What next, after 2008? A book review

Mervyn King (The End of Alchemy, W. W. Norton, 2016) has a message. We are not safe. The economics profession has failed us. So have the economic policy makers of the US, Germany, China, and Europe. The banks still play a game that King calls ‘alchemy.’ Central banks won’t or can’t escape the infamous Keynesian liquidity trap. And we are prisoners facing dilemmas, macroeconomic policy is a paradox, sovereign debts are unbearable, and the world is full of ‘radical’ uncertainty.

In short, what we have today is pretty much a lull before the end of the world; 2008 was just the preview trailer. Alternatively, the world may not end but it will take a long while for robust economic growth to re-emerge, and there is very little that can be done about the matter. Either way, it’s a sobering conclusion.

Is the book worth reading? Yes, if only to get a handle on how central banks thought as they dealt with 2008 and its immediate aftermath. In addition, the curious but uninitiated reader gets introduced to the concepts of Prisoners’ Dilemma, the Keynesian Liquidity trap, liquidity transformation by banks, and the difference between risk and uncertainty.

King’s book also contains a longish but bureaucratic take on why 2008 happened. King gets to it on pp. 26-39 and pp. 317-328. Going by his view, as well as that of others in the fields of central banking and macroeconomics, the ‘conventional wisdom’ on 2008 might be summarized as follows.

It began with the fall of the Wall in 1989, also known as The End of History, that ushered in the Great Stability, an era of low inflation and robust economic growth all around. The main central banks finally imbibed the religion of the Quantity Theory in the 1990s and early 2000s, making themselves accountable to the public through pledges to abide by (low) inflation targets. King calls this period The Great Stability. (Never mind the hiccups of the 1997 Asian crisis or the bubble-crash of dotcoms in 1997-2001.)

Beneath the gloss of prosperity were gathering problems. Banks were raising their leverage in the hunt for profit. Prices in stock and real estate markets outpaced inflation of everyday goods, and central banks felt that paper wealth was not a worrisome thing (after all, one cannot eat stocks or houses), and the US Fed actually thought it would boost consumer spending. Some countries pushed their luck with foreign borrowings, notably Greece, Italy, Ireland, Portugal, and Argentina.

The failure of Lehman Brothers in September 2008 is considered the trigger of the crisis. It was, with hindsight, the outcome of the unexpected fall of real estate prices in the summer of 2007 and associated mortgage defaults in the US. The failure exposed the extreme leverage in the US financial system, and with banks unwilling to recognize their paper losses in the derivatives market for sub-prime mortgages, a run for liquidity, called The Great Panic, ensued. The panic was arrested only by official rescues. Consequently, in 2008-2009, the financial crisis affected real economies, with world trade falling and global GDP decelerating into The Great Recession.

King, as do other observers such as Edwin Truman, believes that underlying macroeconomic imbalances were also to blame. The extreme example often cited was the ‘savings glut’ in China that fueled ‘overconsumption’ in the US. Supposedly, the excess saving in China was intermediated by the banking systems of both countries. The theory is that without such imbalances, there would have been no resources that could fuel the asset price inflation in the US and in other countries.

So far so good. King then ends up suggesting that the re-capitalization of major banks since 2008 is a good thing but probably not enough.

As to the book’s shortcomings, they are:

King seemingly ignores the work of Charles Kindleberger (Manias, Panics, and Crashes, 2005) where Kindleberger had formulated an economic model of financial crises, based on the work of Hyman Minsky. King does mention Minsky but in a somewhat negative light.

King nonetheless cites (on p. 34), with some tongue in cheek, two ‘laws’ on financial crises, which he attributes to Dornbusch. One is that ‘an unsustainable position can continue for far longer than you would believe possible.’ The other is: ‘When an unsustainable position ends it happens faster than you could imagine.’ It is of course almost vintage Minsky.

And yet, to date, the economics profession’s best ever model of financial crises still seems to be the Kindleberger-Minsky model. That model cannot be used to make precise predictions, but it does give the best explanation, ex post, of how a financial crisis plays out. The major central banks had been using, in 2008, something called DSGE (‘dynamic stochastic general equilibrium’) macro models. These models were not at all designed to incorporate Keynes’ deus ex machina of ‘animal spirits,’ except as ‘shocks’ external to the structure of DSGE models, which meant that the central banks had essentially no inkling of the crisis before it hit. The IMF insiders called it ‘group think.’

