Terms like “securitisation”, “derivatives”, “longitudinal diversification” and “dynamic hedging” would make most of our eyes glaze over, I suspect. Yet all this arcana is now having an impact on us - vie the subprime mortgage crisis and the shock waves it’s set off in the world economy. There are at least two factors which mitigate against discussion and examination of causes and solutions - the arcane nature of the math and language used by the finance wonks, and the reactive press coverage - attuned more to reporting on what pollies and regulators are saying or doing than assessing causes and debating the way forward. So I’d thoroughly recommend taking the time to read author and sociologist Robin Blackburn’s article The Subprime Crisis. It took me about half an hour to read, but I think it was time well spent, as Blackburn takes great care to demystify the nature and history of the crisis, and thus provides a basis for thinking about its implications which is far better than skimming spin laden or impenetrably written articles.
In what follows I interpret the credit crunch as a crisis of financialization—otherwise put, as a crisis of that venturesome ‘new world’ of leverage, deregulation and ‘financial innovation’ which Alan Greenspan celebrates in his recent memoir. I show how the pursuit of a market in almost everything led to a banker’s nightmare in which key assets could not be valued. I urge that attention be paid to the ideas of Fischer Black, the improbable inventor of structured finance, who warned against ‘loading up on risk’ when declining to become a founder member of Long Term Capital Management. I evoke both the New Deal response to financial failure and the rise of consumer finance in the postwar world, before considering, in conclusion, what can be done today.
No doubt some will decry any intervention by a non-specialist, and others run in horror from the idea that banking and finance should be brought under social regulation, and should act to serve social purposes. Since they’re the people who contributed to this mess in the first place, and since this mess is causing social havoc, I don’t much care.
Kim,
I’m sorry, I have to disagree with just about everything here. To me, the whole sub-prime thing arose from a desire by lenders to profit from lending to people that had previously not been able to borrow through regular financial institutions before - the poorer members of our community. Perviously they had needed to rely on loan sharks, permanent renting, pawn brokers etc. so that the poor had to pay interest rates typically multiple of what the rich were paying. From a “social equity” point of view this sucked. Having the banks do it, at much closer rates to those that the richer people pay, is (IMHO) a much better outcome.
It also meant that, for many people, it was the first time they could borrow to fund a home acquisition, get a credit record etc.
The simple problem was that lenders ended up lending too much too cheaply as inexperience in the market (because the banks were not loan sharks) meant that they underpriced the riskiness of the lending. Once this happened, and with the US system of non-recourse lending* the sheer amounts lent meant there was a glut in the market for houses - dropping the price.
Sure, there is a hangover now, but the cheaper lending we all experienced during the last 10 years (IMHO) makes up for it. Let’s face it - what this meant was simple. The net result was that many poorer people in the US got to borrow for the first time, at rates far below what they had been paying before. This was (ultimately) paid for by bank shareholders. There has also been some more generalised pain in the process.
The long term position will be better as well (IMHO). Lenders know the pain and gains from lending to poorer people better now than they did before. They are unlikely to mis-price risk as badly again, meaning once things turn around they will lend again, but more cautiously.
Once you cut through all the BS of the instruments, this is the bare bones of what happened. No rocket science needed.
*In the US if a mortgage goes into collection - i.e. the bank forecloses - the bank only has rights over the house, not the borrower.
Andrew, Blackburn’s article suggests that the story is more complex than that. Your position appears to be similar to Greenspan’s - but the “social equity” argument collapses when those who were initiated into the credit and housing markets now find themselves without both. Note that he’s largely discussing the US experience, and the non-recourse lending point needs to be remembered. But it doesn’t appear to me that “socialism for bankers” has really driven home the costs of mispricing risk and elaborate forms of debt bundling. It seems more like the poor and the average working folks have been left to pick up the pieces. Nor am I as sanguine about self-correcting and regulating markets in this context. As Blackburn points out, the sorts of regulatory interventions which would be desirable would not have a major impact on the capacity of markets to do what they do best, but would be very beneficial for society generally.
(Remembering that he discusses both minor forms of regulatory response and a more ambitious Keynesian agenda).
Andrew Reynolds wrote:
Not really. The vast majority of those sub-prime mortgages were done at teaser rates - once they reset and the interest rate represented the risk properly, those lenders could no longer afford the repayments and started walking away. In a very fundamental sense, they were living in places they simply couldn’t afford.
The teaser rates (and the dodgy financial instruments that enabled them) caused a much bigger problem: major asset price inflation as the influx of customers drove the price of housing upwards. The asset inflation caused another problem: over investment in new building.
Once the teaser rates started unwinding, it was apparent that there was a glut of housing on the market and a rapidly shrinking number of customers. Basically, it was a genuine ponzi scheme.
Banks will always mis-price risk if they don’t understand the implications of the instruments they are trying to price. You only need to have a dig through the documents of LTCM to see just how self deceiving the magic of the Black-Scholes option pricing formula is when there are yearly profits to be made.
Crossed with David.
Kim,
They do find themselves without either - but then, without it, they would not have had the house anyway and would have been renting, at higher payments.
