What have we learnt?

Ok, so the *crisis* is in full swing, so maybe it's a tad too early to start, but what have we learnt from the current problems.

• My feelings are that models need a big ol shake up. This doesn't feel like a 1 in 200 risk but is looking to breach those tollerances
• Or maybe we should just be looking at greater than 1 in 200 shocks
• Do the FSA and/or credit rating agencies need a shake up?

Be interesting to hear other peoples thoughts...

CC

 

This was never a 1 in 200 occurrence, it was more like 5-10% per annum chance, and has been since about 1990, when debt levels became unsustainable.

What do we learn?

1 Most bankers are f*ckwits
2 Most politicians are clueless
3 Bailouts will only extend the crisis and store up potential for hyperinflation and the rise of fascist type governments at a later stage
4 Economics departments in Universities should teach Keynes (the original version not the bastardised version currently taught), Marx and Schumpeter who all emphasised that capitalism is crisis prone.
6 Some sort of gold standard should operate as this will reduce the scope of future credit expansions
7 Friedman and Bernanke got it wrong. The great depression was not caused by the Federal Reserve's policy's in the early 1930's, but by their policies in the 1920's which allowed such a large accumulation of debt. That is Bernanke is not going to prevent a crisis this time and Greenspan's policies were disasterous
8 Central banking should probably be abandonned and interest rates set by the market

 

Hi Cardano, as usual you've given plenty of food for thought! Point three in particular is a bit - can you expand a bit?

Also, any links to "pure" Keynsian theorey - mine is limited to CT7 (which is probably all wrong!)

Big fan of 8, or at least the central rate being the headline figure... I don't know how many times I've ranted at yet another "member of the general public" wheeled out by the media!

Cheers!

CC

 

Cymro Card, I'm busy teaching tonight and most of tomorrow. I'll put up a longish reply on Sunday or Monday.

Incidentally, I reckon you knew when you started this thread that I would put up something controversial. The political consequences of this crisis, I believe will be more long lasting and critical than the economic consequences.

 

Cheers! Always enjoy reading your essays!

I did have you half in mind when I posted... you seem to have a bigger view of the world than most of us! I see it as less controversioal, more a few steps removed from our little bubble!

 

The mass bailouts of a raft of banks, financial and insurance companies are an unwelcome development for a number of reasons.
Firstly it creates a precedent and there are going to be queues of overleveraged manufacturing and even service industries who are likely to go broke as the crisis gathers pace. These players, not unreasonably will ask why if the banks are bailed out, why shouldn't they be bailed out. Also why shouldn't the reckless and feckless who have borrowed too much to fund their Buy to Let empires and to go on an orgy of overconsumption buying the latest plasma screen TV's and going on canoeing holidays in Bolivia be bailed out. When the government bailed Northern Rock out they sent the message out that no matter how reckless you are the tax payer will pick up the tab.
Secondly, the banks have paid their executives and even junior staff vast bonuses from pools which should obviously have been used for reserving. Since many of these loans have been made or packaged up without due diligence, this may well constitute fraud. I feel that there is one area of public service that should be expanded and that is the the Fraud squad. Reclaiming much of this bonus money not only sends the right message to the ordinary people of this country but would be the obvious first recourse to recapitalising the banks. About 200 high profile bankers should probably also go to prison for terms in excess of 15 years.
Thirdly, since the banks have absolutely no intention of eliminating the bonuses unless absolutely forced to, it is completely unreasonable for the government to act as a guarantor of last resort. Either they should have been told that there will never be a bailout, or if as was the case the bankers knew the BoE would come riding to the rescue, their activities should have been regulated to the same extent they were in the 1950's
Fourthly the most important point however is the burden of debt it places on the taxpayer for generations to come and this is the point at which the political consequences will become apparent. The amounts of money thrown at these banks is absolutely staggering. Governments talk about making profits on these loans, but thats nonsense, there will be massive losses.
Inspite of every reflationary and reckless monetary measure short of printing and handing out cash, it looks as if we are going into the first debt deflation for 75 years and it is going to be awful.
At the end of the 1920's when this last happened, most people in the English speaking world and continental Europe did not own there own homes, were not able to raise personal loans for consumption and certainly didn't have access to credit cards. Thus the personal indebtedness of the populace is much larger this time and deflation will have a much more broad based effect. As people and companies begin paying back there debt the money supply will fall. This will increase the value of the money owed and hence the debt burden on the remaining debtors. This will increase the default rate and hence contribute to more bank failures which in turn will mean the government will feel obligated to bail out more banks and financial institutions. Bankruptcy of overleveraged firms, will throw large numbers of people out of work, and thats in addition to those forced to stay on at school to 18 now, those on disability benefits, those who have retired early on obscenely generous public sector pensions and those who are already unemployed. This again will increase the rate of debt default and again lead to more banks getting in trouble. Probably the same ones that have already been bailed out once.
A mood of great conservatism will descend on banking executives and they will be reluctant to lend out any money without the best collateral. This actually won't matter much as by then debt revulsion will have descended not only over the populace but the business class as well. They will swear never to get in debt again, which is a good job as there will be no one lending anyway.
This process will probably reduce the corporate and personal debt by 2/3 or 3/4, but government debt will have sky rocketed due to all the bailouts. In effect, much of the corporate liabilities will have been taken on to the governments books. It is then that the real political problems will begin