If we could ask Kindleberger or Minsky today on their views on 2008, most likely they would say that it fits their model that sees a financial crisis in three parts — mania, panic, crash. The story is not much different from King’s, except that Minsky would give greater emphasis on the trigger of 2008 as one rooted in overconfidence, what Greenspan had called ‘irrational exuberance.’ That there had to be other villains is a given. In 2008, they included the toxification of bank balance sheets (with inexplicable financial derivatives) that was an outcome of a ‘deregulation’ tilt that allowed subprime debts to be brazenly sold by lenders as ‘almost prime.’ Since King doesn’t like the fractional reserve nature of modern banking, he gives more emphasis to the alchemy-like leveraging that modern banks practice. In effect, King would not disagree with Minsky that it was a kind of Ponzi game that allowed banks to trap themselves into a corner that would eventually ‘blow up.’

This comparison of models means that King’s main proposal — his view that central banks should act like a ‘pawnbroker for all seasons’ — to narrow monetary base creation to ‘safe’ banks, while widening the securitization of other lending by bank-like institutions, is just another way of allowing excessive exuberance to be seen as a can to be kicked down the (future) road of ‘fundamental uncertainty.’ In short, since King has set up the medium and long term as a problem of fundamental uncertainty, there isn’t much that central banks or governments can do to tame business cycles. That is not different from Minsky and his ‘moments.’ There is an inexorable underlying tension between free capital markets and macroeconomic management by governments and central banks, something Robert Shiller and others had more or less also observed (see Shiller and Akerlof’s Animal Spirits, 2009).

King does not quite succeed in explaining the arcana of modern economics in the areas of: (a) how Keynes was co-opted into the ‘neoclassical synthesis’ (King merely says that Keynes was at odds with ‘neoclassical economics,’ a basic lesson from an introductory economics class); (b) the ‘paradox of policy,’ where he asserts that the short-run need to overcome the liquidity trap is inconsistent with the need in the long run to let the private sector decide how to correct ‘structural imbalances’ in the economy; and (c) how ‘fixed’ exchange rates and differences in saving rates across countries lead to ‘imbalances’ that in the long run need to be addressed.

It appears that it is up to others to try to make better sense of what King wants to recommend as a way out of the economic doldrums post-2008. Perhaps this explains why the book blurbs on the outside back cover hint of mystery amid faint praise from the usual suspects.

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Bitcoins are forever

This is a story of mania, panic, and crash. It’s not new. 

Today’s market cap is roughly $150 billion. Averaged over, say, 3 million holders, that’s $50,000 each. Peanuts, if you belong to the 1%.

The trick is to kite the price to anywhere from 5 to 20 times the current level of $4,000.

The sales are essentially wash sales, as coins just go round and round. That’s why they’re coins, see.

Spectators – the victims – then want in, and the insiders pump and dump swimmingly, until the 3 million can get out with huge profits, at the expense of the latecomers.

The end is a classic Minsky Moment, when the latecomers try to sell. The algorithms in the trading platforms would ask: ‘To whom?’ And the price spirals to nothing.

Question for economists: Can the end trigger a financial or economic crisis? A dire scenario is that the latecomers’ loss results in bankruptcies and loan defaults, a retrenchment in purchases of housing and consumer durables, or in a general malaise in business and consumer confidence. Banks may fail if they finance bitcoin purchases.

With the benefit of foresight, monetary authorities will likely institute safeguards. Trading platforms are like banks, and will need adequate capital in case of an epidemic of ‘fails,’ which can happen if traders engage in short sales, or in margin trading. The Know Your Customer rule will have to be integrated into the block chain data base, and imposed by banks on customers operating trading platforms. 

Of course, theoretically, since virtual currencies can function as money, all trading can take place outside the banking system. If that were the case, the ponzi won’t work: How would the victims’ money enter into the bitcoin system? The price would go up and down forever, but that’s all. It’s funny money after all.

