What did you think they would do with all that money?

28/08/2013 Comments Off on What did you think they would do with all that money?

A friend pointed me via social media to a column/post on The Leveraged Buyout of America:

As Representative Grayson and co-signers observed in their letter to Chairman Bernanke, the banking system is now dominated by “global merchants that seek to extract rent from any commercial or financial business activity within their reach.” They represent a return to a feudal landlord economy of unearned profits from rent-seeking. We need a banking system that focuses not on casino profiteering or feudal rent-seeking but on promoting economic and social well-being; and that is the mandate of the public banking sector globally.

The core argument is that banking should be an auxiliary activity in service of the commercial sector. The current set-up (in both senses of the term) promotes (a) risk-taking and (b) rent-seeking in ways that harm the economy. Responsible public banking should be promoted as an alternative, to achieve better well-being.

The column packs a lot of ideas into a small space, so it might help to tease them out a bit.

Rent-seeking: This is jargon for economists but isn’t being used exactly that way in the column. Economic ‘rent-seeking’ is trying to fix the rules of the game to get an unfair advantage. ‘Rent’ is super-normal profits for not doing anything useful. So, for example, getting the government to change copyright laws to protect a monopoly over a certain cartoon character — that’s rent-seeking.

The letter the author cites focuses on:

businesses [in] such fields as electric power production, oil refining and distribution, owning and operating of public assets such as ports and airports, and even uranium mining.

We’re talking capital-intensive infrastructure businesses, some of them with local monopolies. These sorts of businesses can have a standard return on investment, including a payment for the land they use (‘rent’ in the everyday sense). In addition, they can use their market power to extract economic rents or excess payments. It’s a classic problem with infrastructure — they tend to be ‘natural monopolies’.

What’s not clear is what ‘rent-seeking’ is alleged. The purchases could be innocuous: just people with lots of money buying things that cost lots of money and generate a consistent return over many years, sort of like buying bonds. On the other hand, they could be nefarious: sharp suits buying local monopolies with a plan to extract super-normal profits. But that has to happen over time — it isn’t the buying that’s the problem, it’s what they do with the assets once they own them.

Risk-taking: The deals described are risky, in the sense that they are done with borrowed money and expose banks to Minsky’s debt ratchet (pdf). It isn’t the underlying assets that create the risk, or the fact that someone new has bought them. It could be an insurance company, a pension fund, a sovereign investor or a consortium of private investors who buy the asset hoping to make a profit. The fact that it happens to be financial holding companies linked to banks isn’t all that important. It’s the structure of the finance that creates the risk.

But the deals create a problem I find more interesting: a privately planned economy. Think about it. These finance companies are trying to manage a whole bunch of assets and make as much money as they can — they are trying to manage small economies. This was Schumpeter’s and Galbraith’s insight about modern industrial economies. Especially as they start to manage the supply side through infrastructure investments and the demand side through credit card policies, they are now faced with trying to be Soviet planners. Do they relax credit conditions for their customers to goose spending on their airports and ports, or would they be better off charging monopoly prices for port access but thereby reducing demand and credit card earnings?

Here’s my prediction: they will fail. The problem, though, is that they are going to take down an even bigger portion of the economy than last time. That’s the ‘macro’ or ‘systemic’ risk that is now being created.

Cash is king: In a financial crisis, when a Ponzi bubble bursts (see the above Minsky paper), cash is king. People are trying to reduce debt as quickly as possible, so they sell assets at whatever price they can get. The people with the cash have the power. In this case, the banks have the ‘cash’ — safe, liquid assets. Highly indebted people with large, illiquid assets are looking for buyers. It’s not really a surprise that mines, airports, ports and other big expensive items are being converted into cash. Heck, New Zealand is following the same strategy. There’s not a lot you can do about it once you’ve got a Ponzi situation — it’s a natural consequence of the debt cycle.

But let’s ask ourselves, why are the finance companies cashed up? Well, that’s where any reasonable justification falls over. The same swaggering sultans spending large to buy all these assets crashed the world economy a few years back. They were bailed out by public money. It is like they went to a casino, bet large and lost, and then the house gave them the money back and let them try again.

The real problem isn’t so much what they are doing with the money they have. It’s the fact that they still have any money in the first place.


Propaganda masquerading as advice

28/05/2013 § 5 Comments

Over the weekend, I had a chance to read some advice from Yahoo! Finance on teaching kids about money. As parents ourselves, we try to discuss money and finance and debt with our children, explain what works and how, etc. As an economist, I’m interested in financial literacy. I started reading this piece with interest and hope. I soon realised it was just financial propaganda.

