Politics and Economics

It's time to recognize an inconvenient truth--circumstances beyond our control have put the politics back into political economics. Yep, that's right. The playground has been invaded. And the invaders won't necessarily be all that impressed or swayed by technocratic arguments. The systemic risk will go up, and the breakage will be, well, non-trivial. Blame for the breakage, incidentally, will fall erratically on those who caused it, those who suffered, those who tried to prevent it and the completely uninvolved.

Timely indicator #1--This morning Bloomberg's website (of the organization, not the mayor)carried the following headline, "Profit Not Satanic, Barclays Says, after Goldman invokes Jesus". Now, there is a mindset. I suppose next we'll have evangelical pastors of megachurchs trumpeting the profitability of their organizations?

Timely indicator #2--McKinsey distributed a piece to its readership entitled, "Sociopolitical Issues in Hard Time . . . ", which is elegant corporate speak for 'the usual payoffs to politicians aren't working and we need to try something else'. The usual operating assumption of successful private sector executives is that regulatory/legal/public policy issues can be resolved through litigation, negotiation, lobbying, political contributions, and, if all else fails, compliance. That version of reality is, er, no longer operative.

It has taken over a year, but the political class in the United States is awakening slowly to a couple of facts:
1. A year ago the financial system failed. It has been on government support ever since.
2. The public is slowly, lost job by lost job, home appraisal by home appraisal, realizing that something is seriously wrong in its collective pocketbook.
3. The people running the financial institutions cannot be trusted to play the new game--they have used the respite to default back to their old reality.
4. A previously oblivious and indifferent swath of the public is in the process of a volatile and potentially disruptive political awakening.
5. Something's up.

Note that one rhymes with three and two rhymes with four, and five is the conclusion.

It's not clear whether the Republicans or the Democrats will grab onto this issue. The Republicans do the politics of bitterness and resentment better than the Democrats (regardless of who is in power). But the issue plays better into the Democratic world view (the Republicans are such toadying wealth worshippers on economic issues). And, while the Republicans enjoy the advantages of indiscipline and experimentation, they currently are squandering it by putting their kooky right on display (it will take a while for the new governors of Virginia and New Jersey to offset the antics of Sarah "the Maverick" Palin and Rick "Tea Party" Perry). Play to the faithful, play on, but remember, the rest of the world is looking on. The Democrats are busily rolling in the hay with the Wall Street Tar Baby, but tar can be washed off, and all the White House to do to shift gears is accept a couple of resignations (Geithner and Summers), install Volker in a postion of authority, and use the presidential pulpit to light into Wall Street (malefactors of great wealth, and so on, I believe there are some scripts in the vault).

Obama is a careerist, but he turned his back on Wall Street once before (after being president of The Harvard Law Review and clerking on the Supreme Court), and he could do so again.

Puzzles, Mysteries and the Rise of the Blogosphere

Some old fart who retired from the CIA years ago used to claim that there were two kinds of intelligence problems--the puzzles, which could be solved with additional pieces of information, and the mysteries, which required analysis, and, in the end, a judgement call. Puzzles tended to be quantifiable (both as formulated and as answered) while mysteries tended to be more subjective and dependent on analytical work (again, both as posed and in terms of response). The late-20th century mandarins of Pax Americana were, on the whole, happier with puzzles than with mysteries (at least as they surveyed the external world).

Certainly, today, the pride of the mainstream media lies in its ability to provide coverage and hard information. Some of this coverage may verge on the ridiculous (Anderson Cooper on the tip of the spear facing the Taliban, Anderson Cooper on the seawall facing the storm surge). Some of the coverage is historically heroic (printing the Pentagon Papers). But when the defenders of the existing media, with its far flung network of bureaus and stringers, its travel budgets and longstanding sources, make the argue that navel-gazing bloggers can't hope to meet the need for reporting, for hard information, they are focusing on the puzzles, not the mysteries.

What the bloggers do well--frequently better than the traditional media--is address the mysteries. And right now, and for the foreseeable future, the ability to decipher the mysteries is more useful than the capacity to unearth more pieces of the puzzle. The isn't always the case. But right now, particularly in the financial sphere, it is. Given that most financial news consists of rewritten press releases, conference calls posted on the internet, and statistical series with highly choreographed release rituals (admittedly designed more to insure the integrity of the financial markets and level the playing field than to insure maximum publicity), the opportunity for SCOOP are pretty small.

So, floreat Blogonia!

Just charge down Majuba Hill and don't worry to much about the point of the spear.

Repricing Risk vs. Reappraising Risk

Eighteen months ago no one would have argued that a triple A rated CMO was a riskier investment than Brazilian or Indonesian corporate debt. Eighteen months ago, no one would have claimed that the equity securities of Lehman, Citibank or AIG were riskier than those of Banco Itau or China Life. It was established to the point of truism, well grounded in any review of recent financial history, that, independent of the returns required to compensate for risk premia, that the relative riskiness of various kinds of investment were well quantified and the relationships presented opportunities for arbitrage and relative return strategy that could be safely based on the immutable and unchanging relationships between the various investment alternatives.

At the same time--eighteen months ago--a great deal of ongoing handwringing was in progress about the extremely low levels, on a historical basis, of risk premia generally. Spreads to risk free returns were at historically compressed levels. Barrels on ink were spilled on paper, and electrons beyond count sent zipping through the blogosphere, on the subject. Since then, a similar amount of descriptive time and effort has been spent on the mispricing of risk, in light of the untoward subsequent developments.

Risk can be priced, or mispriced. Risk can be mispriced in insurance markets, even assuming competent underwriting. Risk can be mispriced in financial markets, when for regulatory or other reasons the attractiveness or ugliness of an asset distorts the buy side or the sell side. But in all circumstances, the pricing of risk needs to be distinguished for the appraising of risk, even though realistically misappraised risk will almost always also be mispriced.

I suspect emerging markets debt and equity have been misappraised (at least on a relative basis) as well as mispriced for the last decade or so--since the Russian and Asian debt crises late in the last century. Even assuming that all financial assets have been overvalued during most of that timeframe (i.e., until late 2008 risk premia had declined only to reprice violently at that time), as an asset class, the riskiness of emerging markets securities was also mis-appraised. And, I suspect, as far as emerging markets securities were concerned, the errors were offsetting rather than reinforcing. Because of losses in the relatively recent past, the riskiness of emerging markets assets was overestimated. Because the tendency of market participants to drink the current koolaid, the riskiness of highly-rated structured products created by the rocket scientists was significantly underestimated. The end result--seriously skewed relative valuations.

What does this mean for the future? It suggests that near term, the prospects for structured product are bleak indeed, since history suggests markets are none too kind the detrius found in the vicinity of ground zero of the latest serious embarassment. It'll be a long time before the yield hogs can be slopped with structured product.

I don't think, near term, that the prospects are high for a blissful trip on the rocket ship are in order for the emerging markets. Short term, there will be a great deal of pitching and yawing as the reappraisal of the riskiness of those securities proceeds. But, in the longer term, if those economies perform as anticipated, and those issuers generate the growth to be expected in tandem with that performance, there is likely to be a postive outcome to that reappraisal. And that, in term, will result in a repricing of those securities.

And that repricing will occur without regard to the prevailing levels of risk premia. If risk premia remain elevated and the price levels of financial assets are generally impaired, the securities of emerging markets issues will record subdued performance (though perhaps relatively less weak as compared to alternative investments). If risk premia stablize, the performance of the emerging markets may be less subdued, and the potential for a bubble may be realized.

Coordinated Policies or Vigilante Justice?

The former present of Sinopec is sitting in a Chinese prison under a suspended sentence of death for having taken $30-million in improper payments. The founders of Satayam Computer Services, their accountants and various others are stewing in an Indian jail, while their individual responsibilities for the fraud dubbed 'India's Enron' earlier this year are sorted out. Both Sinopec and Satayam (now Mahindra Satayam) survived the malfeasance, continue to employ thousands of staff, and remain participants in their respective national economies. Even their stockholders survived.

Meanwhile, if you look at the aftermath of the carnage caused on Wall Street or the City of London by the practitioners of global finance, you find utterly no parallel success in holding the most senior executives of the institutions that failed personally accountable. A couple of hedge fund managers at Bear Stearns are on the scorecard, and that's about it. When you consider the arguments being made several years ago that superior corporate governance and a more sophisticated regulatory regime were competitive advantages of U.S. and Western finance, and a 'public good' to be exported to less advanced countries, you can reasonably ask yourself why anybody would want to import a system so demonstrably ineffective? All it yielded was behaviors sufficiently marginal and arguably non-criminal that they could not be effectively condemned and punished.

There is one American practice that has been pioneered for the last generation that the rest of the world might want to consider adopting. The United States government has aggressively pursued extraterritorial activities with conseqences within the United States which violated U.S. law. Leaving aside the issue of pursuing terrorists abroad (more a matter of national defense than enforcement of domestic laws), the least controversial of these initiatives has been in combatting drug trafficking. The United States government has, with considerable success, pursued various Columbian drug lords for their activities outside the United States that had inevitable consequences inside the United States.

Various agencies of the United States government have been willing to pursue overseas activities that led to domestic consequences in connection with other, less clearly criminal activities. The trials and tribulations of UBS in connection with facilitating tax fraud and evasion are currently in the media. A few years ago, there was some controversy over rendition of several British bankers who had defrauded their (British) employer, in connection with the Enron affair. From time to time, the Department of Justice has pursued foreign cartels fixing prices who met (outside the U.S.) to set prices within the country. In each situation, there must be a jurisdictional nexus with the United States, but it can be pretty attenuated.