A full explanation of my position would probably take a lot more time than I have at the moment - but the complex financial instruments that everyone loves to blame were not the problem here. As with most examples of this sort of thing the lending simply got seperated from the risk assessment, so mistakes were made. The tradable nature of the instruments allowed that - not their complexity. Most of them were actually fairly simple by modern standards.
If you want me to go through why I believe this happened I am happy to, but to me it is at least partly down to the screwy way US regulations force the banks to do odd things in the normal course of business - but I do not have time for it now.
Don’t get me wrong, this should not have happened. Lending into this area is something the banks are not good at. People have been hurt during the learning process and that is unfortunate and in some cases tragic. I would strongly disagree witht he idea that this means we need more regulation, though. I would say it is good evidence we need less.
I covered some of the issues here a while back and I think my conclusions there still hold true.
.
David,
You are sounding like GMB there, throwing around the word “Ponzi” without, to me, understanding what it means. There was no element of a Ponzi here. Please actually understand the term before you use it again - wikipedia is a good enough reference.
I do not mean to be insulting, but a Ponzi scheme has nothing to do with this.
Andrew, I’m not sure from your comments if you’ve read the article I linked to. As I said, it’s not a quick read, but if you do get a chance I’d be interested to hear your view as Blackburn’s seems quite different to yours.
The increase costs in the financial markets aren’t about the direct risk of sub-prime mortgages, but rather about the uncertainly of the risk within the traded mortgage assets. The crisis was driven not because some people couldn’t make their repayments, but because investors that bought the debt were not aware of the associated risk factors. This then eroded the confidence investors had in the market drying up the liquid capital. It’s this lack of liquid capital that drove the risk of a ‘big crash’ and the lack of confidence in the financial market that will drive up the cost of credit in the medium term.
Andrew Reynolds wrote:
Andrew, these are the exactly the same thing: the instruments enabled the separation from risk assessment - you can’t untangle them.
Andrew Reynolds wrote:
Well, I’m flattered at being compared to GMB. Obviously you’ve never seen the “flipper” phenomenon on TV - paint the bathroom and increase the value of your home by $30,000 and sell it on to the next sucker as quickly as possible. Like all schemes of this nature, it collapsed. It was enabled via massive and easily manipulated market for barely assessed credit - not that different to Amway really, just a lot slower and without a catalog.
I should also add holders of US currency to that list, as the federal reserve bought a lot of the ‘bad debt’, presumably by printing up more money.
David,
Flip schemes are not Ponzis, no more than this issue was. Price increases can happen for any number of reasons - and none of them are related to Ponzi schemes.
On the instruments - it was not any complexity that was the issue, nor was it the ability to transfer risk. It was simply that the risk was not priced correctly.
.
Kim,
I have skimmed the article - and (IMHO) it is standard boilerplate stuff by a person who has academically studied the lending market but does not understand it. This quote, in particular, I object to:
IMHO the ignorance of the way that regulation works embedded within that is almost breathtaking. One of the root causes of the problem (again, IMHO) is that banks were stuck with a (excuse the strong language) bloody stupid, risk insensitive regulatory driven method of calculating risk under Basel I. The Basel II methodology, while it has its faults, is much, much better and if it had been in place in the US this would have been much less bad, if it had happened at all. The risk systems under Basel II would have gone a long way to forcing correct pricing. Striking them down would be a step towards ensuring this happens again, not stopping it.
Andrew Reynolds wrote:
…but the Wikipedia article you recommended says:
Pretty much an exact description of house flipping I would reckon, without a central organising authority.
J. M. Keynes’ view of the long term is well enough known.
It is perhaps true that anything that doesn’t kill us makes us stronger.
The same is true of the Great Depression. The world learned much about financial stability, which provided more than half a century of relatively crisis-free financial management, until Greenspan and Clinton knocked many of the chocks out from under that edifice of stability.
However, these missteps cause what economists call externalities. It is impossible to isolate financial causes from social, political, and military results.
While in future financiers may be able to meet at the club and swap old war stories about the exciting times when the LIBOR rose to 8% and they will congratulate themselves on keeping their nerve when all around them sere inclined to panic, still small issues like the rise of fascism, the collapse of world markets, the rise of protectionism accompanied the last major financial crisis. Lives were blighted. Millions died. Revolution roiled the world.
These items tend not to be mentioned on banks’ balance sheets.
Andrew I agree with you to some extent but feel that you are damaging your argument by being so unequivocal in your assertion that “the complex financial instruments that everyone loves to blame were not the problem here”.
It has been documented in the press that UBS were giving presentations up until recently whereby they demonstrated via Powerpoint how they could splice up a $100,000 mortgage into $80million of securities. Surely this is an extreme and unrealistic example of the way in which CDO’s work but the fact of the matter is that this practice has been occurring albeit not to such a gross extent. The fact that they can be so artfully spliced up has contributed to the fear. Inter-bank lending has been in crisis due to this.
I don’t see how you can argue with the fact that these products were inherently defective. Securities which were given AAA ratings were suddenly written down to in some cases 10% of their face value. Clearly the inbuilt credit protection mechanisms such as tranching failed to work.
