
Right?
The other thorny issue of such an assessment- marking to market securities which few apparently hazard to value- was easily ignored with these words: The adherence of SCAP to current practices is important because the majority of assets at most of the BHCs participating in the SCAP are loans that are booked on an accrual basis. As a result of the loss recognition framework for assets in the accrual loan book, the results of this exercise are not comparable with those that would evaluate such assets on a mark‐to‐market basis.
In other words, if we marked these loan books to market the BHCs would need to substantially raise capital levels, far beyond those recommended by the Fed. The virtues of continuity must be great indeed- outweighing the concerns of sovereign credit risk and virtues of marking to market- all in one report, mind you.
I wonder if our foreign creditors are aware of continuity's great virtues. Given recent talk about changing the global financial architecture, I suspect they aren't, mainly because the virtues are not universal.
Sometimes interests collide.
To wit, theft is virtuous for the thief but not for he from whom the goods were stolen. The owner's interests are not aligned with the thief's. Nor, it seems to me, are our foreign creditors' interests aligned with our BHCs'.
Continuity is only in the interests of those within the system in question in the event that different, more efficient modes of thought and action cannot be implemented for less than the cost of maintaining that continuity- a view which seems to have escaped the men at the Fed.
Perhaps the Financial Powers That Be have, as is the wont of those who use econo-metric models, gotten confused by recent history. In the early 90s, during the last reliquification of Big Finance- remember the job-less recovery- Japan was in the role China plays today. If Japan had a Army, instead of a US military base on Okinawa, they too might have called for changes to the global financial architecture.
China, unlike Japan, has an Army. Like Japan, China sees the virtues of trading internationally in one's own currency. Unlike Japan, whose talk of "internationalizing" the Yen never came to much, China is internationalizing the RMB.
Returning to the early 90s experience, the resolution had 3 main facets: 1) raise capital 2) use the capital to take non-performing assets off bank balance sheets 3) maintain a large spread between short and long rates for an extended period of time to raise bank profits. In my view, global economic growth during that period was sluggish, in part, because the banks increased the "vig."
I suspect a similar strategy is in play in the sense that the BHCs will need a wide spread for an extended period of time. Thus the key question arises. Will our foreign creditors, who might (or might not) be willing to purchase an equity stake, also agree to pay the increased "vig" in the form of a wider than normal spread, to use US$s?
Side note: Would we be willing to sell an equity stake big enough to make a difference, can sufficient capital be raised without loss of control?
Perhaps, but only if the Fed is right about the lack of credit risk in Treasury Securities. If inflation returns, as I suspect it will, the cost benefit analysis of continuity in the global financial system changes radically.
At some point the cost of a devaluation would exceed that of creating a new system, although the cost of creating a new system increases dramatically if a war is required to "align everyone's interests."
I truly hope the powers that be can manage this mess, for it seems to me a collision of interests is imminent. The more success China has in RMB based international trade, the less willing they will be to use US$s and thus the longer will recovery take. In a sense, expansion of US$ use in the 90s dug the BHCs out of a hole. A decline in US$ use while trying to dig out of a much deeper hole seems to me a desperate situation.
Wednesday, May 06, 2009
Losing the Exorbitant Privilege
I don't think there's any prospect of any big shift in portfolio preferences of foreign investors right now. Ben Bernanke
The bank stress tests are beginning to create a perception problem, but not – as you might think – for banks. Rather the issue is top level Administration officials’ own optics (spin jargon for how we think about our rulers).
At one level, the government’s approach to banks – delay doing anything until the economy stabilizes – is working out nicely. This is the counterpart of the macroeconomic Summers Strategy and in principle it is brilliant. “Don’t just do something, stand there,” is great advice in any crisis – eventually everything bottoms out and you can take the credit, justified or not (unless an election catches up with you first; check with Herbert Hoover.) Simon Johnson
Harry Truman, who famously wished for a one-handed economist, would, I suspect, be quite pleased with Mr. Bernanke and Mr. Summers, both of whom, according to the passages above, are singularly concerned with restoring US citizen's faith in finance.
Summers and Bernanke seem to have forgotten the wisdom of Machiavelli; For a prince should have two fears: one, internal concerning his subjects; the other, external, concerning foreign powers. These princes of finance apparently have no fear of external powers.