The first clue was that the author tied financial literacy to the Grand Funk in which we find ourselves. I maintain that financial literacy wouldn’t have helped one iota. To review the events of the last several years:

  • lenders and borrowers entered into loan contracts. Borrowers were encouraged to lie on applications, and lenders — y’know, the professionals with all the financial knowledge — accepted those applications and encouraged people to borrow more
  • these questionable mortgages were turned into opaque financial products without proper documentation, so that no one knew who owned what
  • the main financial companies bought and sold these derivatives, and derivatives of the derivatives, until no one knew what the risks were and who was responsible
  • when the whole thing collapsed, the US government bailed out the big banks, the UK government bailed out the big banks, and the German banks used their power to refuse to take losses
  • once the losses were dumped on the public, the above governments got religion about debt levels and started a fiscal austerity programme that left millions unemployed.

So, the borrowers were involved, way back there at the beginning, as one party to a contract that the other party should have known not to write. The rest was about business decisions in the finance companies and governmental decisions — decisions that could have gone another way.

The other line that got me — the punchline without the proper set-up — was this:

While banks and lending institutions may have accepted considerable criticism for their role in triggering the recession….

Stop it, you’re killing me! [Wipes eyes.] Accepted criticism? They may have been criticised, but I’m pretty sure they haven’t accepted any of it. They have fought it every step of the way, braying about how they are the core of advanced economies and how dare anyone besmirch their reputations.

I would note, too, the way the sentence is written. This isn’t a declarative sentence, ‘Banks have accepted criticism.’ That would be a statement, which then invites the reader to assess it for accuracy. Instead, the clause is written as an introduction to another thought. The idea is to say, hey, here’s the context that we all can accept, and my main point comes next. Well, buddy, I don’t accept it.

Teaching my kids about finance is good for them (and good for me). It would be great if more people were better informed, so they don’t get themselves into awful situations like this family. But better financial skills in the broader population wouldn’t have avoided this mess. The mess has been made by well-informed, well-educated people who know what they are doing.

Outsiders on the inside

18/03/2013 § 4 Comments

The subject of gifted children and the kinds of adults they become has been studied for a century. A good starting point is ‘The Outsiders’, an article from high-IQ society publication. Although it was first published in 1987, it is still relevant.

One researcher of giftedness, Lewis Terman, found that children with IQs above 140 tended to become one of three types of adults: Satisfactory, Some maladjustment, or Serious maladjustment. Maladjustment appears to be positively correlated with IQ.

Leta Hollingworth discussed four specific sources of maladjustment. Two of these are failure to suffer fools gladly and isolation from the rest of humanity. Quoting the author quoting Hollingworth:

This tendency to become isolated is one of the most important factors to be considered in guiding the development of personality in highly intelligent children, but it does not become a serious problem except at the very extreme degrees of intelligence. The majority of children between 130 and 150 find fairly easy adjustment, because neighborhoods and schools are selective, so that like-minded children tend to be located in the same schools and districts. Furthermore, the gifted child, being large and strong for his age, is acceptable to playmates a year or two older. Great difficulty arises only when a young child is above 160 IQ. At the extremely high levels of 180 or 190 IQ, the problem of friendships is difficult indeed, and the younger the person the more difficult it is. The trouble decreases with age because as persons become adult, they naturally seek and find on their own initiative groups who are like-minded, such as learned societies [3, p. 264].

In a nutshell, gifted children may be poorly socialised because society doesn’t have much to offer them (or so it seems) and doesn’t have a place for them.

With that in mind, it was interesting reading Corey Robin’s take on William Ackman, a billionaire hedge fund manager. It’s a riff on a profile of Ackman in Vanity Fair. It seems that Ackman, um, well, Corey can tell you:

What’s odd in Ackman’s case is how loathed he is by his colleagues.

Ackman is smart. Let me amend that. Ackman has a high IQ. And, it seems, also works hard, plays hard, et cetera and so forth. He remembers his college entrance exam (SAT) score — 1530. That puts his IQ around 160, in the top 99.99%. It also puts him in the ranks of ‘more likely than average to be maladjusted’.

Socialisation — learning the rule of society — puts restrictions on our behaviour. If you don’t learn the restrictions, then they don’t bind you. No, let me change that. You can learn the rules in two different ways. You can internalise them, so that they just become part of what it is to be a good member of your society. Or, you can learn them as anthropological phenomena: in this sort of situation, members of this tribe do thus-and-such. The rules bind you when you allow them to, and you cast them off when they aren’t functional. When you’re the smartest guy in the room, you just might decide that the rules don’t apply to you.

