After Peak Finance: Larry Summers' Bubble 18 comments
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By Simon Johnson
There are three kinds of “bubbles” - a term often used loosely when asset prices rise a great deal and then fall sharply, without an obvious corresponding shift in “fundamentals“.
- A short-run bubble. Think about 17th century Dutch Tulip Mania: spectacular, probably disruptive, but not a major reason for the decline of the Netherlands as a global power.
- A distorting bubble. In this case, the increase in asset prices contributes to a reallocation of resources across sectors. Think of the Dot-com Bubble: fortunes were made and lost, the collapse was scary to many, and – at the end of the day – you’ve built the Internet and some good companies.
- A political bubble. Here rising asset prices generate resources that can be fed into the political process, through bribes, building politicians’ careers, and lobbying of all kinds. Bubbles in Emerging Markets often generate resources that impact the political process, sometimes in good ways – but most often in bad ways, which eventually contribute to a collapse.
Larry Summers seems to think we are dealing with the consequences of bubble type #1. In his speech last week, “the bubble” is a modern deus ex machina – it explains why we have a crisis, but there is no explanation of where this bubble came from, what exactly was bubbling, and what changes this bubble brought to the real economy or to our politics.
To the extent that Summers talks about the bubble at all, it seems to be in residential real estate. It’s hard to argue that there was an unsustainable run-up in housing prices and that the fall has real consequences. But what model – or even story – can explain the size of the global disruption we are facing without reference to what happened specifically in the financial sector?
The overall official consensus - which Summers continues to shape – seems to be that our problems are: housing bubble plus bad management in a few big financial firms and slightly too weak regulation. So we’ll tweak regulation, ever so gently, and let the “good” big firms gobble up the people, market share, and perhaps even assets of those that fall by the wayside.
But what if we are looking at the effects of a distorting bubble? In previous formulations – but not last week – Summers acknowledged that when financial sector profits hit 40 percent of total corporate profits, a few years ago, we should have seen that as a “warning sign”. But was this a warning sign of something just about houses, or more broadly about the financial process in and around securitization that was both feeding the housing price increase and also reflecting a longer-run shift of resources into the financial sector?
Even James Surowiecki, a most articulate defender of our current financial sector, implicitly concedes that as a percent of GDP, finance is likely to fall from around 8 percent to GDP back towards 6 percent of GDP (its level of the mid-1990s; see slide 19 in my recent presentation). Of course, there is no way to know exactly where finance is heading – except that it is likely down as a share of the economy.
If the bubble (or metaboom with a series of bubbles) was in finance and pulled resources into that sector, we face an adjustment away from Peak Finance – and perhaps this will even more overshadow the next decade than Peak Oil.
The economic adjustment will not be easy for the U.S. but it will be much more painful for smaller countries that have specialized in finance. The U.S., however, will likely struggle with the political adjustment – the financiers will not easily give up their licence to extract resources from citizens, either directly or through newly found rents channeled through the state (and coming ultimately out of your pocket, of course).
The political consequences of Peak Finance greatly complicate our economic recovery.
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The inability of Larry Summers to fully see the big picture reasons behind the collapse of the credit bubble highlights the dissonance that is endemic amongst this generation of the financial elite.
Assuming that we don't have another meltdown like experience (which is by no means a wise assumption to make) we will require another generation of differently educated individuals to provide better financial policy and leadership.
The question however is are there enough educators at the top business schools who see the bigger picture and structural reasons behind asset price bubbles and can amend the curricula accordingly?
We know the Fed can not lead the administrations policy on international affairs and international bubbles. Hell, no one can. Hilary is confused by finance, and the President has no idea how it all happens, but the global effects are substantial and too important to leave to the IMF, the BIS or any other international institution.
We need to work closely with the EU and China to reestablish some minimum level of trade flows we can build upon. The Baltic Dry Index suggests parts of the world are soon to become isolated from trade. This isolation bubble may trump all others soon.
