Economics

Let me be clear up front: I do not like this bailout.

Having said that something has to be done. We are in the grip of the worst financial crisis since the Great Depression. So action needed to be taken. The problem is that this plan seems so ad hoc and ill conceived that it smacks of desperation.

The latest from the New York Times is here: News Analysis – A Bailout Plan, but Will It All Work?

My position, which obviously will change as details leak out to the public, is that there seems to be no real downside in this plan for the shareholders of the banks being rescued. Whereas the taxpayers see virtually no upside. Economists call that moral hazard, and this plan appears to blow away any semblance of hazard. The message is clear: lose whatever you want, make your fortunes, and the public will bail you out on the downside. That’s ugly. It is truly awful public policy. And I don’t believe that Fed Chairman Bernanke wants to go down that route. After all he is the co-author of one of the most popular micro-economics textbooks, which most likely preaches loudly against the very actions he is now lobbying Congress to adopt.

The few details we know are that this bailout will cost us about $700 billion over the next few years. Compare that with the recently announced Federal Deficit of $407 billion. Those are horrific numbers. If anyone ever wanted to find facts with which to indict the Bush regime and its complete incompetence these figures are surely enough. The country is awash with debt. This catastrophe will hobble the Federal government for the next few years. The ramifications for growth, employment, interest rates and general public policy will reverberate for years. How, for instance, can we establish a public health care system when we are already running massive deficits which are now augmented by a virtually unknown, but potentially vast, further debt? Never in American history has the economy been so hopelessly mismanaged.

As the dust settles we have to come to a collective realization that we are living through an historic moment. An era is ending with a resounding implosion of market driven ideology. The entire Republican and free market economics edifice that has dominated public policy making for three decades and which was supposed to propel the economy to great and glorious heights is being exposed as a truly cataclysmic failure. Not only do unfettered and unregulated markets fail to deliver the goods, but they collapse under the weight of their own greed. So the very people who have had to watch as Wall Street bankers gorge on unseemly profits and bonuses, and have had to watch as income inequality balloons to 1920’s proportions, are now being called upon to bail out that self same rich and arrogant elite. The injustice is palpable. It is an insult to every hard working American who has not had the good fortune to participate at the trough.

Why? Lest as the market ‘self adjusts’ it takes us all down with it a la Great Depression.

Did no one in a position of power not foresee this. Did no one study the Great Depression? Well Bernanke is one of our greatest students of that huge failure. Perhaps he should have read his own books more carefully. Or more likely, the ideologically bankrupt Administration pushed back too hard early on, and only caved this last week as the sunami threatened to engulf their precious markets.

Meanwhile, let’s all hope that this bailout is restructured so that we, the people, can actually salvage something. And that those responsible feel the pain of the loss they are trying, right now, to foist on us.

This bothers me, it really does. Here is today’s column under the masthead of ‘Freakonomics’ in the New York Times: Diamond and Kashyap on the Recent Financial Upheavals – Freakonomics – Opinion – New York Times Blog

Now I understand the good intentions. The amazingly popular Steve Levitt, author of the Freakonomics column has prevailed upon two University of Chicago economists to provide a simple explanation of the turmoil in the financial markets.

Great.

But they miss the much larger and more fundamental point. This melt down is as much a melt down of economic theory as it is of practical finance.

The Chicago school of thought in economics is predominant in today’s academic circles. It provides the basis for what we learn in every major economics text book. In the trade it’s known as ‘neo-classical’ economics and is tightly associated with the University of Chicago and the late Milton Freidman amongst others.

Since the arrival of Reagan in the White House, America has run its economy increasingly according to the tenets of the neo-classical model. The basic rules of the model are familiar to anyone who has followed politics during the past three decades: government is a problem, reduce regulation, allow markets to go ‘free’, cut taxes, and generally let individuals be unfettered from restrictive laws. The idea being that once markets are free they will generate more wealth than a government controlled market can. The theory that supports this conclusion is too arcane for most people or politicians to bother with so there is a tendency to take the academics word as gospel.