The America Economy is, I believe, a wondrous thing, a powerful engine of production. Despite what I believe to have been a lack of need, the US added a turbo-charger to the economic engine- the, in the words of Valery Giscard D’Estaing, exorbitant privilege of issuing debt to foreigners in our own currency. The exorbitant privilege will not be retained by restoring US citizens' faith in finance, but rather by restoring the faith of external powers.
Without the exorbitant privilege the US would already be deep in the throes of a currency crisis familiar to many banana republics. Without the exorbitant privilege big finance would have no bargaining chip with the state and as President Obama is reported to have said, My administration is the only thing between you and the pitchforks.
While it might be fear of the pitchfork wielding public that drove Summers and Bernanke to one-handed-ness I suspect a bigger factor is residual self-image from the heady End of History days. Summers' Don’t just do something, stand there policy implicitly accepts what Bernanke explicitly stated, no prospect of shifts in foreign investors' portfolio preferences. I can almost imagine these two advising the Pope during Martin Luther's time- "there's no prospect of a shift in sinners' desires to buy indulgences from us."
The genius of Paul Volcker, informed by current problems, becomes clearer by the day. Mr. Volcker didn't just break the back of inflation, at great risk of angering the pitchfork wielding public, he maintained the exorbitant privilege. He understood that one needs to compete to stay at the top. With Russia (in 1979) flexing its muscles and Iran breaking free of US control, US$ dominance wasn't assured, as Volcker learned during an IMF meeting in Belgrade that year. US policy needed to ensure the $ was a solid store of value.
Sadly, the Obama administration seems to be listening to Mr. Summers rather than Mr. Volcker. The most recent G20 meeting was, in my view, another Belgrade- a warning that US$ dominance is not a given.
I think we, and even his backers in big finance, will greatly regret this summer with Summers. The recovery for which he waits might be driven by China, and the pitchforks his backers fear might yet be brandished- made in China and purchased with RMB.
The bank stress tests are beginning to create a perception problem, but not – as you might think – for banks. Rather the issue is top level Administration officials’ own optics (spin jargon for how we think about our rulers).
At one level, the government’s approach to banks – delay doing anything until the economy stabilizes – is working out nicely. This is the counterpart of the macroeconomic Summers Strategy and in principle it is brilliant. “Don’t just do something, stand there,” is great advice in any crisis – eventually everything bottoms out and you can take the credit, justified or not (unless an election catches up with you first; check with Herbert Hoover.) Simon Johnson
Harry Truman, who famously wished for a one-handed economist, would, I suspect, be quite pleased with Mr. Bernanke and Mr. Summers, both of whom, according to the passages above, are singularly concerned with restoring US citizen's faith in finance.
Summers and Bernanke seem to have forgotten the wisdom of Machiavelli; For a prince should have two fears: one, internal concerning his subjects; the other, external, concerning foreign powers. These princes of finance apparently have no fear of external powers.
The America Economy is, I believe, a wondrous thing, a powerful engine of production. Despite what I believe to have been a lack of need, the US added a turbo-charger to the economic engine- the, in the words of Valery Giscard D’Estaing, exorbitant privilege of issuing debt to foreigners in our own currency. The exorbitant privilege will not be retained by restoring US citizens' faith in finance, but rather by restoring the faith of external powers.
Without the exorbitant privilege the US would already be deep in the throes of a currency crisis familiar to many banana republics. Without the exorbitant privilege big finance would have no bargaining chip with the state and as President Obama is reported to have said, My administration is the only thing between you and the pitchforks.
While it might be fear of the pitchfork wielding public that drove Summers and Bernanke to one-handed-ness I suspect a bigger factor is residual self-image from the heady End of History days. Summers' Don’t just do something, stand there policy implicitly accepts what Bernanke explicitly stated, no prospect of shifts in foreign investors' portfolio preferences. I can almost imagine these two advising the Pope during Martin Luther's time- "there's no prospect of a shift in sinners' desires to buy indulgences from us."
The genius of Paul Volcker, informed by current problems, becomes clearer by the day. Mr. Volcker didn't just break the back of inflation, at great risk of angering the pitchfork wielding public, he maintained the exorbitant privilege. He understood that one needs to compete to stay at the top. With Russia (in 1979) flexing its muscles and Iran breaking free of US control, US$ dominance wasn't assured, as Volcker learned during an IMF meeting in Belgrade that year. US policy needed to ensure the $ was a solid store of value.
