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Investors hve rushed from private debt to public debt in a flight to safety 
– but is sovereign debt really safer? This is the question that Gillian Tett asked in yesterday’s Financial Times and I agree with her that the answer might be, No!
Private debt has been risky, of course, because private investments were so highly leveraged. A small absolute fall in value had drastic consequences due to the high leverage rates. Public debt was safer because it was more fully backed tax revenue streams. That was true then (in the rearview mirror, as Tett puts it), but it may not be true looking ahead.
The problem is that government policy makers needed to de-leverage the financial sector without causing a collapse of the economy. This was accomplished, especially here in the United States, by leveraging up the public sector to compensate for de-leveraging the private sector.
This has worked pretty well (judging by the recent growth figures) although not as well as you might have hoped (judging by the unemployment data). Still de-leveraging the private sector without the debt-financed public sector expansion would have resulted in much worse macroeconomic results.
But here’s the problem. If we remember the principle that leverage increases risk, then we must acknowledge, as Tett does here, that this means that private sector risk has been shifted to the public sector — and to public sector debt in particular. The current returns on this debt do not seem to take this risk into account. And that’s a problem — possibly a big one — as I explain in the forthcoming Globaloney 2.0
A front page article in today’s Wall Street Journal argues that “Crisis Compels Economists to Reach for New Paradigm.” It features a discussion of Yale economist John Geanakoplos’s “previously obscure” theories that focus on the role of collateral and leverage in financial bubbles and cycles.
Professor Geanakopolis says that he was inspired to examine the role of collateral while re-reading Shakespeare’s Merchant of Venice, where pound-of-flesh collateral plays a such a prominent role. From the article …
The play’s focus is collateral, with the money lender Shylock demanding a particularly onerous form of recompense if his loan wasn’t repaid: a pound of flesh. Mr. Geanakoplos, too, finds danger lurking in the assets that back loans. For him, the risk is that investors who can borrow too freely against those assets drive their prices far too high, setting up a bust that reverberates through the economy.
Collateral is of course the fulcrum on which leverage is based, with borrowed funds being the arm that transmits the force. You would think that financial economists would have taken the leverage effect into account — it certainly plays a big part in my analysis of “financial globaloney” in Globaloney 2.0 — but the WSJ reports that
Mr. Geanakoplos is among a small band of academics offering new thinking about those cycles. A varied group ranging from finance specialists to abstract theorists, they are moving to economic center stage after years on the margins. The goal: Fix the models that encapsulate economists’ understanding of the world and serve as policy-making tools at the world’s biggest central banks. It is a task that could require a thorough overhaul of the way those models work.
“We could be looking at a paradigm shift,” says Frederic Mishkin, a former Federal Reserve governor now at Columbia University.
Paradigm shift? About time.
One of the arguments that I make in Globaloney 2.0 is that the risks of international finance were systematically ignored or “misunerestimated” as a former President might have said. I call the false belief that international finance is fundamentally safe and sound “Financial Globaloney.”
When you take even relatively safe domestic investment patterns and add to them the instabilities and uncertainties of international currency markets, I argue, the risks rise exponentially. When those investment are highly leveraged, as they usually are, the risk profile explodes.
The good folks at the Financial Times have produced an excellent brief presentation that explains the “carry trade” (which my students will recognize as an example of “naked interest arbitrage”), showing both why this investment pattern would seem “safe as houses” and why it can go so badly wrong.
Click here to go to the FT carry trade site. (Note: you will need to register — it’s free — to view the article.)
The bad news is that the carry trade, which unwound during the bust, is leveraging up, with the U.S. as the low-interest source of funds. That’s why the dollar keeps falling — investors borrow dollars and sell them to get currencies that earn higher interest. That’s why it has been so difficult to talk the dollar back up — you’d need to raise U.S. interest rates or bring down foreign rates to lessen carry trade flows.
The carry trade collapses during a crisis. Everyone rushes to cash out and bring their money home. That’s why a surge in the dollar would be bad news for the global economy — it would probably be associated with another seismic financial shock.
