Postdicting the meltdown

My column in yesterday’s Fin started with the observation “The pace of events in financial markets has been so rapid that any projection of events in the short term seems likely to be obsolete soon after it is printed.”

Ignoring my own advice, I wrote a piece yesterday for Crikey (over the fold) which included the prediction “The largest remaining savings & loan firm, Washington Mutual is unlikely to survive into next week, with the most likely outcome one involving a large scale default on its mortgage obligations.” By the time it appeared today, it was a postdiction.

The casualty list from the stunning events of the last few weeks on Wall Street is an impressive one. In this short space of time, the US Administration has effectively nationalised the main mortgage guarantors, Fannie Mae and Freddie Mac and the world’s largest insurance company, AIG. The massively profitable Wall Street investment banking industry has ceased to exist, with Lehmans bankrupt, Merrill Lynch sold and Goldman Sachs and Morgan Stanley seeking the safety of commercial bank status. The largest remaining savings & loan firm, Washington Mutual is unlikely to survive into next week, with the most likely outcome one involving a large scale default on its mortgage obligations.

The reputational damage is equally severe. The Bush Administration’s place as the worst in US history has been cemented, with a financial and economic disaster to match the Iraq catastrophe. Alan Greenspan, whose policies were responsible for the current mess, was still being treated as an elder statesman a few weeks ago, but his reputation is gone for good now. And Henry Paulson and Ben Bernanke look set to follow a similar path, as their $700 billion bailout plan is exposed as a massive example of rentseeking.

But there is much more to come. Assuming (a big assumption) that the Democrats hold their nerve, any bailout will require the public to be compensated with equity for any losses they incur on the purchase of mortgage-backed securities and similar toxic sludge. Since such losses are inevitable if the plan is to have any real benefits, the result will be a further extension of public ownership, to include a substantial number of the main commercial banks.

No doubt, when the crisis is over, these businesses will return to the private sector. But it’s hard to believe (as most financial commentators seem to be supposing) that things will rapidly return to something like the situation prevailing before the crisis began. For a start, large areas of financial activity (auction rate securities, CDOs, subprime mortgages, monoline bond insurance) have collapsed, and seem unlikely to re-emerge. The massive market in credit default swaps will almost certainly be shut down, and the even larger interest rate swap market is likely to be scaled back to levels where financial regulators can manage it. Reductions in executive pay have already been accepted as a bailout condition, and it will be a long time before they are reversed.

Going beyond these obvious casualties are the implications for economic and political theories. The efficient markets hypothesis, badly wounded by the dotcom fiasco a decade ago, must surely be discredited now. The most sophisticated financial markets the world has ever seen have produced a situation where securities depending ultimately on debts owed by people with neither income, assets nor any incentive to repay have been treated as if they were (quite literally) as good as gold.

More generally, the whole free-market ideology variously referred to as economic rationalism, neoliberalism or the Washington Consensus, is in serious trouble, at least as regards the role of financial markets. The central element of financial neoliberalism is the claim that modern global financial markets can do a much better job of managing risks than can national governments. Given the array of sophisticated financial products available to individuals and households, for example, it is assumed to be much better to rely on markets to provide retirement income than on public pension schemes.

The neoliberal view is the polar opposite of the Keynesian social democratic view, informed by the experience of the Great Depression. In this view, not only are governments the ultimate risk managers, but financial markets are part of the problem not part of the solution. While being necessary to mobilise private investment in a mixed economy, financial markets are seen, in the Keynesian view, as being inherently prone to destabilising speculation, which can induce large-scale macroeconomic failures.

The events of the last few weeks represent a striking failure of the neoliberal position. Although large-scale financial crises have been commonplace since the breakdown of the Bretton Woods system of financial controls in the 1970s, they have mostly taken place in the periphery of the global economy.

The debt crisis of the 1980s affected mostly the poorest developing countries. The crises of the 1990s hit middle-income countries in Asia, as well as Mexico, Argentina and Russia but had little impact on the main OECD countries. And, while the dotcom boom and bust can be seen in retrospect as a warning that the US was not immune to similar crises, the warning was ignored. Greenspan postponed any real adjustment with easy money and lower interest rates. Even the very modest responses that were made, such as the Sarbanes-Oxley act were soon being derided as an over-reaction.