Further, the products are so complex that it seems impossible to value them. All well and good to mark-to-market but when the models have been proven to be so thoroughly defective this has proven to be impossible.
Also, your argument rests on the fact that the issue is merely one of underlying credit quality. However, the whole securitisation market in the US has dried up including for full-documentation, prime loans. Likewise, the Australian securitisation market is dead despite slightly heightened but still low arrears rate. This cannot be solely attributed to the Australian market’s reliance on American funding markets as previously lots of securitisations were denominated in AUD with plenty of Australian investors. It comes down to people being scared of the products they are investing in, due to their complexity and their observance of what has happened in the US. Surely the fact that the ratings agencies got their assessments so incredibly wrong is testament to this.
That being said I don’t feel that securitisation itself is the problem, merely the fact that it has been taken to such perverse levels with the development of all these exotic derivatives. The fact that most of the assets were held off balance sheet also meant that barely anyone was able to comprehensively assess a company’s exposure, even seeming in some instances its CFO and CEO.
However, I do agree with you that the trigger and underlying cause is that of dodgy credit practices but feel that it is undeniable that this was exacerbated by the financial products in play. I also agree that we should not go overboard with regulation. The main focus should be at regulating the mortgage broker and credit assessment levels. The investment banks are not victims here and only have themselves to blame for their massive losses.
By the way, I am yet to read Robin’s article.
David,
The profit there is from the sale of a home after taking on the market risk over a period - not out of simply incoming funds. The home could equally have gone down in value, as many in the US have. Risk is taken on, profit is earned. No Ponzi there.
.
Katz,
That stability was bought at a huge price - part of which we are paying now. Fortunately regulators now are a bit more informed (and markets more flexible) than they were in the late 1920s. This limits both the economic costs and the potential for battle damage. Perhaps if markets had been allowed to clear and correct then we would not have had the war stories in the first place.
Andrew Reynolds wrote:
Not really. The period risk wasn’t priced correctly (see above: sweetheart and teaser loans, LIAR loans etc). There simply wasn’t enough money turning up in the form of mortgage repayments, enabled by the dodgy securities that underpinned it. Sure, there’s no single person to blame (i.e. it’s not quite a classic Ponzi) but I think it can be successfully argued that the companies re-packaging loans, in concert with fraudulent house valuations and overstated incomes, created a scheme that had all the attributes of a Ponzi. Just because the basis was an asset bubble doesn’t mean the underlying scheme wasn’t basically fraud. The victims turned out to be remarkably similar too - last in, first bankrupt. That massive democratization of lending you were lauding was a mirage.
David,
You forgot the Ninja loans - I will let you look that one up.
To correct your statement: “Not really. I believe, and using the wisdom of hindsight, the period risk wasn’t priced correctly.”
Some people believed that at the time, others did not. Some people made the correct call on future prices, others did not. Standard market operation - no fraud nor Ponzi there.
I should add that I was one of those who made the correct call on future prices, but that was purely my call.
To say that you can have a Ponzi scheme without a fraudster is simply wrong, David.
My contention, Andrew, is that fraud *was* involved - and that re-packaging of debt in the manner it was done constitutes fraud on a massive scale, by removing the ability to adequately price risk in a deliberate fashion, dressed up as exotic financial instruments. I suspect we will have to agree to disagree.
Here’s a link to give you some idea of where I’m coming from: Merrill Lynch Fraud
Do I detect some lurking Rooseveltophobia?
Need I remind you that Hitler was in office in Germany before Roosevelt was inaugurated. Therefore, FDR can’t be blamed for that externality.
You have absolutely no basis upon which to assert that the market would have corrected itself speedily enough to avoid the externalities of which we speak.
Indeed, the banking reforms of the Depression Era preceeded decades of stability? Post hoc, ergo propter hoc? Perhaps. But the repeal of Glass-Steagall in the US has allowed a raft of rash financial transactions which serve as the underlying causes of the present crisis.
David,
While there may have been a few instances of fraud in some transactions, there are elements of fraud (in that sense) in every market. Some of the smaller players that were originating these loans almost certainly knew that the borrowers could not pay the full rate.
I would strongly disagree it was systemic, as you seem to be implying. The participants in the market as a whole simply got their risk pricing wrong.
David,
I fail to see how that example of the sytematic fraud you were alleging. On Merril’s salesman sold one city some instruments that were probably inappropriate for their investment profile.
That does not even get close to, say, the Orange County issue or Gibson’s Greetings, much less an example of systemic fraud.
Interesting discussion and good post, Kim.
On his ABC news segment recently, Alan Kohler alluded to some recent research showing not just an increase in uncertainty, but increasing uncertainty about uncertainty itself (ie. increasing fluctuations in indicies of uncertainty) over the past decade or so. From a non-specialist perspective, this seems to be evidence that changes to the practices of financing are moving further away from the kind of rational self-healing processes that are supposedly intrinsic to the marketplace.
I don’t buy David’s account of fraud as the root of the problem. I think it’s more subtle insofar as the assumptions built into financial models can only be thought of a ‘representations’ in a very limited sense.