The problem is that once the theory is exposed to daylight it looks very insecure. Unlike scientific theories like those of physics or chemistry, it fails to predict anything well and cannot be thoroughly tested against empirical, real world, evidence. It is more concerned with its own internal logical consistency than with explaining how economies actually work. More to the point it sets out to prove that markets are better than any other form of allocation model [that’s what a market does: it is a mechanism for allocating scarce resources across competing multiple needs]. So boiled down to its essence: neo-classical theory starts with a set of assumptions cherry picked such that the conclusion is that markets are efficient and other methods of allocation are not.

This is more ideology than theory. So it not surprising that right wing politicians the world over preach from the neo-classical playbook. It advocates unfettered capitalism. Thus the Republican infatuation with ‘market forces’.

The problem is that nowhere is there a truly free market. Nor can there be one … people are not automatons and make mistakes. The result is that the theory is hopeless in the real world.

Nevertheless we have been governed by free market ideology since Reagan. Moreover most, if not all, the wizardry on Wall Street [those fancy products called derivates] are built upon financial theories that are a subset of neo-classical economics. So here we have practical banking being distorted by fallacious modeling. Sooner or later the contrast between reality and theory was sure to show up.

Throw in the inept way in which financial markets were deregulated back in the 1990’s and it is more surprising that the current meltdown took so long arriving.

So that’s what annoys me when I read Chicago School professors explaining what’s going on without issuing a vast ‘mea culpa’ along with their opinions.

Guys: you’re what’s wrong. Maybe we need an ethics test for economics professors. Perhaps they should shut up and find a better theory. But I suspect the wait for a better theory will be a long one while the neo-classical model reigns supreme in our universities … they don’t even acknowledge that’s it’s part of the problem!

Meanwhile those of us who have to deal with the consequences of appalling theory should clean up and muddle through unguided by any support from academic economists. Maybe we can get their attention by cutting off funding for their research?

I have been trying to follow events on Wall Street all day. It has been an extraordinary experience. For those of you who are only peripherally aware of what’s going on it’s hard for me to put the right words together. I suppose melt down will have to do. As of midday the stock market had found a floor to its decline at around a drop of 250 points from the opening. That would have been reasonable for the day as a whole given the roiling chaos in the banking world. But as the news failed to improve the market losses gathered steam and the Dow closed just over 500 points down.

Amidst the torrent of bad news we have learned that the New York State Insurance regulators have granted AIG a $20 billion ability to borrow from its own subsidiaries in order to bolster its capital. Earlier AIG’s stock price had plunged 60% on rumors that it might be downgraded by the rating agencies, a downgrade would have the effect of requiring AIG to carry more capital which it would have difficulty raising given the precarious nature of its balance sheet. Here’s the New York Times update on AIG:New York Allows A.I.G. to Lend Itself Money

The shocking news here is hidden in the fine print: other, non-financial firms like General Electric are also having difficulty raising capital for their financial subsidiaries. So they are being tempted to seek government aid also. Were they to try, it would represent a massive breach of prior rules and could potentially spread the effects of the credit crunch deeper into the economy. Many of these non-financial companies use financial subsidiaries as a way of supporting sales [think of the old GMAC]. To the extent that these subsidiaries are exposed to the vagaries of the credit crunch they will be less able and willing to lend … the result will be an extension of the slow down into the consumer sector. The consequence of that would inevitably be a drastic curbing of GDP growth at a time when growth is already fragile.

So after the first day of this new crisis where are we?

Amid uncertainty and gloom.

The loss of Lehman’s jobs will hit New York and London hard [although London seems better placed to weather the hit]. The two remaining large dealers: Goldman and Morgan Stanley have had their stock prices slammed today. they are now much weaker and there has to be medium term doubt about their ability to survive.

This tumult is incredible. As a participant in the markets a few years ago I worked with all these firms. Now they are all gone or look as if they will go. The banks left standing are the huge European style mega banks: here in America it will be Citibank, Bank of America, and JP Morgan Chase. In Europe it will be Barclays, HSBC, Deutsche Bank and so on. The landscape has changed forever.

All I can say at the moment is … wow!

Well the first ‘post Lehman’ morning has come and gone. The stock market is clearly shaken, but did not collapse either. Plenty of investment bankers are busy sharpening up their resumes. Media experts are opining. And both presidential candidates have waded in with comments.

