Economics

Arthur C. Clarke’s third law reads: “Any sufficiently advanced technology is indistinguishable from magic.” What’s the difference between technology and magic? As this blog post points out, “magic” is the halting of inquiry. With that formulation, it’s possible that science can paradoxically plunge us into a second Dark Ages, when the world around us are controlled by forces beyond our ken.

It has become obvious that, among recent technological advances, no field has moved so far so quickly as the world of high finance, specifically, the world of complex derivatives. George Soros testified in 1994 to the House Committee on Banking, Finance, and Urban Affairs, “We use derivative instruments to a much lesser extent than generally believed, very largely because we don’t really understand how they work.” Both he and Warren Buffett restricted their dabbling in derivatives after being seriously burned.

In his 1994 quote Soros didn’t mean that he didn’t know the role derivatives play in the market. Rather, he was pointing out that — like an iPod, or a jet engine — it’s quite difficult to figure out what is going on under the hood of any particular derivative instrument. In other words, they are magic.

Which is not to say that widespread understanding can’t catch up to complex derivatives to make them safer as bona fide financial instruments. Many derivatives have genuine value: consider weather-based derivatives as a hedge for farmers. A heap of regulation to ensure transparency when useful and block abuse when it’s not would help close the gap between financial technology and magic.

As a matter of public relations, no one has ever gone wrong blaming financial disasters on “greed.” But we all know that greed is the basic engine of capitalism. Greed may not be “good,” but it’s there, and we rely on it to power our modern economy. So the problem isn’t greed: greed, like the poor, will always be with us. The key to a thriving capitalist economy is channeling that greed in productive directions.

(That channeling, by the way, is called regulation.)

So when Alan Greenspan argues that the current meltdown is due to “greed” (Taking Hard New Look at a Greenspan Legacy, NYT), warning bells should go off that this guy is trying to get himself off the hook.

The whole point of regulating markets is to manage systemically what we cannot count individuals to do wisely. Mr. Greenspan is no fool. He knows that, and he knew it at the time when he was unscrewing the safety latches that prevented Wall Street from venting all that red-hot greed into the unprotected sectors of our economy. And in deregulating exotic derivatives, he stood by while Wall Street created a risk-laundering scheme of epic proportions.

Conservative think-tank dead-enders keep insisting that the blame for the market and financial crisis lays at the feet of do-gooder efforts at Fannie Mae and Freddie Mac, all the way back to the Community Reinvestment Act of 1977, to help more Americans buy homes. I have never believed in the virtue of home ownership. But the facts simply don’t support the conspiracy theory, no matter how good it might feel to blame poor people for all of our woes.

If the CRA were the main cause of this crisis, we would have a bad, but manageable, collapse of one sector of the economy. An important and big one, yes, but not the entire banking system and everything around it. The real culprit lies with Wall Street’s numerous financial “innovations” over the past decade. We are in crisis not because of some bad loans, but because those bad loans (a) were sliced into so many little pieces that to find them all would be like picking out molecules of poison from a reservoir; and (b) they were leveraged so hard, so far beyond their reasonable limits, that small disruptions would cause enormous calamities.

It is as if an entire skyscraper were built on the foundation of a single matchstick. And the matchstick has burned.

I am waiting for a responsible investigative team to tell us the real story of this meltdown: how Wall Street laundered risk through a combination of opaque derivative products and sweetheart bond ratings to turn lead into gold. The story works quite a bit like disposing of stolen goods: first you need a way to disguise your source, then you need a fence willing to “certify” them as legit. The main difference is that the criminals in this story used fancy mathematics, not slim jims, to execute this massive heist.

Total economic meltdown sure is confusing, isn’t it?