Sadly, the Obama administration seems to be listening to Mr. Summers rather than Mr. Volcker. The most recent G20 meeting was, in my view, another Belgrade- a warning that US$ dominance is not a given.
I think we, and even his backers in big finance, will greatly regret this summer with Summers. The recovery for which he waits might be driven by China, and the pitchforks his backers fear might yet be brandished- made in China and purchased with RMB.
Tuesday, May 05, 2009
Bank Stress Test Results Released
US Treasury Department Recommendation: Economic growth must be lifted slightly (but not too much) to validate bank balance sheet solvency
What a pleasant surprise to read an interview with President Obama this weekend which contained the following:
What I think will change, what I think was an aberration, was a situation where corporate profits in the financial sector were such a heavy part of our overall profitability over the last decade. That I think will change. And so part of that has to do with the effects of regulation that will inhibit some of the massive leveraging and the massive risk-taking that had become so common.
Now, in some ways, I think it’s important to understand that some of that wealth was illusory in the first place.
If he could just share this view with Mr. Geithner and Mr. Bernanke who, according to the WSJ, have a different view: the news [of the stress tests] sparked concern among investors and depositors that the results would be used to shut down or nationalize some of the country's weaker institutions. But Federal Reserve Chairman Ben Bernanke and Treasury Secretary Timothy Geithner assured investors that none of the banks undergoing stress tests would be allowed to fail and that all would have access to government funds if needed.
If, as President Obama argues, some of the wealth created by the financial sector was illusory, financial sector profits need to shrink relative to the rest of the corporate sector and leverage in the sector must be reduced, why won't banks be allowed to fail?
For how much longer will the economy be the tail wagged by the financial sector dog- a tail, mind you, which can only wag in ever smaller amplitudes to avoid overturning that dog? If the Auto sector was viewed as the Financial sector is the response to their troubles would have been a $20K stimulus check such that each family could buy a new car.
What a pleasant surprise to read an interview with President Obama this weekend which contained the following:
What I think will change, what I think was an aberration, was a situation where corporate profits in the financial sector were such a heavy part of our overall profitability over the last decade. That I think will change. And so part of that has to do with the effects of regulation that will inhibit some of the massive leveraging and the massive risk-taking that had become so common.
Now, in some ways, I think it’s important to understand that some of that wealth was illusory in the first place.
If he could just share this view with Mr. Geithner and Mr. Bernanke who, according to the WSJ, have a different view: the news [of the stress tests] sparked concern among investors and depositors that the results would be used to shut down or nationalize some of the country's weaker institutions. But Federal Reserve Chairman Ben Bernanke and Treasury Secretary Timothy Geithner assured investors that none of the banks undergoing stress tests would be allowed to fail and that all would have access to government funds if needed.
If, as President Obama argues, some of the wealth created by the financial sector was illusory, financial sector profits need to shrink relative to the rest of the corporate sector and leverage in the sector must be reduced, why won't banks be allowed to fail?
For how much longer will the economy be the tail wagged by the financial sector dog- a tail, mind you, which can only wag in ever smaller amplitudes to avoid overturning that dog? If the Auto sector was viewed as the Financial sector is the response to their troubles would have been a $20K stimulus check such that each family could buy a new car.
Sunday, May 03, 2009
Stressing the Banks
What Is a Stress Test?
At its simplest, a stress test is a way of revaluing a portfolio using a different set of assumptions. The results of a stress test show the sensitivity of the portfolio to a particular shock. Stress tests can be useful because for most asset markets, the history of returns does not provide sufficient information about the behavior of markets under extreme events. Stress tests complement traditional models with estimates of how the value of a portfolio changes in response to exceptional but plausible changes in the underlying risk factors. IMF
A long time ago in a galaxy far, far away (it sometimes seems to me) I used to work in one of the big banks now undergoing stress tests. As an FX Options trader I had access to some fairly advanced (for the time) software that allowed me to examine the changes to my portfolio under a variety of different conditions. I very quickly learned that unimaginable scenarios were not just more plausible than I thought, they were actually happening.
When I started trading I would run a few simple "ladders"- calculations that would tell me my spot, forward, theta, and vega positions over a sequence of spot, interest rate, volatility and time changes. As time went on and my sense of the possible changed- hard lessons indeed- I learned the value of knowing how my book would change under a much wider set of assumptions than was normal practice at the bank. Informing me of how my book could change over the course of a few days was the goal of this process.
