Tuesday, September 30, 2008

Is the Depression Near?

There was a lot of action this last week that was plastered all over every newspaper on earth, so I won't repeat it here. Suffice to say that everyone is deeply upset. Most people hated the Paulson bailout plan. Most people hated its rejection by Congress. The modified plan had accountability and ownership. The real problem is nobody thinks that it will work. The markets in most things are gyrating in a way that makes them a joke. The Euro lost 3 cents in 3 hours this afternoon, while the NYSE was going up, having lost 777 points the day before. Krugman denounced McCain's flipflops, and why not? But everything is flipflopping.

Naomi Klein was on the radio a few times saying the crisis is an example of the "shock doctrine," in which unpopular and radically anti-populist policies are rammed through because everyone is paralyzed with fear. It's not quite happening that way. She's generally right, but it's also worth remembering shock works best when it's genuine in people like Paulson.

A fairly sober End of the World column is Martin Wolf's. For the End of American Power, see ye olde British conservative John Gray.

We were joking over the weekend that the FT is the New Left of anti-finance. It's not literally true, but close enough to be the scariest part of this. As of yet, there is no alternative. Amy Good man did a sequence yesterday on FDR, just to show you how backward things are.

Monday, September 22, 2008

A Progressive Bailout?

Dean Baker takes his shot at a recipie for a progressive bailout.

Progressive Conditions for a Bailout

By Dean Baker

The events of the last week showed the urgency of dealing with the financial crisis. There is a real risk that the banking system will freeze up, preventing ordinary business transactions, like meeting payrolls. This would quickly lead to an economic disaster with mass layoffs and plunging output.

The Fed and Treasury are right to take steps to avert this disaster. While there is an urgency to put a bailout program in place, there are several important issues that Congress should address in the context of bailout.

While there is not time to prepare all the details of the financial restructuring that will follow after the bailout, there can be an agreement on the outlines that this restructuring should take. This list of suggestions is presented in that context:

Principles to Guide the Bailout

1) Financial institutions should be forced to endure the bulk of the losses with taxpayer funds only used where absolutely necessary to sustain the orderly operation of the financial system.

2) The bailout must be designed to minimize the opportunity for gaming.

3) The bailout should be designed to minimize moral hazard.

4) In the case of delinquent mortgages that come into the government's possession, there should be an effort to work out an arrangement that allows the homeowner to remain in her house as owner. If this proves impossible, then former homeowners should be allowed to remain in their homes as renters paying the market rent. This should be done even if it leads to losses to the government.

5) There should be serious efforts to severely restrict executive compensation at any companies that directly benefit from the bailout.

Principles for Restructuring the Financial System

1) Combating asset bubbles must be one of the Fed's key responsibilities.

2) The government should impose a modest financial transactions tax, comparable to the one in the United Kingdom. This can both restrain excessive trading and raise more than $100 billion a year in revenue.

3) Regulatory agencies should require that potentially tradable assets (e.g. credit default swaps) actually be traded on exchanges.

4) There should be strict limits on leverage for all regulated financial institutions.

5) Fannie and Freddie should remain fully public institutions, returning them to a status comparable to Fannie's prior to its privatization in 1968.

6) The Fed should be restructured so that all the key decision makers (e.g. the open market committee) are appointed by democratically elected officials. Its responsibility is to manage the economy in the interest of the general public, not the financial sector.

Given the urgency for passing a bill, Congress should look to enshrine principles in a bailout bill that will allow subsequent legislation to circumvent ordinary procedural issues (e.g. the filibuster in the Senate).

Sunday, September 21, 2008

Am I Reading the Onion?

This is Bloomberg, really:

The Wall Street that shaped the financial world for two decades ended last night, when Goldman Sachs Group Inc. and Morgan Stanley concluded there is no future in remaining investment banks now that investors have determined the model is broken.

The Federal Reserve's approval of their bid to become banks ends the ascendancy of the securities firms, 75 years after Congress separated them from deposit-taking lenders, and caps weeks of chaos that sent Lehman Brothers Holdings Inc. into bankruptcy and led to the rushed sale of Merrill Lynch & Co. to Bank of America Corp.

``The decision marks the end of Wall Street as we have known it,'' said William Isaac, a former chairman of the Federal Deposit Insurance Corp. ``It's too bad.''
Wall Street ain't over. One reason is the Paulson plan, and Krugman has a good short critique this morning.

The Left on the Crisis

The main problem with the Bush bailout and its colossal scale is that we don't know what the public gets in return for its money, and we don't know that decision-making power will be moved from Wall Street to Main Street. We need some arguments to accomplish this.