That’s not possible this time. The losses are so great that they threaten to bankrupt most of the major remaining financial institutions in the US. And even if the original plan of a bailout without any compensating equity stake were politically feasible, it’s no longer economically sustainable. The foreigners on whom the US is depending to finance the bailout are already losing faith. A massive handout would raise a large risk of extending the panic from the financial sector to the US government as a whole.

So, there is no alternative to a drastic cutback in the size and power of the financial sector and to a return to reliance on government as the ultimate risk manager. The events of the past few weeks have been so rapid that people have had little time to absorb them, let alone adjust their world views. But, as time passes, it will become steadily more evident that the day of neoliberalism is done.

45 thoughts on “Postdicting the meltdown

  1. Here’s a pretty succinct precis of the options for providing some ‘appropriate’ liquidity
    Note the time problems in assessing ‘appropriate’ liquidity here and also ask yourself where does buying good assets from our banks fit with any of those options? This is not a liquidity crisis. It’s a massive demographic solvency crisis upon us right now, because there was never any chance an aging demographic could sell out and retire on the proceeds of their past so called ‘investments’. It was all just old fools gold. A dwindling youth cohort could never pay the real price of that tectonic shift in economic resources and asset prices are about to reflect that obvious reality now.

  2. “…with fiat money beginning to collapse globally.”

    So, you’re predicting we’ll all be back on the gold standard?

  3. jquiggin, the US financial markets are have tanked, whereas Australia’s haven’t (except by way of global contagion). You say the US approach is neoliberalism, which has failed. So my question is this: are Australia’s financial markets neoliberal or social democratic?


  4. In answer to Temujin at #14.

    I think we may be in danger arguing a little past each other rather than directly at each other’s points. I used the term “neoliberalism�. You preferred the phrase “efficient markets hypothesis� and went on to say “which isn’t really relevant here at all�. To me, this indicates I was talking Political Economy and you were talking Economics. There is no problem in that. Each of is entitled to come to the subject in our own way.

    The Wikipedia defines neoliberalism as follows.
    ‘Originally coined by its critics and opponents, “neoliberalism” is a label referring to the recent re-emergence of economic liberalism among political and economic scholars and policy-makers. Its supporters and proponents are influenced by neoclassical theories of economics and libertarian political philosophies and usually describe themselves simply as “economic liberals”.’

    I will admit a problem of categorisation always arises when one uses a term for one’s opponents when those opponents do not accept that term. I was using “neoliberalism” in the political-economic sense in which the position embraces policies of minimal government and more extreme free market economics (laissez-faire capitalism) combined with vigorous anti-unionism and a concerted program to dismantle the welfare state. “Thatcherismâ€? and the Omega Project prescriptions coming out London’s Adam Smith Institute were perhaps the apotheosis of this approach though George Bush’s administration has done a fair copy of the program.

    I think you were talking more about “economic liberalism� and the “efficient market� itself. I would simply argue that in Political Economy, i.e. in society, we can never separate politics from economics. Any package of economic settings is imposed by political process. Minimalist government may be defined as government limited to the Fisc, Treasury, Courts, Police and Military. Under this view, welfare, public education, communications, power and infrastructure utilities etc. are not seen as proper functions for the state. The ostensible purpose of minimal government is to basically guarantee contract law and maintain the state’s monopoly on violence (police and military). The state’s monopoly on violence is necessary to maintain the rule of law because otherwise anarchy would prevail. I have no problem with the state possessing these functions (with proper checks and balances) but I do have a problem with the state being limited to only these functions.

    Under neoliberalism or economic liberalism, one class (the rich or rentier class essentially) wanted to limit the state to these functions ostensibly out of a concern for the values of liberty and freedom but in reality because such a set up vastly favours their own class. When political power is thus limited (with democratic elections only ever producing minimalist government) then naked economic power comes to the fore and the rich basically get almost everything they want.
    The Wikipedia also notes, “Economic liberalism last exerted significant influence during the 1970s and early 1980s, in particular during and after the 1970s stagflation crisis and the wider effects of the 1970s to early 1980s Latin American debt crisis.[1] After a period of relative prosperity during the mid to late 1980s, renewed interest in economic liberalism began following the end of the Soviet Union in 1991. By the end of the 1990s, it had become an established trend.�

    Seeing economic liberalism and neoliberalism as a combined political-economic program and seeing it as the program which held all the reins in the Anglophone countries since 1990, I can judge that the current crisis as being what you get from such a program. The proof is in the pudding.