A "structural contraction" would seem inevitable with RBS/HBOS type consolidations not to mention MANY percentage points of real industry shrinkage and yet everyone in the UK seems to be 'whistling past the graveyard' hoping 'recovery' will make it all better! As the grumpy gnome Robert Reich has said: "It ain't coming back"! (don't think he said "ain't"/but something close enough)
On Jul 24 12:58 PM RJMoran wrote:
> Finance in the UK, traditionally 6% of the economy, has, in recent
> years risen to 30% of the entire economy. Not to mention the 'feeder
> economies dependent on a healthy 'finance' sector like high end restaurants,
> the art market, high end real estate (both city AND desirable countryside,
> retail, toys: boats,planes,airline tickets) as well as real estate
> in countries like France, Spain, Italy, etc benefiting from increased
> British purchases of properties and assets.
> A "structural contraction" would seem inevitable with RBS/HBOS type
> consolidations not to mention MANY percentage points of real industry
> shrinkage and yet everyone in the UK seems to be 'whistling past
> the graveyard' hoping 'recovery' will make it all better! As the
> grumpy gnome Robert Reich has said: "It ain't coming back"! (don't
> think he said "ain't"/but something close enough)
Here is a little info about churn and turning it off: hubpages.com/hub/Why-G...
You asked a very important question -
>>The question however is are there enough educators at the top business schools who see the bigger picture and structural reasons behind asset price bubbles and can amend the curricula accordingly?<<
From what I have seen over the past twenty years of being involved in "Finance" I would say that the answer is a resounding "NO."
The bigshot theorists, noted professors and business economists are, almost to the last man (and woman), much more the disease than the cure.
Summers and the rest of the cognoscenti are now advising the President and Wall Street about the true nature of what happened during the past decade in the U.S. economy, which resulted in an enormous dislocation, wasted investment, and a severe credit crisis. If these people are so thick-headed and blind to the obvious problems of financial corruption, far too much power in a few hands, and a ludicrously flawed compensation structure on both Wall Street and in Fortune 500 executive suites, they should resign in disgrace.
We can't afford to have a bunch of corrupt and misguided jokers running our country further into the ground, IMO.
I think that we should encourage the trend of their systemic greed and accelerate it. Those at the top of wealth pyramid will dilute and obfuscate any regulatory attempts to control them. IMO only real and lasting change will come if the system is pushed to catastrophic failure and revolution. Our Constitution needs radical change if not a total rewrite. The fundamental flaw with the Constitution is that it allows for laws that treat people and businesses differently. IMO laws need to be applied universally without exceptions. If we are ALL CREATED EQUALLY, then the law should reflect this. If we are taxed, then we all pay the same rate - individuals and businesses. Congress has allowed complexity to favor the wealthy at the expense of the other social classes. The playing field should be level for everyone, so everyone has the same chance to succeed! And, keeping the laws universal and simple reduces the costs of enforcement, i.e. smaller government.
I recently read a scholarly history of 'the new finance' (but for some odd reason I can't find it again) in which securitization is the vehicle that shifts the carrying of loans from commercial banks to global capital markets. And I think it is Michael Hudson who has been pointing out that the purpose of this shift is to reabsorb the trillions of US dollars that have been released into the world by nearly 30 years of US balance of trade deficits.
Really, the US has been paying for imported oil and Chinese consumer goods with IOUs, not with US made Cadillacs and other trade goods. An Arab company was blocked from using some of its US$ to buy an American seaport company, and Chinese efforts to buy US (and Cdn and Australian) industrial assets have been similarly blocked. Someone has pointed out that the only US assets these foreigners can buy with their US$ is overpriced commercial real estate. If they can't spend or invest their US$ earnings what is the point?
At some point exporters are going to start thinking that US IOUs really aren't redeemable for anything but more IOUs. In the meantime what has been done is to offer these holders of large amounts of US$ some interest paying investments, and this is where securitization comes in.