If you are looking for a clearly progressive or left-wing perspective on the Internet, what can you find? Here's a start (just from this past week).
  • William Greider at The Nation. Greider is one of the country's leading financial journalists, and has written books on the Federal Reserve, globalization as the return of super-exploitation of labor, democratic economics, and much more. His short piece says that the "new financial architecture" was based on irrational leverage, the absence of prudent reserves to cover possible losses, and the selling of false hopes for sustainable high returns. The problem is systemic, he writes, and this may be a new 1930s. He concludes: "At some point, the new president might have to do what FDR did in the wreckage of early 1933--declare a "bank holiday" and announce emergency rules to govern banking and finance until the crisis is broken. For the country's sake, I think this a better approach than buying up junked banks and failed financial firms, one by one. People have the right to ask: what exactly are the rest of us getting for our money?"
  • Naomi Klein argues that since market ideology is a "servant to the interests of capital," its ideologues will use the version that works best at a given time. For many years financiers made the most money off of laissez-faire (utterly untaxed transactions, capital gains federal taxes at about half what wage-earners pay - this one especially bothers me). Now they will make the most money (or lose the least money) with massive government intervention and taxpayer-funded bailouts, not to mention transaction restrictions like the temporary ban on short-selling a list of 799 financial stocks). When the wind shifts, Klein says, laissez-faire will come roaring back: the consistency can be found in the financial interests behind the statements. Klein ends by saying that governments ignored speculative excesses because they thought they lead to economic growth: "What is really being called into question by the crisis is the unquestioned commitment to growth at all costs. Where this crisis should lead us is to a radically different way for our societies to measure health and progress."
  • Willliam Pfaff, a genuine conservative "maverick," most clearly points out that "The financiers, as Joseph Stiglitz has observed (in a recent CNN interview), were doing what the system demanded of them. They were assured generous rewards for managing risk and allocating capital so as to improve the efficiency of the economy enough to justify their generous compensation. 'But they misallocated capital; they mismanaged risk-they created risk. They did what their incentive structures were designed to do: focusing on short-term profits and encouraging excessive risk-taking.'" Incentives must be redesigned to favor public rather than private interests.
  • Chuck Collins points out that the financial leaders that caused this crisis get to keep what they made while we pay what they lost. The head of Lehman, which declared bankruptcy last week, does not "disgorge" his $354 million in compensation from the last 5 years. Collins offers six taxes that would raise the bailout money from its beneficiaries, including closing off-shore corporate tax havens (the sucking of major capital away from large, complex societies and into "fiscal paradises" is a big issue in Europe), and "Instituting a 50 percent tax rate surcharge on incomes over $5 million and a 70 percent rate on incomes over $10 million[that] would generate $105 billion a year."
  • In another Nation article, Greider calls the Paulson bailout (the $700 billion general one) a "historic swindle" that will cause popular unrest. "The scandal is not that government is acting. The scandal is that government is not acting forcefully enough--using its ultimate emergency powers to take full control of the financial system and impose order on banks, firms and markets. Stop the music, so to speak, instead of allowing individual financiers and traders to take opportunistic moves to save themselves at the expense of the system. The step-by-step rescues that the Federal Reserve and Treasury have executed to date have failed utterly to reverse the flight of investors and banks worldwide from lending or buying in doubtful times. There is no obvious reason to assume this bailout proposal will change their minds, though it will certainly feel good to the financial houses that get to dump their bad paper on the government." Greider is calling for a serious nationalization that would not mean Washington running finance permanently but an imposing of political and social imperatives on the financial system and its leaders. For starters, a new "central authority' would obligate banks to continue to lend responsibility to individuals and business at affordable rates so that the real economy doesn't tank. Direct government lending may be required, as with some loans for college students.
  • Then there is the old-fashioned "Screw Wall Street." Why should we figure out how to save them. Let them drown.
  • There is also the "unchecked greed" thesis, accompanied by the observation that the little people will pay yet again for this rich man's bailout.
  • And a somewhat classic summary from Steve Fraser: "It's time for a reversal of course. Stringent re-regulation of FIRE is not enough anymore. Washington's mission may, at this late date, be an even greater one than Roosevelt's New Deal faced. The government must figure out how to deploy its power to shift the flow of investment capital out of the mine-fields of speculative paper transactions and back into productive channels that will help meet the material needs of American society. Real value must be created in place of chimeras. In the meantime, we all have ringside seats -- in fact, far too close to the action for comfort -- as another gilded age is ending. What comes after is, in part, up to us."
I got this first clump of pieces from "Common Dreams," which is a progressive site that has in general not covered economics at all until now. Most of the pieces come from "The Nation,' and the rest from the Nation alum who run a handful of prog websites. Maybe this says something about Common Dreams, but it also says something about the current state of the Left on economics. For starters, it is too small.