Don Mackenzie in a forthcoming edition of the LRB [link]
Mackenzie, who has also published on Black-Scholes though takes more of an analytic than activist approach compared to Blackburn, goes through the complexities of creating trust in CDOs because they are largely private ‘facts’. This is compounded by the loss of trust in credit ratings, one of the only ‘public’ facts. It’s worth reading. He points out that ‘correct pricing’ is not a simple process that will happen automatically:
Apologies to Tom S and Katz for their comments being held up in the spaminator and the mod filter (it’s that Hitler reference!) respectively. People participating in this thread might like to scroll back up to 20 and 14 to read their contributions.
Should’ve checked that spam filter before I wrote my comment!
I’m not sure that Blackburn is taking an “activist” rather than an “analytic” approach in the article, dk.au (and I read it last night in hard copy). It seems to me that he’s trying to do two things - the first being to analyse and describe what went on and why, and the second is to draw some parallels with the first tranche of financial market regulation stretching from the Great Depression to Keynes’ original conception of what the IMF and the World Bank would do (which didn’t really survive Bretton Woods itself). It seems to me that you can accept the accuracy of the former without agreeing that the historical parallel is either relevant or the solutions proposed appropriate (or of course you could agree with them!)…
To introduce a little levity:
How the subprime crisis began
Despite flogging a possibly dead horse, I think that the financial instrument known as a CDO is basically a fraudulent misrepresentation of the underlying asset. In this case, it’d be nice if perhaps banking regulation were not so much increased but the existing provisions tightened. That includes instruments that nobody can reliably price being re-classified as fraudulent in the sense that the packagers and sellers of them are deliberately misrepresenting their attributes. Selling the cashflow from a sub-prime mortgage as a higher value security is, in my opinion, fraudulent.
Maybe that dichotomy came out more harshly than I intended. I seldom read articles of that length on my screen alone. I’ll have a shot at a printed version. I took my cue from this line without digesting what followed:
which strikes me a fair assessment of the situation. I don’t think the current problems cannot be extricated from the, at times fanatically, positivist social science that financiers base their decisions on. Enter the growing body of literature on the performativity of markets … (eg. [link] )
Hmmm - what had been a comfortable little stoush between two has expanded greatly. I may miss a couple - if so, apologies.
To deal with them in no particular order:
Katz,
No Rooseveltophobia in that - although his actions (IMHO) certainly made it worse and prolonged it. It was directed (poorly) at Silent Cal and the mine manager after him, along with most other nations that had steadily been “protecting” industry, playing around with the monetary system etc. before he got there.
.
TomS,
There are thousands, if not millions, of example of instruments much more complex than a tranched securitisation out there and pricing them is not an issue. The problem (IMHO) was not that the instruments were difficult to price, but the credit risk under them was. This accounts for the “gumming up” of even the simplest of the instruments. Most participants in the market had one set of assumptions about the underlying credit risk of the mortgages. When that proved false liquidity simply dried up while participants waited to see what the credit risks were. Prices for even the highest ranking tranches dropped not due to high credit risk but because some of the more leveraged in the market had to sell at whatever price could be obtained.
The highly leveraged participants knew thay had more risk and were using it to drive returns. They had made more money over the last decade. They lost much of it when the market turned. This is normal. More risk = more variability in returns.
Bears, for example, went not because the underlying assets were bad - they were not - but they simply ran out of cash. Again, perfectly normal. Banks, like other businesses sometimes fail.
The staggering thing is not that Bears went, but that for a decade or so almost no banks in the US had.
In Australia no major banking institution has collapsed for over a century. That is also abnormal. The system could be better, but we should start with an appreciation of the simple fact that it is not bad.
.
dk.au,
I would agree that part of the problem (as with most market problems) was informational. I would not agree, however, that the problem is a circular one. Credit, market and liquidity risk affect each other but can (and typically are) managed seperately, but with each influencing the others. To relate that back to the head article, though, I see no reason why more regulation will create better information. The whole history of regulation (IMHO) reinforces the view that the opposite is the case.
Cheers, Andrew.
Can you point me to something explaining how?
David,
I like this one:
[link]
On your main point, using a “waterfall” structure you can make a fairly safe instrument out of a parcel of unsafe ones. I would agree that it should never be classified as being as safe as a government bond, but they can be made fairly safe by prioritising the cash flows.
dk.au,
I think that this is just as demonstrative of the “…failure of Anglo-Saxon capitalism with its deregulation, privatization and belief in the alchemy of financialization…” as the 17 years of strong stable growth we have had is, along with the millions, if not billions of people it has lifted out of poverty.
Everytime there is a little hiccup like this people are proud to stand up and declare the failure of whatever it is they want to proclaim the failure of. It is nonsense.
dk.au,
Are you happy to pay my consulting fees?
Seriously though, here is one I wrote a while back. (False) modesty aside, it gives you an idea of how the tests are brought together.
[link]
On liquidity specifically:
[link]
If you want some of the more serious mathematics, anything by clive at ozrisk will do. His maths are much, much better than mine.
[link]
Oops - too many links. dk.au - your answer is pending.
Andrew Reynolds wrote:
Safe for who?