more later in the week...

 

Hi

Cardano, brilliant indication of the potential chain.

I think a big question that will soon be asked in teh shake up: how important are the investment banks, exotic derivatives etc to society/economy? which activities are needed and which are not?

I think you mentioned somewhere else in your posts that this could have a knock on effect on education - if so that is interesting - I remember at univeristy presentations, these banks used to pride themselves on high pressure interviews when hiring e.g (you'd be asked to do things like 59 * 67 in 5 seconds w/out calculator)? Yet this same mental agility is responsible for reckless, thoughtless toxic debt packaging and the crisis today, so what use was it!
This is where I give some credit to the actuarial exams - although they seem to be regarded as boring and have little resemblance to the real world, at least following the non-sense rules invokes a sense of discipline in the learner! And this "discipline " (rather than content itself) may in turn help him/her become a more responsible professional, unlike their "cousins" in banking!

 

Examstudent,

I remember discussing a cascade of counterparty failure in the derivative markets with the mother of one of my students who was considering going into banking at the end of 2006. (The silly fool went into banking anyway) That process has already started and will only get worse requiring more bailouts. At the end of it bankers will be so conservative, regulators so vigilant and counterparties so wary most of this nonsense will almost certainly not reemerge for decades. What remains will be derivatives with well capitalised clearing houses, like plain old commodity futures

Academia moves slowly, it is very very conservative. The ideas of equilibrium economics and governments ability to control our economic future will be given up last by the vested interests in academia. I think university economic teaching needs a revamp but I doubt it will happen quickly. They need to make economic history at least 1/3rd of the course. My economic knowledge comes from political activity in my youth, reading and some speculation. I was lucky not to be tainted by university economic departments.

I always felt that investment banks swept up the secondrate, as I remember them taking all the lower end PhD students when I did my PhD in the mid to late 1980's. I wouldn't really be that interested in people who could do 59*67 in there heads. I would want people who could talk knowledgably about for instance the 19th century economy , the great speculative manias (South Sea Bubble, Tulipomania) and also about tactical games like poker and bridge. I would immediately get rid of anyone who applied the normal distribution in assessing financial risk.

The actuarial exams are a peculiar mixture of the useful, the arcane and the erroneous, but they do at least show "stick at it ability". However I can't think of anybody more likely to lose money than 25 year old qualified actuary, they simply wouldn't be worldly enough to appreciate the risks in finance

 