    Your specific arguments in some cases come close to my position. The Fed may have set interest rates too low and this may have been one of the causes of mal-investment. Other causes do include the moral hazard issue of implicit guarantees for certain institutions. I agree that a too ready availability of credit, particularly for consumer spending can and does cause inflation, particularly asset inflation and ‘bubbles’.

    ‘Market failure’ is a funny beast. If individual companies fail that is usually a sign of market success. The market is working to clear out inefficiency. If vast slabs of the market are failing, dozens of big banks and financial institutions failing, knocking on or potentially knocking on to the productive real economy where companies also begin failing and the whole market begins seizing up then this is a market failure as macroeconomic failure. Going back to what I said earlier (namely that it is always a matter of Political Economy and not merely politics or economics) this market failure contains a government failure too. On this point we would agree. However, the combined danger of government-market failure cannot be solved by giving the reins entirely over to the market. Just as giving over the reins entirely to government (the command economy) does not work either. This failure is a failure (and a spectacular one) of neoliberalism as a political-economic program.

    It is the death knell of neoliberalism just as it is the end of the “Project for the American Century�. It didn’t even last seven years. Overall, the USA’s dominance as the greatest power and one fully involved in world affairs lasted about a century or perhaps only 90 years. That is from about 1908 or 1918 to 2008. As I said in another post, this is now a very dangerous time as the USA’s massive military power will soon be badly out of balance with its waning economic power. We can expect the USA to begin acting even more aggressively and irrationally than it has been doing for the last 8 years. That is a very scary thought.

  5. “So, you’re predicting we’ll all be back on the gold standard?”
    Truth is I don’t know Ian and neither does anyone else but something really big is going down and it’s only just beginning to dawn on them-,22606,24408632-2682,00.html?from=public_rss
    It’s only just dawned on me that this is probably the massive demographic solvency crisis that was always hanging over our heads. There was no way a shrinking young cohort could be loaded up with the levels of taxation, HECS debts and inflated asset priced mortgages required to sustain its dependent parents’ generation in the manner to which they presumed they were entitled. That is what’s happening now. Those baby boomer expectations are being rapidly unwound and as they are it has obvious consequences for the very value of fiat money. I suspect that enormous strain will threaten the very medium of exchange now and inevitably gold is the last sanctuary. This is big, really really big and we are all in uncharted waters now.

  6. Sorry, I have to laugh (but not unkindly) at those who want to go back to the “gold standard”. And I am not sure that Observa is necessarily advocating that. But some visitors here do seem to advocate that.

    There is nothing intrinsically magical or special or fundamental about gold that renders it more worthwhile as a money standard than anything else. The notion that you can only make “true money” out of gold or backed by gold is specious specie-ism; the specious theory of specie backed money. (I could not resist that play on words.)

    Specie backed currencies have given way to Fiat Currencies for good reasons. ‘The terms fiat currency and fiat money relate to types of currency or money whose usefulness results, not from any intrinsic value or guarantee that it can be converted into gold or another currency, but instead from a government’s order (fiat) that it must be accepted as a means of payment.’ – Wikipedia.

    Money exists to represent exchange values in an agreed accounting unit which is portable (think paper money) and now tele-communicatable (think data representing money. It is the business of the government to regulate the money supply. I am no expert on this and I haven’t read Keynes or subsequent theorists.

    But where there is a severe problem with the Fiat currency itself I would say the fault lies with the regulation of the money supply ie. the rate of creation of money by fiat relative to the economy’s need for money as a means of exchange to represent real values and real rates of exchange (trade) in the economy.

    So the problem in this case lies not with Fiat currency per se but the government’s poor regulation of it. Bad government regulation of the fiat money supply is no doubt not the only problem that impinges on fiat currencies but if that regulation is bad enough it will cuase a major problem.

    I don’t see how a gold standard could ever work now. There aint enough gold in them thar hills any more to back all the currencies and all the real values in the modern world economy. So any gold standard would be a kind of attenuated fiction now; not just a fiction but an attenuated fiction! 🙂

  7. Oh, by the way, I don’t think gold is the last sanctuary. You can’t eat gold any more than you can eat paper money. I think hunter-gathering skills and a sufficient tract of land to exercise them on are the last sanctuary. By which measure, I seriously doubt there are any sanctuaries left.

  8. “I seriously doubt there are any sanctuaries left.”