The spectrum of Left responses runs something like this.

1. the financial system was spoiled by greed and excess (of leverage, of made-up securities, etc). Most conservatives would also agree with this, and it wouldn't not allow, say, Obama, to distinguish himself from McCain. This view is compatible with a $700 billion Bush-Paulson bailout.

2. new regulations are necessary to block future bubbles by stamping out greed and excess, starting with the deeds of the bad actors . We could implement new rules about minimum margin requirements to reduce leverage, for example. This is compatible with the Barney Frank position as a liberal Democrat in Congress who hated having his chops busted about the evils of big government for 25 years and is going to get a little payback. It is also close to Dean Baker's preoccupation with bubbles that competent professional economists can measure and deflate before they blow up.

3. We need not only reform, but a government takeover of the financial system. This is Grieder's position, and few others', as far as I can tell.

4. We need to identify the winners and the losers when the financial system was working, and make the winners pay for their crimes. The losers under Bush should not lose again by paying for the crisis. This is Collins' position, and is compatible with Greider's. It is sometimes called "populism" in the press, and it makes class distinctions. It is an insurgent view in the US only because conservatives who say the wealth of the wealthy helps the poor have successfully marginalized clear discussions of wealth and and income inequality for 25 years.

5. We need to reconceptualize the purpose of economics, and resubordinate economics to the public's cultural, political, and social goals. This is Klein's position, and Fraser's, and also Pfaff's, and historically speaking is a close to the old Popular Front, to Marxist humanism, to various kinds of democratic socialism, to parts of the enivronmental movement, to some forms of anarchism, and also to civic republicanism (small r), which helps explain Pfaff.

The most urgent position for the Left is (3), in order to block a Trickle-Down Bailout, in which the public will buy private junk that enables the main perpetrators to keep deciding what does and doesn't get funded in the wider economy.

The problem with American politics is trying to get beyond (2) to some combination of (3-5). A lot of people like (5), and I have argued in Unmaking the Public University that the public university was unmade in part because it was cranking out a millions of grads a year who thought economics should serve their existential, personal, and political visions. This was very bad for conservative rule, and conservatives managed to discredit most if not all of this vision with culture wars and budget wars, among other things.

But even where (5) is solid, most Americans are uncomfortable talking about class inequality and economic victims, especially when it involves contemplating the possibility that the victimization was deliberate - that big investors win big by getting the companies they own to outsource jobs, pay less in taxes for hospitals, schools, and in general shrink the middle class and impoverish lower-wage workers.

So (4) is an uphill battle. And few people in the US love (3), Greider's government takeover, unless they are absolutely desperate. We don't have France's tradition of "la republique" in which the central government constitutes a balanced and effective society. To get (5) in the US, a kind of humanist economic democracy, by using (4) to justify (3) - that is, by using systematic inequity to justify government control - you need an acute, desperate crisis (e.g. the Great Depression). And skeptics like me would point out that (3) doesn't generally lead to (5) - the New Deal was limited and lacked a strong economic alternative to neoclassical economics, which made it vulnerable to the politicization of technical critiques of monetary and inflation people (cf. the strange triumphs of Milton Friedman).

Left economics needs to work much harder this time around on the Klein-Fraser-Pfaff side of the critique, without abandoning Greider. We now need much stronger humanist visions of what economics is for.

Friday, September 19, 2008

Post-Finance Capitalism

Today it looks like the Fed and Treasury are not just buying highly-visible crap owned by say AIG, but are buying all the crap in sight. They're also buying a lot of crap they can't see at all, but are only guessing at. The markets went ape all over the world, running up prices on everything they could find.

This is all pretty goddam unbelievable. Watching Bush, a guy whose entire career rests on attacking big government, say that government intervention is not only right but necessary, I thought I'd been teleported to Earth 2 in a parallel universe.

Actually, Republicans specialize in pushing public money into private pockets. Remember Haliburton's cost-plus contracts that have done so well rebuilding Iraq? There are actually more strings on this deal than usual - the public actually owns something - crap debt - rather than giving money away hoping for trickle-down.

The New York Times had a decent editorial today about the situation, driven by anger at the absence of honesty and reality in the official versions of investment banking behavior. It assigns blame to underregulation. As I said yesterday, that's only the beginning.

