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Financial Sector Induced Systemic Instability bulletin, 2008

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[May 25, 2008] Willem Buiter: Reigning in ‘Leverage’ to Restrain Asset and Credit Boom-busts

In a very good Financial Times post, Willem Buiter weighs in on "leverage", "asymmetry", and the very important need to create institutional means to disallow financial entities from capitalizing via leverage on the upside of credit booms while running for the protective cover of the government on the often sudden downsides.

Buiter has three recommendations, highlighted below, that ought to be vetted carefully as we work our way from the 'wilds' of our current deregulated escaped-from-regulation system into a relatively tamer future-world of once-again, reasonably 'structured finance'. In short, Butier recommends (shortening his commentary a wee bit): (1) common risk-adjusted Basel II-type capital adequacy requirements and reporting requirements imposed on all large institutions whose leverage exceeds a given value, (2) minimal funding liquidity and market liquidity requirements be imposed on, respectively, the liability side and the asset side of the balance sheets of all large leveraged financial institutions, and (3) all large leveraged institutions deemed too large, too interconnected, or simply too well-connected to fail, be made subject to a Special Resolution Regime along the lines that exists today for deposit-taking institutions through the FDIC. To Butier:

Restraining asset and credit booms, Willem Buiter,, May 25, 2008: … [There is] a major asymmetry in the macroeconomic policy and financial stability framework. This asymmetry is not that interest rates respond more sharply to asset market price declines than to asset market price increases. Even if there were no 'Greenspan-Bernanke put', such asymmetry should be expected because asset price booms and busts are not symmetric. Asset price busts are sudden and involve sharp, very rapid asset price falls. Even the most extravagant asset price boom tends to be gradual in comparison. So an asymmetric response to an asymmetric phenomenon is justified. This does not mean that there has been no evidence of a 'Greenspan-Bernanke' put, of course. In fact I believe that phenomenon - excess sensitivity of the Federal Funds target rate to sudden declines in asset prices, and especially US stock prices - to be real, unfortunately.


Fundamentally, the key asymmetry is that the authorities are unable or unwilling, whether for good or bad reasons does not matter here, to let large leveraged financial institutions collapse. There is no matching inclination to expropriate or otherwise financially punish or restrain highly profitable financial institutions. This asymmetry has to be corrected. Therefore, any large leveraged financial institution, commercial bank, investment bank, hedge fund, private equity fund, SIV, Conduit or whatever it calls itself, whatever it does and whatever its legal form, will have to be regulated according to the same principles.

Operationally, the asymmetry is that there exists a panoply of liquidity-and credit-enhancing measures that can be activated during an asset market bust and during a credit crunch, to enhance the availability of credit and to lower its cost, but no corresponding liquidity- and credit-restraining instrumentarium during a boom. When financial markets are disorderly, illiquid or have seized up completely, the lender of last resort and market maker of last resort can spring into action. …

Leverage is the key
These asymmetries have to be corrected through regulatory measures, effectively by across-the board credit controls. Every asset and credit boom in history has been characterised by rising leverage. The one we are now suffering the consequences of is no exception. Leverage is a simple concept which may be very difficult to measure, as those struggling to quantify the concept of embedded leverage will know. …

Traditional sources of leverage include borrowing, initial margin (some money up front - used in futures contracts) and no initial margin (no money up front - when exposure is achieved through derivatives).

I propose using simple measures of leverage, say a measure of gross exposure to book equity, as a metric for constraining capital insolvency risk (liabilities exceeding assets) of all large, highly leveraged institutions. Common risk-adjusted Basel II-type capital adequacy requirements and reporting requirements would be imposed on all large institutions whose leverage, according to this simple metric, exceeds a given value. These capital adequacy requirements would be varied by the monetary authority in countercyclical fashion.

To address the second way financial entities can fail, what the CRMB calls liquidity insolvency, meaning they run out of cash and are unable to raise new funds, I propose that minimal funding liquidity and market liquidity requirements be imposed on, respectively, the liability side and the asset side of the balance sheets of all large leveraged financial institutions. These liquidity requirements would also be tightened and loosened by the monetary authority in countercyclical fashion.