What does all this imply?

Well, there is a choice. The G-20 can announce its intention of pursing lowest common denominator coordinated action to regulate financial institutions and cap banker pay. Or individual countries can leave Pittsburgh and take advantage of the announced common intention and each pursue its own more or less aggressive approach dealing with the issues. The opportunity to follow the American lead and assert extraterrorial jurisdiction is there.

Then the prudent banker would be well advised to comply with the most restrictive regulation arguably applicable to his activities. Might throw a bit of cold water on the animal spirits.

Rx Healthcare

I'm not sure what the argument is about.

The United States already has an effective, working system of universal healthcare. It's called Medicare.

It covers substantially all the population, without regard to ability to pay, pre-existing conditions, or anything of the sort. All a person has to do is meet the age-based enrollment requirement. I'm not sure what the policy justification is for the extremely high minimum age requirement, but we have age requirements related to voting, the consumption of alcohol and tobacco, driving an automobile, and so on, so I don't have any problem in the abstract with an age requirement.

If the opponents of universal medical coverage had any political courage or intellectual integrity, they would be working hard to repeal Medicare and get the government the hell out of the health insurance business. If the supporters of universal medical care were clever, they would be working hard to repeal (or at least lower) that minimum age requirement.

But, no, we are all knotted up in our underwear not quite sure what to do with an incoherent health care delivery system that perversely expects private for-profit entities operating in a free market to ration medical care in an efficient, fair and politically acceptable way. Wrong tools for the job, fellas.

Ruthless Default

Now let us praise Ruthless Defaults.

In the lexicon of financial institutions that extend consumer credit, a 'ruthless default' is a decision of a consumer borrower to discontinue servicing his or her debt obligations even though current cash flow (or unused borrowing capacity) would allow that borrower to do so. Rather than being recognized as a prudent financial decision in some circumstances, it is subject to mockery and denigration on a blanket basis. The mockery tends to focus on the past bad financial decisions the borrower made to get into the current financial bind (such as overpaying for a house or incurring uninsured medical expenses). The denigration tends to focus on the sanctity of contract, which is an escalation in to the moral sphere of earlier warnings about damaging one's credit rating.

Leaving the mockery and denigration aside, as I understand the concept, a ruthless default occurs when a person assesses their current financial situation and makes a 'zero based' decision on how to go forward. The priority given to staying current on the mortgage, the credit card debt and car payment, versus buying groceries, continuing the 401(k) contribution and keeping the utilities turned on, is matter of personal decision. The borrower disregards how he or she came to be in the present situation, and prioritizes and makes decisions on the basis of what makes the most sense going forward.

To the chagrin of commercial lenders, consumers stupid enough to have succumb to all sorts of insane credit blandishments in a prior incarnation, are turning out to be intelligent enough to realize that it's more important to keep the lights turned on than to protect the vanished equity in a house that they will eventually lose to a short sale or a foreclosure. And retirement plan balances frequently have greater protection in a personal bankruptcy than the personal goods bought on credit.

So, call it ruthless, call it self-interested, default is apparently beginning to occur with sufficient frequency that it's gotten the attention of industry and of the main stream media. It's not clear whether it will become so widespread as to impact general public attitudes towards indebtedness, but is becoming clear that earlier industry and rating agncy assumptions about the behavior of consumers in financial distress are no longer operative.

There should be no surprise in this. People are going to put protecting themselves before protecting the people who have lent them money. What is a little surprising is the reasonable conclusions people are reaching about how best to protect themselves. At a minimum, people have lost faith in the proposition that house prices only go up, and that your house is the best investment you'll ever make. Beyond that, I'm getting the sense that the weird belief that a good credit rating, or credit score, was some kind of financial 'asset' is beginning to fray, though I'm not ready to announce a return to a 'pay as you go' mentality.

One interesting thing about ruthless default is that it is an alternative to entering the chute of credit counselling, debt repayment plans or personal bankruptcy. In each of those officially sanctioned alternatives, the debtor relinquishes autonomy over his or her personal finances in exchange for some form of forbearance and accomodation. By contrast, ruthless default is a zen move. The debtor simply does nothing (more precisely, stops making paymens) and leaves the response up to the creditor.

The mortgage servicer can initiate foreclosure, foreclose and pursue any deficiency. The credit cards can be cancelled. The car can be repossessed. Foreclosure takes months. The cancelled credit card issuer is still stuck as a general unsecured debtor for a bad loan. Only the repo man gets his collateral back promptly and in immediately saleable condition. But in everyone of these situations, the transaction costs and the administrative effort associated with pursing the remedy was simply not factored into the original extension of credit. And the machinery to accomplish the remedy is not in place, at least systemically at the levels of activity required to respond to widespread ruthless default.

Or perhaps I should say 'rational default'?

Animal Spirits

Not yet dead. And that carries with it an immediate and an intermediate implication.

Short term--we'll have a period of incomprehensible but irritating giddiness in the financial markets which will significantly grate on both the general public and the political classes. Ballooning bank profits will highlight the different fates of Main Street and Wall Street while rising unemployment and credit card defaults plague the middle and working classes. But, bankers will get highly publicized base salary increases, equity markets will remain bouyant (despite anemic corporate profits), and the public's suffering and misery will remain oddly invisible.

Intermediate--the adjustment to the 'new normal' will be sour and seriously constrain the ability of policymakers and the regulatory apparatus to respond to the next systemic crisis. The refusal of animal spirits to die will undermine any meaningful reform initiatives, which in turn will absolve the political classes of any meaningful commitment to defend or sustain the institutions that survive the current financial crisis. Efforts by those institutions at some point down the line to call of public resources to save their private bacon will not exactly be rebuffed, but will result in an outcome currently unforeseen by anyone and that will be the product of a gesalt that has yet to develop a recognisable identity.

A year ago, under the leadership of President Bush and Secretary Paulson, the financial services sector was politicized. The implicit government guarantee of the leverage of the 19 TARP institutions forever changed the character of those institutions and made them quasi public entities. They continue to be run for private purposes, but that situation cannot last forever.

And won't.

Lehman, Redux

The looming failure of CIT offers the real possibility of a repeat of the Lehman Brothers shock.

The reasons that Lehman Brothers was permitted to fail in a disorderly fashion aren't worth visiting in any detail, mostly because of the storm of post-hoc CYA bullshit that cascades forth from otherwise decent people at the first inquiry into those reasons. Suffice to say that no one adequately appreciated the consequences of the Lehman bankruptcy, and everyone immediately (okay, it took the House two tries) sprang into action when those consequences were understood.

Does the CIT failure have the same potential for systemic risk that Lehman did.

The answer is simple. No, if you are concerned only with the stability of the financial services sector. Within the financial services sector, Lehman was more systemically important.

Unfortunately, if you are concerned with the general economy and not the casino, the answer is also simple. The answer is, Yes. CIT is systemically more important to the flow of credit in the general economy than was Lehman, which was, after all, merely a capital markets player.

CIT provides financing to businesses that operate in the general economy. You can call that financing liquidity, working capital, floor planning, receivables factoring, whatever. It makes no difference how you describe it, the financing provided by CIT and its competitors is critical to the continued operation of a huge swath of the economy.

It is easy from a certain perspective to dismiss this swath as a bunch of Dunkin' Donut franchises. After all, we could all do with a few less donuts, right?

It is more accurate to describe this swath as the Main Street mom-and-pop merchants who have survived the onslaught on the Walmarts and Targets and Costcos. The businesses who are CIT's customers are hardware stores, furniture outlets, franchised tire dealerships, music stores, boat dealerships, etc. Anybody who has to finance inventory or receivables.

And times are tough for these businesses. The consumer has retrenched. Not so many big ticket consumer durables are being bought (the auto industry may be the poster child for this observation, but it extends to clarinets and baby furniture, too). Many, many of these businesses are operating on the forebearance of their lenders, they aren't making the inventory turns the floor planning arrangements contemplate, the receivables are a little hairy. Some of them have waiver letters, others are simply letting it ride. And lenders, like landlords, are working with their good tenant/borrowers.

Only a mandarin safely entrenched from the realities of the marketplace and the credit markets would blithely assume that following the failure of CIT, companies like GE Credit, Litton and Wells Fargo will step into the void and meet the credit needs of former CIT borrowers. Two reasons they won't. First, they are too busy rebuilding their own balance sheets to do much more than give lip service to meeting the broader social needs that provide the only conceivable justification for the special privileges the government has accorded them. Second, the reason CIT is teetering is that its customers are teetering. Those customers aren't very attractive credits. As new business, they are non-starters.

So, this is likely to be a learning experience. While Vikram Pandit wanders across the landscape proclaiming that the future of Citi lies in global adventures, the credit needs of Main Street will be unmet. Small and medium size businesses will fail at an accelerated rate. Unemployment will rise, the economic 'recovery' will stall. In some ways it will be like last Fall's commercial paper adventure, except that the administrative challenge of providing credit to thousands of small to medium sized business will probably prove insurmountable.

Clearly, the economy will not tank on the failure of CIT. From a cool and dispassionate perspective, it almost seems like an experiment worth running. But that perspective may be hard to maintain if bankrupt small businessmen start dousing themselves in gasoline and setting themselves on fire on the Washington Mall.

