Saturday, November 22, 2008

Keep Your Head, Write Some Theory

This was not a good week for Planet Economy.

The Financial Times reports that mass layoffs came to 80,000 in just five days.

In the same paper, financial editor Martin Wolf summarizes the bad bad bad financial indicators.

This week, Citigroup lost half its market value.

After Thursday's massive plunge, Wall Street greeted the appointment of New York Fed chair Tim Geithner as Obama's Treasury Secretary with a festive one-day increase of about 6.5%. Is it because the Markets were as worried about Larry Summers as I was? There was some certainty-effect - the news was finally in. Geithner is what we could call smart-orthodox. He came up under Summers in Treasury in the late 1980s, has lived abroad and seen other systems, has criticized aspects of the paradigm without breaking with it.

For example, FT reports
In speeches going as far back as 2004, Mr Geithner praised innovations in finance such as securitisation and globalisation. But at the same time he warned that these developments, while reducing the probability of a crisis, could exaggerate the downside if one ever did occur.
Plus, "Within the Fed, Mr Geithner has a reputation as a fiercely competitive sportsman." So they don't really know anything. I would say he's like Obama himself: an ecumenical insider - an insider with the ability to see what the outsider thinks, without actually responding to it.

The markets continued to refute the existence of "market rationality." Or more accurately, the markets revealed the panicky followership that has always been the real meaning of "market rationality." Leaving aside the Buffet-exceptions, investors imitate other investors, going up or going down. The reason is simple: the "market" controls the value of their position. If they don't follow it, they lose out (going up), or lose (going down). The master gesture here is imitation. Look at the volatility boom in the chart below (from Yahoo Finance). Increased risk has made the logic of the market more dramatic - but the mass of the markets always simply followed the trend - wherever it led.

I have never experienced that apparently widespread gut feeling that markets are the most effective way to allocate resources. The markets are a complicated network of financial institutions that broker and mediate all individual contact with them. These institutions, like all brokers, take a piece of the action. Commissions in high-end investment banking were famously huge - one standard was 2% of assets under management as an automatic fee, and 20% of profits. In 2007, the financial sector produced 40% of all the profits of that advanced industrialized country known as the United States. Often capital got moved into exciting new things that needed it. But the price of this capital was much higher than we think.

We cannot assume money wouldn't have gone to those things under a leaner and more democratic system, in which public policy debates shaped resource allocation, as they may do with Obama's infrastructure plan.

Deregulated markets have been a good way for the best - the best-connected? - brokers to get very rich. After 1980 they were a good way for the middle classes to feel in this money. It's a seductive feeling. Small investors grew their money through a variety of brokered instruments in a 20-year bull market - a bull created in large part by the mass obligation to stay in the action, not so much to buy and hold but to buy and sell. The bull also arose from the action - and the expectation of action - that spread from Wall Street to Main Street as companies converted pensions into personal investment funds. The bull continued with massive leveraging - buying assets with borrowed ones, sometimes in a 30:1 ratio of borrowed to owned, or even more. This ran the price up on most things. It created the mass expectation that the price could go up on anything. Leveraging, cheap and easy credit, high fees, new money from the market's munchkins - all this was enabled by rising prices, which enabled prices to rise even more.

I was always impressed by the absence of critiques of rising housing prices. Huge portions of the population were shut out from home ownership - or forcibly relocated from more to less desirable areas by cost. Not that I don't like Las Vegas, but why do half of my African American students at the University of California, who grew up in places like San Francisco or San Pedro, now have to go to Vegas to visit their parents. But the critique was stifled by the combination of sprawl development - low-cost outland development - and almost-free credit, deliberately cheapened by Fed Chairman Alan Greenspan.

The critique should have been part of the pricing of housing, credit, and stocks. Some kind of social discourse should have been in the mix. One way of putting the problem is that the theory that markets are both free and self-regulating was factually wrong - as Greenspan himself now admits.

We aren't close yet to understanding the mass psychology of markets - or the more basic fact that markets are mass psychology. When we do, the Age of Markets will indeed be over.

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