Finally, I would propose that all large leveraged institutions that are deemed too large, too interconnected, or simply too well-connected to fail, be made subject to a Special Resolution Regime along the lines that exists today for deposit-taking institutions through the FDIC. … [emphasis mine]

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May 23, 2008 'Presidential' Challenge: Confronting the Medical Industrial Complex

Recently I watched Frontline's Sick Around the World, and was once-again reminded how our various "industrial complexes" have gridlocked the US into at best mediocre economic performance relative to other economies around the world. At worst we Americans face a painful "day of reckoning".

Noteworthy is how Frontline's Sick Around the World helps us see that to fix the Medical Industrial Complex problem requires that we confront not only the American Medical Association's long-recognized power base and physicians (particularly "specialists") outrageous pay scales, but also the insurance industry, big medical consortiums, the pharmaceutical industry, and trail lawyers all feeding at the same trough. No small task. But a worthy, timely cause.

It will prove interesting to see how an incoming American president begins to confront the medical industrial complex, along with the petrochemical industrial complex, financial industrial complex, and military industrial complex. Wikipedia on Military Industrial Complex.

It will also prove interesting to see whether or not mainstream American media will ever begin to explore recent war profiteering and connections to American political power bases linked to Bush and Cheney. A military industrial complex that we have been forewarned against since the late 1950s. Here is Counterpunch, Bush Family War Profiteering, April 12, 2007. For more see Sourcewatch on this-round War Profiteering.

{Update, May 25}:

More on Bush Administration's War Profiteering, from Capital Gains and Games: The Bush Administration's Teapot Dome

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Gas Prices Not 'Outrageous'

On mainstream news this morning I heard our Utah Governor declare US gas prices "outrageous". Memorial Day national news coverage labeled them "sky high." Wrong! Gas prices only seem outrageous to we Americans who George W. Bush correctly noted are "addicted to oil".

Europeans, by contrast, have lived with high gas prices for years, using proceeds to fund social programs, re-build infrastructure, etc. In addition, as noted in a May 21 Senate-side Congressional hearing Exploring the Skyrocketing Price of Oil (3 hrs), Europeans used gas tax differentials to correctly steer transportation systems toward diesel and away from gasoline, which proves ever-more important now that clean diesel is available. And to steer transportation system toward mass transit and away from single-vehicle transportation. Meanwhile we Americans sat around watching TV and partying until world market forces pushed prices upward, allowing most of the recent 'surplus' to be captured as record profits, record CEO compensation, etc. by what I'll call the Petrochemical Industrial Complex. Finally, Europeans are now beginning to look toward a future free of dependence on petrochemicals and their commingled carbon-loading propensities.

Even though we Americans are just now beginning to face the reality of high gas prices, the prices themselves are not the problem. In fact "sky high" prices are finally getting us to pay attention, however feebly, to alternative sources of energy that are compatible with global climate systems and human survival. As noted in the Congressional hearing, planet Earth is not in jeopardy, rather it is we humans (along with myriad other species) who are at risk. The Earth has worked its way through five Great Extinctions in the past and arguable done remarkably well. But it is in no way clear that we humans will survive the Sixth Great Extinction. Tragically, we humans may be contributing to our collective demise by clamoring for lower gas prices.

This is not to say that all is well in petrochemical industrial complex, medical industrial complex, financial industrial complex, military industrial complex America. But that is a story for another post (or several hundred posts). In the meantime 3 hours are well-spent viewing the hearing. If you want a sneak peak, go to 2:15 in the videocast and watch Senator Charles Schumer (D-NY) in action, followed by others as the hearing winds up.

Note: cross posted at Ecological Economics

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May 12, 2008 Soros: Financial Crisis Stems from Super Bubble

Like me, George Soros is no believer in "equilibrium economics". Rather he believes that sometimes we will see an equilibrium, but that it will be short-lived. Like Hyman Minsky, Soros argues that stability will itself sow the seeds of the next instability. Soros says we are in a unique place with our current crisis, experiencing both inflation and a recession at the same time. Hear/read more from Soros on today's NPR Morning Edition, Financial Crisis Stems from Super Bubble:
… Soros blames what he calls a "super-bubble" that started about 25 years ago. That's when a less-is-more philosophy became popular with economic regulators. That allowed Wall Street to invest increasing amounts of money in credit.


"The idea was that regulators always make mistakes, state interference in the markets just messes things up," Soros says. "And that was a false idea .... Regulators are human and bound to make mistakes, but markets are also human and they are also bound to make mistakes. Instead of markets always being right, they're actually always groping at trying to find out what the facts are. But they never get it right." …

Soros says there's a "super-bubble" in the economy that's bigger than just the recent housing crises, and he blames exotic financial instruments for helping cause it.