Get Ready for the Kooky Ideas

Because here they come. A veritable flood. Certain to be dismissed initially. But some, like Sarah Palin, will gain traction.

Right now we (the collective 'we') have framed up our economic, political and social issues with a shared set of assumptions that are themselves becoming a casualty of the current unpleasantness. A mainstream articulation of that framework can be found in the Larry Summers interview in today's Financial Times. From one flank a more offbeat expression is offered by Nouriel Roubini on a very regular basis. On Summer's other flank, (if any still survive) can be found the pollyannish house economists of various organs and organizations promoting real estate purchases and equity investment (current faves, 'this is a stock picker's market', and 'buy and hold is a dead strategy'). Up above, from the academic highground, Krugman lobs his contributions down on us (to his credit, asking rhetorically last week who defines this framework and why there are 'unpersons').

But, the framework exists. And it exists for good reason. Nobody wants to have to listen to the kooks who think there is a pill that can turn water into gasoline, or who believe they've invented a perpetual motion machine (the call for economic salvation through a War on Global Warming comes close to these, IMHO, but it enjoys bizarre credibility that I personally chalk to the need even in a secular society for public demonstrations of faith).

I think the framework may be about to shred, in part because it's losing its objective utility, and in part because the participants are losing their faith in it. On the one hand, it may be possible to salvage the intellectual fabric and construct a workable, if makeshift set of policy responses using the salvage. On the other, it may be time to put the 'political' back into 'political economics'. And if that's the case, the current lineup and the current teams need to be recast.

"Paging Dr. Reich? This is central casting. Governor Palin would like to meet with you. We know you've heard of her, and are probably skeptical, but she's an empty headed vessel just waiting to be filled. You be da guy."

Personally, I've immunized myself (more or less) to all this by spending the last few months reading the Cantos of Ezra Pound. Pound was a guy who gave kooky economic theories the full monty. (Other kooky theories, as well--notably, anti-semiticism). He fell for a guy named Clifford Douglas, who was sort of an unhousebroken Hyman Minsky. Yes, folks, when it's broke it gets a great deal more baroque that H.M.

And EP ended up under indictment for the capital crime of treason, finally going over the edge sitting in a prison cell near that of a fellow named Till (who was one day led from his cell and hanged for 'murder with all the trimmings'). That Till was the father of the Emmet Till who was murdered in a racist incident in the mid-50s that contributed mightily to the emergence of the Civil Rights movement (and whose coffin is currently playing a bit part in a rather lurid bit of graveyard crime in Chicago).

You can immunize yourself however you want to. Just don't go deaf to reason listening to the siren songs of Bristol Bay.

Financial Reform A.D. 600

"Bankers shall not file coins,
nor make false ones
Nor put a slave . . . in charge of their business
. . . .
if they do not notify counterfeits that come in
and from whom
shall be flogged, shaved and exiled
And in this there can have been few innovations"

Pound, The Cantos of Ezra Pound, Canto XCVII (p. 687, New Directions Edition)

That being a rough translation (per Pound) of the Code of Justinian, coming after the rules for the notaries, goldsmiths and bakers and such.

It does tend to put the current rather modest proposals for financial reform in perspective. And the suggestion that there need be few innovations resonates of the observation that the only indisputably beneficial financial innovation of the last generation has been the ATM. But do not despair, ye serfs of finance, at least Justinian's Code did not proscribe branding, blinding or cropping (as in amputating the offending hand) for your transgressions.

The Forty Percent Problem

In 2007, approximately 40% of the earnings of the S&P 500 were attributable to the financial services sector. It is difficult at this point to estimate with any assurance the extent to which those financial services sector earnings were inflated by fraud, aggressive accounting practices, overleverage and a cyclical spike in levels of transactional activity, but all of those factors contributed. And it's difficult to say the extent to which appropriate regulatory reform and consumer protections initiatives will undermine the core earnings power of the predatory franchises on which so much hope for sector recovery in pinned.



If you remove that 40% of the earnings from the price earnings ratio of the S&P 500, and you look at the 40% decline in the price level of the S&P 500 since 2007, one nicely offsets the other. That is food for thought.



There are other factors at work, of course. Earnings in 2007 outside the financial services sector were at a cylical high, and can be expected to deteriorate sharply in a recession (just as recovery from recession-depressed levels to some idealized norm can be expected). No one really knows what the price/earnings ratio of a stock, much less of a market index 'should' be--though much ink has been spilled on the subject.



It's sufficient to say that the market has discounted the collapse of the financial services sector, though the sequence of events through which that occurs has yet to unfold. And the ramifications of that haven't yet been fully felt--nor, perhaps, fully discounted by Mr. Market.



My own guess is that unemployment will continue to rise, the magnitude of commercial real estate problems will be revealed with ghastly consequences for any number of traditional bank lenders, house prices will, in the aggregate, continue to decline until residential real estate has roughly half the value prevailing at the peak in 2006 or so, credit card delinquencies will rise, and so on. And an already crippled financial services sector will founder. Someone along the way, it will lose its place at the table.



It will be interesting to see what the new world looks like. I suspect that the transition issues and difficult adjustments of the formerly middle class, the elderly, upside down homeowners, the structurally unemployed, etc., will dominate the discussion, and strategies for restoring the global edge of the American financial services sector, if any, will have a distinctly archaic ring. My gut feeling is that the developed world is in for a prolonged period of painful adjustment, and deteriorating public sentiment will be fueled by reports of relatively progress in those parts of the developing world that have sufficiently large domestic demand that their economic growth in not dependent on the American consumer. I'm not predicting blood in the streets, or even bread riots. Just an opaque and heavy economically glum environment that sours the social mood, and contrasts with the innocent happiness of the furriner on holiday, using the cheap dollar to rub it in.

Not Quite Ready for Prime Time

Let's get real. There seems to be a great deal of dissatisfaction with and disappointment in the Obama Administration's approach to the reforming the financial services sector and and outlawing the current (admittedly toxic) executive compensation practices. I think the disappointed are confusing cognitive recognition of a problem and identification of potential solutions with the actual process of change.

So why isn't meaningful reform in the cards for the next year or two?

Team Obama did not exactly enter the 2008 presidential race focused on the economy or the financial services sector in particular. As I recall, the global hot button was the Middle East (a/k/a Islamic terrorism, the wars in Iraq and Afghanistan) and the domestic hot button was reforming the health care delivery arrangements. Not much bandwidth was devoted, until around Labor Day, to the general economy, much less Wall Street (except when it came to fundraising).

So, if the first reason expectations should be low at this point in time is simply that financial reform wasn't on the agenda, the second has to do with that second little fact--the fund raising business. The financial services sector has bought and paid for the government and its regulators for at least a generation. It is easy to get angry about this, but it is also pointless to do so. Big campaign contributions and the machinery of retained lobbyists buy access and mindspace, and influence policy and regulation. But there is a limit to their impact. The Marc Rich pardon notwithstanding, it is very difficult to actually buy an outcome. When the result is controversial and the groups opposing it have made their campaign contributions and hired their own lobbyists, the impact of it all is, if not neutralized, at least offset (and can lead to truly bizarre outcomes and terrible policies with unbelievable real world outcomes--viz., the attempted privatization of military services by the like of Blackwater).

Right now, sitting here today, the financial services sector retains its seat at the table and is still regarded as a participant in the process, a patient whose informed consent is required for the procedure. Soon, enough, unless there are magic reversals in the unemployment rate and the direction of commercial and residential real estate prices, the financial services sector will come to be regarded as a corpse to be harvested for useful organs and dissected for the enlightenment of future generations of medical students. Not yet.

Then there is the issue of executive compensation. Given the extent to which Summers, Emmanuel and Geithner's wife have all suckled at the Wall Street teat over the last decade, I think it is impossible for those guys to approach the issue without trepidation. What made Larry Summers worth over five million dollars to Wall Street or Rahm Emmanuel worth over fifteen million? Politicians are not notoriously introspective, but it would be hard not to question yourself under the circumstances, and that is disregarding entirely the public embarassment and political advantage to one's adversaries of the situation, and without even reaching the ethical implications of either betraying a constituency you have allowed to buy you or failing to act in the public interest while in public service.

There are three reasons not to have high expectations. They are all grounded in the realpolitik of expediency. In the short term they are insurmountable. In the intermediate to longer term, they fall away, depending on the course of future developments. But for the time being, expect experimenting with the cosmetics and some serious rearranging of the deck chairs. And don't get mad or excited about it. Just wait patiently.

Flavors of Players

To understand the state of play, you need to know the players. Right now, as the economic crisis unfolds in the United States (and, for that matter, globally), there are three flavors of players (Stateside). They are:

1. The Financial Elite.
2. The Political Class.
3. The Technocrats.

The financial elite, formerly known as the Masters of the Universe, are the varied and assorted hedge fund managers, traders, merchant bankers, etc., etc.--the whole of the seven-figure income and eight-figure net worth (formerly) herd bulls/alpha males of the financial services sector, their direct reports, and those who report to those direct reports. They are convinced they've done nothing wrong, that they've been overwhelmed by unforeseeable circumstances that have similarly impacted everyone else within the ambit of their world view, and they are collectively responsible, directly, proximately for the global economic crisis. They are clueless, and the incomprehensible ineptness of their responses to their current situation is slowly sinking in.

