Monday, November 30, 2009

A Daisy Chain of Crises

What should you conclude upon hearing of the financial crisis in Dubai?

Perhaps the question is too vague. So let me give a hint:

  • after the collapse of the financial system in the U.S.;
  • after the collapse of the financial system in the U.K.;
  • after the collapse of the financial system in much of the Western Europe;
  • after the collapse of the financial system in the Eastern Europe;
  • after the collapse of the financial system in the emerging countries;
  • after the collapse of the Russian economy in 1998;
  • after the collapse of the Mexican economy in 1994;
  • after the collapse of the financial system in Argentina in 2001;
  • after the collapse of the “Asian” economies in 1998 – that would be Hong Kong, Indonesia, Malaysia, Singapore, Thailand, The Philippines, South Korea, Taiwan;
  • after the economic and financial crisis in 1998 in Latin America – that would be Brazil, Argentina, Chile, Bolivia, Ecuador, Columbia, Uruguay;
  • after the collapse of the Japanese economy that has been going on for almost two decades;
  • after the protracted economic and financial crisis in Turkey in 1980s and 1990s and the 2000s that saw Turkish lira lose its value 1,000,000 times;

After all these crises, what should you conclude when you hear of the crisis in Dubai?

You must conclude that theses economic and financial crises cannot, by definition, be aberrations or exceptions. They are more like a natural phase of the system, the inevitable and necessary aspect of its operation.

That is the subject of the Vols. 4 and 5 of of Speculative Capital: the crisis as the “property” of the financial system currently in place in much of the world, with all the social, economic and financial implications that follow.

Stay tuned.

Thursday, November 19, 2009

A Question of Perspective

Last Friday, William Dudley, the president of the Federal Reserve Bank of New York delivered a long speech on “Lessons From the Crisis” in the Center of Economic Policy Studies Symposium at Princeton University. I don’t suppose you could get any more serious than that in terms of authority and setting, even though the speaker felt compelled to issue a disclaimer: “As always, my remarks reflect my own views and opinions and not necessarily those of the Federal Reserve System.” It is astounding how no one dares to speak freely, even when the subject is a non-political, technical one and the speaker is the president of the New York Fed.

My aim is not to offer a blow-by-blow critique of the speech. What I want to focus on, rather, is Dudley’s perspective, the way he sees things. I wrote about this seeing-things-through-the-eye-of-finance-capital in here and here. So the focus is not on Dudley. He is merely a Rumian part that adequately reflects the whole.

The technical description of markets and processes in the speech are generally accurate. But look at the circumlocution and the child-like narrative when the speaker explains the tri-party repo market.
In the case of the tri-party repo market, the stress on repo borrowers was exacerbated by the design of the underlying market infrastructure. In this market, investors provide cash each afternoon to dealers in the form of an overnight loan backed by securities collateral.

Each morning, under normal circumstances, the two clearing banks that operate tri-party repo systems permit dealers to return the cash to their investors and to retake possession of their securities portfolios by overdrawing their accounts at the clearing banks. During the day, the clearing banks finance the dealers’ securities inventories.

Usually, this arrangement works well. However, when a securities dealer becomes troubled or is perceived to be troubled, the tri-party repo market can become unstable. In particular, if there is a material risk that a dealer could default during the day, the clearing bank may not want to return the cash to the tri-party investors in the morning because the bank does not want to risk being stuck with a very large collateralized exposure that could run into the hundreds of billions of dollars. Overnight investors, in turn, don’t want to be stuck with the collateral. So to avoid such an outcome, they may decide not to invest in the first place. These self-protective reactions on the part of the clearing banks and the investors can cause the tri-party funding mechanism to rapidly unravel. This dynamic explains the speed with which Bear Stearns lost funding as tri-party repo investors pulled away quickly.

The result was a widespread loss of confidence throughout the money market and interbank funding market. Investors became unwilling to lend even to institutions that they perceived to be solvent because of worries that others might not share the same opinion. Rollover risk—the risk that an investor’s funds might not be repaid in a timely way—became extremely high.
These words are simultaneously convoluted and simplistic. When the speaker says that in the tri-party market “investors provide cash each afternoon to dealers in the form of an overnight loan backed by securities collateral”, it is as if a 5th-grader is explaining the market. And he has the order wrong. The drivers of the tri-party repo market are not investors who provide cash but the broker dealers who seek money to buy an asset that they themselves could not otherwise afford. If you miss this point, you will not understand the tri-party repo market.