"The markets have introduced financial instruments with fancy names — CDOs and CLOs and all these strange instruments that are traded in very large volumes. And they were all constructed on the belief deviations are random.

Soros also has a new book out. Here is a snip from the introducion:
A New Paradigm for Financial Markets, Introduction, George Soros: We are in the midst of the worst financial crisis since the 1930s. In some ways it resembles other crises that have occurred in the last twenty-five years, but there is a profound difference: the current crisis marks the end of an era of credit expansion based on the dollar as the international reserve currency. The periodic crises were part of a larger boom-bust process; the current crisis is the culmination of a super-boom that has lasted for more than twenty-five years.


To understand what is going on we need a new paradigm. The currently prevailing paradigm, namely that financial markets tend towards equilibrium, is both false and misleading; our current troubles can be largely attributed to the fact that the international financial system has been developed on the basis of that paradigm.

The new paradigm I am proposing is not confined to the financial markets. It deals with the relationship between thinking and reality, and it claims that misconceptions and misinterpretations play a major role in shaping the course of history. …

Let me explain briefly how the theory of reflexivity applies to the [current] crisis. Contrary to classical economic theory, which assumes perfect knowledge, neither market participants nor the monetary and fiscal authorities can base their decisions purely on knowledge. Their misjudgments and misconceptions affect market prices, and, more importantly, market prices affect the so-called fundamentals that they are supposed to reflect. Market prices do not deviate from a theoretical equilibrium in a random manner, as the current paradigm holds. Participants' and regulators' views never correspond to the actual state of affairs; that is to say, markets never reach the equilibrium postulated by economic theory. There is a two-way reflexive connection between perception and reality which can give rise to initially self-reinforcing but eventually self-defeating boom-bust processes, or bubbles. Every bubble consists of a trend and a misconception that interact in a reflexive manner. There has been a bubble in the U.S. housing market, but the current crisis is not merely the bursting of the housing bubble. It is bigger than the periodic financial crises we have experienced in our lifetime. All those crises are part of what I call a super-bubble—a long-term reflexive process which has evolved over the last twenty-five years or so. It consists of a prevailing trend, credit expansion, and a prevailing misconception, market fundamentalism (aka laissez-faire in the nineteenth century), which holds that markets should be given free rein. The previous crises served as successful tests which reinforced the prevailing trend and the prevailing misconception. The current crisis constitutes the turning point when both the trend and the misconception have become unsustainable. …


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May 09, 2008 NPR Does Subprime

If you want a very good lay person's edition of the Credit Bubble mess, listen to NPR's Global Pool of Money Got Too Hungry (audio, 13 min., All Things Considered, May 9): "Adam Davidson and This American Life's Alex Blumberg jointly report on how rising defaults on subprime mortgages in the U.S. have became a global financial crisis. This American Life host Ira Glass talks with Michele Noris".

NPR demystifies SEVs, CDOs, MBSs, "Liar Loans," and more. The narrative concludes: "… Nobody really questioned things. And why should they? Everybody was making money — right up to the day the bottom fell out."

An hour-long version — The Giant Pool of Money — airs this weekend on This American Life.

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May 01, 2008 One Approach to Financial Re-Regulation

At Vox, Avinash Persaud serves up a regulatory finance model I think might work:
The inappropriateness of financial regulation, Avinash Persaud, May 1, 2008: … [The] model we have today, I venture [to say] is a highly dangerous model. It is expropriation of gains by bankers and socialization of costs by taxpayers. Paying for a decade of bank bonuses can be very expensive for the taxpayer and the opportunities for moral hazard are enormous. …


The alternative model rests on three pillars. The first recognises that the biggest source of market and systemic failure is the economic cycle and so regulation cannot be blind and deaf to the cycle — it must put it close to the centre. Charles Goodhart and I have proposed contra-cyclical charges — capital charges that rise as the market price of risk falls as measured by financial market prices — and a good starting point for implementation of such charges is the Spanish system of dynamic provisioning (Goodhart and Persaud 2008).