2. The Political Class, happy in the good times to take money from the financial elite and rein in the technocrats in exchange for the lucre, which much rather be prattling on about gay marriage, narco terrorism, green energy and any other available hot button that doing the heavy lifting of making decisions about the government's role in the economy. Unfortunately for them, the screw ups of the financial elite compel official notice. The earliest inclination of this group was to punt the problem to the technocrats, but we may well have reached the limits of that strategy. Past that point, these guys will engage, and the results of their engagement will be stunning. Time will tell whether that means good stunning or bad stunning.

3. The Technocrats are suddenly in the uncomfortable situation of getting what they've been wishing for--an opportunity to perform front and center, on stage, with power (or influence, depending on their niche). There are limits to this opportunity, and it's rather opaque at this point, since they pretend to serve their masters in the political class and the public sensibilities (not to mention to the innate conservative stupidity of the political class) require adherence to the convention that the private sector (read, financial elite) is capable of managing its own affairs. That is a convention which the political class is finding daily more laughable. Unfortunately, at the very moment these have been given to shine, they're finding that most of the tools in their kit are, er, inoperative. Though whiny, they are collectively quite bright, and if appropriately engaged with the political class they have the potential to make a positive contribution to the situation.

Odd Resonances

A current question in economic circles is why the massive expansion of the money supply as aresult of the Federal Reserve’s strenuous efforts to deal with the financial crisis and ensuing general recession has led to utterly no discernible inflationary pressures, at least in the short term. After all, it’s a generally accepted fundamental precept of modern macroeconomic theory that, ceterus paribus (ah, such as old fashion phrase, a whiff of napalm in the morning), an expansion of the monetary supply will generate inflationary pressures, and we have witnessed over the last year a veritable explosion in the money supply.

The succinct and apparently indisputable answer is that the expansion of the money supply has occurred in tandem with a slowing in its velocity, dressed up with the occasional pontification about appreciating the difference between statistics that are expressions of first derivatives and those which express second order derivatives. Without honoring the mathematical window dressing, let’s accept that observation as simple, gospel truth.

What is stunning to me is that the idea resonates with the long-discarded ideas of an English engineer-civil servant-social theorist named Clifford Douglas who in the early 20s developed an idea of Social Capital. I am currently reading a magisterial exegesis of the poetry of Ezra Pound, and, before falling in with Mussolini’s fascism, Pound was temporarily captivated by the ideas of Douglas.

Douglas was not talking about the money supply. Douglas was not a Marxist (he felt the attribution of all value ultimately to labor and toil of the contemporary working classes and peasantry was fallacious). He was not an economist (not even by the more flexible standards of his day). He may have been a crackpot. But his diatribes on cost accounting and contempt for the reliance on markets to both price and value goods and services are seductive.

In a nutshell, he argued, with respect to capital, not the money supply, that the velocity of capital, not the quantity of it, explained the vicious grip of banks and the financial interest on the general economy. His argument echoed that of the American populists and progressives of a generation earlier that Wall Street held the country in its talons, crucifying Man on a Cross of Gold as surely as our Savior suffered on a Roman cross of timber. In a wonderful analogy, he made the argument that to ignore velocity would lead one, in the context of demographics, to claim that, because everyone who is born eventually dies, the birth rates and the death rates must be identical, and so the population must be stable, which it patently is not. These statistics are matters of rates, not absolute quantities (and it hardly required the invocation of Calculus to understand it).

I’m not sure if Douglas is worth exploring, or not. He was a whacko, and, like Pound, more than a whiff of anti-semeticism pervades his writing. But clearly, all of the post World War II macro orthodoxies are being found wanting. Hence, you have Paul Krugman reading Hyman Minsky. Thus, the endless invocations of the same few phrases of John Mayard Keynes (efforts to restore ‘animal spirits’ by fiat seem to me about as likely to succeed as efforts to repulse the Mongols by sending the patriarch and his bishops beyond the city walls to parade the icons before the approaching horsemen).

It’s enough to make me wonder if these issues are, at bottom, really issues of the economy, at all.

Non Quant Indicators

that the credit markets are close to deconstructing again. Not sure if they mean anything. But two salient factoids are being systemically forced down the throats of those who trade:

1. The U.S. housing market is continuing to deteriorate, and the deterioration, so far, has no end point.
2. The financial services sector, and the debt instruments generated over the last decade, cannot survive point 1, and so it, its equity and its contractual obligations are valueless.

Given enough time, which it has had, the federal government can step in to sponsor a utility-like financial services sector that will meet the needs of the general economy (point 1), but the consequences of point 2, over the intermediate to long term, are quite opaque.

Vive l'opaquace!

Confirmation Bias

'Confirmation bias' is a term to describe the tendency of the human mind, once a conclusion has been drawn, to emphasize subsequently received information that supports the decision or conclusion and to diminish, distinguish or otherwise minimize the significance of information which contradicts, undermines or otherwise calls it into question.

The current reporting of the trends on residential housing prices offers countless examples of confirmation bias in action. The operative conclusion/decision is the conviction which has prevailed for the last several generations in the United States that house prices always go up, that your home is your best investment, etc. The date coming in recently, to put it mildly, calls that conventional wisdom into question.

All of that data is bad for homeowners, homebuilders, anyone in the real estate business. Some of it is less bad that others. But none of it is exactly positive. However, it is possible to draw some second-order inferences that are non-negative. If the rate of new home construction has falled below the absorption rate for new home inventory and below the rate of household formation, that implies that eventually the situation should turn around. If interest rates are being held at artificially low levels to make mortgages less expensive, that results in an affordability index that would support increased levels of home ownership (if only the sidelined new home owners weren't scared to death of losing their shirts of 'the biggest purchase you'll ever make").

But, even though all the data is bad, the talking heads find someone willing to say something neutral, and the headline writers twist those words into something positive. I really don't think this is the machinations of the National Association of Realtors or the Homebuilders at work. I think it's confirmation bias in action.

Which would suggest that we have a ways to go before it's purged.

The Bush Legacy, Memorial Day 2009

Ever notice how in the last year of the second term of a presidency voices are raised in speculation about the hallowed legacy that the incumbent soon to be departed will leave behind? The fund raising machine is cranked up one last time for the benefit of an ever more grandiosie presidential library and respectful columns written about His concern for His legacy dominating His remaining waking hours of Power.



Well, it's Memorial Day Weekend, time to consider legacies and such, even if we haven't heard too much about the Bush legacy recently. Dick Cheny is out there defending torture, the invasion of Iraq and various other crimes and mistakes, to what purpose I know not. But as to the legacy, all is quiet on that front (apologies to Erich Maria Remarque, another good Memorial Day read, in any country, though he wrote as a German after the Great War).



Perhaps there won't be one. Perhaps we will simply roll it all back to 2000. I think that right now if you gave people that choice, without much thought, they'd grab it. In retrospect, most of the 'productivity' gains of the last eight years resulted from 'innovations' in the financial services sector, and just about everyone would like to pretend like that never happened. So, take her back to 2000, skipper.



Well, there is a little problem with that. If you take house prices back to 2000 (not that far really), house prices have to fall roughly another 30% (nation-wide, based on the Case Shiller index, peak to trough), or as far again as they've already fallen (a bit worse that the more adverse scenario of the recently completed stress test exercise). Awful, but in the ballpark of people's tolerable reality dosage. The real horror would be in taking levels of economic activity back to that level. If you reverse 8 years of 2.2% annual economic growth, you drop the standard of living by some 15-16%. That is not quite a Depression Era level of readjustment, but it's far worse than anything since World War II in the United States.



That prospect exceeds the dosage of any tolerable reality check. But, it's a distinct possiblity, if not already baked in. Kinda leaves a guy wondering where the recent stock market rally came from (not that I'm betting against it continuing).



Of course, the Clinton Legacy was Bush, so maybe the Dems better keep quiet. To borrow the title, itself borrowed, of course, of Dean Acheson's memoirs, Messrs. Geithner and Summers, at least, were Present at the Creation of the current economic mess, even if Phil Gramm played the role of Gilgamesh.

Minsky, Path Dependency and the Hegelian Dialectic

It's been all downhill since the Hegelian dialectic was hijacked by the Marxists and became dialetical materialism. Start with a mode of argument--thesis, anthesis and synthesis-and deploy it to analyze problems in 19th century political economics. And you have a concept that takes into consideration the prosaic and indisputable observation that the seeds of the next problem are generally found in the solutions to the current problem. An economic and political context in crisis yields an outcome, dependent on the prevailing correlation of forces, and, lo and behold, the new stasis has in it an internal tension that results in eventual crisis, which in turn yields a resolution that creates yet another new set of circumstances, that in turn . . .



And so you have dialectical materialism for idiots. I mean, there is a great deal more to it than that, if you are interested.



In its most recent iteration there is the lovely thought that future outcomes are path dependent, which is even easier. I believe path dependency can be summed up in the observation that what happens eventually depends on what happens between now and then. And that differing intermediate outcomes either foreclose or increase the probability of different ultimate outcomes.



Path dependency is a useful corrective to what Hyman Minsky referred to as the Olympian fallacy. The Olympian fallacy, which also has theological overtones and resonate with chaos theory, holds that a prime mover can set a process or policy or strategy in motion and it will inevitably lead to the desired outcome. Nice as it is to think that the butterflies wings half a world away cause the typhoon, the thought has little practical application in human affairs. Rather, in application, the ideal is transformed into the real, or becomes something alien to those who originally imagined it.



So, it's not entirely clear how all this will come out. But it's pretty clear that future choices and options will be determined by choices made today and the outcomes of those choices. And perhaps by choices made in the past, which are only working out as real world outcomes today.

