Jim Hamilton is a godsend

Certain academic economist are really proving their worth to the greater financial community in this crisis, and high up on the list of contributors is Jim Hamilton of Econbrowser.  Follow the link to the clearest description I think I've ever seen of what the Fed normally does, what it's doing now, what it might do in the future, and why you should give a shit.

Well boo-fucking-hoo

What pathos one has when reading the punchline of this FT article about how the Fed will now lend to Hedge Funds so that they can buy up credit-card securitizations:

The loans will be secured only against the securities and not the borrower. However, the Fed will lend slightly less than the value of the securities pledged as collateral. The Treasury has committed $20bn to cover potential losses.

Since the credit crisis erupted, hedge funds have complained that they cannot get the leverage they need to arbitrage away excessive spreads and meet high hurdle rates of return.

 

I'm literally aghast here.  You mean hedge funds weren't able to meet their high hurdle rates?  That will simply have to be fixed.  I mean, if these guys don't get free money guaranteed by the Fed, then nobody can get free guaranteed lunch, I mean money.  If the sharks don't eat, the whole ecosystem will collapse by god!  This whole bailout has become just a blatant farce with every pig in town feeding at the trough.  It's like we're literally imitating Japan on purpose.

It's so sad to watch America get looted.  I hope there's still enough great things about this country that it one day comes back.

The Greatness of Ponzi

I read somewhere that towards the end of his life, Deleuze was working on a book about "The Greatness of Marx". He jumped out of a window before he finished it, and I don't exactly know in what sense he meant this, but my own fairly recent re-appraisal of Marx (I continue to mercilessly flog Kolakowski's book as the best thing ever written about Marx) has made me realize that a thinker can come at something deep and fundamental -- but from the wrong angle, or in a confused way that obscures the important novelty of the concept.

So this morning I'm eating my bagel and reflecting that someone should write a similar book about Ponzi. The structure of a Ponzi scheme is one of the greatest inventions of all time. In a nutshell it is just a faster version of the concept of trust -- we get together and cooperate today for some mutual benefit tomorrow. As long as the trust continues and expands, a Ponzi scheme is the surest and fastest route to progress. You can get rich along with everyone else.

I already hear some objections to my fevered praise of Ponzi. What, you might acidly ask, about when the trust breaks down and more people are leaving the system than coming in? That's a fair objection. But I never said that Ponzi's scheme didn't have flaws. All I was pointing out was that those flaws were the same as the flaws of our society. It's instructive to realize that some things we recognize as flat out Ponzi schemes can go on for 30 years. To call that unstable, or a scam, is to twist those words far beyond their usual definitions.

In fact, our society is modeled on a Ponzi scheme, and if trust in it were to break down, the results would be as spectacularly bad as Ponzi or Madoff or any of the other situations we recognize as "scams". You could argue that the US political system has gotten to a point where any attempt to shrink the government would cause the whole works to collapse. We already see how the government gets bigger and bigger every year, taking on more and more obligations both for the future and for the control of the present. Ask yourself for a moment what might happen to healthcare and social security and the housing market and ... if the government were to stop expanding in those areas, and even begin to contract. Caught a whiff of chaos ¿no?

And it's not just the government. Our entire productive apparatus (I am now extending this beyond just our financial "system") is based on the idea of a continual and continually expanding progress. If the trading of current consumption for future consumption down the road, if a system that depends inherently on the savings and investment leading to surplus leading to more savings and investment and ... if this concept of progress is not in essence isomorphic to a Ponzi scheme ... well ... then ... I'll have to re-think the title of my book about Ponzi.