So where to turn for helpful information? Well, the sense I’m getting is: while many experts know and agree on what’s happening (collapse of mortgages and mortgage-backed derivatives, collapse of other lines of credit, credit crunch across the board), we are in uncharted territory as far as what happens next and the consequences for our national and global economies. Here are some links to articles that might be helpful based on looking around quite a bit:

• Post today by Dean Baker in TPM : “The main cause of the economy’s weakness is not insolvent banks and lack of credit; it’s the loss of $4 trillion to $5 trillion in housing equity as a result of the bubble’s partial deflation. Families used their equity to support their consumption in the years from 2002 to 2007, as the savings rate fell to almost zero. With much of this equity now eliminated by the collapse of the bubble, many families can no longer sustain their levels of consumption. The main reason that banks won’t lend to these families is that they no longer have home equity to serve as collateral. It wouldn’t matter how much money the banks had, they are not going to make mortgage loans to people who have no equity.”
• Paul Krugman — particularly Crisis Endgame (”This flight to safety has cut off credit to many businesses, including major players in the financial industry — and that, in turn, is setting us up for more big failures and further panic. It’s also depressing business spending, a bad thing as signs gather that the economic slump is deepening.”).
• Pretty serious macroeconomic analysis from Brad DeLong, concluding, “there is now no time for tolerance of the three objections to this analysis and this plan of action, roughly: (1) it’s immoral, (2) it’s unfair, and (3) it can’t work in the long run.”
• RGE Monitor — Financial intelligence company with limited free membership during this crisis. My friend Jarrett highly recommends Nouriel Roubini’s Global EconoMonitor, e.g.
• The Worst Financial Crisis Since the Great Depression — caution — reading this will be like jumping into icewater
• Harsh assessment of the original Paulson/Bernanke Bailout plan

There’s much more out there, but my own conclusions, in trying to keep things simple in my own head, are that (a) we have been in a bubble since the close of the Clinton years; (b) Greenspan refused to pop the bubble, instead superinflating it; (c) exotic new financial products multiplied the force of the bubble many times greater than normal; (d) the final popping of the bubble will have real and psychological effects that will crash the economy to below where it “really” is right now.

There’s nothing that policy and leadership can do, now, about (a)-(c). We can only hope that wise leadership will steer us away from (d) if at all possible…

A few days ago I discussed how Treasury Secretary Paulson came to the negotiation with an extreme, highly “anchored” opening move, and how negotiations research shows that anchoring works. Why, then, don’t we always use absurd opening moves when engaging in a negotiation over used cars or other purchases? The answer is that the party making the offer can lose credibility with or respect of the other party, and the chances of reaching an agreement can go down. That’s precisely what happened when the House rejected Paulson’s plan — even as modified — on Sunday.

By including unacceptable terms — most notably, non-reviewability — Paulson et.al. were perceived as overreaching. Even though the Administration quickly gave up those terms, the mistrust was already sown, especially because the proposal echoed the earlier “trust me” terms of the Iraq war authorization.

Maintaining a strong working relationship with the other party in a negotiation is critical to successful outcomes for both parties. In this case, by playing chicken with Congress, the Administration may have precipitated the worst outcome for both sides: failure to reach an agreement. Let’s hope our economy can survive the results.

The Obama campaign has a unique opportunity to show us what leadership in his Internet-savvy administration might look like. Americans are panicking now over the crisis on Wall Street, panicking but completely at a loss as to what we should do. This is Obama’s chance to show us real leadership through running a serious of Web spots and TV ads that:

• Explain, in simple English, what is happening on Wall Street, and how that affects Main Street;
• Use graphics and Ross Perot charts to illustrate rather than use words;
• Outline the options, and the pluses and minuses of each one in as non-partisan way as possible;
• Do it in the calm, serene, and non-partisan manner in which Obama excels — and which the citizenry really need right now.

This would:

• Assert high-minded leadership at a time when everyone else is embroiled in politics;
• Demonstrate Obama’s belief that we are mature and intelligent;
• Spread like wildfire — because we are all desperate for answers, and no one — including the MSM — is giving us any.

Obama has run a spectacular, Internet-infused grassroots campaign for the Presidency. I’m ready to see how that translates into leadership and governance.

This week’s Economist describes a difficult negotiation underway in Washington:

An impaired mortgage security might yield 65 cents on the dollar if held to maturity. But because the market is so illiquid and suspicion about mortgage values so high, it might fetch just 35 cents in the market today. Recapitalising banks would mean paying as close to 65 cents as possible. Those that valued them at less on their books could mark them up, boosting their capital. On the other hand, minimising taxpayer losses would dictate that the government seek to pay only 35 cents. But this would provide little benefit to the selling banks, and those that carried them at higher values on their books could see their capital further impaired.