Death of the Sinecures?

Our economy is littered with sinecures.

Technically, I suppose a sinecure in a position, generally a government or academic appointment, in which very little in the way of work, effort or responsibility in required of the incumbent, who nonetheless enjoys a handsome income from the position. In 18th century England, the politics of the day depended heavily on a patronage system involving sinecures, livings and rotten boroughs, which in turn were political appoints, clerical positions and parliament seats filled through appointment by a senior member of the local nobility. In 19th century America, political patronage filled precisely the same role--I had a great grandfather who was the Republican postmaster of Omaha, Nebraska for decades, as a party stalwart and veteran of the Grand Army of the Republic (not something my Georgia kin deemed appropriate to notice officially).

So much for the history lesson. The modern American economy is littered with positions that amount to sinecures. Today's Republicans love to take pot shots at public sector sinecures--as though a horse breeder named Michael Brown had been appointed head of FEMA at the time of Katrina through some merit driven process. And the academic bureaucracy that has developed over the last century probably has more than its fair share of positions in which time serving well positioned bureaucrats have found themselves a safe haven, pending retirement in a decade or perhaps a generation.

But we have private sector sinecures, as well, if you take a somewhat expansive definition of sinecure, and consider any job offering a heavy paycheck for light lifting a form of sinecure. Consider all those divorcees peddling real estate to their still married sororiety sisters. That gig rolled to a close about a year ago. Consider all those credit managers and service managers at sleepy auto dealerships where business has been slow for years, but where the axe finally fell last week. The pay was good, the work was easy, you just had to be a good fit with the family that owned the place. Now, gone. Poof.

On another level, think about all the businesses that serviced the needs of booming sectors of the recent credit-bubble inflated economy. A read an internal memo circulated at J.P. Morgan trying to control car hire, tipping and deal toy expenses. These are probably not good times to be an event planner on Manhattan or in Southern California. Not too sure how the personal trainers and life coaches are doing, either.

Finally, how about good old print journalism? Every decent sized community in the country has a daily newspaper that fewer and fewer people read. Every daily newspaper has local news coverage--business, sports, community affairs. All that requires staffing. To hear the publishers lament, their communities will be culturally impoverished with the loss of that coverage. Perhaps, but if readership is collapsing, and craigslist has ended the want ad gravy train, something is going to give. I don't think the replacement of want ads by craigslist will diminish the vitality of community culture, any more than a shrinking real estate section or using the email instead of the Sunday supplements to flog department store sales will.

But what will change are the job prospects of those reporters. Journalism is apparently one of the favorite majors at the University of Oregon. Mock if you will, call it an English major without the rigor of taking a course in Shakespeare, but it was a major of choice for kids looking for sinecures.

And it appears that the sinecures are being squeezed out of the economy. Oh well, back to work.

A Better Class of Victim

For the last half century in the United States the victims of any economic downturn were invariably the same, at least in the sense that they generally came from the bottom half of the income distribution. Oh, occasionally there'd be some regional variety--petroleum geologists in the Oil Patch back in the 80s, a bunch of white shoe paperhangers in the 60s (i.e., go-go year stock brokers), the occasional wave of aeronautical engineer layoffs in Southern California as the defense cycle turned, the almost comical dot.com geek zillionaires turned burger flippers. But, on the whole, the burden generally and relentlessly fell on the unionized worker, the craftsman, Joe Sixpack, AS the people for whom he voted dismissively labelled him.



Now, the for the first time, we may actually be in a situation where the pain and the burden falls disporportionately on the well employed, well-educated and well off. The 32% of the population that doesn't own a home are spectators to the popping of the housing bubble. The majority of Americans will less than $50,000 in financial assets (or is it $15,000) are not taking the paper losses on their 401ks that their supervisors, and their supervisors' managers, are letting pile up unopened. You've got to have some wealth to feel its destruction. And the elements in the service sector which are for the first time bearing the brunt of the downturn include lawyers and architects as well as retail clerks and minimum wage waitstaff. When an auto dealership closes, the credit manager, sales manager and service manager are all out of a job, not just the floor sales reps and the cleaning staff.



I don't want to overstate this. But the political implications of economic distress that really touches the midle class and the upper middle class in this country is unexplored territory. Conventional wisdom is that the reaction will be conservative--politically and socially. I don't doubt for a minute that in this instance there will be a conservative social reaction. But the political one is harder to call. The political right is so thoroughly tainted with responsibility that it is difficult, for a couple of election cycles, at least, to see it benefiting, even if Team Obama flubs completely. If Team Obama muddles through, I could see a shift to the right as the slog gets longer and longer and memories fade about how the mess came about in the first place. But, in the short term, it's hard to see it.



In terms of historical precedent, I'd offer two conflicting possibilities. One is the rise of fascist tendencies in '30s Europe. The other is the Populist/Progressive movements in the United States of a century ago. I'd guess we're more likely to see a reprise of the latter than the former (in the United States, at least), but I'm far from certain.

Criminalizing Financial Mismanagement

A nuance that has generally been missed about the recent episode allowing the banks to negotiate the outcome of the stress tests is the practical consequence to those responsible for running those institutions. In their discussions with their regulators, they cannot possibly have appropriately qualified their representations and negotiating positions to take into consideration all of the internally available information tending to question or undermine the assertions confidently made to, and taken at face value by, the federal civil servants who, if events do not play out as projected, will ultimately testify in criminal proceedings that they were not apprised on the information available to the defendants that contradicted or undermined their criminal misrepresentations. Let a lay jury determine, in light of subsequent events, whether criminal liability should attach to those conscious decisions to present without qualification unfounded hopes as though they were grounded in fact, rather than result-oriented self delusion.

Give the dialectic time to work out. The stakes are getting higher, and, like gamblers three sheets to the wind, the players aren't cognizant of it.

Weapons of Class Destruction

As we lurch towards a new global financial architecture, each country has something to learn from the other, and each has something to offer. In the spirit of international brotherhood, I'd like to offer some suggestions--about what the United States has to offer China, what China has to offer Russia, and what Russia has to offer the United States.

From the United States, the Chinese can draw valuable and specific lessons as to how various technocratic policies and initiatives can effectively work to refine and fine tune a powerful, globally competitive economy. While the example of the last 24 months isn't particularly edifying, U.S. policies drawn from the second half of the last century can be mined for extremely valuable precedent.

From China, the Russians need to take away a more impressionist sense of how better to accomplish the transition from a command and control economy to one that unleashes the productive potential of a large population occupying a continental space. Over reliance on natural resources and preferential dismantling of state enterprises transforming former managers into oligarchs did not work so well as continuous agnostic meddling. The first step is for the apparachiks to acknowledge they have something to learn from the Mandarins.

From the Russians, the Americans need to learn how to deal with their oligarchs. The first step, of course, is to stop thinking of the financial oligarchy as a meritorious elite in any sense, and admit the cognitive capture of the regulators by Wall Street. Then, redefine the Masters of the Universe as Enemies of the People. The Masters of the Universe were, after all, the ones who orchestrated the evisceration of the American economy and the conversion of a productive citizenry with savings into a mewling horde of consumers indebted up to their eyeballs. While showtrials and bullets in the stairwell aren't in the American tradition, tarring and feathering certainly is.

What we need are weapons of class destruction that maximize wealth impairment while minimizing the loss of human life.

Happy Mo-Fo Day!

On behalf of hedge fund managers, financial services CEOs and other Masters of the Universe, I wish to publicly protest the injustice of this Hallmark Greeting card holiday called 'mother's day'.

Why doesn't the public celebrate Mother Fucker's Day?

Yes, the financial elite has captured the commanding heights inside the Beltway. Yes, we have secured the better part of a trillion dollars to support our equity, and God knows how much more for the preferred, the debtholders, the counter-parties, and the control group. But how much respect, how much affection, has accompanied that niggardly acknowledgement of just how necessary financial oxygen is for the morons to keep on breathing.

We want the morons to worship us as infants worship their mothers. Suck on this!

A Mexican Standoff

Or, more appropriately, a Chinese American standoff. Here, in a nutshell is the situation:

1. The Chinese are nervous about holding large dollar denominated foreign reserves, but are also nervous about allowing their currency to appreciate. The only way to keep the currency to appreciate is to buy dollar denominated assets in sufficient amounts to keep that from happening.

2. The Americans want the Chinese to allow the Chinese currency to appreciate, but need the Chinese to continue buying U.S. government securities to finance the American deficits (fiscal and trade). If the Chinese were to stop increasing, much less begin liquidating, their dollar holdings there would be a serious problem.

So, the Chinese cannot achieve their currency objective without continuing to finance the American deficit. The Americans may lecture on currency manipulation (lecturers fallen silent recently) but urgently need the Chinese purchasing presence.

What makes this situation unusual, from an American perspective, is that the outcome is dependent more on how the Chinese assess the situation than on any American initiative.

The United States is in the unfamiliar position of responding to the policies of others, rather than framing an initiating its own. This is Un-American, and a situation ripe for miscalculation.

Neo-Marxist Caveats, Part 2

The first step towards assessing the current American situation employing a neo-Marxist analysis is to assess the Marxist approach itself in little of current circumstances. In particular, the continuing conceptual viability of several of the key building blocks of the approach is questionable.

The first of these is the notion of defining class in terms of relationship with the means of production. Forest of trees have died, and oceans of ink have been spilled in an effort to define class, which is a slippery concept indeed. A bit less attention has been devoted to defining the idea of 'means of production', mostly, because doing so actually requires some understanding of how things work, how work is done and all sorts of grubby details about all sorts of odd little backwaters in which the vast majority of humankind labors.