Before I left the bank I felt reasonably assured that my "doomsday" assumptions would cover all but the most dire of possibilities. Before I list them here's a few words on the US Treasury Department's assumptions in the current stress tests: According to the new Treasury Department guidelines, the banks would have to assume that the economy contracts by 3.3 percent this year and remains almost flat in 2010. They would also have to assume that housing prices fall another 22 percent this year and that unemployment would shoot to 8.9 percent this year and hit 10.3 percent in 2010.
My assumptions, and the experiences on which they were based, were:
1) short term interest rate changes of 5% (as I traded currency pairs, this covered both countries raising rates by 5% or one country raising by 5% while the other lowered 5%): Britain raised rates by 5% during the ERM crisis of 92
2) spot FX changes of 10%: The GBP fell 10% over a few days in 1992 (as did the A$ a few years earlier)
3) implied volatility changes of 10% in the front months and 3% in the back end: The A$'s volatility curve exploded in Feb '89, as did that of the GBP in '92. When the GBP entered the ERM the volatility curve for GBP/DEM collapsed
Armed with the information I then calculated the trades I would need to do to negate my risk as quickly as possible. As time went on and the book got bigger- 20 years ago when such things were many orders of magnitude smaller than currently- I found that the trades I would need to do couldn't be done in a short period of time, under normal market conditions. In other words my book grew big enough such that I had to be right, for I couldn't change things quickly enough if I wasn't.
This problem today is orders of magnitude larger.
If I was in Geithner's shoes, I would want to know how the big bank's positions would change if:
1) China didn't show up at a Treasury Auction and bond rates jumped 3-5%
2) China started dumping US$s on the open market and our exchange rate dropped 10%
3) The Fed, under such conditions, had to raise the Fed Funds rate by 5% quickly
4) An act of war or natural disaster struck one of the big coastal cities, putting it entirely out of commission thus pushing GDP down 6-10% quickly
Now that would be a stress test.
Admittedly, the Treasury is more interested in a longer view than I was, although given the highly leveraged derivatives positions, they might be well served to also inquire about substantial, discontinuous price changes.
I'm troubled that they don't test for what the past suggests is possible.
What if Unemployment goes to 30% as it did in the 30s?
What if Inflation falls to -5% or rises to 12%?
What if Fed Funds goes to 17% as it did in the early 80s?
What if we can't roll-over our foreign held debt, as has happened to most nations which have run up as large an external debt position as ours?
Friday, May 01, 2009
You Can't Handle a Recovery!
You can't handle the truth!
Son, we live in a world that has walls. And those walls have to be guarded by men with guns. Who's gonna do it? You?
I have a greater responsibility than you can possibly fathom. You weep for Santiago and you curse the marines. You have that luxury. You have the luxury of not knowing what I know: That Santiago's death, while tragic, probably saved lives. And my existence, while grotesque and incomprehensible to you, saves lives......
I have neither the time nor the inclination to explain myself to a man who rises and sleeps under the blanket of the very freedom I provide, then questions the manner in which I provide it. A Few Good Men
Before our economy, generally, and financial sector, specifically, became so "resilient" and "robust", interest rates had to be raised significantly and for long periods to slow credit and economic growth and thus inflation. Over the past 2 decades, however, the same damping effect could be achieved by much more modest and shorter duration tightenings. Unlike previous decades, it seems as if credit can only flow under an ever narrowing set of conditions, with change in flow acting digitally- on today, off tomorrow.
In the late 60s, before we dropped the Gold standard, Fed Funds was raised from just under 4% to over 9%. As we were dropping the Gold standard, in the early 70s, Fed Funds was raised from under 4% to well over 12%. During Volcker's term, Fed Funds rose from an already elevated 9.5% to almost 17%, admittedly during a period when interest rates weren't the fulcrum of monetary policy.
Since the Volcker peak, as noted, and as can be seen in the graph below, a few percentage points increase in the Fed Funds rate has been sufficient to "cool" the economy. Moreover, over a few cycles now, what had previously been considered a normal level for rates, like the 5.5% level during the mid 90s, becomes too high during the next recovery- 5.25% was the peak in late '06 through summer of '07.