Gillian Tett of the Financial Times has been one of my favorite sources for commentary and analysis during the financial crisis. Perhaps one reason she is capable of providing fresh insights is that her background is not one you would expect for a financial journalist. No MBA. No journalism degree. Not the usual career path at all.
Nope — she earned a Ph.D. in social anthropology before joining the FT staff. Her fieldwork was in a mountain village in Tajikistan “where I analyzed how marriage rituatals were used to preserve religious and ethnic identity in the Soviet System,” she reports in a fascinating essay titled “Icebergs and Ideologies: How Information Flows Fuelled the Financial Crisis” in the October 2009 issue of Anthropology News.
It was, she writes, perfect training to understand global finance. “That is partly because,” she say, “bankers (like Tajik villagers) operate as a tightly defined group, with specific cultural patterns and a quasi language (or jargon) of their own. Also like Tajik villagers, bankers are generally trained to think in rigid “silos” and, as a result, find it hard to see how their overall system operates, or to see the contradictions in their own rhetoric and internal organizations.”
Tett’s brief article is a must-read if you want to understand the human dynamics of the financial crisis — and why so many well-informed people didn’t see it coming. Click here to download the article.
Harold James, The Creation and Destruction of Value: The Globalization Cycle. Harvard University Press, 2009.
Princeton Professor Harold James is the author of one of my favorite globalization books, The End of Globalization: Lessons from the Great Depression (2001), so I was excited to learn about his new book on the economic crisis. James is unique in his deep understanding of how financial crisis pushed globalization over the edge in the 1930s and how the current crisis compares with that devastating experience.
I know of only one person who might be James’s equal in this regard: his name is Ben and he works for the Federal Reserve. Since Bernanke isn’t free to write books about the crisis just yet, James is my go-to-guy for deep insights.
And I am not disappointed. Each chapter provides key ideas and raises questions that will draw me back to re-read this book. James’s comparison between the Crash of 2008 and the crises of 1929 and 1931, for example, helped me understand both the recent past and the Great Depression much more clearly. His chapter on the chronology of the crisis is well crafted and broadly useful. I guess I am especially drawn to the last two chapters, however, which look at power and values.
Major financial crises really shake things up. In the penultimate chapter James considers how power will shift in the international system. Will the US retain its strong position or will China or the EU rise to fill the void. James’s wise analysis reminds me of Paul Kennedy’s writings of 20 years ago — informed and useful, raising many questions.
The final chapter on values is very thought-provoking. The collapse of values leaves people confused about whom and what to trust. This is true about market values, which is what the chapters mainly discusses, but also about values more generally, which is how James concludes the book.
Regaining trust is a long and arduous process. That is why when globalization is broken, it is not easy to put it back together again. We will look for communities of virtue, but inevitably we will not find them at once. And the globalization cycle will resume, but not immediately (page 277).
James is right about this, as I argue in Globaloney 2.0. Globalization will come back, but not in the same form. Market values will come back first (see the stock market’s recent surge) but faith in broader values will not be so easily restored.
I am reading through a stack of new books about the Crash of 2008 and the lessons to be learned from it and I’m having a bad case of déjà vu.
Lessons of History
Back in the early 1990s everyone was writing books about America’s fall from power (Japan was kicking out butt — remember?). Paul Kennedy’s The Rise and Fall of the Great Powers was a best seller, proving that people would pay good money to read hundreds of pages of European history if they thought there was a chance it would help them understand why their paychecks weren’t keeping up with inflation.
Many others contributed to the discussion. I even wrote a book, Mountains of Debt, that attracted some attention.
Looking back I now recognize that we all approached the problem in pretty much the same way. We retold a section of history (recent history in some cases, ancient history in others), including and omitting facts and events in order to advance our particular viewpoint.
Why History Works
It got pretty tiresome after a while visiting and revisiting the same potholed patch of road, but it worked. History is really the study of change and the historical approach is the most useful one in transitional times. Now for example.
I’ve copied a couple of posts from my book review website to start a series on the Crash of 2008. I’ll add more in the coming weeks. Each book tells the same story in a different way, making a different point. Hopefully this will help you decide which books you want to read.