Politics aside, what kind of crap are we buying today? A lot of Credit Default Swaps, for one, and I found a nice explanation of them on Money Morning's website from last April, when we still weren't worrying about our "$50 trillion problem." CDS's were sold and resold by and to what even mainstream NYT columnists have taken to calling "the shadow banking industry" that rules the world. Actually, that holds the world at gunpoint until we give them the REST of our money.

Here's a frighteningly accurate prediction from the April column (it will make more sense if you first read the definition of CDSs).
There are two sources of likely loss on CDS:

Default by the underlying borrowers, the companies that originally took out the loans.

And default by the banks or other financial firms that bought the credit default swap - counterparties in the endless chain of banks, insurance companies, hedge funds and general riff-raff that have done these deals.

Since the total outstanding balance of the CDS market is $50 trillion, compared with the entire U.S. home mortgage market at about $11 trillion and the subprime part of that market at only $1 trillion, you can see why people are worried.

American International Group Inc. (AIG), the insurance company, lost $7 billion on its CDS portfolio in its fiscal quarter ended November 30, and that was on "super senior" CDS.
A more recent piece by Shah Gilani notes that "Credit default swaps are not standardized instruments. In fact, they technically aren’t true securities in the classic sense of the word in that they’re not transparent, aren’t traded on any exchange, aren’t subject to present securities laws, and aren’t regulated. They are, however, at risk - all $62 trillion (the best guess by the ISDA) of them."

and it continues:
What is happening in both the stock and credit markets is a direct result of what’s playing out in the CDS market. The Fed could not let Bear Stearns enter bankruptcy because - and only because - the trillions of dollars of credit default swaps on its books would be wiped out. All the banks and institutions that had insurance written by Bear would not be able to say that they were insured or hedged anymore and they would have to write-down billions and billions of dollars in losses that they’ve been carrying at higher values because they could say that they were insured for those losses.

The counterparty risk that all Bear’s trading partners were exposed to was so far and wide, and so deep, that if Bear was to enter bankruptcy it would take years to sort out the risk and losses. That was an untenable option.

The Fed had to bail out Bear Stearns.

The same thing has just happened to AIG
Since the insurance companies AIG owns are OK, and the Fed now owns their assets, the Fed - we taxpayers - may do OK on this.
FT's chief economics commentator Martin Wolf, not what you'd call a huge fan of government intervention, said "the whole regulatory regime has to be transformed."

And FT columnist John Pender, in his piece "Toxic Assets Head Towards the Public Balance Sheet," writes
In the space of just two momentous weeks, the landscape of global finance has been dramatically transformed. President George W. Bush’s administration has mounted a multi-billion-dollar rescue of the financial system at the cost of inflicting severe damage on the US model of free- market capitalism.
There are two moments of interest in Pender for the coming era after finance capital:
  1. A shift from leverage: "This is what happens when an overleveraged global financial system unwinds. Borrowing is being forcibly reduced across the world after the greatest credit bubble in history. It amounts, says David Roche of Independent Strategy, a research boutique, to a “tectonic shift from leverage to thrift as the means of financing growth and the concomitant dramatic reduction in global imbalances such as the US current account deficit.”'
  2. Finance's revealed incompetence on society and the "real" economy: "This inability to handle externalities has again been apparent in the markets over the past two weeks as speculators have engaged in short-selling strategies against AIG and the investment banks in the US and HBOS in the UK."
Let's see what we can do with this.

Thursday, September 18, 2008


They were selling junk. They were selling it for lots of money. People were paying lots of money. They were borrowing to buy more and selling to borrow more. They could put down one dollar and borrow 30 more. For a while the junk was expensive. Then it was cheap. It was just junk again. And there was no end of the stuff.

In the Financial Times, Gillian Tett says the markets are disoriented. No they're not. They're soaking up all the public money in sight, revalidating their credit, and waiting to see what will run up next.

On Tuesday and Wednesday newspapers described the markets as "panicked." The Financial Times described investors' "flight to safety" (to bonds and gold) as the most acute since early in World War II. The information was already known, and the current pattern was predicted by the FT in August 2007, and by Warren Buffet in 2003. It is minefield investing, in which half the moves you make will blow you up. And you have no idea which moves those are.

The main thing that was lost was belief that all the structured investment vehicles weren't junk. They'll start believing again. On Wednesday the Dow lost more that 400 points. On Thursday it gained them all back again.

The political shock was the markets' need to be saved by governments. Rep. Barney Frank put it well: "this is one more affirmation that the lack of regulation has caused serious problems. That the private market screwed itself up and they need the government to come help them unscrew it.” Can we finally stop bowing to self-regulating markets?

