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Friday, May 28, 2010

Transcript 387: Black holes in financial regulation — too big to fail, derivatives

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Today on the podcast,

What did financial regulation not do? Forecast Friday with Nouriel Roubini. A Look at markets. And the recurring Demand Side solution with some help from Irving Fisher.

On recent regulation

Many, particularly some in the Obama administration, have applauded the provisions of the new financial sector regulation passed by the Senate last week. No doubt positive is the financial product safety commission, whatever its title and location, that threatens to return some structure and order to financial products shopped to consumers. But there are a couple of holes, black holes, that mean as a remedy for future crisis, this legislation does not have the strength attributed to it.


That was Maria Cantwell, Senator of Washington State, speaking on the Senate Floor. Cantwell and Russ Feingold were the two Democrats to vote No on the Senate bill. Here is Nouriel Roubini, talking about the other essential that was missed. Too big to fail.


Nouriel Roubini

Indeed, getting a grip on the derivatives, breaking up the big banks, and shaking some sense into the economics profession might give us a chance against the upcoming crises. Sadly, that was not done in response to the current downturn. Maybe the next one will be big enough.

Elsewhere in this London Telegraph interview, Roubini was adamant that the great recession is not over. But a temporary economic pick-up, which would convince governments that reform is unnecessary, could bring its own problems.

Which is a good segue into the Forecast portion of Friday's podcast

Two things we noted from a recent ECRI chart: One: the recession shading has mysteriously swept past June 31, 2009, the shading we remember from the last ECRI chart we saw, and into the present. This is a period that includes the Anapurna of spikes of ECRI leading indicators into positive territory. And two: we remember sidling over to the great flock of economists on the NO RECESSION side of the boat in January 2008 to see what they were smoking. They were looking at the ECRI leading indicators which were still in positive territory at the outset of 2008. Edward Harrison of Credit Writedowns responded to our raising this point by saying you have to look at the second derivatives. Maybe. But Lakshman Achuthan of ECRI was talking about the possible recession ahead in January 2008, three months after its onset.

The recession shading is correct, in any event.

Read more: http://www.creditwritedowns.com/2010/05/ecri-leading-economic-index-at-42-week-low-recovery-is-already-fading.html#ixzz0oyHmnaCK

As to the timing of the second dip, David Rosenberg put out another list of ten, pointing out that ECRI's leading index has peaked, as have the Conference Board's leading economic indicators (in March), the ISM orders to inventory ratio (in August 2009), the University of Michigan's consumer expectations (In September 2009), the U of M's index of big ticket consumer purchases (in February-March), Single family building permits (in March), Mortgage purchase applications (April 30 and now down to a 13-year low even though mortgage rates have come down), Auto production (in January) and electrical utility output was down 0.1% YOY as of May 15.

In the week ending May 22, the advance figure for seasonally adjusted initial claims was 460,000, a decrease of 14,000 from the previous week's revised figure. The 4-week moving average was 456,500, an increase of 2,250 from the previous week's revised average.

The current level of 460,000 (and 4-week average of 456,500) is still high, and suggests ongoing weakness in the labor market. The 4-week average has been moving sideways for almost five months. This in the context of the strongest quarter to be expected from the stimulus bill, as gauged by the nonpartisan CBO

The Markets: As we record this, the Dow is back above ten thousand and oil is continuing to rebound, from a low last week of below 69 to now above 74.

But here from a Marketwatch podcast, we find someone on Wall Street has been reading George Soros.


That's Jim Paulson. Who has a positive spin in the remainder of his comments which we excise for our purposes here. Indeed, financial markets have been operating in a virtual environment for a long time now. Their punching and kicking is hurting real people out here. Hard to know what they're seeing behind the headsets.

Now finally, and more briefly than we had planned, the two steps to economic recovery, assisted by Irving Fisher


"Debt deflation" is the brainchild of Irving Fisher, who -- writing in the 1930s -- sounds a lot more coherent than most economists today. One might think it is an odd name, since it is not debt that deflates, but asset prices. The term should have a hyphen. It's two primary explanatory events for depressions are, first, an outsized level of debt, which is then followed by deflation and the deflationary spiral.

Perhaps it is worth quoting Fisher for a moment.

... These two economic maladies, the debt disease and the price-level disease (or dollar disease), are, in the great booms and depressions, more important causes than all others put together.

Some of the other and usually minor factors often derive some importance when combined with one or both of the two dominant factors. Thus over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money. That is, over-indebtedness may lend importance to over-investment or to over-speculation.