I figure that’s what’s happened with Ackman and others  like him. Gifted children all grown up, they feel above and outside society, which gives them carte blanche to act as they choose. And what they’ve chosen to do is compete about everything, just to prove they are the Masters of the Universe. The hard part is, a billion dollars can’t fix the maladjustment. In some ways, it probably makes it worse.

Just remember, these are the guys running the international financial system. These are the guys who needed the US taxpayer to bail them out.

Functional stupidity, a reference

18/02/2013 § 2 Comments

A friend sent a link to an article in Le Monde that highlighted the role of stupidity in the financial crisis. Not any old stupidity, but ‘functional stupidity’:

Selon cette théorie de la “stupidité fonctionnelle”, le monde de la finance serait dicté par le “fais d’abord, réfléchis après”. Une attitude qui tend à écarter les questions gênantes, et les longues réflexions sur les actions des salariés – alors même qu’on attend d’eux de grandes compétences.

(According to this theory of ‘functional stupidity, the financial world is ruled by ‘act first, think later’. This attitude tends to avoid difficult questions or considered reflection on behaviour by employees — even while they are expected to be extremely capable.)

The journal article in question is Alvesson and Spicer (2012), ‘A Stupidity-Based Theory of Organizations’ (here). I liked this comment from the conclusion:

Furthermore, we think the consensus in this broad field needs to be challenged – perhaps key developments and contemporary conditions also mean that modern economies and organizations become more ‘stupidity-intensive’?

Can I add ‘stupidity’ as a factor of production in our CGE model?

The central idea is not far from Simon’s bounded rationality (which they discuss briefly). Cognitive power is limited, we can’t take everything in, so we use shortcuts. One problem is feedback loops. When things are going well, the positive feedback reinforces the mental shortcuts. If ‘go along to get along’ keeps producing results, you do more of it.

But, if the behaviour is increasing the risk of low-probability events, there isn’t a feedback loop to tell you that. The negative feedback doesn’t kick in until something happens. Alvesson and Spicer suggest that this becomes a time for reflection and reassessment. The stupidity is no longer functional, so people have the opportunity to find new behaviours.

Reassessment is only one possibility. Zizek noted (in First as tragedy?) that in times of crisis people tend to return to safe ways of thinking, return to the old ways, even return to an imagined past. If functional stupidity is that past, then there is the possibility of more of the same only worse. In a paper I’ve discussed here before, ‘What can psychoanalysis offer organization studies today?‘, Costas and Taheri describe two possible directions that ‘authentic management’ leads: greater authoritarianism or more reflective behaviour inside organisations. It’s the same with functionally stupid organisations in crisis. They could hold fast to what worked in the past or reconsider how to adapt to new conditions.

Of course, the argument presupposes that the financial sector actually has to bear any consequences of its myopia. If it just gets rewarded regardless — which is what happened in the crisis — the herd behaviour described by Alvesson and Spicer will continue unabated.

h/t Y.K.

How do we teach this?

15/02/2013 § 10 Comments

Reading through the post-mortems of the financial crisis, I’ve been struck by something. The behaviour of the finance sector doesn’t fit the standard economics model, the Samuelson textbook depiction, or the Heckscher–Ohlin model of trade, or the Solow model, or any of the other bog-standard depictions of the economic system that we like to teach.

A key idea is that capital is a factor of production, like labour, land, and maybe entrepreneurship, management, natural resources, human capital, or any of the other factors people like to add. Two things about this capital:

  • capital gets a return for its use, which accrues to the owner of said capital, and
  • owners (capitalists, entrepreneurs, whatever) receive a return commensurate with the risk they take: higher returns are required to entice people to take greater risks (and thereby promote innovation).

But, but, but…that’s not what’s happened.

If you read the accounts of the financial crisis, two things are clear:

1. The people administering the mortgage-backed securities (MBSs) are having a hard time proving they own the mortgaged they say they do. To quote Adam Levitin:

The mortgage foreclosure process is beset by a variety of problems.  These range from procedural defects (including, but not limited to robosigning) to outright counterfeiting of documents to questions about the validity of private-label mortgage securitizations that could mean that these mortgage-backed securities are not actually backed by any mortgages whatsoever.  While the extent of these problems is unknown at present, the evidence is mounting that it is not limited to one-off cases, but that there may be pervasive defects throughout the foreclosure and securitization processes.

That is, these folks aren’t sure of what they own, and yet they are selling derivatives based on what they think they might have. More frighteningly, banks are taking or selling houses they don’t own.