If a drawn out deflation occurs as outlined above, with the transfer of large corporate liabilities to the public sector, then this does not bode at all well for political stability.
The deflation will impoverish anyone with large debts, particularly mortgage debts, anyone who loses their job and there will probably be an overall real fall in wage levels too. This will be exacerbated by the penalties for default being increased. It will simply not be the case the people who have impaired credit history will be able to carry on regardless as they have done in the last twenty years. The penalty for default will not just mean that it is harder to borrow money as it will become nearly impossible for most people to borrow money anyway. It will mean it will be harder to get and retain jobs and even obtaining rented accommodation will become more difficult. Defaulters might in the worse circumstances become "lepers" within society as conservatism and the "protestant ethic" make a welcome return. The increased borrowing to bail out financial institutions will also crowd out the welfare state to some extent and I expect to see a lot of benefits go or be reduced. Thus there will be a very very unhappy underclass who have been used to living on benefits and find that they are no longer subsidised to extent they once were.
However, the deflation will not impoverish everyone. In fact although deflations tend to make the population poorer as a whole there is an equitable redistribution within this process. The rich who have a much larger proportion of there wealth in real assets will see there net wealth fall proportionately more than the lower classes who are more likely to have their savings in cash. In fact those with cash are going to find it is worth much more and that they are big gainers in the deflation (as long as they keep their jobs).
What comes next however will impoverish the entire lower and middle classes and give an "in" to some very unpleasant political parties indeed.
At the end of the deflation the government will have enormous liabilities. They are already pretty big as it is if you include the national debt, the unfunded pension and Health liabilities and private finance initiative. Add to that Northern Rock, Bradford and Bingley, possibly HBOS and a large number of other financial and nonfinancial companies that may be nationalised as the crisis worsens. Then the lower tax takes as economic activity stagnates, the cost of increased unemployment etc etc. Also factor in the fact that the baby boomers are all about to start retiring and they haven't had many children as they came of age when abortion was legalised and made freely available on the NHS. Factor in that inspite of what is written in the Daily Mail, net immigration has not been that large, in fact it was negative between 1980-92 and it will become negative as economic opportunity crashes in Britain in the next few years. The Government will look at its debts, do the calculations to work out what tax rates would be require to pay them off and then introduce an austerity drive for a few years before giving up and printing large amounts of money to pay off its debts. The way the lower classes could protect themselves from this would be to borrow loads of money and buy real assets, but the debt revulsion and return of conservative banking during the deflation will mean this is impossible. Thus the government will be able to relieve itself of this burden at the expense of the most prudent class in Britain, those who save. Hyperinflation impoverishes everyone to a certain extent but it impoverishes the lower classes who hold very few real assets the most. Thus we will find that there is a very inequitable distribution of the remaining wealth - a political disaster.

The possible rise of Fascism, next week

 

At this point I am going to outline Hitler's rise to power in the period 1919 to 1933, and how the dire monetary and fiscal policy of firstly the Weimar Republic and then the Governments that followed virtually guaranteed his triumph.

In 1918 Jack Pershing, the American General wanted the allies to push on to Berlin such that Germany sustained a complete defeat. This was actually the right policy but given the miliions of lives that the allies had expended this was never going to happen. It may well have cost another million lives.
Had Pershing got his way, a fairer peace would have been expedient and a rerun twenty years later could almost certainly been avoided.
As it was Germany had soundly beaten Russia in the East and could largely claim to have been undefeated on the West where they had put up a very good show given that they were running out of everything. The Versailles treaty was therefore draconian as it had to be to prevent Germany making the claim it was undefeated. The allies weren't going to take paper Marks in reparations they demanded coal, steel, factory equipment and just about everything of any value that wasn't nailed down. The German government had enormous debts due to the war mainly but also to a certain extent to the legacy of Bismarck's introduction of a welfare state. Revolution stalked Germany and a Soviet style government briefly took charge in the Southern state of Bavaria. There was absolutely no way Germany was going to pay its debts back to its bondholders, given that its productive capacity was going to pay the reparations. The Weimar Government ran out of money and simply started printing it to pay all its debts. This largely robbed the lower classes of all the savings they had, brought about a massive increase in violent crime (those of you who followed the hyperinflationary collapse of Yugoslavia in the 1990's might see parallels here. People shot each other in Belgrade just to get a tank full of petrol), middle class women turned to prostitution as they had no other way of earning a living. No agricultural goods made their way into the towns as farmers weren't prepared to exchange their valuable food for worthless paper. Unemployment skyrocketed as it always does in hyperinflationary depressions and to a much greater extent than it does in deflationary depressions. The people who did work, took wheelbarrows to collect their pay and burnt it on their fires. It was more economical than swapping it for firewood.
When the middle and lower classes had finally sold everything off and were ruined in 1923, Hitler tried a Putsch and failed, ending up with a hefty jail sentence.
The hyperinflation meant the end of the German Bond market. No longer could the German Government borrow in its own currency and this became crucial later on in the 1920's. The German government had however got rid of its obligation to its bondholders but still had to pay reparations to the allies. The desire to keep up a substantive welfare state was already ingrained in the German people at this stage. It would have been sensible to abandon Bismarck's plans but they didn't. (It would be sensible for us to abandon the welfare state now too, but we won't and it will drag us into the abyss of economic crisis at some point in the none too distant future.) Germany borrowed money in hard currencies such as pounds and dollars and began racking up large foreign currency liabilities.
The rest of the twenties weren't great but, they did leave one legacy and that was a morbid fear of inflation. This can still be seen in Germany and frankly I would rather live in a country with a morbid fear of inflation like Germany than a morbid fear of deflation like USA. Inflation is a far more effective way of ruining a larger number of people than deflation. At the end of the 1920's the world went into a deep deflationary crisis and Germany could not meet in foreign currency liabilities. Unlike liabilities in Marks which it could print, there was no way the German government could print dollars or pounds. Thus it had to make deep cuts into government expenditure in order to meet its liabilities and this was at a time of low economic activity and the erection of large tariffs across the globe. Germany's GDP fell to below that of 1908, unemployment was massive, the banks failed, the middle class was ruined for the second time in 10 years.