The second pillar focuses regulation on systemically important distinctions, such as maturity mismatches and leverage, and not on out-dated distinctions between banks and non-banks. Institutions without leverage or mismatch should be lightly regulated — if at all — and in particular would not be required to adhere to short term rules such as mark-to-market accounting or market-price risk sensitivity that contribute to market dislocation. Bankers will argue against this, saying that it creates an unlevel playing field, but financial markets are based on diversity, not homogeneity. Incentivising long-term investors to behave long-term will mean that there will be more buyers when banks are forced to sell.

The third pillar is requiring banks to pay an insurance premium to tax payers against the risk that the tax payer will be required to bail them out. If such a market could be created, it would not only incentivise good banking and push the focus of regulation away from process to outcomes, but it would provide an incentive for banks to be less systemic. Today, banks have an incentive to be more systemic as a bail out is then guaranteed. The right response to Citibank's routine failure to anticipate its credit risks is not for it to keep on getting bigger so that it can remain too big to fail, but for it to whither away under rising insurance premiums paid to tax payers. …

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April 29, 2008 James Galbraith on the 'Collapse of Monetarism'

Hyman Minsky, John Kenneth Galbraith and John Maynard Keynes take center stage as James Galbraith throws down the gauntlet to contemporary mainstream economists. Speaking at the 25th Annual Milton Friedman Distinguished Lecture at Marietta College, Marietta, Ohio, Jamie Galbraith asks Fed Chair Ben Bernanke and a host of others to embrace the " intellectual victory of John Maynard Keynes, of John Kenneth Galbraith, of Hyman Minsky." — else to explain "why not". We will search and update on any "why nots" if and when they surface. To Galbraith:
The Collapse of Monetarism and the Irrelevance of the New Monetary Consensus [PDF], by James K. Galbraith, March 31, 2008 : … I come to bury Milton [Friedman], not to praise him. But I would like to do so on the terrain that he favored, where he was strong, and over which he ruled for many decades. This is monetary policy, monetarism, the natural rate of unemployment and the priority of fighting inflation over fighting unemployment. It is here that Friedman had his largest practical impact and also his greatest intellectual success. It was on this battleground that he beat out the entire Keynesian establishment of the 1960s, stuck as they were on a stable Phillips Curve. It was here that he set the stage for the counter-revolution that has dominated academic macroeconomics for a generation, and that – far more important — also dominated and continues to influence the way in which most people think about monetary policy and the fight against inflation.


What was monetarism? Friedman famously defined it as the proposition that "inflation is everywhere and always a monetary phenomenon." This meant that money and prices were tied together. But more than that, Friedman believed that money was a policy variable — a quantity that the Central Bank could create or destroy at will. Create too much, there would be inflation. Create too little, and the economy might collapse. There followed from this that the right amount would generate the right result: stable prices at what Friedman came to call the natural rate of unemployment.

The intent and effect of this line of reasoning was to defend a core proposition about capitalism: that free and unfettered markets are intrinsically stable. In Friedman's gospels government is the lone serpent in Eden, while the task of policy is to stay out of the way. Just as this was the vulgar lesson of "Free to Choose" so it turns out it was also the deep lesson of the larger structure of Friedman's thought. Friedman and Schwartz's Monetary History for all its facts and statistics carried a simple message: the market did not fail; the government did.

Friedman succeeded because his work was complex enough to lend an aspect of scientific achievement to his ideas, and because the ideas played to the preconceptions of a particular circle. As Keynes wrote of Ricardo:"The completeness of [his] victory is something of a curiosity and a mystery. It must have been due to a complex of suitabilities in the doctrine to the environment into which it was projected. That it reached conclusions quite different from what the ordinary uninstructed person would expect, added, I suppose, to its intellectual prestige. That its teaching, translated into practice, was austere and often unpalatable, lent it virtue. That it was adapted to carry a vast and consistent logical superstructure, gave it beauty. That it could explain much social injustice and apparent cruelty as an inevitable incident in the scheme of progress, and the attempt to change such things as likely…to do more harm than good, commended it to authority. That it afforded a measure of justification to the free activities of the individual capitalist, attracted to it the support of the dominant social force behind authority."

Friedman's success was similar to Ricardo's but not in all respects. Yes he also explained away injustice and supported authority. But the logical superstructure was not vast and consistent. Rather Friedman's argument was maddeningly simple, yet slippery. He would appeal to short run for some effects and to the long run for others, shifting between them as it suited him. … His money growth rules promised stable employment without inflation. Their promise was not austere, but happy. Ricardo was Scrooge. Friedman was more like the Pied Piper.

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