If we want DC to drive a hard bargain and get taxpayers maximum value, we want them to lowball for $.35. But that would be self-defeating, as the economy would likely seize up. If we go for the $.65, we might be overpaying for them, rewarding Wall Street for its greedy stupidity at taxpayer expense.

There’s a spectrum here between what is “fair” and what will “work” — and what’s worse, we can’t know if/when we cross either threshold. It’s possible, as The Economist suggests, that $.65 will NOT work — AND yet still be perceived as unfair.

The thing that’s impossible for most American taxpayers to swallow with corporate welfare is exactly the same as for individual welfare: you (the taxpayer) will personally pay a certain amount of money for an uncertain and socially distributed benefit. It’s hard enough to convince Americans that we are our brother’s keeper when it comes to getting homeless people we can actually see off the streets with programs that we can understand (if not agree with). The bailout wants us to enact that same value with people who aren’t that sympathetic using mechanisms that even most economists are having a hard time articulating.

I spent five years working with poverty law advocates and analysts, and it is with those eyes that I’m viewing the proposed $700B bailout of Wall Street. There’s an obvious point to be made here that maybe finally the bootstrappin’ free-marketers finally might develop some empathy for the deadbeat moms and learn that everyone is vulnerable and occasionally needs a helping hand.

But I also take note of liberal demands that banks and their executives should not profit from taxpayer largesse. This is understandable and morally defensible. But there’s a funny parallel between their claims and the argument that’s been advanced by conservatives for the myriad punitive clauses in welfare — dozens of rules to prevent benefit recipients from “defrauding” the American public. Advocates for the poor have rightly pointed out that these clauses provide negative incentives for people to work, and sometimes so rigidly curtail allowed activities that people can’t find their way out of poverty. As a pragmatic, not a moral, matter, I wonder if the same analysis applies to efforts to cap the banking industry’s forward-looking profits.

Seems to me like the argument being advanced for expensive corporate welfare opens up some new possible discussions around the much cheaper and more down-to-earth family welfare programs. Maybe both sides of that debate can have a little more empathy for each others’ positions now that the tables have turned somewhat.

We keep hearing from our leaders that “Institution X is too important to fail.” And I’m not in a great position to second-guess just how important companies like Freddie Mac, Frannie Mae, and AIG are, and whether their demise would lead to worldwide depression or not. But what I do now know is that when things are “too important to fail,” free-market capitalists suddenly become proponents of socialism and government handouts.

We will live in a just society when we begin to see ordinary people as “too important to fail.”

Marxism may be dead, but lefty activists still seem to itch for some good old-fashioned class warfare. With rising inequality in America (see this New York Times article from 2006), it’s easy to understand why. But Marxist cynicism is, I think, exactly the wrong way to look at inequality.

We often assume that people vote with their wallets: whoever can can line my pocket gets my vote. But a funny thing is happening in America: the rich are increasingly voting Democratic, the party of progressive taxation. That is to say, wealthy Americans are increasingly voting against their own financial interests.

Fretting about the future of the Republican party in the face of vast American equality in the New York Times Magazine, David Frum casually mentions that the more unequal a place is, the more Democratic it tends to vote; the more equal, the more Republican. He dallies around with many possible reasons for this — an extreme Republican social agenda, disdain for good governance — but ignores the possibility that equality is, itself, might be core value that people — even Americans — cherish.

It seems there are better (and less expensive) ways for rich people to buy off their guilt than support progressive taxation. So I’m left to conclude that, once a person’s financial needs are more than comfortably taken care of, s/he turns to less tangible interests like self-fulfillment. (This is something advertisers have understood quite well with luxury brands). And it heartens me to find that people really do care about each other’s welfare. At least, when they can see each other.

So it strikes me that we care about closing the wealth and income gap in America, class warfare is not the way to go. We care about our fellow Americans — but only, it appears, when we can see them. If we want to close the income gap, we ought to look into closing the empathy gap between the rich and the poor.