Interfluidity has said it better than I could hope to, though he foolishly fails to mention Ponzi by name:

We, collectively, have not figured out a means of addressing an incompatibility between the incentives by which we encourage production and the means by which we distribute it. Human effort is driven by positional as much as material incentives: We measure ourselves against one another. Two centuries ago, a person could be rich with no running water, electricity, or internet person. But wealth was still wealth, and people worked just as hard to be rich then as now. But since wealth is positional, people's desire for wealth may far exceed their intention or ability to consume. When great wealth is earned by contributing to production, this leads to a surplus, which seems like a good thing, but creates the "problem" of excess capacity. The obvious solution is to redistribute claims on production, so that those with unmet wants make use of the excess. But doing so reduces the differences in station that inspire Herculean efforts to produce, and provokes conflicts over who gets what.

The macroeconomic stories of this decade have all been about squaring this circle: Rather than redistributing claims outright, we adopted the fiction of trading present goods for future claims. The ambitious grew wealthy by accumulating claims on the future of the less ambitious, in exchange for which the less ambitious (and sometimes very distant) consumed present production, and demanded more. Entrepreneurs could measure their position against their fellows by the quantity of their claims. Others could consume in proportion to their ability to manufacture claims that entrepreneurs would accept, that is, they could consume what they could borrow. But high quality claims on future wealth are in reality very scarce. An economic system that depends upon ever expanding claims on the future in order to provide current incentives to produce can not be stable. Once the "wealthy" learn that many of their claims are worthless, the system falls apart. The less-wealthy have no means of consuming, as new claims are shunned. Owners of capital gain nothing but bear costs for maintaining productive infrastructure. "Excess capacity" appears.

The challenge of macro

I find that I'm spending a lot of time these days trying to reconnect financial concepts with real world macro-economic concepts. There's a feeling that I'm trying to break through some sort of veil of analogy in order to see what it actually means when people make proposals to "get credit flowing again" and "stimulate the economy" and whatnot. I'm hardly alone in the effort of course, and a post from interfluidity goes in this same direction:

Think about that: "overcapacity in almost all industries". Perhaps we exist in a more enlightened world than I ever imagined. I've always thought that human want for material goods was basically unlimited. Apparently not! We have enough, not just here in the once gluttonous U.S. of A., but everywhere. All of the nearly seven billion humans of planet Earth have no use for anything more than they already have. Subsistence farmers in Africa prefer to live as they do, because it plays charmingly in National Geographic. If you offered them 10 million Yuan and a shopping trip, they'd shyly refuse.

The world does not now, and never has had, a general problem with "overcapacity". It might be sensible to talk about overcapacity with respect to a particular good or service in a particular setting. Maybe five Starbucks Cafes really are too many for one city block. But as a macroeconomic phenomenon, overcapacity is bullshit. Capacity can be misaligned — there might be too many sock factories for too few shoe factories. But there can be no general overcapacity, only underutilization.

This is an important thought, but only partially true. It leaves out an irreducible psychological element. The human desire for cheap plastic shit is limitless, but it is not constant. People and societies really do go through periods of over and under confidence, over and under desire.

Win some

I don't see why they don't just give me a Nobel Prize right now and get it over with. Or at least a column with the New York Times:

The Madoff Economy, by Paul Krugman, Commentary, NY Times: The revelation that Bernard Madoff — brilliant investor (or so almost everyone thought), philanthropist, pillar of the community — was a phony has shocked the world, and understandably so. The scale of his alleged $50 billion Ponzi scheme is hard to comprehend.

Yet surely I’m not the only person to ask the obvious question: How different, really, is Mr. Madoff’s tale from the story of the investment industry as a whole?

China's big rebalancing act

Interesting comment from Michael Pettis today in the FT:

The second way is for trade-surplus countries to engineer sharp increases in domestic consumption, most likely though massive fiscal expansion, that match the decline in US household consumption and so reduce the overcapacity problem. The problem with this solution is that the scale of the adjustment is beyond the capacity of most countries. A decline in US consumption equal to 5 per cent of US GDP, for example (which is a low estimate), would require an increase in Chinese consumption equal to 17 per cent of Chinese GDP – or a nearly 40 per cent growth in consumption. This is clearly unlikely.