The reaction, with respect to employment, of the real economy to the financial has also changed. The pattern of employment growth- with each cyclical trough being much higher than the previous peak- evident from 1962-200 has also changed. For the first time in decades, the trough (thus far) of employment is almost equivalent to the old peak- i.e. the current level of employment is roughly equal to that of early '01. By contrast, the '03 trough was 20M jobs higher than the '90 peak and the '91 trough was 16.5M jobs higher than the '81 peak.
The current pattern of employment growth more closely matches that of 1942-1962 with the caveat that median income gains were substantially higher in the earlier period.
The reaction, with respect to real median household income, of the real economy to the financial has also changed. For the first time in decades, real median household income in a recovery failed to exceed the previous cycle peak- the recovery under Bush the younger was restricted to the upper income class.
The above is a long "winded" (byted might be better given the medium) way of noting increasing income inequality. The quality of US recoveries has changed from one which benefited the middle and upper classes to one which only benefits the upper classes, and given the recent declines in real estate and equity based wealth, many of the upper class are finding that GDP gains may not translate into their gains. Increasingly the beneficiaries of recovery are restricted to the top tier of finance. The trickle down which was used to justify the shift to a financially centric economy in the 80s and 90s has become a trickle up in the 21st Century. To paraphrase Abraham Lincoln, policy increasingly aims to ensure that government of the financial oligarchs, by the financial oligarchs and for the financial oligarchs, shall not perish from the earth.
The question then arises, "why have we forsaken the old faith, which carried us through the tumultuous 60s and 70s, that a robust middle class is good for the stability of the state?" Have we forgotten the lessons of Aristotle's Politics (Book 4: Part XI)? Is it simply a case of self-interest run amok, or are their other reasons behind trickle down becoming trickle up?
On a related note, I wonder how different the results of the '08 election would have been if the trickle had been down rather than up under Bush the younger. The Democrats might want to take note, pandering to the financial oligarchs does not ensure electoral success.
Returning to the main point, why has policy allowed the quality of recovery to change so significantly? It is almost as if the financial oligarchs fear an old style recovery to maintain their grip on power. This fear would not be without precedent in human history. The European Nobility feared the rise of their middle class, fortunately for the Burghers, they often found a friend in the King or Queen.
I suspect, however, an additional reason behind the policy shift- a most insidious reason. As the wealth of the nation has shifted from production to financial it has, as noted above, become increasingly fragile and sensitive to changes in financial variables.
During the 70s the price of oil rose by a factor of 10, settling, if you will, in the 80s at about a 6 fold increase. Interest rates, as noted, fluctuated wildly, ending the decade at double digits across the board. Equity markets too fluctuated wildly, although the Dow Jones was at roughly the same level in 1982 as it was in 1968. While the 70s were no picnic, as I recall, the wealth of the nation, and the well being of many improved.
Back then though the wealth was of a different sort- we made, mined, and grew things. Changes in financial variables were onerous, but they didn't cause the world to stop turning. Even the financial world seemed to take the 70s somewhat in stride, despite the Fed funds rate moving from a low of roughly 3.5% to a high of roughly 16%.
I doubt our supposedly much more resilient current financial system could survive in that environment, perhaps it would be more accurate to say that few of the top tier financial firms would make it through a decade like the 70s. So long as fear of loss of financial wealth drives policy, policy will fight to ensure that discounting (i.e. interest rates) remains minimal. Few changes kill a leveraged long bond position than a hike in rates. Restraint of the middle class then is, in modern terms, collateral damage.
And that, it seems to me, is the insidious problem that trumps all else. We can't handle a broad based recovery because if we do we'd get significant inflation and eventually, substantial increases in interest rates. Just as it isn't the fall that kills you, it's the sudden stop at the end, for the highly leveraged financial oligarchs, it isn't the inflation that will kill them, it's the substantial hike in interest rates at the end. For my money, wealth that cannot survive necessary changes in interest rates isn't wealth at all, it's just a mirage.
George Friedman, of Stratfor, recently argued that the US is worth some $340T (a bold assertion, but let's go with it for the sake of argument) and thus our debts are trivial in comparison. As with any corporation, however, that depends on how the assets are managed. Nonproductive asset is a contradiction in terms. Iraq, too, is, in theory, a wealthy nation. Alas it was and still is crippled by poor management.
