Cognitive Capture

Last August at the Federal Reserve's Jackson Hole Conference a European economist named Wilhem Buiter told his audience the federal regulators of the financial services sector had become the victims of cognitive capture and were no longer capable of regulating the institutions subject to their purview in the public interest. In this May's Atlantic Monthly, Simon Johnson, a former head economist of the International Monetary Fund will make, in essence, the same argument, in a more provocative form. He argues that the current American financial crisis resembles those that have struck emerging markets economies in the last generation not only in the unexpected suddeness of its onslaught (a liquidity event), but, more importantly, in the extent to which the local financial institutions have succeeded in establishing autonomy from local government, and, indeed, compelling government support for their own failing strategies.

Events since last August have tended to confirm Buiter's argument, and Johnson's article is a reasonable explanation for the ad hoc and disjointed efforts to date of the federal government to address the collapse of the money center financial institutions. In defense of the Paulson-Geithner approach, it's not clear that any better alternative was available, or, for that matter, is available yet.

The obvious takeaway is that the interests of the financial institutions, their executives and the providers of their capital must be subordinated to the public interest. A further takeaway is that the economic power and political influence of the financial elite must be clipped. The human part of this latter is oddly difficult, since it requires summarily dispatching a leadership that, as recently as a year ago, was popularly lionized in the cult of the billionaire CEO. Finally, and perhaps most difficult, some alternative to the ideology of the perfect deregulated free market has to be developed to underpin a different approach to the provision of financial services, and that is very hard to do on the fly.

The other, huge problem with the Buiter/Johnson argument is that it amounts to a restaurant review when what is called for is a new recipe. Still, it's a start . . .

But Will They Work?

Or maybe a better question would be, what about the side effects or unintended consequences?

Right now the U.S. government is attempting to address the financial crisis with two unprecedented programs, each of which explores new ground. The Treasury is unrolling the much criticised Troubled Asset Relief Program, to great and sensible criticism that it will enrich a few speculators by guaranteeing the downside of their investment to encourage them to overpay for toxic assets and free up bank balance sheets. Over course, even if the assets change hands at prices above what they would clear in a market transaction, that price is likely to be below their carrying value on the books of the institution owning them, which will necessitate further writedowns and result in additional capital impairment.

Variation on TARP have been kicking around for six months. My sense is that six months ago there was far more confidence than there is today about the capacity of financial institutions to raise additional capital. I will predict that TARP will unfold as follows:

1. A few deals will be done.

2. The writedowns will be horrific, and the impairments will occur not only at the institutions selling their exposures at an agreed price but at all institutions holding similar instruments (the accounting rules are being changed even as I write this so that won't automatic, but it will nonetheless be very difficult to avoid).

3. The insolvency of the capital markets institutions will be again demonstrated, and piecemeal nationalization will proceed apace.

4. If the housing markets continue to deteriorate (in the sense of declining house prices, not levels of real estate activity), the deals that are done will end up underwater.

The other big new initiative is, of course, quantitative easing. I think this boils down to one arm of the government (the Fed) buying the debt securities of a second arm of the government (Treasury), and, when the dust settles, proceeds from the short term obligations of the Fed being 'invested' in the long-term obligations of the Treasury. It vaguely resembles the operation of the Social Security Trust Fund. I believe the idea is to gain some control over the yield curve, and it may succeed in doing that. But it is premised on the ability of the Fed to fund its operations at the short end of the curve, which has never been in doublt, but then, an operation like this has never been tried.

My sense is that in the intermediate term, there will be either, a currency crisis, a surge of domestic inflation, or both. Just because deflation is currently a bigger threat than inflation doesn't mean inflationary possibilities in the longer term can be dismissed out of hand (though the argument is made from time to time). And my sense of the currency issue is that the effects of quantitative easing will be subsumed in a greater set of issues.

But, 15 years ago James Carville, then working in the Clinton White House, memorably said that when he died he wanted to come back as the bond market, because everybody was scared of the bond market. I get the feeling the government has lost its fear of the bond market and, if that's the case, that would be a bad thing.

