Oh How They Are Mistaken!

In today’s Financial Times is an op-ed by Frederic Mishkin, a former Federal reserve Board governor advocating a benign attitude towards the current asset price run up that has all the worrying aspects of a bubble in the making. He urges us not to confuse what he sees as two kinds of bubble: the first, such as the hi-tech stock boom of the 1990’s leaves the banking sector largely untouched because it was concentrated in the equity values of the notorious ‘no-hope’ companies that popped up every day back then. The people who were burned were the folks who fell for the hype – they deserved to be taken for a ride, and many fell flat as a result of their gullibility. It is the second kind of bubble Mishkin describes that he argues calls for policy level push back. These second bubbles are dangerous because they are fueled by and feed back into a parallel credit boom. It is this feedback that creates the danger since it implies the accumulation of vastly overvalued assets within the financial system.

To me this is just too nuanced to make sense.

The second type of bubble is indeed the one we just suffered through. Or rather was the kind foisted upon us by the incompetence and greed on the big banks. For those of you who want to dig deeper into the instability of finance I suggest a reading of Minsky’s Financial Instability Hypothesis. He articulates what, I think at least, Mishkin is trying to say. Finance is inherently unstable and therefore needs constant and vigilant regulation. bankers cannot be trusted to make socially sound investments or judgements because they are prone to waves of speculation. Unless a particular wave crashes and deflates asset values it is amplified by the next. Each larger subsequent wave attracts more bonus driven short term investing by bankers who starve the real economy of capital and divert cash into the creation of what ends up being a monstrous asset bubble. Eventually, as we all know, the bubble burst and the bankers come hat in hand to the taxpayers for help. We clean it all up, and the bankers start all over again.

The problem I have is that there is no way to tell whether a run up in asset prices is a type ‘A’ or a type ‘B’ bubble. And given the ability of banks to manufacture ‘synthetic’ assets in the conference rooms of their lawyers and accountants, I am not sure there is a difference anyway. The credit and asset markets are so intertwined nowadays I don’t think a policy maker should regard any sudden escalation of asset prices as benign: I suspect the banks will find a way to lose money somehow.

Then again there is always the fact that Mishkin himself is tainted by his own inability to understand banking. Take this quote from one of his speeches:

‰ÛÏMore recently, developments in the subprime mortgage market have raised some additional concern about near-term prospects for the housing sector‰Û?. While these problems have caused undeniable hardship for many families and communities, spillovers to other segments of the mortgage market or to financial markets in general appear to have been minimal.

Variable-interest-rate loans to subprime borrowers account for a bit less than 10 percent of all mortgages outstanding, and at this point the expected losses are relatively small. Moreover, because most subprime mortgages are securitized, the risks associated with these loans are spread widely.

Banks and thrift institutions that hold mortgages are well-capitalized, and exposures of individual banks to possible subprime losses do not appear to be large. On the whole, some borrowers may find credit more difficult to obtain, but most borrowers are not likely to face a serious credit constraint.‰Û?

Fed speech Aril 10, 2007

Not to pick on him too much, but that’s horrible forecasting.

This leads me to another point: the really big problem we all have at the moment is that the folks being quoted and sought out by the press are, by and large, the same folks who missed the problems of 2005 through 2007. They are wedded to the theories that brought the economy to its knees. While I am all for giving people a second chance, they need to prove their competence. Too many of them are maintaining a high profile at a time when they ought to be beavering away correcting the errors in their theories.

I would throw Geithner, Bernanke, and Summers into this bucket also. None has a stellar record and all are far too close to the old ways of Wall Street to be able to sense what truly went awry.

That’s why I am a fan of paul Volcker at the moment. He seems to ‘get it’.

Bankers are perennially ‘rent seeking’. They rig the game to their own advantage. They cannot be trusted. They reward themselves for playing in a game where the odds are stacked in their favor and then claim to be ‘smart’ and thus worthy of those rewards. They seem to forget the trillions of losses they impose upon the rest of us.

I am afraid that people like Mishkin provide cover for the antics of bankers by trying to be too clever.

There may be a ton of different kinds of bubbles.

I don’t care.

Bankers should be prevented from playing in any of them.

Letting a bank get involved in an asset bubble is like giving matches to a pyromaniac and then wondering why there’s a fire.

Bankers just can’t help themselves. Take Citibank for example: all of the asset bubbles of the past thirty odd years – most have been explosions of Third World debt – have a common theme. Lax regulation in the epicenter of the trouble and an over eager credit provider trying to cash in on the ‘opportunity’. Citi has managed to impale itself on at least three of these bubbles, and has been bailed out each time. The cost to the taxpayer has been enormous. And the bank has never learned.

Bankers like those at Citi [or Goldman etc] just aren’t grown up enough.

Someone has to take the matches away.

That would be us.

Re-regulate the banks.

Now.