global financial crash yay!

[vimothy]

Have to be quick. For now,

1, Is about global imbalances and capital flows, and is indeed a root cause of the crisis. There is a sense in which Bernanke is right, though its an exaggeration. To simplify, "China" (or whoever) don't spend, they save, and they export to America. internal demand is weak, so growth is lead by exports (to the US). In order to maintain competitive prices in US markets, they keep their currency low against the dollar. How do they do that? Well, they have a lot of savings... Which is what is actually happening, believe it or not.

2, Agreed, yes, there are important principal-agent problems in dire need of fixing.

3, Is about how we value assets. What do think determines the value of a financial asset, makes it worth more, less, etc? The answer to this problem tells us a great deal about the crisis.

4, Not sure, but think the impact will be profound. The implications, not in a theoretical sense, but in a sense of what is happening to our economies, are truly massive. Governments' reactions have been inadequate. (Not a very libertarian thing to say...) Germany's has also been poor. The EU has problems given its shared currency yet individual governments.

 

[vimothy]

Losses in asset values first -- which I think I may have underestimated by about $10tn -- then macroeconomic imbalances:

A financial asset is a claim on future cash flows. What is the value of this claim? If you think about it from the side of the borrower, having C amount of cash now might be worth C+i, where i is a given rate of interest, in a year’s time. This basically describes a bond. You lend me £100, and I pay back £100 in a years time, plus £5 interest (which would be the bond's coupon payment), to make it worth your while. To have £100 now, I am willing to pay £105 in the future. If you look at it from the lender's perspective, you see, unsurprisingly, the same thing in reverse. What is the present value, of having £105 in a year's time? To find the present value of a future payment, you discount at the same rate of interest: £105/1.05 = £100. That is, £105 in a year’s time is worth £100 today. Our financial assets were worth $80tn and are now maybe worth $50tn, which means the present value of those claims on future cash flows has gone down.

The present value of financial assets (IOUs) is determined by the discount (interest) rate, but what determines the discount rate? If you again put yourself in the lender’s shoes, you see that having £100 in a year is never likely to be worth the same as having £100 right now. The borrower might default. You might need liquidity. The value of money might have changed. Maybe the borrower knows something you don't. So we have the actual amount (£100 -- its par value), and various discounts: default, duration, risk and infomation. In answer to your question, where did all the money go, money was lost from defaults on the mortgages and mortgage backed securities, and from the effects of the recession (default discount), some of which was off-set by central banks flooding the world with liquidity (duration discount). However, this is a matter of a few trillion dollars. The real, substantial losses have come from a massive reduction in tolerance for risk in financial markets. The risk discount has gone way up, and therefore the present value of our assets has gone way down. It's like we had claims with a present value of £80, but the interest rates shot up as everyone's tolerance for risk shot down, and now the claims are only worth £50.

 

[vimothy]

Does that make sense?

 

[IdleRich]

"And if the possibility of illusory wealth is admitted, how can this then be distinguished from real wealth?"

Well, what exactly is real wealth? Once you have worthless stuff (money) as a token of exchange for actual items then you've introduced a thing that depends on confidence or a shared agreement to recognise that stuff and to some extent any wealth that you hold in the form of money is based on something that isn't concrete. Is it real? I don't know.

 

[josef k.]

"Does that make sense?"

It does, but mysteries still lurk. The central one is this concept of risk. Who has good theories about this? About how risk can be calculated. The larger the data set becomes, this must become more and more difficult and prone to error. Actually, this was what brought down Long Term Capital Management, if I am not mistaken...

It seems that the operation essentially consists of attempting to predict the future.

**

"Well, what exactly is real wealth? Once you have worthless stuff (money) as a token of exchange for actual items then you've introduced a thing that depends on confidence or a shared agreement to recognise that stuff and to some extent any wealth that you hold in the form of money is based on something that isn't concrete. Is it real? I don't know."

Good point, that.

 

[vimothy]

Depends what you mean. Knight's Risk, Uncertainty and Profit and von Neumann and Morgenstern's Theory of Games and Economic Behavior are the foundational economic texts dealing with risk. Daniel Kahneman and Amos Tversky are also worth checking out for some of the problems associated with risk taking and making choices. Banks use risk models like VaR (value at risk -- how much could I lose today) and CoVaR (conditional value at risk -- the same question but incorporating counterparties), dependence modelling using the Gaussian copula function (a method of formulating multivariate distributions -- used to price CDOs and other forms of structured credit), as well as stress testing (how hard do you have to push a security before it falls over), and doubtless lots of other stuff I've not heard of.

A very simple model of risk would be something like this (works for either profits or losses):

Expected value = probability of event * cost of the event or the event's pay-offt​

Knight distnguishes between risk and uncertainty, where risk is what you know (and can number) and uncertainty is what you don't know. But of course, they might be the same thing (i.e. uncertainty is a problem of knowledge), or equally, probablities of risk might be subjective papering over the cracks of our own limitations (i.e. quantifiable risk is an illusion).