The subprime crisis pretty much demonstrates that the theoretical “safeness” didn’t match the actual aka. it’s akin to polishing a turd and putting it in a box, then putting several wrappers of paper on it with a little prize at each layer, like a childrens game of pass the parcel. The first 10 players get a trinket, the last player gets the box.
Again, I don’t think it’s a failure so much of market capitalism, but it sure is a failure of at least imagination on behalf of the institutions who created a willing market for CDO’s without really understanding what might be in the box at the centre.
David,
I have done due diligence around some of those instruments in Australia. If, for example, you have the safest 50% on a parcel of home loans in a waterfall structure you are pretty bloody safe. The chances that losses will exceed 50% on Australian home loans is very low.
Andrew Reynolds wrote:
For good reason. We don’t have an overbuilding problem (although we do have an asset bubble), we don’t have anywhere near the number of low-doc / no-doc home loans with the same stinkyness level that the US produced, we don’t have systemic fraud in home valuations and income overstatement driven by commissions payed to mortgage writers. i.e. our housing market is better regulated.
There are far less opportunities to repackage junk than there were in the U.S. and far less incentive to do so.
However, I don’t think the crisis is finished just yet - there are plenty of pockets in Western Sydney and the Central Coast in NSW where a lot of home equity loans have been written. A lot of that money is heading into plain old living costs as petrol and food prices are heading north. Those home loans, once considered “safe as houses” are about to acquire a stench all of their own.
David,
You asked if they could be made sfe - I think I have demonstrated that, even if you think some of the homeowners in Western Sydney and the Central Coast are deadbeats.
But AR, I’m a great fan of market sovereignty myself.
However, I’m also realistic enough to know that folks don’t act according to market prescriptions. It’s not sufficient to lecture these folks after their collective decisions have tipped the market out of bed and after all sorts of nasty externalities have been visited upon the world. It’s too late after it has happened.
Consider the following analogy. It would be possible for boat designers to build a ferry that is much more efficient than the ferries we have now. These ferries could be sleek and light. They could power through the water much quicker and with much less expenditure of fuel to drive them. Unfortunately, these ferries would require their passengers to to trim the boat and to ensure that they don’t capsize it by moving around and by crowding the gangplanks. Unfortunately, when passengers do this, these efficient ferries capsize and sink to the bottom, causing all sorts of nasty externalities.
We don’t allow ferry companies to run efficient ferries like these because we know that people don’t act logically, rationally and consistently.
Why is a financial system any different? Roosevelt’s banking reforms protected people from themselves and protected the whole system from the actions of the greedy and the stupid.
How is a sound financial system different from a sound, but somewhat stodgy, ferry system?
Katz,
To adapt your analogy to something I feel a little more close to the true situation:
How about the designers of the ferries did not understand boat building at all and had instead been trained in origami? They believe that the whole idea of ferries travelling on water was the wrong thing to do and only little paper boats should be used. They got pushed around by the ferry owners to come up with something that the owners could live with temporarily provided, as you say, their passengers trim the boat and ensure that they don’t capsize it by moving around and by crowding the gangplanks. The owners also managed to slip a few things in there that increase the amount they can charge the passengers, perhaps by persuading the designers that the ferries should be wide enough to stop others using their berths.
Do you blame the passengers, the owners or, perhaps, have a look at the designers when one of these things capsizes?
No AR, your adaptation doesn’t work because it’s ahistorical.
For much of the modern age, financial transactions weren’t regulated at all. A cycle of boom, panic and bust characterised finance. In other words, no one dictated the shape of the financial world apart from financiers.
The worst of these busts that arose from unregulated finance was the 1929 Crash that presaged the Great Depression.
This era can be characterised as the era in which the ferry builders decided on how ferries should work. They sank regularly.
In the wake of the 1929 crash banking and finance reform built controls and redundancies into the system. There followed 70 years of remarkable financial stability.
In 1998, the Glass-Steagall Act, one of the great bulwarks of redundancy, was repealed. Within a decade, massive instability has returned.
Coincidence, or not? You decide.
Katz,
I would suggest that looking at a history of US banking regulation would be helpful for you. There were several regulators before 1933 and the actions of the Fed from 1913 were not exactly those of an all-wise participant. The OCC (est. 1863) and each state’s regulators could be almost guaranteed to the directing finance.
Not as ahistorical as you may think
Glass-Steagall operated by pushing most financial innovation offshore and did nothing to stop massive inflation.
The repeal of Glass-Steagall marked the beginning of one of the most powerful decades of growth in US (and world) history. Coincidence, or not? You decide.
AR, more ahistorical fallacies!
I’d recommend thatyou develop some understanding of the history of finance in the century to the outbreak of the Great War.
Until the outbreak of the Great War, the US was a net importer, and a large net importer, of finance.
The actions of parochial regulators in various US states up to 1913 had minimal impact upon the conditions of world fiance, which was in fact dominated by London.
Re Glass-Steagall, I never suggested that it was perfect. I merely suggested that it may have encouraged the longest panic-free era in world finance.
Inflation during the 1970s and 1980s was much lower in the US than in most western, industrialised nations. This fact puts the lie to your assertion that Glass-Steagall caused massive inflation. Perhaps, if the rest of the world had Glass-Steagall, there would have been less inflation in the 1970s and 1980s.