    Speak for yourself. I’m a farm boy and have a pretty decent-sized back-yard. Just finished planting out some strawberries.

    I’d probably need to get some more chooks though.

  9. Ian Gould says:

    “75% of mortgage lending and 90% of subprime lending was done by institutions not subject to such laws but I’m sure if you and your compatriots keep repeating that the CRA was a major cause of the crsis it’ll magically become true.”

    Where did you get that figure from, Ian?

    Libertarians are certainly hammering the point that affirmative action lending is one of the major causes of the current US crisis.

  10. “As Robert Gordon shows, however, this is crap. First, there’s the timing. CRA came in 1977. The crisis came in 2007. Indeed, by 2004, the Bush administration had weakened the CRA — and after that (though not, presumably, because of it), bubble lending really took off. Further, CRA only governs a certain class of federally insured banks. Problem is, half of the subprime loans came from mortgage companies with no CRA involvement at all. Another 25%-30% came from companies with very little CRA exposure. For those who left their abacus at home, that’s 80% of the loans which were fully or largely outside CRA jurisdiction. More than that, the non-CRA mortgage firms made subprime loans at twice the rate of CRA-covered firms.”

    “Before I turn to potential interventions, I want to make one final point. There has been a tendency to conflate the current problems in the subprime market with CRA-motivated lending, or with lending to low-income families in general. I believe it is very important to make a distinction between the two. Most of the loans made by depository institutions examined under the CRA have not been higher-priced loans,16 and studies have shown that the CRA has increased the volume of responsible lending to low- and moderate-income households.17 We should not view the current foreclosure trends as justification to abandon the goal of expanding access to credit among low-income households, since access to credit, and the subsequent ability to buy a home, remains one of the most important mechanisms we have to help low-income families build wealth over the long term.”

    This is yet another case where libertarians are essentially buying into arguments which boil into “Decent white folk just can’t ahead because them Jew Lib’ruls in Washington be takin’ their hard-earned tax dollars an’ givin’ it to lazy no-account blacks.”

    Now if these arguments were actually presented in those terms the overwhelming majority of libertarians would reject them out of han but dress them up as “big government interfering in the free market” and they’ll happily swallow them.

  11. Has anything been done to address the problem from the ground up?
    Why are there so many American households in financial crisis?
    How much would it cost to ensure these people have jobs, or that those jobs provide adequate pay, or that financial counselling is widely available, or that home loans must be paid before an employee recieves the pay packet? $700b?

  12. Ikon — if you agree the current problems are caused primarily by mistakes from the federal reserve and government, then it doesn’t make sense to declare this the death of neo-liberalism.

    Ian — I didn’t say the CRA was the major cause of anything. It was one cause among many. I did mention 5 or 6 problems in my first comment.

    For those who think this is a failure of the market, can you explain exactly the mechanism by which the current financial problems have come about?

  13. “For those who think this is a failure of the market, can you explain exactly the mechanism by which the current financial problems have come about?”

    People in the private sector paid too much for assets, including US Treasury bonds.

    That’s how essentially every financial crisis has occurred since at least Tulipmania and the South Sea Bubble.

    It is, as I’ve noted before, part of the cost we pay for the greater freedom of choice and the higher living standards capitalism can deliver.

    People who claim to support capitalism would use their time better admitting that and putting the case far capitalism rather than engaging in pointless scapegoating and insisting that the markets are good and therefore can never ever produce anything but good.

  14. I wish we had a Weekend Reflections thread, but seeing as the US economic mess seems to have taken over the blog and seeing as the various threads on it seem to have pretty much bled together, I might as well throw out a couple of thoughts here:

    1. Of the $700 billion proposed to be used to bail-out US institutions how much will end up going to federally-insured banks. The Federal Deposit Insurance Corporation seems to be rapidly running out of funds and may need to be bailed out itself to protect individual bank depositors.

    If it turns out that in the absence of a bail-out the US government would ultimately ende up paying otu a similar amount to depositors of failed institutions then the debate becomes somewhat academic doesn’t it?

    Secondly, is anyone else as appalled as I am by the astonishingly hypocritical behaviour of the US congressional Republicans?

    Knowing that the bail-out will be unpopular, they’re adopting a deliberately obstructionist approach and are trying to posture as enemies of “The Washington Establishment”.