You’ll find my account of the Crash of 2008 in two chapters of Globaloney 2.0. Chapter 2 “Financial Globaloney: Safe as Houses” identifies several principles of “Financial Globaloney” that I argue helped blow up the bubble and contributed to bust.
Then, in Chapter 3 “The Crash of 2008 and the Global Market Myth” I tell the story of the crash in terms of the seven stages of financial crises, stressing the importance of Financial Globaloney.
I think my argument makes sense, but then I’m the author. I’ll be interested to see what people have to say when Globaloney 2.0 is published later this year.
Matthew Rose has a fun article in today’s Wall Street Journal titled “The Devil’s Dictionary — Financial Edition.” It is an amusing account of how certain financial terms have taken on a new meaning in this post-crash world. Here’s a sample.
SUBPRIME, adj. A measure of diminished intellectual capacity and increased financial mendacity.
TOXIC ASSETS, n. 1. A collection of bad loans and other botched financial bets that caused big losses for banks, prompted a credit crunch and sank the economy (Sept. 2008 to May 2009). 2. Long-term investments that will pay handsomely when the housing market recovers (June 2009 onward).
I’d like to offer up an addition to the dictionary:
FINANCIAL GLOBALONEY n. The persistent but misguided belief that global financial markets are “safe as houses” despite repeated evidence to the contrary. Also the rhetoric used to support this belief and to sell it to investors, policy-makers, etc. See Veseth, Globaloney 2.0.
Catherine Rampell’s article “Same Old Hope: This Bubble is Different” in today’s New York Times echoes a theme I raise in Globaloney 2.0, where I break down all the reasons investors and policymakers allowed themselves to be fooled — to believe that “this time” was really different.
In my new book I argue that we need once and for all to learn the lessons that financial bubbles are a fundamental characteristic of financial markets — this time is no different from all the times before. Rampell’s article suggests that this lesson is very hard to learn, however. Here’s a brief quote. Click on the link above to read the complete article.
“Globally, a lot of money is now seeking higher returns once again,” said Rachel Ziemba, senior analyst at RGE Monitor. The steadying of the economy, liquidity injections by governments and big returns reaped early this year by investment banks are encouraging more traders to dip their toes back in the water in search of the next big thing.
“As long as compensation and bonuses are based on short-term performance in the market,” she said, “that’s going to encourage risk-seeking behavior.”
Globalization will return, I argue in Globaloney 2.0, but in what form? Although the economic crisis will be shorter if the economy and financial systems simply “bounce back” in more or less the same form as before the crisis, this would be a mistake. Repeating the mistakes of the past is not a receipe for feasible, sustainable globalization. The old system of boom and bust, crash and burn needs to change.
An article “Financial Overhaul Falters as ’08 Shock Fades” in this morning’s Wall Street Journal provides unwelcome news. It suggests that the momentum for financial reform is fadding as early signs of financial and economic recovery emerge. Banking (and other financial instututions) are pretty much the same, the authors note, there are just fewer of them.
A good article — click on the link to read it all.
Paul Krugman has a very interesting piece in today’s Sunday New York Times magazine on How Did Economists Get it So Wrong? Click on the link to read it.
Krugman comes to many of the same conclusion I do in Globaloney 2.0 regarding what I call Financial Globaloney, although he focuses much more than I do on the internal debate within the economics profession (I am a bit more interested in how the ideas were sold to and bought by investors, officials and the general public).
The discussion of Freshwater versus Saltwater economists is a good introduction for non-economists to the debate within the profession. I have mixed emotions about his discussion of “ketchup economics;” his point about research methods is well taken, but relative prices, which are at the heart of the ketchup metaphor, really do matter more than they seem to here.
Krugman successfully walks a fine line here between criticizing the ideas that have been proven wrong and attacking the personalities behind them. I prefer to keep the personalities out of the critique when I can, but I appreciate that Krugman’s position is different from mine.
The article is a good read (and a good introduction to his most recent book, The Return of Depression Economics). A highly recommended antidote to the Globaloney influenza.