My early observations: McCain is dead wrong. The collapse of Lehman and Merrill Lynch is not a sign or result of the failure of too much government regulation. It is exactly the opposite: lax government regulation helped create this mess. Back in the day, when I was in banking myself, the laws separating investment banking and commercial banking were removed. The effort was to unleash ‘market forces’ and allow them to shape the future instead of giving that role to government regulation. The only problem was that the rules that remained, such things as mandatory capital requirements etc, were imposed on the mainstream banks and not on the so-called ‘shadow financial system’ were players like Bear Stearns, Lehman, and Merrill Lynch roamed unfettered by much oversight. Yet those companies, and the various banks they did business with [their ‘counterparties’ in the industry jargon] all implicitly assumed that there was a government provided safety net should they fail or threaten to fail. In economics this is called the ‘moral hazard’ problem. In short the assumed safety net allowed these unregulated banks to play for big gains with ever increasing risk safe in the knowledge that they would not be allowed to fail. The high street banks like Citibank and Bank of America are covered by regulations that limit their activities somewhat: in return their deposits are insured by the FDIC which provides those banks retail customers with a security that players in the riskier games of the other Wall Street banks don’t get. Or shouldn’t get.

When Bear Stearns failed as a result of its incompetence the government did indeed step in and provide significant aid to J. P. Morgan Chase who thereupon bought out the Bear Stearns assets. So Bear Stearns was aided by the government even though it had never been subject to regulation, and moral hazard reared its ugly head.

This is why McCain has it so wrong: if the taxpayers are going to bear the brunt of bailing out Wall Street, then the banks being bailed out, and those buying up the assets with government guarantees, should fall into the regulator’s realm. Their activities should be subject to greater and more public scrutiny. Perhaps they should even try to understand the securities they are buying and selling! In other words once taxpayer money can be used to bail out a bank, or anyone else for that matter, the taxpayers have a right to set the conditions and rules that the companies involved play by.

Ultimately that message seems to have sunk in at the Treasury department: Lehman has been forced into bankruptcy precisely because the government refused to step in and provide the guarantees needed for another bank to ‘save’ the day. In this case Barclays Bank, a huge British bank, stepped away at the last minute when they could not get those guarantees.

And so Lehman and Merrill are gone. That leaves Goldman and Morgan Stanley as the two remaining major US based investment banks. Let’s hope that the credit crunch abates soon. Otherwise more failures [Washington Mutual? AIG?] are almost certain to occur and the economy will suffer even more than it has.

It looks very much as if we lose one of Wall Street’s better known firms in the next few days, if not tomorrow. Talks to bail out Lehman via a take over by Barclays Bank of the UK have broken down and now the only option seems bankruptcy. Here’s the latest from the New York Times: Lehman Heads Toward Brink as Barclays Ends Talks

It is astonishing how fast things are unravelling for some of these investment banks. The real estate binge that they all went on coupled with a disastrous faith in mathematical models built upon the foundation of neo-classical economic theory has been their downfall. It is this latter point I want to bring to your attention because it is arcane and hidden within the welter of bad news. Many of the so called derivative products the investment banks invented in the past decade to ‘manage’ risk were based upon financial theories that were, themselves, outgrowths of text book economic theory. Those theories are wrong. They live only in an abstract world where information is freely and widely available to all the players in the market. Indeed in a strict interpretation of text book economics there is no ned for risk management at all since all players know everything! Nonetheless models have been built on that rickety foundation and now we are seeing the damage that poor theorizing can do!!

Meanwhile: not only is Lehman going down, but now it looks as if Merrill Lynch is also on the block, with Bank of America making a take over offer today. Such a move in this environment is more than a strategic attempt to take advantage of the chaos enveloping Wall Street. It also smacks to me at least, of an attempt to forestall the collapse of another famous Wall Street firm.

Who knows when this credit crunch will end? But it looks as if the reputation of Wall Street will have taken a huge, if not fatal, blow. Lehman and Merrill Lynch are not light weights or fringe players the way Bear Stearns was. They are core players. By this time next week Wall Street could be a much diminished place. Think of what impact that may have on New York, let alone the national economy.

I have said before that I believe the economy is the central issue for this election. This weekend and its aftermath are an example of why we need a proper and adult debate about it. I hope John McCain calls off the sleaze and starts to get serious. Otherwise there is no choice but to question his courage, judgement and patriotism. In times like these the country deserves leadership and discussion. Let’s see if he has the qualities necessary.