    I’ve seen a lot of really cynical behaviour by politicians over the years but this is probably the worst.

  15. Would this be a fair way to para-phrase what you see as the problem: “market players have made bad decisions”.

    Because that one of the things I said in my first post.

    I’m glad you agree. Perhaps you will also agree that these mistakes are at their base caused by an incorrect assessment of risk.

    Mistakes by businesses do indeed have costs. But business mistakes do not constitute a failure of capitalism or a market failure.

    Anyway, it seems that we agree that people made investment and busines mistakes. Our difference is that I also think moral hazard, lax monetary policy and bad regulation also had a role in the current problems. Without those added causes, businesses will still make mistakes… but the market will correct them quicker and the problems will be smaller.

  16. “Our difference is that I also think moral hazard, lax monetary policy and bad regulation also had a role in the current problems.”

    The moral hazard argument is overstated because the major motivating factors for the primary decision makers in big companies (senior execs etc.) is maintaining and enhancing reputations and future earning capacity. If a big company goes bust the reputations and future employment prospects of the senior execs are effectively destroyed; the fact that there is a reasonable expectation that the company they sent to the wall will be the recipient of a Government bailout is irrelevant.

    The point about lax monetary policy sounds like Monday morning quarterback banter. As far as I can tell there was nothing approaching a consensus among classical liberal scholars on the perils of lax monetary policy before the current crisis. Where is the evidence of such an outcry?

    If I understand your point on bad regulation correctly, Ian seems to debunk it at #35.

  17. Mel — there were plenty of bad regulations. Ian only mentions one, and then admits that it still is a factor for 1/4 of loans. So it clearly was a factor. Another dodgy regulation was allowing home-owners to walk away from their home as soon as it has negative net equity. That’s not how things work in Australia.

    While plenty of neo-classical economists felt comfortable with recent fed monetary policy, nearly all Austrian economists have been complaining about it for a long time. The same people have also been complaining about lax monetary policy in Australia. I agreed with them about America but disagreed with them concerning Australia. I’m sticking with that assessment.

    Incidently, the reason for my relatively optimistic view in Australia is that I think the majority of house-price increases in Australia have been real increases in asset value, not a bubble. But that’s a different story.

    I accept there may be an agency problem at play in banks (as with many businesses), and this may decrease the size of the moral hazard problem (though it could also work the other way, as bankers would prefer to keep their job rather than maximise profits). Either way, I don’t accept that it could ever entirely remove the moral hazard problem. I know of few economists who think that moral hazard is insignificant. None actually.

  18. One thing that doesnt seem to have been mentioned here (unless I’ve missed it) is the role of resetting mortgages in the crisis. The low honeymoon rates allowed for the inflation of US house prices over the last few years and the growth of the sub-prime sector which spilled over into the wider financial markets due through packaging them as CDO’s. Now house prices have fell as the situation unravels effecting other mortgages.

    The problem is a problem of regulation which allowed a sort of large scale ponzi scheme to develop. If loans werent allows to reset I really dont think that we’d be in this situation, as subprime borrowers wouldnt have been able to afford the initial interest rates stopping this process well before it reach the levels it did.

    The failure is of regulation and the assumption that market participants are rational. I think that on the whole this will lead to increased regulation of the financial sector rather than the wide scale collapse of neoliberalism. (although hopefully a fair bit of neoliberal doctrine takes a hit).

  19. Laughing and Crying at the Same Time

    In June the Sunday Edition of New York Times published an analysis of growth in US household debt.

    The trends displayed should not allow any economist to pretend they did not know the bust was coming.

    Debt as a proportion of household incomes has been increasing since 1900.

    The contradictions of capitalism have been papered over by continuous new forms of debt from early ‘hire purchase’ to ‘automobile loans, ‘housing loans’, then credit cards, then huge amounts of tuition loans.

    Now capo banks, who will kick workers out of their homes for the smallest credit default, want the government to keep them in their wealth for the biggest credit default.

    What economic theory covers this? What social justice makes sense here?

    I well remember when the Bankcard was proposed in early seventies. Opponents of Bankcard predicted dire consequences – I should go back to the pages of the now defunct “National Times” and check my recollection.

    I think we should blame the lazy career economists in the Universities – at least I do. They ignored fundamental underlying trends. The key trend is the decade by decade build up of per capita (or per household) debt.

    You cannot sell an item for more than was spent to produce it.

    Chris Warren

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