Dudley’s language reflects his thought process, the ways he see things. But the language is not only a passive reflector. It has an active, pernicious side as well: It hinders thinking by creating the impression that something new was told and learned while in fact nothing of the sort happened. So the real cause remains unexplored. Look at this explanation of the crisis:
At its most fundamental level, this crisis was caused by the rapid growth of the so-called shadow banking system over the past few decades and its remarkable collapse over the past two years.
But why was there a remarkable growth of shadow banking? Why did it collapse? Mr. Dudley is giving as the explanation of the crisis the very things that he is called upon to explain.

With such muddled thinking, his “framework” to fix the problem naturally degenerates into a discussion of the “psychology” of lender and borrowers, as in this gem:
This second cause of liquidity runs—the risk of untimely repayment—is significant because it means that expectations about the behavior of others, or their “psychology”, can be important. This is a classic coordination problem. Even if a particular lender judges a firm to be solvent, it might decide not to lend to that firm for fear that others might not share the same assessment.
This is the nonsense that he must have heard from some CEO or one his minions as the cause of the crisis.

I wrote about the role of the tri-party repo market in fermenting the crisis here and here. Read them to see why I emphasize, and mean by, the perspective, the “angle of vision on reality”; it liberates the language and allows for imparting knowledge.

On the larger question of the cause of crisis, I have already pointed out that only two issues matter: the structure of the financial system which develops naturally and could be said to be imposed onto the system, and the fall in the value of the securities due to the transformation of values to prices. Most of this blog has been about the first issue. The question of transformation I will take up in Vols. 4 and 5 of Speculative Capital.

Wednesday, November 4, 2009

On “Industrial Policy”

What type of stories would I cover if I were a financial journalist?

A couple of weeks ago, The New York Times had an interview with William Clay Ford Jr., “perhaps the most seasoned auto executive in Detroit.” He has more than 30 years on the job at Ford Motor Company which was founded by his great grandfather. He is presently the executive chairman of the board. A Q&A and the follow-up went as follows:
Q: Is the financial support given by taxpayers to G.M. and Chrysler a positive development for the American economy?

A: The biggest concern that we had all through this was the collapse of the supply base. I believe that if G.M. and Chrysler had gone into free-fall bankruptcies, it could have devastated the entire industrial base of this country.

Q: Does the average American value the domestic auto industry?

A: They should. One cannot find a healthy economy anywhere in the world that does not have a strong industrial base, period. We seem to be the only country in the world that doesn't strongly value that. Everywhere else Ford does business in the world the government and people understand it, and do everything they can to enhance it. The notion that we can just simply become an information-age data provider as a nation is ludicrous.
The interview was published in a special section about cars and not in the business section.

If I were conducting the interview, I would note that Ford Jr. was lamenting the lack of an industrial policy, although he did not dare/care/want to mention that phrase. I would also note that he was lamenting the lack of an industrial policy the way one would lament the lack of, say, good beaches in the country.

I would gently push him on the subject, encouraging him to continue with his thoughts.

“Mr. Ford”, I would ask, “as a high ranking executive of Ford Motor Company and a powerful business executive, your views carry tremendous weight on the subject of manufacturing. You have the ear of every Fortune 500 executive and every policymaker in this country, including the president of the U.S. Since you maintain that without an industrial policy a nation is doomed, “period”, why is it that you have not pushed for the creation and adoption of just such a policy? More importantly, given the critical role of such policy, one would expect it to be the playbook of the business and the government activities. But it is not. Who and what stand in the way? Please take your time.”

I would then go to Larry Summers, the wunderkind working from the While House, and ask him the flip side of the question.

“Dr. Summers”, I’d ask. “The Wall Street Journal of February 13, 1998 carried an incredible news story on page A2 pertaining to your testimony in front of a congressional committee in the context of the Asian financial crisis that was then raging. Here is what you said:
There has been more progress in scaling back the industrial policy programs in these countries in the last several months than there has been in a decade or more of negotiations.
“In your testimony, you expressed satisfaction at the scaling back, or even the destruction of, the industrial policies in Asian countries. Is it now or has it ever been the policy of the U.S. to dismantle the industrial policies anywhere it finds them, including within the U.S.? If so, how and where is this policy set? If there is no coordinated opposition, why do you think that there has not been any such policy despite the conviction of manufacturing executives that it is absolutely needed?”

These are the questions I would ask if I were a financial journalist.