The growth of the US economy past repeal has been quite aenemic compared with China, the real locomotive of world growth post repeal. You aren’t trying to suggest that the repeal of Glass-Steagall caused the rapid growth of the Chinese economy, surely?
Katz,
Are you confining your look to the US or not? If we are looking generally then there is little scope for claiming there were any large problems before 1913 - with a few localised issues the system coped well with the expansion from around 1770. The odd thing is the period from 1913 to 1929 when the regulators and legislators were blocking capital flows, trade and were stepping in on other areas in which they had little competance and even less knowledge.
There were some problems, but for any system to grow and evolve over such a period was (IMHO) little short of stunning.
Sorry, missed a bit.
You seem to think that Glass-Steagall (and I would add its equivalents elsewhere) caused stability. I would tend to agree - such stability that banks all opened and closed at the same time, lent at the same rates to people who could prove they did not need it, borrowed at the same rates from everyone and made fat margins on both. Great stability.
On the China bit - any idiot can encourge growth from a starving country simply by removing his hands from its throat. To compare China’s growth to that of the US is laughable. On the specific point - Glass-Steagell’s repeal certainly did not hurt. It (finally) allowed a proper mobilisation of US funds towards productive outcomes, and away from the moribund places they had been kept in - resulting in increased productivity and, yes borrowing. Yes, there has been some instability as a result - but I, for one, do not see the 1950s as some sort of ideal. That sort of stability you can keep.
In the era of globalised finance, which began shortly after the end of the Napoleonic Wars, the study of finance at a purely national level is of marginal utility.
This is epecially true of the US in the nineteenth century, which was a wide open market for massive capital flows, especially from London.
Your characterisation of the nineteenth century as a period of financial stability is very strange.
I recommend that you read up on the (London) Panic of 1825, the panics of the 1840s, and the so-called “Long Depression”, which persisted for the last 25 years of the nineteenth century. The Australian colonies were particularly hard-hit by this financial panic after 1891. These panics had world-wide ramifications, wheras the episodic American panics ofthe nineteenth century were either local reflections of larger events or were simply local phenomena. The US did not export its crises in the nineteenth century.
It is true that the bone-headed intrusion of economic nationalism in the 1920s was particularly destabilising. But don’t forget that this was also an era of the biggest economic boom in history.
Depends on your sense of humour.
But for folks who takes economics seriously, there is only one valid economic measure — growth in GDP per capita.
Using that measure comparisons are valid, and telling.
And again, the repeal of Glass-Steagall occurred at a time when the US returned to its nineteenth-century condition as the world’s biggest net borrower of capital. US banks borrowed overseas funds to lend to US consumers and persons enmeshed in the housing bubble.
These borrowings were supposed to generate interest to reward foreign investors’ risk. Some of the largest banks in the US now threaten to default on these obligations. And willy nilly, these foreign lenders have found themselves on the receiving end of a massive decline in the exchange value of the US dollar. Any way you cut it, foreign lenders to US banks have taken a huge hair-cut since the repeal of Glass-Steagall.
From the US point of view it was a good thing, then.
Most of the lending has been from the Chinese government - which is hardly a bastion of free-market economics. The US reaction has been to take advantage of that. This is hardly a bad thing from their PoV.
US banks, governments and residents owe more than ever and their dollar has collapsed. The US appears to be incapable of sustaining its living standards without massive injections of foreign finance. And now these financiers are beginning to consider their options.
Here’s an externality for you: what happens when folks are evicted from their homes, have no job to go to and no safety net to catch them? My guess is that it will be ugly.
Katz (#46),
Seriously, mate. Trying to say that China growing from the pits of probably the worst period of mass starvation in history and the single most destructive government ever can be compared to a modern industrialised country is just plain silly. Sure it is growing fast - but it has a long way to go before it can come close in per head terms to the US. A Trabant can accellerate form 5kmh to 10kmh faster than a Ferrari can accelerate from 150 to 300. That does not mean I would be thinking the Trabant is the model to buy.
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#45 - Looks like we both consider the other has a lot of reading to do. To me you have to look at the times they were in. The way the system changed and grew while no-one knew where it was going was remarkable. Could an over-arching regulator have done it better? Sorry - but I am not on those particular drugs.
As for the 1890s - please remind me, when was the McKinley tarrif passed by the country that was just about to become the largest trading nation?
Look at all of those crises, Katz. For all of them there was at the very least a major regulatory change just prior. Coincidence? You decide.
If you want to console yourself that the US still has a much higher per capita income than China, or much of the rest of the world for that matter, feel welcome.
There may even come a time when US decisionmakers make more economic use of the borrowed capital of the world to help sustain that hgh standard o living.
But the point is that since the early 1980s that hasn’t been happening.
And then this:
Your point being…? Why do you continue to insist on confusing finance with trade? By the end of the nineteenth century the US economy was the largest in the world. Yet the US continued to be the largest borrower of foreign finance. There’s no contradiction here.
The salient point is that, contrary to your roseate view of the nineteenth century, the era was rife with financial panics that arose out of an unregulated, market-driven financial system. No amount of special pleading alters that fact.
