The last two weeks in finance have certainly been interesting, not just for the spectacle of market volatility and the federal reserve blundering but also for the stream of ill-informed drivel appearing on the pages of the press and broadcast media. At this rate I may have to revise my forecasts for the year.
What is currently billed as a credit or liquidity crisis is nothing of the sort, if it was then the federal reserve’s liquidity injections would be having some effect and they are not. This is a confidence crisis in the whole American banking system following decades of deregulation, lax regulation when applicable and corruption colluded between government and business.
The origins of the present sub prime crisis can be found in the Nixon Administration when with his appointment to the SEC, Mitchell, removed the prohibitions to trades in futures and similar “bets” that has made the American markets so unstable. A number of academics including Fisher Black, created a series of formulas by which traders could manipulate the markets to realise huge profits. The result of these moves would inevitably lead to our crisis by creating the impression that risk could be eliminated.
The current crisis on trading floors of the major markets and the hedge fund offices and banks might lead one to think that no one has had any idea that such a crisis might unfold. However, lessons from the Crash of 1907 and that of 1929 led to changes in the laws governing finance during the 1930s under FDR.
Many feel that the government should step in and correct the problem by making the taxpayers pay for the imprudent acts of some, while noting that we have learned that financial institutions were too lenient with credit. Others have traced the evolution of the crisis and shown that post-Depression (1929) laws regulating credit producing entities were removed in the last 30 years making way for the sub prime collapse. This is the correct lesson to learn. As Donald MacKenzie and Yuval Millo have shown in their 2003 article, “Constructing a Market, Performing a Theory,” J. of Sociology, the legal barriers to the trading in derivatives were removed by political interference with the post-Depression experience with speculation. This grew out of the peculiar social environment of the Chicago markets in the 1960s and 70s and the way traders rediscovered option theory, taking advantage of volatility skew.
The Chicago Board of Trade hired former Presidential aide H.H. Wilson to become its president in 1967. Wilson hired Joseph W. Sullivan, a Wall Street Journal political correspondent as his assistant. Together they began to explore the feasibility of trading in futures on commodities of a variety of products with the involvement of a trader named Leo Melamed. This led to discussions to revive trade in financial futures that had fallen into disrepute during the first half of the 20th century. Gillian Tett in an article in the Financial Times (27/08/07) noted that market collapses have been associated with innovations that seem to have changed the rules. However, as in 1907 and 1929 our present dilemma is not due to a new innovation but an old one packaged as new. Stock options and futures were, as MacKenzie and Millo note “integral to 19th century exchanges.” The 1929 crash put such activities and speculation in derivative instruments under the category of wagers and gambling. They note that as late as the 1960s the SEC “remained deeply suspicious of derivatives… A futures contract was legal, the Supreme Court ruled in 1905, if it could be settled by physical delivery of a commodity such as grain. If it could be settled only in cash, it was an illegal wager.”
Sullivan and his associates went to work on the political framework to undermine this institutional memory of disaster and the legal restrictions that reinforced it. SEC Chair Manuel Cohen refused to listen comparing options to “marijuana and thalidomide.” But by using university economists like Burton Malkiel and Richard Quandt, Sullivan was able to create the argument that there was a mathematical and rational basis for options to make the market more efficient. With help from William Baumol, Malkiel and Quandt, and with the resources of Robert R. Nathan Associates, they produced a campaign purporting to show that an options exchange was in the public interest. In 1971 Richard Nixon appointed tax lawyer William Casey as chair to the SEC and the result was an end to the prohibition of a market in options and futures derivatives. In the 1980s Fisher Black and Merton, two professors of economics, developed formulas to streamline this process in the modern context and a number of firms like J.P. Morgan invented financial devices in the 1990s to sell debt associated with securitized mortgages based on their ideas. These began the current explosion in liquidity, the devices were called derivatives and we know them from a number of letters, like LCDS (Loan credit default swaps), CDS of CDOs (credit default swaps of collateralized debt obligations), CFDs (contracts of difference) and basically they are means of placing bets on movements in the markets. The way was open to the floodgates of speculation.
What we need is a longer institutional memory and to reinstitute the laws prohibiting speculation and to separate banking, insurance and brokerage functions as we learned was necessary after 1929.
We presently live in a globalized financial economy where if there are problems they affect everyone. A lack of diversity in any system makes it susceptible to any stress throughout the entire system. There is little resilience in a flat world. The Chinese and the Japanese are constantly under pressure to become more enveloped in this system. At present the Japanese are less affected that other economies, but the Anglo-Americans the most. The idea of such an economic unity has been favoured by a number of economic theories, but in historical comparison it looks little different from the binding of ones subjects by kings or as happened in the late Romanic Republic it takes on the character of tribute to a hegemonic centre, like Italy after the Civil Wars where little was produced and its people had to be increasingly supported by imports. In likewise fashion Americans have been on a spending spree for nearly 20 years with little or no saving.
The amounts involved in this current financial bailout is frightening, but minor in effect in the financial markets, as described in Krishna Guha’s article in the Financial Times (18/12/07). What is disturbing is the transfer of the risk created in the past 5 years via SIVs, derivatives, etc. from private financial institutions to the Federal Home Loan Bank system. Guha reports that “roughly three-quarters of a trillion dollars a year” has been assumed. Essentially while we were all watching the Fed lower interest rates and create cooperative agreements to shore up the financial system, the “shadow banking system” that created the current sub prime balloon and the derivative industry has been shunting off the risk to the public purse. In our present case, the FHLB may eat all the sins of the banking industry but we cannot expect the process to take place without catastrophic effects on the dollar. The only winners will be the financial wizards who have had sufficient connections to be able to regurgitate their risk on the taxpayer. It is also interesting that Japanese companies, like Nomura’s recent interest in Collins Stewart, the British investment bank, are making purchases abroad. We may be seeing Japan coming out of the collapse of credit and a property bubble, while America is heading into one.
While we have been fixed on the spread of the collapse of liquidity and credit, the answers to fix the problem have been old school those based in past theories of governmental intervention when markets fail. As Schumpeter argues in his analysis of Business Cycles (1939), these he noted are related to changing tempo in investments needed for the periodic renewal of productive forces. However, he also saw that discovery of new resources or invention and innovations could affect this tempo. Financial devices of the past two decades have been described in academic circles to have been productive innovations , but this is debatable, instead of productive innovations they seem to have been in the class of wealth transfer devices. When looked at in this light, it appears as if there has been little productive innovation since the advances of biotechnology and internet expansion in the 1990s. There have been none in energy, certainly bio fuels and ethanol have been shown to be poor advancements in existing technology and raise the cost of food. The main overall change in technology investment in the past 8 years has been in security and military spending and this has produced little in new technology and general applications. If there is a recession it is due to low real investment in the developed countries coupled with low saving and too much spending on luxury and prestige goods in the Anglo-American sector and this includes a large segment of spending in the housing area on renovations and overbuilding of large energy dependent housing units.
Update :
If that was a bit hard for you to digest (via Bearwatch), try this :
The Credit Crisis, Illustrated - The Adventures of Accordian Guy in the 21st Century