Suffice it to say that a mid-19th century focus on the industrial wastelands and imperial steamship routes of the dominant European nationstates of the era are about as relevant to the beginning of the third millenium as exegesis of Sharepeare's bare ruined choirs of 16th century Catholicism would have been to understanding the 18th century Enlightenment on England.

I would be inclined to acknowledge from the get go that class is defined in political and social as well as economic terms, and that the 'means of production' has to be understood to mean something radically different in a service dominated economy with an significant public sector than it did a century and a half ago. That said, focusing on what makes fmembers of the population productive (or economically autonomous) rather than blathering on about the "American consumer" or the "consumer society" or looking to renewed credit flows to stimulate consumer spending as a way out of the economic malaise is probably a step in the right direction.

A second major caveat to a neo-Marxist analysis is what I'll call the Freudian problem. Like Freudian analysis, Marxism was a product of a time and place, and it's not at all clear how well either travels through time and space so as to be usefully applied elsewhere (even assuming that they served explicatory purposes where they originated). There can be perfectly valid, local belief systems that organize human activity and regulate human conduct that do not serve the came purpose once exported. Voodoo and witchcraft may have local power in Haiti, but in New Orleans, they are merely camp. Clearly, the Freudian approach to understanding the human mind was premised on a set of bourgeoisie family relationships that were simply not to be found in, say, the Japanese imperial court or an Amerindian tribe.

A fair amount of the Marxist tradition falls prey to the same tendencies. There is a progressively more complex self-referential conceptual trend of increasing refinement that is progressively less-intelligible to outsiders and, indeed, less and less concerned with the external world and more and more focused on the internal balance of philosophical construct.

This criticism is not, however, confined to Marxist philosophical developments. No fair minded legally trained American can help but look on the development of First Amendment jurisprudence and not marvel at how we have tied ourselves in knots in a similar fashion. The ancient criticism of the Scholastics debating how many angels can dance on the head of a pin shows similar theological tendencies. So, while the Freudian analogy is cautionary, it is not a grounds for discarding the approach.

Basically, this is boiling down to a question of whether one can identify groups of actors sufficiently well defined by their roles to be deemed classes, and whether those actors have a reified class consciousness that determines (in some sense) their actions.

Neo-Marxist Approach, Part 1

It's time to put the politics back into political economics.

The Financial Times is taking a first tiny step by introducing ideas of behavioral economics into the discourse. But that is a timid, trivial and bourgeois approach to a bigger problem.

Let's begin by accepting that the current analytical framework is roughly as bankrupt as the financial services sector that crucified the general economy on its own contradictions. So, folks are casting about for something a bit more, er, operative.

There are some serious problems with attempting a neo-Marxist construct to explain the current mess. And that's leaving aside the delicate American queasiness at being labelled a socialist, a commie, a pinko, or anything of that sort. Forget, for the moment, that queasiness, or at least enjoy the outre opportunity to leave respectability behind.

First serious problem is that state directed economic production schemes utterly failed in the 20th century. Call it communism. Call it socialism. Call it state planning. Call it Marxist-Leninist. As a way of organizing complex economic activity, the approach which had its genesis in the writings of Karl Marx and Frederich Engels in the mid-19th century failed the test of history. Their thoughts, as developed and implemented by their followers and adherents, were relatively inferior to alternative approaches to organizing collective economic activities. This approach failed in multiple cultures and different societies. So, let's not even suggest that Marxist-Leninist state planning provides a viable approach to organizing and regulating the economy of a developed or developing country. But that doesn't mean it doesn't offer a tool with which to critique the current situation.

Second serious problem is that no one, and I mean no one, has been pursuing seriously an attempt to apply this analytical framework to the current economic situation for at least a generation. Following the collapse of the Soviet Empire in Eastern Europe, I believe all the departments of Marxist-Leninist studies were shut down. In the West, the few adherents of the approach focused themselves of issues of social justice, income distribution, and the like--not so much attempting to understand the prevailing economic system as critique certain of its outcomes. And most of those guys are either dead or pensioned off. There is no expertise, and there are no experts.

Third serious problem is that there is no coherent and agreed theoretical framework that can be applied to the current crisis. There are (or were) as many flavors of Marxism as there have been flavors of ice cream in the last century or so. And they've all melted into a big puddle. On the other hand, this may be an advantage, since it would allow picking and chosing, adapting and applying what's useful, while leaving the rest of it in the intellectual recycling bin.

With those caveats, we proceed.

Stale News Remains Important

Some things to remember if you want to anticipate the future:

1. In the United States, the financial services sector is and will remain until recapitalized, insolvent. This is a solvency problem, not just a liquidity problem. 6 of 19 per the leaked stress test results, need additional capital. And that's the official story. We need to learn how to get along without those guys.

2. U.S. house prices are and will continue to decline, making it impossible to value a huge chunk of assets critical to financial services sector liquidity. The sociological consequences of unemployed company store peons trapped in real estate they don't own are interesting. And, commercial real estate is in the early stages of joining the residential stuff in a revaluation. While the trajectory is the same, the commercial stuff will be, ah, lumpy, and less suceptible to smoothing.

3. The regulatory apparatus has been captured by the financial services sector. Whatever squabbling is under way within the political classes (viz., the competitive outing of Raul Emmanuel and Larry Summers this month, and the Thain/Lewis catfight, with Paulson calling the count), has yet to metastize into a purge of the financial elite. While bullets in the head aren't called for in America, a rather less drastic purge in, ahem, called for. This is, incidentally, a global issue.

4. The epicenter of this particular crisis was in at the heart of the developed world, and that is where the pain is most likely to be felt most intently. Countries like China, India and Brazil have an opportunity to, if not displace their betters, at least join them at the high table. If that happens, look for some changes in the menu.

And that is the way it looks from here, today.

Why I Mock John Maynard Keynes

In case anyone has missed it, we are in a bit of a fix financially, on a global basis. The policy works and mandarins of assorted stripes generally responsible for keeping this sort of thing from happening are perplexed, and more than aggravated that a number of the formerly reliable levers that worked when employed now produce--when tugged--nothing. New techniques from the bottom of the toolbox are being taken out--quantitative easing--and much dark muttering of 'pushing on a string' can be heard in the distance, in the darkness.

So, if the macroeconomic tools of a lifetime and the institutional expertise of the worlds central banks and international monetary authorities has most its magic, it's time for something else. Because most of these guys were trained in the second half of the 20th century, and because John Maynard Keynes was the fellow whose approach had been most recently superceded, there is a group grope of the Keynesian canon, for something that, if not functional, at least sounds profound.

That's why I mock all the invocations of J.M. Keynes. If you actually go back and read the guy, he has some interesting observations that shed light on the current mess. For that matter, so does Ezra Pound. But the solution is no more to be found in Keynes' writings than in Pound's Cantos. And the aspects of Keynes that are being invoked are among the least interesting of his observations (to me, at least, I find his policy prescriptions pretty pedestrian, while his conjectures on how his world got in its fix quite intriguing in the application to the current fiasco).

So, my first alternative is Marxist economic analysis. Unfortunately, while the Marxists have some great one-liners, as I've tried to deploy what I remember of Marxist economics to the current situation, I find that it really doesn't work very well. It is destructively inspirational, rather than immediately applicable.

But more of that another time.

Bank Earnings

Okay, confession time.

I personally have been involve--not within any applicable statute of limitations, I hasten to add--in the preparation of quarterly and annual earnings reports for publicly held financial institutions. As a matter of fact, one of those institutions is, today, buried deep inside the AIG mess, and for my services to that predecessor entity I am entitled to a small pension which, a recent communication from AIG assures me, is safe. I happen to believe that communication because the pension is so small that it's guaranteed by the PGBIC so, while the dollars in which it is paid may be worth far less when I receive them than anyone would have anticipated, I would assume that when the times comes, I will receive my pittance in what script is then legal tender.

Based on personal experience, I can say that, with the most honorable of motives and the best of intentions, accurately reflecting the financial results of any financial institution in a quarterly or even annual time frame is an exercise in subjective judgement, and, to put it mildly, reasonable people can differ. Based on what I'm seeing as a member of the great unwashed, I cannot tell whether the motives are honorable and the intentions above reproach with the financial institutions currently reporting their earnings, but these are stressful times, and such times test the mettle of all involved, a certain number of whom always fall short.

So I can understand how some of the the banks are actually reporting earnings. What I can't understand is why.

Citicorp reports earnings. But those earnings are dwarfed by an item that reflects the impairment of the value of its own debt (which is only impaired because of doubts about the enterprise itself). In other words, they are making money by going broke. Or so they claim. Wells Fargo is reporting record earnings at the same time that it is adding to its loan loss reserves in amounts that are virtually certain, in hindsight, to seem laughable. Goldmans Sachs is reporting earning, but its CFO is essentially lying to the public about the benefits Goldman received from payments on AIG CDS and the firm orphaned the month of December.

Why? These guys are setting themselves up for serious trouble down the road. The phrase 'buying time' comes to mind, but buying time only makes sense if you expectd something to change. And the way the political classes and their technocrats are going to remember this will be truly ugly sometime between the World Series and Thanksgiving. The first quarter will be remembered as when the banks reported the government bailout of AIG as their own profits.