After the first oil shock in 1973 Western banks scrambled to acquire Arab petrobillions to invest for them. The money ended up in 3rd world resource plays because commodity prices were high at the time. A few years later when all those new mines started producing, the new glut of commodities caused their price to collapse. Soon Latin America was in a debt crisis because they couldn't sell enough commodities to service their debts, which were ultimately Arab oil money lent through London and Wall St and other big banking centers (5 of Canada's big 6 banks also lost billions on these loans). This culminated about 1982 when the Western banking system wrote off a great deal of that debt as unpayable. So 3rd world commodity plays was the first bubble in this recent series.
After that came "the great moderation" where no obvious bubbles formed for about 20 years, though the total amount of debt being recycled through global capital markets continued to rise to its current enormous bubble levels, and the total amount of money absorbed by stock market capitalization likewise rose to high if not bubble levels.
It is important to remember that what is money or capital to one person is debt to someone else. If I borrow $300k to buy a house from you, you now have $300k of money and I have $300k of debt. The whole world uses this same monetary system, where money is created as bank loans by the 'fractional reserve banking system'. So all money is created as debt. One side of the trade has the money, the other side of the trade has the asset and the debt. The trillions of US$ held by foreign exporters is US debt, or "IOUs". Americans got the oil, the stuff, and the debts. Foreigners got the money.
The dotcom craze hit and formed an obvious bubble, followed by the most recent real estate bubble. I don't think the dotcom bubble misallocated a huge amount of real resources, but it certainly sucked in a lot of people's money and concentrated it into a few people's hands. The real estate bubble misallocated a lot of real resources. Materials, equipment and labor were misdirected into building way too many houses that were way too big and luxurious to be affordable on a prudent banker's judgment of affordability. And way too much commercial space.
I think the main political bubble, as Mr. Johnson has been warning us about, is the greatly increased role of financial players in the political process. But this stands to reason if it is true that the shift to securitization is primarily a means to keep US trade deficits viable. By being able to offer US$ holders some attractively performing investments such as tranches of US mortgage debt, credit card debt, etc, those exporters will continue to believe their sales to the US are worth doing.
GS and the other investment bankers who handle these trades work hand in hand with the US political system to make the American way of life (borrow and consume) viable. Policies like the CRA encourage Americans to borrow large sums for houses, and those large debts become the "investments" that Wall St sells to US$ holders. Without all the US mortgage and consumer debt there aren't enough investments to reabsorb the trade deficit dollars.
So this is what Mr. Johnson calls bubble type #3, the political bubble, where finance has essentially become a necessary associate and enabler of the government's policy of maintaining the status quo. Without reversing the balance of trade deficits some version of this system must continue. Otherwise, I don't see how these bubbles can be unwound, other than a repeat of the Latin American solution of simply defaulting because no matter how hard you squeeze your economy there's no way you can pay.
American consumers and taxpayers are paying interest on all that debt which is the source of the money that global capital markets are managing. Just like some mortgage options, Treasury interest is rolled into new Treasuries so the principal balance keeps rising and the interest payable each year gets bigger and bigger, unless interest rates on all these debts are reduced to zero. Who will buy an investment from you that pays zero return? Unless the world agrees to continue subsidizing American consumption and military spending, the trade deficits and this enabling financial system are not sustainable.
Your second to last paragraph scares the bejeesus out of me. It's been 20 years since I took an International Economics class as a part of my minor, and I believe we'd had a negative international trade balance for the preceding decade or more, and we sure as heckfire have been running monster trade deficits since the fall of '89.
The world now finds itself in a twisted version of the Cold War MAD doctrine: If China (and others) doesn't buy our debt, we don't/can't buy what they produce and everyone collapses: Mutually Assured Devastation.