Financially, the best summary of this week's trigger is John Gapper's:
The thing that frightened me was that Mr Paulson put up US government money when he so obviously did not want to. Having examined the heart of darkness – AIG’s $60bn book of derivatives written on other derivatives based on bad residential mortgages – his resolve crumbled.

Lord knows where this leaves us, since only He knows what a credit default swap (CDS) on a collateralised debt obligation (CDO) is worth.
Actually we do know where this leaves "us," that is, regular folks who work for cash. It leaves us without our play money, the stuff we used via stock run-ups in the 1990s and housing run-ups in the 2000s to supplement the real-money raises we weren't getting.

Causes and critiques are flying in every direction, so let's sort them out:

1. the markets were corrupted by the government. This is the argument that government guarantees, like those for mortgage-lenders Freddie Mac and Fannie Mac, allowed executives to take ridiculous risks without the market discipline of looming sudden death for big mistakes. Look for the phrase "moral hazard," a technical term from neo-classical economics that is being used even by financial journalists I respect, like John Authers.

2. the markets were corrupted by too little government. This was the meaning of Frank's comment above. Nearly everyone is calling for some kind of reregulation, as are both McCain and Obama. But nobody is saying what kind of regulation would have or will actually work.

Just to make things more confusing, most outfits are saying (1) and (2) at the same time. The FT is a good example, since it calls for more regulation while also calling for the end to government protection for financiers and, by implication, very few bailouts like the one for AIG.

It would be more accurate to say this:

3. The crisis was supposed to happen, because it follows from normal market incentives.

It works like this. Financial instruments have no intrinsic value. They are worth exactly what people are willing to pay for them. People paid what they think these things are worth. Some people made up new financial instruments with bizarre, complicated, arbitrary rules - Credit Default Swaps, whatever. If you land on Go, collect $200 dollars, unless you took more than seven rolls to go around the board and your last roll was a three, in which case you collect $200 minus the average of each of your 7 plus rolls. Other people made up stories about why this made sense, usually consisting of saying if prices go down you get paid something, and if they go up you win big. Still other people bought this stuff by the ton - pension and mutual fund managers, etc.

here's John Gapper again, but this time missing the point:
The word “irresponsible” does not begin to describe AIG’s behaviour. Like Bear, Lehman and others, it saw a way to get in on the growing action in mortgage-backed derivatives. Its bankers were soon earning huge fees for themselves and AIG by piling up unimaginable risks.

Call me a spoilsport, but I do not believe that AIG or any other capital markets institution should be allowed to play like that with my money (I am a US taxpayer) in future
OK, you can call them names, but that represses your knowledge that AIG's bankers were heroes and geniuses in their time, doing exactly what they were supposed to do - take risks and maximize shareholder value. Why is this arbitrary process with huge cuts for the players OK when prices go up but bad when they fall?

There's also the sucker's rationality to think about. After 9/11, the prime rate went to 1 percent. Stocks went sideways or down. Housing prices were going up. If you stayed in the market or in savings accounts, you were by definition economically stupid. Only a stupid person would get 1.5% a year when she could get ten times that. Everyone piled into houses. It was logical and rational. This made housing prices go up even more - helped by deliberate financial policies that kept interest rates low. Why stick with 1 percent instead of 10?

This is true for ordinary people, and also for financial professionals. If you stuck with low-risk instead of high, and 3.5% instead of 18, you wouldn't stay a financial professional for long. If you avoided leverage, you were a fool. I can't tell you how many university faculty I've heard complain about the University of California's low pension return by comparison to Yale's, without having any idea of the content of the private placements - the Structured Investment Deals, maybe the CDSs tied to CDOs - that Yale was using to get more than 20 percent.

All this talk of moral hazard etc avoids the nature of market rationality, which is herd instinct. The contrarians often do well, but they are few. Overall, "the trend is your friend." You buck the trend, you lose. You ride the trend, you win. Add in the stagnation of US wages and the conversion of traditional pensions to investment funds - 401(k), 403(b) - and the trend became your ONLY friend. Then throw in "mental hazard." This refers to the absence of actual knowledge about investment vehicles, e.g. what's in them. These vehicles had names and marketers, and it was all press releases, TV authorities, what I think this morning as opposed to yesterday afternoon. It's also proprietary investment models whose assumptions are not only too abstruse for most people, but deliberately, systematically, and legally veiled. They are models created by companies that profit from them. They are there to benefit me, but not to benefit you. Meaning that you, the regular investor, had to buy a model and stick it out to the end.

Which is where we are now, with widespread market failure and damage done. But market failure was happening all along, and never should have been left to themselves

Tax them properly, regulate them, bring them back into society. This will take lots of the profits out of them, but that would be good. We'd have more money back in the real economy.