2. Risk and reward are now de-coupled. Companies in the finance sector took gambles on the housing market, and things didn’t go their way. That happens. An evolutionary account of the market economy is that success should be rewarded and failure should lead to extinction. AIG, just to name one company, took massive risk onto its books by insuring the value of MBSs. Their clients claimed against the policies, which was going to drive AIG into bankruptcy. AIG got bailed out, as did a number of other financial firms. So, for finance firms, success is rewarded but so was failure.

Thomas Baxter, Jr., New York Fed:

In the months leading up to early November 2008, AIG had been actively engaged in efforts to negotiate tear-ups of its CDS contracts with its counterparties. AIG was completely unsuccessful. The need for the tear-ups was real; AIG was effectively hemorrhaging cash.

But what happened? Wall Street posted record profits in 2009 and had its fourth-most-profitable year in 2010, after it ‘benefited from a series of federal bailouts as well as low interest rates’.

Why aren’t more economists having a crisis of faith? The story and the models that we use to talk about the economy appear flawed in a fundamental way. It isn’t about innovation and efficiency, the supply side responding to signals from the demand side. Instead, fraud, crime, and collusion seem to be the path to riches.

Notes on the financial crisis

14/02/2013 Comments Off on Notes on the financial crisis

I’ve been writing a paper for today’s conference, ‘Lacan and the Discourse of Capitalism’. I’ll post an abstract or paper later, but I wanted to point to a few resources about the financial crisis for your viewing pleasure.

One is this great graphic from the IMF about the structure of MBSs and CDOs. The structure is kind of simple but kind of not, and the graphic captures that pretty well. It’s funny that they use water pipes to show the flow of funds — very MONIAC.

Trawling around looking for information on the problems with MBSs, I came across Professor Adam J. Levitin (Georgetown Law, Washington D.C.). He has been writing about the legal issues of MBSs and testifying to the US Congress (so they have no excuse not to understand the problems). For example, in ‘Robo-Signing, Chain of Title, Loss Mitigation, and Other Issues in Mortgage Servicing’, he bluntly states

The chain of title problems are highly technical, but they pose a potential systemic risk to the US economy.

Unfortunately, I think there’s a tendency just to hope it sorts itself out.

And finally, just in case you’ve forgotten what happened and when, they are places to refresh your memory. The UK Guardian has a nice timeline. For more detail (much more detail), I found a paper by Robert E. Marks, ‘Learning Lessons? The Global Financial Crisis four years on’, helpful. It includes lovely gems like:

2005 August 25−27: Raghuram Rajan (MIT PhD ’91), Economic Counsellor and Director of Research, International Monetary Fund (IMF), presents a paper at a symposium to honour Alan Greenspan’s tenure at the Fed warning that the financial system is taking on potentially dangerous levels of risk. He is mocked.

Just a few reminders of the chaos of the last few years.

Bank advice for the forgetful

07/08/2012 § 2 Comments

Front page of the Dominion Post business section was the Reserve Bank wagging its finger at the economy. The guts of it are on the Bank’s website. The main message:

“But it is fair to note that we have suspected for a long time that New Zealand’s private and external debts were too high to be sustained,” Dr Bollard said.

Getting older is strange. I remember things, how things were — and not just from some book, but because we lived and breathed them.

Fifteen years ago, we lived and breathed two financial ideas. One was the Modigliani–Miller theorem (the other was the Black–Scholes model of asset prices). Wikipedia helpfully summarises MM:

The basic theorem states that, under a certain market price process…, the value of a firm is unaffected by how that firm is financed.

Most of the time, we just discarded the phrase between the commas, the one that says it all depends on the market being just so. Instead, we carried on as if equity and debt were basically equivalent. It didn’t matter because equity demanded a return and would seek it wherever it could, which was equivalent to paying for borrowed funds. Given the predictability of asset prices afforded by Black-Scholes, risk could be managed — it could be priced into the asset valuation which was independent of finance structure. What we believed was true for firms we then also shifted to households. It didn’t matter how you structured the financing for your household assets — debt was as good as equity.

It turned out that Minsky was right in a way that Modigliani and Miller were not. MM of course had the get-out-of-jail-free card stuck between those commas, but that didn’t matter to the firms and investors who believed the vulgar version of the theorem.

Now, Dr Bollard tells us that the debts were too high. When he says, ‘we have suspected for a long time’, it is fair to ask who this ‘we’ is. Fifteen years ago, the greybeards and the young hustlers told us something else. In those days, debt was equivalent to equity and the path to greater riches through leverage.

Now, ‘we’ think they were wrong. Then, when we accumulated the debt, we thought they were right.

If Dr Bollard wants to wag his finger at someone, he should start with the experts.

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