However as tens of billion$ became hundreds of billion$ became trillion$, with tens of trillion$ looming, the fecal matter must eventually collide with the rotating air deflector. China et al are desperately trying to develop and stimulate their own internal and emerging market consumption so as to make the US's main product - consumption - less relevant.
Damn good thing that many Asian nations have not read the memo that you can in fact consume 110% of your income for literally decades, and someone is always there to 'lend' you more. Otherwise our national day of reckoning would only be a few years off instead of the better part of a decade*
*it WILL take China, India, et al that long to build up sustainable internal consumption. About the time our Baby Boomers average 65, retire en masse and attempt to start collecting from IRAs, Social Sec and really impact Medicare, China will write us off for good.
> ...and the Pound and Euro just levitate like nothing is wrong!
For now ...
Dear Sir,
Miss Tett has written extensively about the credit crisis but once more fails to elucidate salient points regarding the issue of securitisation.
She correctly points out that research from Pimco states that "Until the 1980's the expansion of nominal gross domestic product tracked the volume of outstanding private credit closely. But since then credit has dramatically outstripped economic growth as securitisation took hold". Meaning credit growth beyond nominal growth rate does not lead to economic growth.
According to Prof. Aswath Damadaran (NYU Stern), one of the foremost experts of valuation today, the most significant input into a discounted cash flow model is the stable growth rate. This growth rate can be sustained in perpetuity allowing us to estimate the value of all the cash flows. No firm can grow forever at a rate higher that the growth rate of the economy. So, the value all things can't grow faster than the economy (Damaodaran, Investment valuation, Chapter 12, 2002)
Therefore, at a certain point the growth of credit must become unstable when it is rises faster that the rate of growth in the economy. This is essentially the nature of our financial crisis. Valuations based on the growth of credit (leverage) were not able to be supported by the nominal growth rate of the economy.
There are additional features to our economy that have happened since securitisation has taken off. The stock market has grown faster than the economy, CEO pay has gone from 30X to 300X of the average American worker, real wages have fallen, and wealth disparity has reached heights not seen since the great depression. All of these issues are in fact related.
Securitisation has allowed those whose pay is based upon leverage (credit)to increase many times faster than the growth of the real economy and the vast majority of workers. Securitisation has allowed the experts on credit risk and valuation (bankers) to off load these risks onto the public. This has created instability (highly distorted valuations)and a moral hazard where society bears the brunt of costs, while bankers and CEOs reap the benefits.
When Ms. Tett reports that respected figures such as William Dudley of the NY Fed consider it paramount that securitisation markets get jump started if we are to recover she fails to mention that Mr. Dudley, as a former managing director of Goldman Sachs, and the majority of people who are calling for this to happen are the very people who have benefited the most from securitisatiion.
I hope the American people will wake up and see that efforts to jump start securitisation are nothing more than an attempt by those who caused the crisis to restart the system that allowed them to reap the rewards and off load the risks of that system onto others.
With these facts in mind one must wonder what the point of the Feds easy credit (money)policy are. Are they benefiting society? Not very much. Are the benefiting wall street and the banking class? Well, Goldman Sachs profits answer that along with a stock market that does not reflect economic realities.
It also answers the inflation issue. Growth in money supply faster than the ability of society to use it (nominal growth rate) has to result in inflation or asset price bubbles.
"America’s oldest university suddenly at risk of not being able to keep the lights on. Over the past year, Harvard’s endowment has collapsed (it lost $8 billion between last July and October), its fundraising has declined, and its construction cranes have been idled. Gripped by the worst economic crisis in its history, Harvard is in trouble, and no one can decide who’s to blame....Harvard sold ...$2.5 billion [in] bonds because it needed cash, fast, to cover what sources say was an almost unthinkable $1 billion unrealized loss from interest-rate swaps. The swaps were put in place under former Harvard president Larry Summers in the early 2000s to protect the university against rising interest rates on all the money it had borrowed." - Vanity Fair
www.vanityfair.com/onl...
cedar.barnard.columbia...