This is an important point. China stimulating domestic demand to compensate for the US going on a diet is all well and good, but we cannot expect it to work miracles. China is growing in importance in the world economy, but it still constitutes a tiny fraction of world GDP.

Fractional Reserve Banking is an Inherently Unstable System

There, I said it. File me away with the unibombers, the conspiracy theorists, and the gold bugs.

But the fact of the matter is that the whole system is really a sort of Ponzi scheme where you pay the people who want their money back with what you get from the people who are coming in. This works great until more people are going than are coming, a la Madoff. It makes you wonder if something fundamental will change once we pass through the steepest part of the global demographic phase transition.

This thought is inspired by a reading some commentary from Robert Bruner who recently wrote a book about the panic of 1907. I haven't read the book yet, but the commentary is probably sufficient to judge the conclusions he reaches. The basic idea is pretty simple. Fractional reserve banking is inherently unstable. Banks have a mismatch in the duration of their liabilities (I can get my deposits back any day of the week) and their assets (especially when they have made loans against that tried and true, but particularly iliquid, asset class -- real estate). Normally not everyone wants their money back at the same time, so this is fine. In a panic, even a solvent bank can be unable to pay its depositors.

The solution to this problem, as far as Bruner is concerned, is also pretty straightforward. You need some entity that backstops the banks, and convinces depositors not to pull their money out of solvent banks. You accomplish this by someone having enough cash in reserve to give the first group of depositors all their money back, so those after them realize that it's unneccesary even to ask for it. Simple enough. It's a con game really. Or a prisoner's dilemma, if you prefer. The success of fractional reserve banking as a business model depends on confidence and trust.

So how do you instill or recover that trust when for some reason people begin to lose it? In 1907 J.P. Morgan restored trust. Personally. I find it both sad and amazing that this could have worked. Sad, because it shows you how dominant a position this man had. In his commentary Bruner poses the question of whether there was a money trust (analogous to the oil trust and the cotton trust, etc ...) at the turn of the century. Poses it as if this were a question. I think the fact that any single man could restore trust in an entire system more or less tells you empirically that he had monopoly power. On the other hand it's kinda amazing that one man commanded such respect and was so competent that he could save an entire system. Imagine anyone trying to do this today. Are you going to put your trust in Geore W. Bush? Bill Gates? The suits from Goldman Sachs?

Bruner is clearly in awe of Morgan, and who wouldn't be? On the other hand, he obviously thinks that this was the last time any person could singlehandedly save the financial system. Today the problem is too big even for Warren Buffett, and requires a central bank instead a central financier (though wouldn't you rather have "Buffett Bucks" than dollars at this point?). A central bank is a perfectly sensible solution to the problem. Who can best restore confidence? The government. Where do all monopolies ultimately migrate to? The government. How do we solve problems of collective action? It's the government, stupid.

It's also the kiss of fucking death.

You haven't actually solved the problem with this, youv'e just pushed it up a level. Because there's no guarantee that we will always have confidence in our govenment. If we think it is run by a bunch of lying kleptocrats and their buddies, legitimized by dozens of pseudo-scientific technocrats who have had their heads in the sand for as long as we can remember, if perhaps we think the government and the people in it might, just maybe, be looking out more for themselves than for us -- well ... let's just say it may not be a foolproof firewall between us and the armageddon of zero-sum-ness.

Is anbody seeing a pattern here? Is it any wonder that this crisis happened when it did? I don't even trust my own shadow anymore, much less Ben Bernanke, Dr. Evil and mini-me over at the TARP. For all I know these guys are going to bomb the credit default swaps market because they heard somebody say that's where the weapons of mass destruction are. We'll have paper everywhere like confetti after the war.

In addition to creating the mother of all free-rider problems, pushing the question up a level and letting the government be the final backstop for the financial system means that the final instability of is now no longer solely financial, but cultural and political. Would you like to see what this slippery slope looks like when you've slid, repeatedly to the bottom of it?