EC 12. Pointers No. 8

FAQs on Chs. 10-14, and Epilogue of Backhouse

Ch. 10:

  1. What is Keynesian economics?
  1. What is the role of ‘animal spirits’ in Keynesian economics? [Try to research what Robert Shiller has written about animal spirits.]
  1. Who put forward the idea that would later be called the Keynesian multiplier? Explain this idea.
  2. Before Keynes came along, what were the most prominent theories of the business cycle?
  1. How did Irving Fisher think of the interest rate?

Ch. 11:

  1. What are the most important ideas in general equilibrium theory? What’s wrong with it?
  1. What is game theory? Is it a good alternative to general equilibrium theory? Why or why not?
  1. How is equilibrium defined in game theory? What is a Nash equilibrium?

Ch. 12:

  1. What is “welfare economics”?
  1. What is Pareto optimality?
  1. What is Kenneth Arrow’s “Impossibility Theorem”?
  1. How did Backhouse assess the contribution of welfare economics to economic thought?
  1. What is “market failure”?
  1. Explain the Coase Theorem.

Ch. 13:

  1. What is the main difference between the ideas in Keynesian economics and the so-called New Classical Macroeconomics?

  2. What are the main theories of economic growth in ‘development economics’? What is the ‘Washington Consensus’? Would the Washington Consensus be applicable or relevant to the Philippines? Why or why not?
  1. What did Hyman Minsky contribute to economics? (extra credit: not in Backhouse)

Ch. 14:

What is Austrian economics? Summarize the ideas of Austrian economics. Who are the main figures of Austrian economics? Is Austrian economics useful for understanding the Philippine economy?

Other topics (not in Backhouse):

What is the Tragedy of the Commons? Explain.

Epilogue:

  1. What is the so-called “neoclassical synthesis”?
  2. Discuss and compare the two different ideas of competition in economics? (The first is the competition as imagined and written about by Adam Smith and Friedrich Hayek; the other is competition in the sense of perfect competition in neoclassical economics.)

The Holy Grail of investments – Part 3

The problem of survival

In two earlier posts, I outlined the problems of the little guy trying to survive in the stock and bond markets. The problem is that markets are notoriously variable, even turbulent at times, and difficult to predict. This must be so because if the markets were predictable, the efficient markets theory would be reality, and there would be no practical point in investing/dis-investing. Stock and bond prices would reflect the best information then available, and on average investment returns ex ante and ex post across all asset classes would be equalized. The historical experiences of individual investors would differ, but this can be attributed to plain luck or lack of it.

Despite the markets’ inherent unpredictability, still, some rules of thumb have worked historically.

Continue reading “The Holy Grail of investments – Part 3”

PIMCO plays (or PIMCO’s play)

I’ve listened to this for the nth time and still can’t figure it out. So I must be very dumb. Gross is saying easy money will backfire (why I can’t tell), and fiscal policy can’t be relied upon because of politics. It leads to a story of double dip. But with bond yields already low, and PIMCO supposedly holding cash, they want you to think they will prop up stocks.

It could be a soccer play. They want you to buy stocks as they sell short; then later get you scared so you sell back as the economy tanks.

I suspect they also have a way of betting on interest rates falling some more without having to hold bonds. And when they think interest rates are as low as they can sell, they will short bonds while also publicly knocking them with an inflation scare story.

But what if stocks don’t fall, and bond yields rise “too soon”?

… Will PIMCO get bailed out just like LTCM?

Hysteria and Armageddon

This piece by Sebastian Mallaby is fundamentally flawed. It doesn’t matter if the Chinese government sold US bonds. They are US-dollar-denominated, and the Fed can of course print US dollars. This makes the US different from everyone else who issues debt in a foreign currency.

The dire consequences of Egypt’s Suez canal debacle do not apply, unless, which is unlikely, the dollar ceases to be accepted as an international currency. For now, the euro, yen, or even renminbi are way behind the dollar in acceptance.

The stock market crash of 1937

This is a notable event because it is the second worst crash in US history, and one not anticipated by that famous economist John Maynard.  (The worst was not in 1929, but 1930-32.)

It was apparently caused by a premature tightening of both monetary and fiscal policies.  The Keynesian doctrines had not yet become mainstream even within the advisory circles of Pres. Roosevelt.

Moral lesson for today:  Pres. Obama has to be careful in his struggle with the fiscal “orthodoxy” of the Republicans.  If he loses, there goes another crisis.