We too, it seems to me, are crippled by poor management. The financial oligarchs fear a recovery that would make real world assets, which the US has in abundance, productive. The path to such a recovery does not go through them. It goes through a financial system that is thought of as Alfred Marshall thought of a mature industry- like a forest where individual trees come and go but the forest remains. Forests, by the way, are not a few big trees, but many middle sized (OK sometimes they are all big, like the Sequoia, but they need forest fires to propagate) ones. Currently, a few big trees are seeking protection from a cull.
Seeking the safety of power, the financial oligarchs have made what I see as one last gamble- one that, it seems to me they will soon lose- they are channeling flows into government bonds, after taking a nice chunk off the top, for their trouble. So long as the state can borrow cheaply, the financial oligarchs will be safe. Sadly, for them, decades of open capital markets and chronic deficits means that they are not the final arbiter of price in their last hope market. When the BRICs (Brazil, Russia, India and China) discover (and act thereupon) that real world investments offer greater and more durable returns than US Bonds, the financial oligarchs will lose the protection of the state.
It seems worth noting the example of Russia. They too had their state protected oligarchs, until government finance could not be found. But a few short years after they defaulted on their debt and the oligarchs were removed from power, Russia, whose real sector, due to its reliance on resource exports, is not nearly as vibrant as ours, recovered stronger than it had been in decades.
If Russia can do it.....
Son, we live in a world that has walls. And those walls have to be guarded by men with guns. Who's gonna do it? You?
I have a greater responsibility than you can possibly fathom. You weep for Santiago and you curse the marines. You have that luxury. You have the luxury of not knowing what I know: That Santiago's death, while tragic, probably saved lives. And my existence, while grotesque and incomprehensible to you, saves lives......
I have neither the time nor the inclination to explain myself to a man who rises and sleeps under the blanket of the very freedom I provide, then questions the manner in which I provide it. A Few Good Men
Before our economy, generally, and financial sector, specifically, became so "resilient" and "robust", interest rates had to be raised significantly and for long periods to slow credit and economic growth and thus inflation. Over the past 2 decades, however, the same damping effect could be achieved by much more modest and shorter duration tightenings. Unlike previous decades, it seems as if credit can only flow under an ever narrowing set of conditions, with change in flow acting digitally- on today, off tomorrow.
In the late 60s, before we dropped the Gold standard, Fed Funds was raised from just under 4% to over 9%. As we were dropping the Gold standard, in the early 70s, Fed Funds was raised from under 4% to well over 12%. During Volcker's term, Fed Funds rose from an already elevated 9.5% to almost 17%, admittedly during a period when interest rates weren't the fulcrum of monetary policy.
Since the Volcker peak, as noted, and as can be seen in the graph below, a few percentage points increase in the Fed Funds rate has been sufficient to "cool" the economy. Moreover, over a few cycles now, what had previously been considered a normal level for rates, like the 5.5% level during the mid 90s, becomes too high during the next recovery- 5.25% was the peak in late '06 through summer of '07.
The reaction, with respect to employment, of the real economy to the financial has also changed. The pattern of employment growth- with each cyclical trough being much higher than the previous peak- evident from 1962-200 has also changed. For the first time in decades, the trough (thus far) of employment is almost equivalent to the old peak- i.e. the current level of employment is roughly equal to that of early '01. By contrast, the '03 trough was 20M jobs higher than the '90 peak and the '91 trough was 16.5M jobs higher than the '81 peak.
The current pattern of employment growth more closely matches that of 1942-1962 with the caveat that median income gains were substantially higher in the earlier period.
The reaction, with respect to real median household income, of the real economy to the financial has also changed. For the first time in decades, real median household income in a recovery failed to exceed the previous cycle peak- the recovery under Bush the younger was restricted to the upper income class.
The above is a long "winded" (byted might be better given the medium) way of noting increasing income inequality. The quality of US recoveries has changed from one which benefited the middle and upper classes to one which only benefits the upper classes, and given the recent declines in real estate and equity based wealth, many of the upper class are finding that GDP gains may not translate into their gains. Increasingly the beneficiaries of recovery are restricted to the top tier of finance. The trickle down which was used to justify the shift to a financially centric economy in the 80s and 90s has become a trickle up in the 21st Century. To paraphrase Abraham Lincoln, policy increasingly aims to ensure that government of the financial oligarchs, by the financial oligarchs and for the financial oligarchs, shall not perish from the earth.
