I’ve been finding it hard to concentrate on the future of the planet for the last week or so, what with the nationalisation of vast segments of the financial sector, the disappearance of all four remaining US investment banks, the trillion dollar bailout and so on. But I’m going to be presenting a lecture for UQ research week on Wednesday night, entitled “Climate Change and the Murray Darling Basin”. The news isn’t good but there is still some hope if we act swiftly and sensibly. Perhaps the other speaker will have something more solidly positive to tell us. He’s Professor Paul Burn Federation Fellow, School of Molecular & Microbial Sciences talking on ‘Can Light Solve the Energy Crisis?’
It’s time once again for the Monday Message Board. Post your thoughts on any issue. Civilised discussion only. Please avoid snarks and trolling and strictly no coarse language.
I thought I’d repost this piece from March readers can make the necessary adjustments.
The Fed’s bailout of Wall Street investment bank Bear Stearns has, unsurprisingly, been discussed in terms of the domino theory. A more appropriate metaphor is The Wonderful One-Hoss Shay . This was a carriage constructed on the theory that a system always fails at its weakest spot.
The way t’ fix it, uz I maintain, Is only jest T’ make that place uz strong uz the rest”.
On the Fed’s current approach, the system is unbreakable, provided that “too big to fail” protection is extended to every significant firm in the system. The result of this protection is that the kind of crisis where the failure of one firm leads to a cascade of failures elsewhere is prevented. But then
First a shiver, and then a thrill, Then something decidedly like a spill,– And the parson was sitting upon a rock, At half-past nine by the meet’n’-house clock,– Just the hour of the Earthquake shock!
–What do you think the parson found, When he got up and stared around? The poor old chaise in a heap or mound, As if it had been to the mill and ground! You see, of course, if you ‘re not a dunce, How it went to pieces all at once,– All at once, and nothing first,– Just as bubbles do when they burst.
At a time when anyone on the cutting edge is talking quadrillions, it seems a bit petty to worry about a $50 billion component of the latest bailout (only $500 per US household!). Modest as it is, the insurance scheme offered to money market funds by the US Treasury provides the opportunity to explain a little bit more about the theory of insurance.
By now, everyone has heard about moral hazard, that is the encouragement to take risky or reckless action that arises when your losses are insured by someone else. Now it’s time meet moral hazard’s evil twin, adverse selection. That’s what happens when the people you are offering to insure already have a pretty good idea whether they are going to collect or not.
While reviewing this post from 2002, foreshadowing a derivatives crisis like the current one, I found the following:
“At the end of 2002’s first quarter, the notional value of derivatives contracts involving U.S. commercial banks and trust companies was $45.9 trillion, according to the Office of the Comptroller of the Currency’s bank derivatives report. ”
The bulk of the exposure is in interest rate swaps, which are fairly well understood and seem to pose only modest risks in themselves. But there’s still around $1 trillion in more recent derivatives involving securitisation of various kinds of debts. This securitisation is sound only if the credit rating agencies have got their risk assessments right, which in turn requires that the accounts on which those assessments are based should be valid. A few years ago, when the market in debt derivatives was starting up, this assumption seemed safe enough, but now it looks a lot more dubious. The big danger is that defaults in the debt derivatives market could spread to the much larger interest rate derivatives markets.
As an update, the $1 trillion in credit derivatives has exploded to around $50 trillion. While less dramatic in proportional terms, the growth in interest rate swaps is actually more alarming, having reached around $300 trillion in notional values.
It now seems pretty well certain that, as the quote above suggests, the chaos in debt derivatives will shortly spread to interest rate swaps.
Update Unless that is, all normal calculations are rendered irrelevant by a US government asset purchase on a scale that will make all past nationalizations look puny. How that will play out I have no idea. For example, will US-based ratings agencies take the step (automatic if it were anyone else) of downgrading US government debt? End Update
I don’t think even the most alarmist of doomsayers could have anticipated the pace of events in financial markets over the past couple of weeks. In that time, the casualties (bankrupt, nationalised or firesale) include Fannie and Freddie, Merrill Lynch and Lehman, AIG and HBOS and probably others I’ve missed. And the new names on the list are even more startling: Goldman Sachs, Morgan Stanley, Macquarie Bank, GE, even the Federal Deposit Insurance Corporation.
As late as last week, columnists were asking (and answering in the negative) the question “Should I take my money out of the stock market and put it in a money market fund”. Now the question is “If I pull out of the money market funds before they shut down redemptions, what’s the safest alternative: a bank account, T-notes or gold?”.
No doubt, this too will pass. But it’s just about impossible to see things returning to the status quo ante. A severe recession now seems inevitable. And when it ends, we’ll be looking at a greatly contracted financial sector, with governments deeply enmeshed in both ownership and regulation. Among the likely consequences, a huge decline in the economic importance of New York City, as the firms that defined Wall Street disappear. London may gain relative to New York, but is still likely to suffer badly, as will Switzerland. And that will have implications for the national economies that depend heavily on playing a central role in the financial systems.