Hitler had his "in" ... more later

 

There is an interesting article here indicating how the bailout measures compare with historical war costs and they are very worrying indeed

http://www.ritholtz.com/blog/2008/11/big-bailouts-bigger-bucks/

(cut and paste below)

Whenever I discussed the current bailout situation with people, I find they have a hard time comprehending the actual numbers involved. That became a problem while doing the research for the Bailout Nation book. I needed some way to put this into proper historical perspective.

If we add in the Citi bailout, the total cost now exceeds $4.6165 trillion dollars. People have a hard time conceptualizing very large numbers, so let’s give this some context. The current Credit Crisis bailout is now the largest outlay In American history.

Jim Bianco of Bianco Research crunched the inflation adjusted numbers. The bailout has cost more than all of these big budget government expenditures – combined:

• Marshall Plan: Cost: $12.7 billion, Inflation Adjusted Cost: $115.3 billion
• Louisiana Purchase: Cost: $15 million, Inflation Adjusted Cost: $217 billion
• Race to the Moon: Cost: $36.4 billion, Inflation Adjusted Cost: $237 billion
• S&L Crisis: Cost: $153 billion, Inflation Adjusted Cost: $256 billion
• Korean War: Cost: $54 billion, Inflation Adjusted Cost: $454 billion
• The New Deal: Cost: $32 billion (Est), Inflation Adjusted Cost: $500 billion (Est)
• Invasion of Iraq: Cost: $551b, Inflation Adjusted Cost: $597 billion
• Vietnam War: Cost: $111 billion, Inflation Adjusted Cost: $698 billion
• NASA: Cost: $416.7 billion, Inflation Adjusted Cost: $851.2 billion

TOTAL: $3.92 trillion

______________________________________________________________________

data courtesy of Bianco Research

>

That is $686 billion less than the cost of the credit crisis thus far.

The only single American event in history that even comes close to matching the cost of the credit crisis is World War II: Original Cost: $288 billion, Inflation Adjusted Cost: $3.6 trillion

The $4.6165 trillion dollars committed so far is about a trillion dollars ($979 billion dollars) greater than the entire cost of World War II borne by the United States: $3.6 trillion, adjusted for inflation (original cost was $288 billion).

Go figure: WWII was a relative bargain.

I estimate that by the time we get through 2010, the final bill may scale up to as much as $10 trillion dollars…

>

UPDATE: November 25, 23008 10:34am

A few additional details:

-Well regarded Jim Bianco did the number crunching. The easiest method is to recalculate the numbers using CPI data. There are other ways to depict this — such as percentage of GDP, or on a per capita basis, or in terms of costs of common items (eggs, bread, big macs, etc.).

Bloomberg calculates the total amount the taxpayer is on the hook for is $7.76 trillion, or $24,000 for every man woman and child in the country. (Data breakdown is here)

Regardless, no matter you calculate it, we are talking about an ungodly amount of money.

 

Its almost certainly bad form to quote yourself but this seems to be playing out now

 

I think that something needs to break.

Someone either needs to default (and face the consequences), or deflate their currency/increase inflation.

The cost of servicing all this debt has become so large that it just is not possible to do. Add to this lower levels of GDP growth, the problem becomes too large.

Whatever the route chosen, it will probably lead to substantial power shifts in global economies, with those with low debt ending up holding the cards.

 

Deflating and defaulting is my preferred method and then we may retain some semblance of social and political order. Deflation impoverishes overall, but there is an equitable redistribution from rich to poor. The bailout has prevented this process and the longer it goes on the more likely inflationary default will occur and that impoverishes much more thoroughly and much more inequitably - ie the rich, who tend to have a much larger proportion of their wealth in real goods suffer least.

 

Very insightful. Thank you!