That may be simplistic. But there is enough truth to it that it will stick. Fooled me once, shame on you. Fooled me twice, shame on me.

Fiasco 2.0 The Pension Funds are Broken, too.

Just who are the victims of the current mess?

It's easy enough to say that we all are, but that really isn't true.

Are homeowners who used their houses like ATMs to finance everything from their children's college educations to trips to Disneyworld? Are we really going to try to differentiate between those who borrowed for praiseworthy ends (presumably the former) and those who didn't (presumably the latter). Are the first time home buyers who bought into the American dream at absolutely the wrong time? Are the amateur real estate speculators who loaded up on liar loans because they'd attended one of those make a million dollars in real estate using other people's money seminars that used to advertised so profusely?

I suppose the first time home buyers are more sympathetic victims than the high school principals trying to get rich after taking the early retirement package. But, so what?

It's fun to bash the perps--but to what purpose?

I mean, I see the importance of enforcing fraud laws at the local and community levels, and pursuing exemplary justice not merely in the cases of appraisers, mortgage brokers and title companies, but straw borrowers and those who took out the liar loans, as well. I see even more importance and purpose in systematically destroying the financial elite that has grown up with a parasitic financial services sector that no longer serves the needs of the general economy but rather milks the general economy insatiably for its own gaming and profit.

Here is my concern for today--pension funds, endowments and other investment pools that exist to meet non-economic social needs. These things truly are victims of the current mess. Whether a foundation is going to have to curtail its funding of the programs it was created to pursue, a university is forced to reduce its research and educational activities to conform to its resources in a new environment, or a pension fund has become unable to meet its actuarially defined future obligations, a social problem has been created that may have a financial genesis, but doesn't have an economic solution.

Focus on the pension funds. A pension fund is a pool of assets that should be matched to a pool of liabilities. Historically, pension funds have made unrealistic projections of their managers' abilities to generate financial returns from those assets and when the managers actually had good couple of innings, the sponsors used the excuse of overfunding to reduce contributions or even capture the excess. Now, hit the present. The liabilities of pension funds are relatively unaffected by the current financial crisis. But the valuation of their assets most certain is.

Even if the general economy stumbles to some kind of recovery, there will be another round of crisis. Globally, financial assets are taking a hair cut. Globally, liabilities to current and future pensioners have not. That is going to create the mother of all asset-liability mismatches.

On one level, this is the problem of the so-called Social Security Trust Fund, and it is no big deal in terms of economic policy, because it is a demographic problem (a hairy demographic problem, but a demographic problem, nonetheless). But, unlike Social Security, a program of the federal government, private pension funds are, well, private. They have sponsors with limited legal obligations to make them whole, and they have the ability to become insolvent. There is a modest federal underpinning to the whole thing, of course, the Pension Benefit Guaranty Corporation, but it will be looking to its Treasury backstop long after the FDIC has pumped that well dry.

Perhaps, once again, poverty will be the companion of age.

Is Team Obama Clueless?

It is difficult not to be sympathetic to the observation that making policy (or managing an institution) is more difficult that usual when the consequences of decisions play out in so many unpredictable ways. In uncertain times, outcomes are harder to predict, so caution is the order of the day, and any undertaking must begin with an acknowledgement that success or failure will depend or more than just the ingenuity of the strategy or the efficacy of its execution.

That said, we are witnessing some decisions that appear to have been made with no consideration whatsover of their consequences. Not the second order effects, or the knock on consequences, but the basic cause and effect issues. I'm not sure if the Obama administration's stress testing of the major TARP recipients had its genesis in a speechwriter's desire for a good soundbite, a business as usual misunderstanding several layers down in the regulatory bureaucracy or a profound misread of just how interested a number of vocal constituencies would be in the outcome. But it appears to have been set in motion with no clear sense of what the outcome would be, almost as though the government is simply curious about the financial condition of the financial services sector.

These guys now appear to be floundering like students who haven't done any of the work and the mid-term is looming. Getting sick and rescheduling has already pushed back the deadline. But sooner or later, the results of setting the process in motion are going to come out. One way or the other.

And these guys have put themselves in the worst of all possible worlds. To the extent that institutions show healthy, the test itself will be damned as insufficiently rigorous. To the extent that weaker institutions are highlighted, the grounds are laid for an immediate culling of the herd. Perhaps that is a good thing, since it will facilitate the piecemeal dismantling of the financial services sector, which is necessary, but would be hard in a single pass. However, is difficult to believe that the stress tests are a blow in an ongoing campaign to dismantle the financial services sector, given the time, effort and treasure that is going into propping it up.

It's one thing to take a calculated risk and fail. It's quite another to make a move with no appreciation, not even of the risks involved, but of the dynamic you're set in motion. The ongoing saga of the stress tests appear to be a good example of the latter.

Republican Treason

This is slightly off topic for this blog.

What gives with the Grand Old Party? Yesterday, at some kind of staged right wing political event (a 'tea party') the Governor of Texas floated the idea that Texas just might secede from the Union. His trial balloon went over like a lead balloon and today he is busily backtracking. But he is on tape, just like the governor of Illinois trying to sell Barrack Obama's senate seat.

This isn't the first incident along these lines. Several years ago Sarah Palin was a speaker at the annual convention of the Alaskans for Independence movement. She got a free pass during the presidential campaign I suspect because she played the 'my husband made me do it' card (Todd Palin is the seccessionist family member, apparently he doesn't do the dishes, can't see Russia from his kitchen window, or fails to appreciate the concept of strength in numbers).

Palin and Perry are not trivial politicians. Two of the three most populous states in the country have Republican governors, and Perry is governor of one of them. Of course, Palin was the Republican vice presidential nominee in the last presidential campaign, as well as being the sitting governor of Alaska. What gives?

Now, treason has a highly technical definition in this country (unlike some places). For Perry and Palin, the two or more witnesses requirement is satisfied. I'd leave it others to decide whether travelling to and participating in an event promoting the dismemberment of the Union constituting an action aiding the enemies of the United States. FWIW, on the law, Perry might have the better defense, since Palin's Alaskan whackos are presumably serious and presumably plan their events to promote their purposes, while Perry just got carried away at a made-for-media right wing shennanigan.

Why is this getting any attention? I suspect it's an early warning sign of some fairly significant stresses the body politic is about to suffer. The issue of whether the United States are a single country was decided almost a century and a half ago (indeed, Texas was part of that failed succession). But what holds the country together today?

Since World War II, external pressures have played an important role--but now that the old Soviet Union has dismembered, despite the putative threat of militant Islam, those pressures are dialed way, way back. It is a common culture, set of values, and world view? While there continues to be general acceptance of the importance of the institutions of civil society, the rule of law, and a bland non-challenging secular mindset, the praise of diversity, exaltation of tolerance and confinement of religious issues to a private spiritual sphere of the individual citizen have privatised those previous commons.

These aren't easy questions. Almost makes me wish for the good old days of 2006. Back then, leading Republicans refrained from treasonous sentiments, and satisfied themselves with insider trading (Senate Majority Leader Bill Frist), playing political bagman (House Majority Leader Tom Delay) and molesting teenage boys ((House Whip Thomas Foley).

Six Factoids: Oregon v. China

I live in Oregon, but I pay attention to what's going on in China because, well, because it seems like a good idea.

Here are three little Oregon tidbits in the last week or so.

1. Citing inability to obtain construction financing, the developer of a 32 story downtown Portland office building abruptly halted construction on the project last Friday. Right now the building-to-be is a hole in the ground with the foundation poured behind Nordstrom's and next to the Fox Tower (primo location). I'm sure there is more to the story than has been made public, and the blather about redesign and resumption of construction in 2010 is just that.

2. The Oregon unemployment rate shot up to over 12% in March, probably the highest in the nation, according to the state official making the announcement. The increase in unemployment was attributed to previously non-working people entering the job market, rather than job losses. In other words, there is some movement between U-6 and U-3. That movement is probably the most important aspect of the factoid.

3. When it adjourned several months ago the State Legislature announced with great fanfare a program to create 3000 new jobs immediately. Last week the state agency responsible for tracking such things reported that 16 new jobs had been created. Congrats to the 16 lucky winners!

Meanwhile, across the Pacific pond--

1. China has become the world's largest domestic auto market, selling more than a million cars a month. This is probably temporary because the U.S. auto market runs a good deal higher than that before it crashed, and should again assuming we get back to something resuming 'normal', but China's new status is a comment on the effectiveness of their stimulus efforts.

2. Chinese banks are attaining the lending objectives established by the central authorities--in other words, credit creation has resumed in China. They are probably making a lot of bad loans, but the stimulative purpose of the credit creation is being achieved with a speed that the developed world is having trouble matching. This is a bit of a head scratcher, because it calls into question some of the premises of how our own financial sector is organized and why it is coddled.

3. The Chinese central government is busily telling its public that their economic fate is dependent on what happens in China, not elsewhere in the world. They appear to be making a concerted effort to get that message out as broadly and persuasively as possible. This is important for a couple of reasons--it suggests they expecting further export deterioration, they want to prepare their public for massive forex losses and for the time being they are eschewing the strategy of blaming their country's problems on the foreign demons. The first is a no-brainer, the second is simply prudent, and we should all be grateful for the last.

Okay, annetdotal evidence is a lousy substitute for reasoning and analysis. But, sometimes it's worth paying attention to what's going on around you. Otherwise you get blindsided, drift off into irrelevance, and miss out on a great deal of life's daily entertainment.

