Thanks to another conference (a big one, on infrastructure) I’m running far behind on everything. So here, a day late, is the Monday Message Board on Tuesday. Comments on any topic, civilised discussion, no coarse language.
Category: Economics – General
Irony
We’ve all been strictly enjoined to avoid schadenfreude in the current crisis, and indeed few are likely to escape unscathed. Still I’m struck by a couple of examples of historical irony
* Ten years ago, I was debating representatives of the Dutch bank ABN-AMRO, who were pushing for the privatisation of ACT Electricity and Water (ACTEW). A couple of days ago, the Dutch operations of ABN-AMRO were nationalised
* British Bank Northern Rock was nationalised following a run by customers seeking to withdraw their money. Now, seen as safer than it’s competitors, it is being forced to limit deposits.
Martingales
The analogy between the strategies that have made the financial sector so profitable in recent years and the martingale strategy in betting (keep doubling down until you win) have occurred to quite a few people. Jordan Ellenberg has an excellent article in Slate on the topic, in which I get a brief mention.
Meanwhile, in the main game
I’ve been at the Australian Conference of Economists for the last couple of days, talking about climate change. As we all worry about the collapse of the global financial system, the final report of the Garnaut Review reminds us that we have much bigger concerns in the long run (not only climate change, but nuclear proliferation and global poverty to name a few).
Republican talking point whack-a-mole, yet again
The argument by talking point style that characterizes all sections of the political right in the US has been evident as usual in relation to the financial crisis, so I guess it’s time to play whack-a-mole yet again. The most prominent points I’ve seen are
* It’s all the fault of the Community Reinvestment Act, which forced banks to lend to low-income borrowers. Quite a few people have pointed out that many of the subprime loans weren’t required under CRA. More to the point, given that the market structures in the bubble made mortgages a fungible asset, the CRA was a nonbinding constraint. It’s clear that many more subprime loans were given out in the bubble years than were required under the Act and that the excess was greatest in the areas where the bubble was worst. The CRA had no effect at all under these conditions.
* If regulation were the problem, how come the hedge funds haven’t been affected? In fact, it was the failure of Bear Stearns hedge funds that signalled the spread of the crisis beyond the subprime mortgage market. And the main reason hedge funds haven’t yet been hit by the crisis of the past few weeks is that they don’t allow redemptions except at stated dates (for most of them it will be next Tuesday. Perhaps there won’t be a problem, but that’s not what the markets think. In any case, those making the claim seem to be unaware of the redemption restrictions.
Betting on yourself
Robert Waldmann of Angry Bear has a fascinating post exploring the possibility that sharp movements in the value of Lehman senior debt could be explained by the possibility that Lehman had sold Credit Default Swaps on itself. Since a CDS is insurance against the possibility of default on debt, this is a no-lose bet for Lehman. If the firm survives, they collect the premiums and pay nothing and, if it doesn’t the losses are borne by the creditors. And, as Waldmann points out, it’s not crazy to buy such a CDS, since it will retain some value in bankruptcy. If you’ve already sold a lot of Lehman CDS yourself, there’s a significant hedging benefit. So both parties benefit, and the losers are the existing bondholders. Waldmann has an interesting optimization exercise to show that optimal (for Lehman) use of the CDS option could explain the collapse in the value of Lehman bonds.
Thinking about this, I’m more and more convinced that Warren Buffett’s description of derivatives as financial weapons of mass destruction applies in spades to CDSs.
Neoliberalism defined
I’ve been arguing since the dotcom boom and bust that the poor performance of (particularly US) financial markets provides strong evidence against the claim that neoliberalism provides a coherent and effective alternative to social democracy. One objection that’s been made to this argument is that “neoliberalism” is a poorly-defined pejorative. It’s true all political terms are elastic and it’s hard to find any that are used, with more or less the same meaning, by both friends and foes. The only one I can think of is “social-democratic”, though you could perhaps make a case for “liberal” in the US sense. Words like “conservative”, “democratic” and “socialist” have become just about meaningless.
By contrast, I think “neoliberalism” is a comparatively well-defined term. It’s mostly, though not exclusively used in a pejorative sense, so perhaps something like “free-market liberalism” would be better. This post from 2002 gives my definition and some reasons why I thought then that neoliberalism was a failure. I don’t see much reason to revise my assessment in the light of events between now and then.
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.
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The one-hoss shay (repost)
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.
Moral hazard, meet adverse selection
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.
John Quiggin 