The question then arises, "why have we forsaken the old faith, which carried us through the tumultuous 60s and 70s, that a robust middle class is good for the stability of the state?" Have we forgotten the lessons of Aristotle's Politics (Book 4: Part XI)? Is it simply a case of self-interest run amok, or are their other reasons behind trickle down becoming trickle up?
On a related note, I wonder how different the results of the '08 election would have been if the trickle had been down rather than up under Bush the younger. The Democrats might want to take note, pandering to the financial oligarchs does not ensure electoral success.
Returning to the main point, why has policy allowed the quality of recovery to change so significantly? It is almost as if the financial oligarchs fear an old style recovery to maintain their grip on power. This fear would not be without precedent in human history. The European Nobility feared the rise of their middle class, fortunately for the Burghers, they often found a friend in the King or Queen.
I suspect, however, an additional reason behind the policy shift- a most insidious reason. As the wealth of the nation has shifted from production to financial it has, as noted above, become increasingly fragile and sensitive to changes in financial variables.
During the 70s the price of oil rose by a factor of 10, settling, if you will, in the 80s at about a 6 fold increase. Interest rates, as noted, fluctuated wildly, ending the decade at double digits across the board. Equity markets too fluctuated wildly, although the Dow Jones was at roughly the same level in 1982 as it was in 1968. While the 70s were no picnic, as I recall, the wealth of the nation, and the well being of many improved.
Back then though the wealth was of a different sort- we made, mined, and grew things. Changes in financial variables were onerous, but they didn't cause the world to stop turning. Even the financial world seemed to take the 70s somewhat in stride, despite the Fed funds rate moving from a low of roughly 3.5% to a high of roughly 16%.
I doubt our supposedly much more resilient current financial system could survive in that environment, perhaps it would be more accurate to say that few of the top tier financial firms would make it through a decade like the 70s. So long as fear of loss of financial wealth drives policy, policy will fight to ensure that discounting (i.e. interest rates) remains minimal. Few changes kill a leveraged long bond position than a hike in rates. Restraint of the middle class then is, in modern terms, collateral damage.
And that, it seems to me, is the insidious problem that trumps all else. We can't handle a broad based recovery because if we do we'd get significant inflation and eventually, substantial increases in interest rates. Just as it isn't the fall that kills you, it's the sudden stop at the end, for the highly leveraged financial oligarchs, it isn't the inflation that will kill them, it's the substantial hike in interest rates at the end. For my money, wealth that cannot survive necessary changes in interest rates isn't wealth at all, it's just a mirage.
George Friedman, of Stratfor, recently argued that the US is worth some $340T (a bold assertion, but let's go with it for the sake of argument) and thus our debts are trivial in comparison. As with any corporation, however, that depends on how the assets are managed. Nonproductive asset is a contradiction in terms. Iraq, too, is, in theory, a wealthy nation. Alas it was and still is crippled by poor management.
We too, it seems to me, are crippled by poor management. The financial oligarchs fear a recovery that would make real world assets, which the US has in abundance, productive. The path to such a recovery does not go through them. It goes through a financial system that is thought of as Alfred Marshall thought of a mature industry- like a forest where individual trees come and go but the forest remains. Forests, by the way, are not a few big trees, but many middle sized (OK sometimes they are all big, like the Sequoia, but they need forest fires to propagate) ones. Currently, a few big trees are seeking protection from a cull.
Seeking the safety of power, the financial oligarchs have made what I see as one last gamble- one that, it seems to me they will soon lose- they are channeling flows into government bonds, after taking a nice chunk off the top, for their trouble. So long as the state can borrow cheaply, the financial oligarchs will be safe. Sadly, for them, decades of open capital markets and chronic deficits means that they are not the final arbiter of price in their last hope market. When the BRICs (Brazil, Russia, India and China) discover (and act thereupon) that real world investments offer greater and more durable returns than US Bonds, the financial oligarchs will lose the protection of the state.
It seems worth noting the example of Russia. They too had their state protected oligarchs, until government finance could not be found. But a few short years after they defaulted on their debt and the oligarchs were removed from power, Russia, whose real sector, due to its reliance on resource exports, is not nearly as vibrant as ours, recovered stronger than it had been in decades.
If Russia can do it.....
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