Do you have some kind of emotional need to deny it? If so, get help.
“A Trabant can accellerate form 5kmh to 10kmh faster than a Ferrari can accelerate from 150 to 300.”
You got a reference for this outrageous assertion REYNOLDS?
Evidence is what we were after fella.
GO!!!
Andrew Reynolds wrote:
Like I said - safe for who? Certainly, they are safe for the original lender who has neatly packaged up all his junk and sold it on.
The lenders themselves have deadbeat qualities to equal their customers - the idea that house prices in australia only go up is just as invalid as it was in the US. Nobody really has a handle on just how many of those central coast and western sydney properties are under water right now - not even the lenders (who are possibly afraid to ask).
Re: the whole China/US relationship, most financial commentators have agreed that the US, by attempting to avoid a recession after the tech wreck, have merely extended their own misery by fuelling a debt wreck on the back of ridiculous interest rates. That other countries were willing participants in the US economies destruction is neither here nor there, although I’m sure both the Saudi’s and the Chinese are hardly unhappy that the hollowed out US economy is facing an unprecedented disaster.
FDB,
Just coz your chosen moniker is 3 letters long there is no need to channel others of that nature.
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Katz,
Are you seriously saying that you admire China more because they simply stopped slaughtering their own people, are now merely murdering a few, imprisoning some and getting out of the way of a few more and, as a result, are now shining beacons of light in the world of economics? If so, all I can say is to push back on whether it is you that have some emotional needs.
On the finance / trade question - you acknowledge the problems in the 1920s, which resulted in the crash of the 1930s as having an effect on the banking system yet will not accord the same to the 1890s? Odd, if I may say so. If you want more elaboration, look at the monetary changes arising from the Sherman Silver Purchase Act.
I have no rosy view of the period from 1770 to 1913, Katz. Governments were just as capable of passing stupid laws then as they are now - they were just less capable of enforcing them. Fortunately, voters now are a bit more educated than they were then and are more capable of restraining government’s worst excesses through the ballot box. That moderates government’s ability to do some really stupid things. As a result, I believe things are still improving overall - we just have to keep an eye on them.
I don’t admire China.
On the contrary, I’m very concerned that US banks, governments and corporations have mortgaged themselves to Chinese government-run banks. I fear that this will end badly. I acknowledge that these same Chinese decisionmakers appear to be winning this struggle for control of the world.
I’ll try to explain my attitude to US policy-making in the nineteenth century one more time.
In the nineteenth century, US banks and businesses were net borrowers. They were therefore subject to financial conditions that persisted elsewher, mostly London.
Here is a parallel. It would be idle today to attempt to understand the conditions of capital creation by studying Argentinian banks, businesses and it public sector. Argentinian decisionmakers are net borrowers. They can borrow only what is available and what is offered to them. The availability of capital is utterly beyond the competence of any Argentinian decisionmaker to influence.
Argentinians, however, can have some in deciding to accept or reject the terms on which that capital is offered to them. (Sometimes that is Hobson’s choice.)
In the nineteenth century, the US was in the same structural relationship with world capital markets as Argentina is today.
Therefore US regulations in the 19th century are of marginal importance. (And yes, I’ve read Milton Friedman’s “A monetary history of the United States, 1867-1960″, too. In fact it is sitting on my desk right now.
Here is an interesting quote from Friedman concerning the Panic of 1907:
As you can see, the stability of US financial markets was beyond the control of US interests.
The Bank of China now has that kind of power over US markets.
Katz,
Thanks for the clarification - I thought from your previous utterances that your position was different from the one above.
I would agree with you if the monetary system was like that of 1907 - i.e. a gold standard. It is not. China is not holding calls on US gold reserves and is therefore able to call gold, they are holding fiat. The difference is crucial.
If the US simply raised a digit to China, what happens? Under gold, China can call on the gold reserves in the US and ship large quantities of gold out - severely contracting the US money supply, leading almost inevitably, to recession or depression. With fiat, all China can do is dump the holdings to buy - what? Other currencies? China would be sitting on the biggest losing forex position in history. They may not be that answerable to the people, but such a loss would be noticed. Sure, the resulting currency turmoil and US inflation would hurt, but not nearly as much as China would be hurt. The US would also be able to structurally adjust much faster than China. The point here is that, in 1907, the US debt was denominated in gold. In 2008, it is in their own fiat currency. The difference in power that gives the US is marked, IMHO.
Thinking about it, this may be a good reason why fiat may be superior to commodity, in that it gives a cushion to external impacts. I will have to think about that.
I agree that there is a difference between the inflexibility of the gold standard and the flexibility of fiat money. But this simply means that the two systems take different routes to systemic crisis.
The solution you are prescribing arising out of a fiat currency system is a policy of inflation. At the moment the US has a decided advantage in international financial transactions because these transactions are conducted in US dollars, which means that the US does not have to concern itself with adverse movements in exchange rates.
However, there are at least two other dangers:
1. Inflation can undermine the stability of domestic financing, especially in a regime of negative real interest rates. The coincidence of these two factors can stimulate speculative bubbles of the kind that has already been witnessed in the US real estate market.