Fear Greed and all that follows

Right now we are watching a conflict blossom between the financial elite in this country and the political class. This is kind of fun because for the last generation the political class has turned itself into the handmaiden of the political elite (a handmaiden being a euphemism for an Emperor's Club escort), and the financial elite has come to regard the political class with all the trust and respect an Emperor's Club escort gets from her john.

Now, the financial elite collectively has a world view that would have fear and greed serving as the emotional yin and yang driving human behavior. And God knows there is room for the intrusion of behavioral sciences into economic analysis, and it is finally beginning as an offset to the quantative approach so mainstream today. (Fear and greed is just a simplified and bastardized summation of the consideration of behaviorial aspects of market performance and those who worship at the altar of Keynes may prefer the term animal spirits.)

But there is more to the world that fear and greed. Enter the political classes, an intrinsically messier group of people than the financial elite. Traditionally these guys have had their own simplistic yin and yang of the levers of power--the carrot and the stick. The donkey carries his load--feed him a carrot, the mule balks--smack him with the stick. It's roughly as sophisticated as the fear and greed analysis of market movements, and every bit as useful.

The Emperor's Club escorts are still operating on their johns' terms. They are thinking in terms of fear and greed. They need a dose of the old paradigm shift. As the freed slave told ole' Massah, 'de bottom rail on top now.'

It will take a couple of months, and a few more cards will have to turn, but eventually, the political class, or at least some of the less bent over elements within it, will realize that carrots and sticks, not fear and greed are what are operative in the current environment. It would premature, at this point, to start publicly brandishing the stick. It would not be premature to discontinue the endless appeals to greed to get the financial elite to do what it needs to do to salvage its sorry situation. It would not be premature to stop denying the realities of which the public is properly fearful. It would be premature to begin privately reminding people of influence within the financial elite that the stick does exist and has been dusted off. (The best targets for such reminders might be board members, legal counsel, asset managers, anybody but the managements of the institutions themselves, who would find being cut out of the loop even more terrifying than hearing the news directly.) The pretense that this is a liquidity crisis and that we are all doomed if the banks fail is growing thin.

The banks have failed, we are not all doomed, or at least we are not dead yet. But we need to start preparing for the world to come, rather than trying to prop up what's already dead and resuscitate the zoombies.

Patience, Process and Pianos

"See it, solve it, fix it," is the modern day technocrat's translations of "veni, vidi, vici." There is a tendency to look at the mess in the financial services sector, take a look at the state of the general economy, do a down and dirty on just what that means for real estate values, credit card receivables and corporate credits, and reach the inarguable conclusion that the banks are currently insolvent, individually and collectively, that the passage of time is only going to make things worse, and that the only question is whether a few of the strongest ones will tumble into the abyss without government life support from their own stupidity or because of systemic issues of counterparty risk. But that question isn't very important from a systemic perspective--it amounts to debating the seamanship of the Somali pirates.

Having sized the situation up, then it is a simple matter of solving for 'x'--in this case a healthy prosperous private sector banking system meeting the needs of the general economy and providing plenty of post-public service enrichment opportunities to the political classes. Having seen it and solved it, fixing it comes next. This is the part most people aren't very good at. At least not the people who become consultants, venture capitalists, lawyers, professors, investment bankers, analysts, technocrats.

It should not be particularly difficult, assuming everyone involved understands on which side their bread is buttered, that the public is cut out of the process (I'm afraid that 'populist' and 'public' have the same Latin roots), and this inconvenient internet technology invented by the venture capitalist vice president Al Gore doesn't blow the lid off the sausage maker. Still, even without the internet, the sausage maker is perpetually gummed up. I guess everybody's too good and too smart to learn how to take it apart or get their hands dirty cleaning it.

I am as guilty of this as the next technocrat or policy wonk. To paraphrase T.S. Eliot, between the thought and the deed, between the word and the action, falls the shadow.

We are in the shadows now.

There is a dynamic at work that no one is commenting upon. Everyone is growing impatient. Those noted Republican populists Richard Shelby and John McCain are calling on the president to allow Citigroup and Bank of America to fail. Because he won't take decisive action, Obama's supporters to the left are muttering about regulatory capture and threatening to wash their hands of him on the grounds that he's sold out to Wall Street. As for the vaunted stress tests, some are contemptuous of them, some are confused by them, and many are bored with them.

I tend to think of the stress tests as a political fig leaf. Fig leaves can serve a purpose. Travelling through Italy last year, I saw a fair number of fig leaves. It was easy to think of them as rather silly, but they served their purpose. At least, when the choice was being made, instead of getting rid of a significant piece of sculpture and replacing it with something vapid and chaste, there was a minor debasement of a major work of art, which survived as a consequence.

Step back, and regard the current situation as an unfolding dynamic. At the end of the day, all of the major financial institutions in the country will have failed. The survivors will have been chosen by the government, capitalized by the government, and initially managed by the government. While they may continue the wear the colors of the gangs that destroyed them (the Stage Coach may well roll on, the house of Morgan may remain in the lexicon), they will be defined by and dictated to by regulatory authorities more focused on their meeting the needs of the general economy than their maximizing value for their shareholders (assuming they have any).

However, this is a result that is going to take time. Bluntly, the banks must first fail, and the financially elite utterly discredited, before the political will to reform the financial services sector will develop. Even then it will not develop unless the failure of the financial services sector has a sufficiently vicious impact on the public. No one in there right mind would wish for that latter. Unfortunately, if the current regime of technocrats (Bernacke, Paulson, Geithner, Summers, etc.) are correct, that vicious impact is inevitable if there is a systemic failure. So, they are in denial of the possibility of a systemic failure.

It is liberating to say that there is a possibility, verging on inevitability, of a systemic failure, and to start thinking about what comes next. It then becomes possible to start considering steps to ameliorate that vicious impact (recognising its inevitability), and reform the financial services sector, rather than revolutionizing our current forms of economic organization.

I am currently, in my dotage, learning to play the piano. Playing the piano, for an adult, is an interesting discipline. A piece of music has a tempo, it proceeds on a beat. A sure way to muck it up is to hurry it up. It must be allowed to unfold at its own pace. You can't go fast through the easy parts and slow down when it gets hard. And, as you master the piece, you discover that it has a dynamic. To interpret the music, you have to be able to express the dynamic.

That's where we are in the reformation of the financial services sector.

Larry Summers?

Is Larry Summers going to be the Andrei Schliefer of the Obama Administration, or is he merely Henry Kissinger without the refined moral compass?

In any event, I doubt we'll ever hear about Larry Summer praying on his knees with a scotch-sodden Obama. Ultimately, Obama will go looking for siloviki.

A wonderful thing about the internet is that it makes footnotes and explanations less needed. Simply google or use wikipedia for 'Schliefer', 'siloviki' or, for that matter, 'Kissinger' or 'moral compass', depending on your age.

Of Arabs and Arbs

The two words sound about the same in English spoken with a West Texas twang. Just ask the guys who ran El Paso Natural Gas into the ground back in the '80s.

The good news is that if you are still alive, your way of life will probably survive the current financial crisis. The bad news is that you may not survive the next one, which is coming, and if you do survive that one, there is another one coming after that.

I tend to look at the current situation as though it had two components--a severe recession in the general economy and a solvency crisis in the financial services sector. I'm in good company taking that view, but it's important to remember that the one affects the other--so that the recession was triggered by the financial services sector liquidity crisis, and the future solvency of the financial services sector is virtually certain to be impacted by deteriorating conditions in the general economy.

That said, let's statically assume that the stimulus package will 'work', bolstering the level of economic activity and buffering the worst of the recession's impact (without regard to the failure of the social safety net in the current environment). And let's assume that eventually one of the bailouts does the trick and we have a financial services sector in which, even if lending activity is non-existent, the comp committee is meeting again. In other words, the recent bear market rally correctly discounting an imminent mild improvement in short term economic conditions (I leave for you to decide whether that is merely a slowing or end of the deterioration or an actual improvement off the new base--nobody is realistically projecting a return to the glory days).

What does that success buy us? I think it buys us two things. First, it will give the feedback loop time to run from the general economy back into the financial services sector. Already weakened financial institutions will have to absorb the consequences of the recession (remember that the current capital crisis came out of the clear blue sky in a healthy general economy, this new event is much more typical). Of course, whether, even with government injections, the institutions can find the capital buffer to absorb that is a problem for another day (i.e., the next crisis).

The second thing that it buys us is time to deal with the issues the People's Bank of China has begun ventilating in articles and speeches by its personnel and on its website. In the most thought provoking thing I have read this month was Martin Wolfe's conjecture that these concerns will lie at the root of the next global financial crisis. Well, the premise there is that there will be another global financial crisis, and that it will come sooner rather than later. I think that's a sound premise. How it will be manifest--a currency crisis, a refunding crisis, inflationary pressures from monetizing the costs of the bailout--is a topic for the future.

The human mind is wired so that it vividly remembers major events, but memory tends to screen and obscure the details of the circumstances of those events and the mechanics by which they unfolded. There is a great deal of talk about the Great Depression and the 70s, but most of it omits the gritty fact that those Big Events were actually a series of smaller, cumulative crises that unfolded through time, frequently with the policies intended to address on crisis triggering the subsequent one. In neither of those situations did the internal dynamic of a market economy, as tweaked by the inputs of technocrats in positions of regulatory power, determine the more important outcomes.

As much as the economists are clutching to John Maynard Keynes and The General Theory, it might be time to recall The Dialectic of History, too.