Chinese Salvo

In the 1970s Nixon's Secretary of the Treasury, John Connolly, famously told the Europeans that the dollar was 'our currency, but your problem.' DeGaulle's Minister of Finance had earlier complained that the Americans enjoyed, in global financial affairs, the 'exorbitant privilege' of seigneurage. In other words, the Americans controlled the mint, or the printing presses, given the closing of the gold window.

Right here before the G20 meeting, China has officially taken notice.

The head of the Chinese central bank has published an article suggesting that the dollar be replaced as the world's reserve currency with a ramped up set of special drawing rights at the International Monetary Fund.

Now, effectively replacing the dollar as the leading reserve currency would effectively clip the wings of the U.S. government. Of course, it is not likely to happen in the short run, but the Chinese are, in effect, drawing a line in the sand and sooner or later, people may start to cross over. In the meantime, to forestall the development of a trend, the Americans will be compelled to consult, or at least informally consider, the perspectives, instincts and concerns of its largest creditor.

It's also worth remembering that the dollar is the de facto global reserve currency because of the magnitude of the American economy, and the practical decisions taken by central banks and in financial markets around the world. Any shift away from it is liable to be organic, rather than by fiat. That said, organic shifts can be sudden, rather than incremental, and occur as phase changes, rather than trends.

(Un)employment

Given last week's blowup over Wall Street bonuses, and today's ruckus over the asset relief proposal, it's worth remembering for a moment what Karl Marx once called the reserve army of labor--the unemployed.

Prediction--we are headed for a double digit national unemployment rate by the middle of the year.

The West Coast is already there. California, Nevada and Oregon all have unemployment rates of over 10%. I'm not sure about Washington State, but between Nordstrom's, Starbucks, Boeing and Washington Mutual headcount reductions, it is coming. The reason Obama was talking so much about job creation last winter was that his advisors could see it coming in the numbers they had then. I suspect the equity markets are already pricing in these kinds of numbers, although I don't think the current stress testing for financial institutions anticipates it.

In addition, though harder to measure, annecdotal reports of a reduction in hours worked by full time and part time hourly workers are making the rounds. In my own extended family, I'm aware of a truck driver, hospital employee and retail clerk who've all had their hours cut. Making sense of this will be difficult, because you've got seasonality in lots of the businesses that hire part time hourly help. Admittedly, those jobs are generally at the lower end of the payscale, which means that their impact in diminished in the aggregate. On the other hand, all of those paychecks get spent, so in terms of economic stimulus, they are more important than the tax cut for a relatively better off recipient who uses it to rebuild his household balance sheet (the currently popular 25 cent phrase for saving, rather than spending, the government's stimulus package).

Rising unemployment will have as big a political impact as it does economic consequences.

Hedgistan Quiz

The Lords of Hedgistan are, by and large, graduates of Ivy League Colleges and the sorts of places where, to be admitted, one must have scored very well indeed on the SAT. The SAT is a multiple choice test that supposedly measures preparation and aptitude for the purpose of college admission.

In the current economic climate, it's important to get back to the basics, and to give the Lords an opportunity to shine again in the multiple choice context in which they made their first tentative steps towards wealth beyond imagining. So, here's the test, fellas, just two questions, but, just like the real SATs (or the valuation of a Tier 3 asset), the grading is a bit opaque.

1. You have made yourself tens of millions of dollars, your investors have lost hundreds of millions of dollars, and the general public has suffered billions of dollars in damages from your activity. An aroused public has responded. The appropriate response is:

a. You should be taxed of every last penny of the money you made and held up as an example of greed, corruption and short sighted selfishness.

b. You should be taken to midfield of the nearest sports stadium, and, in front of an audience consisting of every business school student within a hundred miles, have a placard describing your offenses hung around your neck, and shot in the back of the head.

c. Like a Chinese prostitute caught dealing drugs, you should be quietly hauled off in a white van and harvested for your internal organs.

2. You live in:

a. New York City

b. Kabul

c. Shanghai.