2. Inflation endangers the exorbitant advantage that the US enjoys in having its currency accepted as the medium of international exchange. There comes a time when foreign interests refuse to accept US currency as a medium of exchange, fearing as they do the effects of inflation on its utility as a store of value.
Both of these scenarios conceive of a rationing of credit, which can be achieved only by an increase in interest rates. This is a state of affairs which imposes further burdens on an already wobbly real economy.
These are further externalities arising from a financial system careering out of control.
I don’t have time to dig it out, but I read a fascinating account of Chinese banks disinvesting in the US in the last 18 months or so. Chinese interests appear to be disengaging from the potential toxic effects of a collapse of the US dollar.
If that collapse continues, the world will feel the pain, but the pain will be greater in the US than elsewhere, including China.
Katz,
I would tend to agree with some of that and, as I said, the US would be hurt - but China would be hurt orders of magnitude more. The Bank of China has over a trillion dollars in USD denominated assets, mostly government bonds. If they dumped that onto the market, the USD would go into freefall - no doubt. But the BoC would find it a Phyrric victory as the value of their holdings would go down with it. The vast bulk of Chinese trade deals are also denominated in USD - meaning any executed deals would have to be done at the “old” price, costing Chinese exporters a huge amount until they were able to re-negotiate deals. While a lot of their imports are also in USD, the nature of the trade in commodities against the trade in finished products would mean that the commodity prices China pays would adjust much faster.
Wal-Mart would be bloody happy, though.
The US, with their more open economic system, would be able to adjust to the new price levels more readily as well. No doubt, it would hurt, and hurt a lot - but the damage to China would be incalculable.
I would personally doubt that the current Chinese government would survive.
Personally, I think they have been vey unwise to build up such a position in USD alone. Allowing the currency to adjust or putting the position across many currencies would have been better, but they are now stuck with fistfulls of dollars and really, not a lot they can do with them.
Not necessarily. Intelligent hedging could blunt the impact.
This is undoubtedly true. However, there are indirect means through currency and bond and interest rate futures and options to achieve the same hedging effect as now pertains in major commodities markets.
This openness is both an American strength and an American weakness. The adjustments you speak of also necessarily involve enormous stresses on household finances. There is alreay a tsunami of liquidation and repossession sweeping through the US population. It is an open question as to how much of this Americans will tolerate before serious civil disorder breaks out.
I’ve been short on the US dollar for two years. I don’t think we’ve seen the end of that rainmaker.
Katz,
If the BoC even started to try to hedge such a position, the effect would be the same. Hedging a billion or a few would probably go un-noticed, although I suspect the Chinese walls (no pun intended) would prove leaky. Hedging one thousand billion, even over a few years, would be noticed.
If they tried to cushion the importers the position would get even larger and the walls much leakier. To me there is no way they can do it.
The potential for serious civil disorder is, IMHO, much, much greater in China - there are already regular riots on considerable scale in the countryside. A government that deliberately tried to beggar their major trading partner, with the consequential job losses and disruption in the cities would be not merely playing with fire but casting themselves into it.
I would agree, though, that a short position in the USD is a good medium term bet.
AR,
I never suggested nor less still recommended that Chinese authorities might attempt to destroy the US financial system.
That certainly was not the intent of the Bank of England way back in 1907 either.
In 1907 the Bank of England was merely attempting to punish the profligacy of issuers of US financial paper. This attempt to discipline got out of hand.
In the same way, I’d suggest that Chinese financial decisionmakers, who are very patient, are attempting to do a number of things:
1. buying US equity when the price seems right.
2. supporting US consumerism while at the same time seeking for alternative markets and looking to the day when the US consumer is less important to Chinese exporters.
3. gradually unwinding gargantuan holdings in US official paper and in non-government bonds.
All this is done not by dumping the US dollar but by a gradual unwinding of positions, while keeping the yuan pegged to the dollar as much as practicable.
These manoeuvres show every sign of being subtle and choreographed rather than rushed and precipitate, unlike the Bank of England coup of 1907.
I would agree, Katz - all of which means that the US posiion will be a slow, gradual change - not 1907 / 1929 or any other crash all over again. The only really scary thing would be when China finally gets a change of government. If they get there through revolution who knows what will happen.
I’d argue that this is a hydra-headed scary thing.
Perhaps the communist regime in China will collapse peacefully like the CPSU.
However, the successor government in Moscow did not have at its disposal trillions of dollars of US financial paper.
Nor, for that matter, did the government that it replaced. A communist Chinese government in its death throes could do immense damage to the US and world financial systems.
The mere threat of such a thing would be enormously destabilitising. Thus, there may be an element of mutually assured financial destruction operating to minimise the possibility of rapid political change in China.
Neither the US nor China, it may be argued, can afford to entertain rapid, destabilising change in each other’s financial and political systems.
I remain to be convinced that China is more prone to systemic crisis that the US.
Katz,
Again - are you serious that China, a poor country with a dictatorial system of government and a long history of violent revolution is less likely to suffer a systemic crisis than the US - a democracy that has a (mildly faulty, at times) system of governmental change that has over the last 140 years regularly proved to be able to handle changes without