Mr. Mehrling's conclusions are that the Fed is successfully backstopping liquidity needs as lender of last resort in the new capital markets finance system, but that private insurers cannot possibly provide the deep pockets required to act as insurer of last resort. He says government must provide this function, at a high price. He suggests that TALF is an early version of what this kind of insurance function might look like but we don't know yet whether TALF's price is the right one.
"
Congress has allowed complexity to favor the wealthy at the expense of the other social classes. The playing field should be level for everyone, so everyone has the same chance to succeed!
"
Good article and comments especially by Celsius above. What you say makes alot of sense Celsius, except that it is not possible within the limits of the profit system. As Mr. Johnson wrote in his Atlantic article, "The Quiet Coup", but which I interpret as follows: capitalism, in the USA, is now merely an instrument by which the financial oligarchy pursues its interests, to the detriment of the other, less wealthy and politically connected capitalists.
Of course, capitalism has always served this role, but historically, its institutions were designed to work, for the most part, to the detriment of the masses only. Now, the financial oligarchs have so much control that they are crowding out even other capitalists, not just the masses, which were always "cannon fodder" for capitalism anyways.
If you consider the current jobless "recovery", where capital has cut almost 6.5 million jobs since the recession began in December 2007
, then the meaning of using the masses of the working/middle class as "cannon fodder", is made clear. That was the private sector, now, even the public sector workers are being used as "cannon fodder" with the expected mass layoffs at the state and local levels as the decrease in tax receipts accelerates.
This will eventually become apparent even to the masses, as life experience, with its continuing mounting job loses and joblessness, tears down the still high illusions in President Obama as the perceived savior from their economic crisis.
For the record, I am a capitalist and I benefit from capitalism but I still know alot of people who make a living with their labor (pull a paycheck) and not capital. Therefore, I am not inclined to ignore the contradictions of capitalism or defend them.
More information below:
Banks Counted on Looting America’s Coffers
tinyurl.com/bkezmt
The Quiet Coup
www.theatlantic.com/do...
"The Fed's War on the Middle Class"
mises.org/story/2983
Another Missed Opportunity: Obama Retreats on Wall St. Compensation
finance.yahoo.com/tech...
Larry Summers, Tim Geithner and Wall Street's ownership of government
www.salon.com/opinion/...
Obama doesn't wield heavy stick on banks
finance.yahoo.com/news...
This view, however widely spread, is not accurate. The 'masses' receive the greatest benefits from capitalism. Here's a short reality check if you don't believe it:
Take inventory of all your lifelong possessions. How many things do you own or use that generate great convenience or benefit in your life that you didn't create personally? Capitalism enables you to have these things and live a better life on your current budget.
Drive a car? Lucky for you that Henry Ford spent his entire life building a better automobile at prices you could afford.
Use a computer? Lucky for you that Hewlett, Packard, Dell, and others spent their entire lives building a better electronics at prices you could afford, and that Bill Gates made a career producing software that makes the internet as easy as clicking a mouse.
Think you could live the life you do now if you had to build your own car, computer, software, etc., etc.? Not by a long shot.
Sure, those guys made millions in profits, but they did so by making life better for billions of people the world over, at lower prices and with greater convenience than they would have had otherwise. And those 'masses' of people didn't have to lift a finger to get those benefits. The heavy lifting is done by the people who risk their savings and work hard trying to fill a need at lower prices.
For every super-rich capitalist there are hundreds who risked their savings and failed or were out-competed. When capitalists fail they lose everything, and hardly anyone really cares. Why is it that when one of those taking the risks succeeds everyone piles on the envy wagon and accuses them of 'exploiting' the masses by producing better products at better prices?
Everyone benefits from capitalism (pure capitalism anyway, not the politically driven crony capitalism we currently have). Don't be misled into thinking that the only ones who are better off are those who collect the profits. They wouldn't be generating profits if they weren't making someone's life better in some fashion.