Politically, even allowing for the incredible triviality of US election campaigns, it’s hard to see McCain surviving once the implications of this sink in. From the Keating Five to deregulation in the 90s, he’s been in the pockets of the financial sector throughout his career.
No doubt there’s lots more I’ve missed. Jump in and comment.
Two days after the US authorities made much of standing firm against calls for a bailout of Lehman, the Fed has announced an $85 billion rescue of insurance company (and large-scale counterparty in all kinds of derivative markets) AIG. There’s none of the ambiguity surrounding Fannie and Freddie in this deal. AIG is not a federally regulated entity, and the insurance subsidiaries are regulated at the state level to ensure their ability to pay out on claims. This is, purely and simply, a case of a speculative financial enterprise that’s too big to fail.
Having reached this point, it’s hard to see how the US can turn back from a massive extension of financial regulation, starting with the derivative markets where AIG got into so much trouble, notably those for credit default swaps (CDS). Along with winding up the affairs of AIG, Lehman and others, the authorities will need to oversee an orderly unwinding of the transactions in these markets which they are now effectively guaranteeing. More generally, it’s time for a partial or complete reversal of the financialisation of the economy that took place after the breakdown of the Bretton Woods system back in the 1970s.
BTW, if you happen to have cash parked in a US money market fund, you might want to read this. (Insert disclaimer about financial advice)
UpdateBrad Setser has the same reaction.
Due to the pressures of real life, I haven’t reacted to the change in Liberal leadership with the lightning speed for which the blogosphere is famed. A couple of thoughts on the players and the implications.
For Nelson, this was only a matter of time. He’s a likeable guy (though of course, the job of Opposition leader typically requires some unappealing behavior) and was of fair average quality as a minister in the last government*, but he was not ready for the leadership of a major political party. Costello’s decision to reject the job (while continuing to collect a parliamentary salary for doing nothing except promote his future career plans and book sales) put him up too soon. As leader by default, he’s floundered from one contradiction to the next. On the whole, losing this job is probably a good thing for him, giving him a chance to start again.
As regards Turnbull, he’s obviously one of the more able people Australian politics has seen in my time. I must say, though, that I’ve marked down my estimate of him pretty sharply over the last couple of years. As Environment Minister, although he clearly understood the issues, he achieved nothing in his tenure of the job. In fact, water policy went a long way back thanks to Howard’s National Water Plan, introduced with Turnbull’s acquiescence. And, if he had the capacity to get things done that I expected of him, he would have made the Cabinet see the obvious sense in swallowing its pride and ratifying Kyoto.
As Shadow Treasurer, he’s been similarly unimpressive. He had a good run early while Swan struggled to come to grips with the job, and particularly its Parliamentary aspects. But he hasn’t made any attempt to mount a sustained critique of the government’s approach, let alone offer a constructive alternative. Rather he’s gone along with the generally opportunistic line taken by the Opposition as a whole.
The big question for me is whether Turnbull will bring the Opposition around to supporting legislation for an emissions trading scheme (after extracting various concessions of course). A couple of years ago, I would have been confident of his willingness and ability to do this. Now I doubt it.
* I have to declare a personal interest here. Nelson introduced the Federation Fellowship scheme under which I’m employed.
In the comments to my last post, reader Peter Schaeffer provides exactly what I asked for: a breakdown of the discrepancy between 30 per cent growth in US household income over the last 40 years and 117 per cent growth in income per person. In addition to the factors I’d mentioned (falling household size and growing inequality) Schaeffer notes two more: the fact that GDP has grown faster than national income and the fact that prices faced by households (the CPI-U-RS) have risen faster than the GDP deflator. He provides the details to show that this fully explains the discrepancy.
What should we make of this. As far as the situation of the average American is concerned, the only correction we need to make to the household income figures is to correct for changes in household size. That makes the increase over the last 40 years about 63 per cent, or an annual growth rate of 1.2 per cent. By contrast, the 117 per cent growth in GDP per person implies a rate of just under 2.0 per cent. So, changes in GDP per person (let alone changes in total GDP) are essentially irrelevant as a guide to how the average household is doing.
And of course, the poor have done much worse. Household incomes for the bottom quintile have barely moved for decades. Growth in consumption has been driven largely by increasing access to debt, a process that now looks to have run out of road. That would seem to indicate a looming social crisis. But the coming election will still turn on whether Obama called Palin a pig.
Mosquito the Rapist aka Bloodlust dvd It’s time once again for the Monday Message Board. Post your thoughts on any issue. Civilised discussion only. Please avoid snarks and trolling and strictly no coarse language.
I won’t have time for a while to post on the startling events on Wall Street over the weekend, but feel free to jump in and have your say.