The same is true as to over-confidence. I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt.


Disturbances in these two factors -- debt and the purchasing power of the monetary unit -- will set up serious disturbances in all, or nearly all, other economic variables. On the other hand, if debt and deflation are absent, other disturbances are powerless to bring on crises comparable in severity to those of 1837, 1873, or 1929-33."

It is investment in productive assets that generate cash flow in the private sector which can be tapped to cover debt service. Thus if these are safe, hedge financial structures. Such structures cannot contribute directly to the liquidation, further deflation and bankruptcy spiral that leads down, since there is no need to sell an asset whose debt service is accounted for. Selling assets to cover debt payments is needed only in Ponzi and speculative situations, recognizing that deflation may turn previously safe hedge positions into speculative positions by reducing the cash flows.

This was all spelled out in Fisher and in the work of Hyman Minsky. Note, however, that the ability of the public sector to invest was as foreign to Minsky as to most economics. It is our contention at Demand Side that the government investments can accrue benefits to the public sector that can be tapped to cover the debt service. Avoiding the worst events of global warming, for example, is a positive economic and financial benefit that needs only honest accounting to be available to capture for debt service.

One feature of successful recoveries from recession in the postwar period is inflation. The Fed has typically eased monetary policy, and the authorities have traditionally backstopped and bailed out financial innovation creating easy money for investors, which has created inflation.

(That, we would argue, and the actual investment.) This inflation has effectively reduced the debt burden by reducing the real value of the debt.

As Minsky points out, nominal values matter. Debt is a contract typically described in nominal dollars. If the price level goes up and the contracted debt price remains the same, the debt is easier to service. It is messy and people do get hurt in inflations, but the economy recovers.

In a condition of debt deflation, or balance sheet recession, when inflation cannot be ignited even with every dollar the Fed can print because people won't or can't borrow it for legitimate investment, debt must be written down as asset prices deflate.

It is the Demand Side view that absent an inflation response to central bank efforts, mechanisms to write down the debt contract can abort debt deflation in the context of investment by the public sector. Thus in the 1930's the Home Owners Loan Corporation facilitated direct negotiations between mortgage holders and lenders to do just that, write down the nominal value of the loan. Debt restructuring by firms or governments is sometimes called "default," because the original contract is abrogated. But it is nothing more than this negotiation between borrower and lender to put the contract into the context of the value of the assets in question.

Writing down the debt repairs the balance sheet in a straightforward way, not by siphoning off cash flow for a decade or more as in the case of Japan. If these returns to capitalists are given a haircut, there is no reason not to do the same with the profits side. In this way, balance is maintained and Kalecki's and Minsky's famous equation deficits plus investment equal profits is maintained without reducing the investment. Reduce profits -- by which Minsky meant more than just the top line return to owners and managers -- and you reduce deficits. This is not a moral argument to tax the rich, but a logical program to support government investment without damaging the economy, recognizing the deflation of asset values in a constructive way.

We are looking at total debt levels to GDP massively exceeding those of any other period in modern history, counting both private and public debt. We are not going to plug all the holes in the dike. Even if we do, the wall of water will only get bigger. A methodical and fair restructuring strategy will cause the financial sector to hyperventillate, but if they knew what was good for them, they would throw in with the rest of us. As it is, they have redefined risk as the bill you send to the government.

Here is worth remembering Fisher again, who offered the example of a stick, which may bend under strain, ready all the time to bend back, until a certain point is reached, when it breaks. Quoting "This simile probably applies when a debtor gets 'broke,' or when the breaking of many debtors constitutes a 'crash,' after which there is no coming back to the original equilibrium." Fisher offers another simile, quoting "such a disaster is somewhat like the 'capsizing' of a ship, which under ordinary conditions, is always near stable equilibrium, but which, after being tipped beyond a certain angle, has no longer this tendency to return to equilibrium, but instead a tendency to depart further from it."

Where are we now?

1 comment:

  1. What surprises me is that all the banks used risk analysis to determine their loan limits, who got them, what type segment they supported, and used it to justify even higher leverage, and they are all now in appalling shape. Most banks are bordering on insolvent.

    In my mind it raises serious doubts about the Basel II Accord. If banks are unable to determine the risks for their own clients and balance sheet why use such a model?

    Maybe a far simpler model of debt ratios which ignore risk would actually be better, as they clearly cannot manage risk even with all the funding and access to the brightest minds around that they had.