And there are many varieties of risk. We touched on four already, but can add currency risk, capital risk, interest rate risk, financial risk, systemic risk, idiosyncratic risk, etc, etc, etc. You work the risk out by looking at the likelihood of an event occuring and the cost it will impose if it does (the product of these two things is the event's expected value). So you build a model and enter your data. It's not really predicting the future, its looking at the probability of an event occuring based on what we know from the past. Obviously, this has some severe limitations. Garbage in, garbage out, as they say.

LTCM's problems were overconfidence (having good models and employing rocket scientists is not always enough -- as Keynes said, "the market can stay irrational for longer than you can stay solvent"), high leverage, and that their highly leveraged, diversified portfolio suffered with the flight to liquidity in 1998: all correlations moved to 1, all positions went in the same direction and any diversification vanished. Boom! Have a look at its share price (yellow line on graph below). Based on past performance, LTCM were a very safe bet, a really great bet. Until they weren't.

 

[IdleRich]

"Good point, that."

Thank you. It just annoys me when you hear people saying stuff like "I never trusted in this funny money and kept all my savings buried in the back garden" when all money is funny money in a sense. Though I do accept that some things are further down the funny money spectrum than others.

"looking at the likelihood of an event occuring"

This is the hard bit.
But yeah, I agree, they're not really predicting the future any more than anyone is when they make a decision that relates to a later date.

 

[vimothy]

'frinstance, check out this (typically great) article by Felix salmon on the Gaussian copula: http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all

In finance, you can never reduce risk outright; you can only try to set up a market in which people who don't want risk sell it to those who do. But in the CDO market, people used the Gaussian copula model to convince themselves they didn't have any risk at all, when in fact they just didn't have any risk 99 percent of the time. The other 1 percent of the time they blew up. Those explosions may have been rare, but they could destroy all previous gains, and then some.

Li's copula function was used to price hundreds of billions of dollars' worth of CDOs filled with mortgages. And because the copula function used CDS prices to calculate correlation, it was forced to confine itself to looking at the period of time when those credit default swaps had been in existence: less than a decade, a period when house prices soared. Naturally, default correlations were very low in those years. But when the mortgage boom ended abruptly and home values started falling across the country, correlations soared.

Bankers securitizing mortgages knew that their models were highly sensitive to house-price appreciation. If it ever turned negative on a national scale, a lot of bonds that had been rated triple-A, or risk-free, by copula-powered computer models would blow up. But no one was willing to stop the creation of CDOs, and the big investment banks happily kept on building more, drawing their correlation data from a period when real estate only went up.

 

[vimothy]

Markets in everything

Total insanity -- sovereign American CDS spreads widen.

EDIT: A Credit Trader has the answer: "one shouldn’t look at CDS as a “default” trade. Though their pricing is clearly driven by the likelihood of default and the payout upon default, I can tell you that 99% of people buying CDS do not believe that the entity upon which they are buying protection will actually default. In this, they are similar to investors in stocks. People buy and sell stocks because they think the stock in question will increase or decrease in price. Same goes for CDS."

 

[vimothy]

http://www.voxeu.org/index.php?q=node/3243

 

[josef k.]

Gentle Ben strikes an optimistic note:

http://dealbook.blogs.nytimes.com/2009/03/15/bernanke-sees-recovery-beginning-in-2010/?ref=business

 

[vimothy]

Quite a coup getting an interview out of a Fed chairman.

 

[vimothy]

Although Bernanke, not unsurprisingly, manages to say almost nothing.

 

[vimothy]

Former Fed chair Paul Volker is more upfront:

Mr. President, it's way too early to know exactly what the stimulus is doing because the money is barely out the door, but I've got to tell you I'm worried as hell. Unemployment is at 8 percent, and underemployment is over 14 percent of the workforce. The economy is shrinking much faster than it was when you put the stimulus together. It will be more than a trillion dollars short of its full capacity this year, and I have every reason to believe the same next. State governments alone are hundreds of billions in the hole, creating a huge drag. So your $787 billion over two years, only two-thirds of which is direct spending, isn't going to get us nearly far enough. I'd strongly recommend you make ready a second stimulus, about the same size, and get it enacted as soon as possible, with the proviso that it will be implemented if and when unemplyment hits 8.5 percent or underemployment reaches 15 percent.

Oh, and by the way, Mr. President. You may not want to hear this, but your Treasury Secretary is making things worse. His dithering on what to do about Wall Street, and his incapacity to speak clearly to the Street and to the public about what needs to be done, is spooking everyone. Why doesn't he just put the irrevocably insolvent banks into receivership under the FDIC, sell off their assets, protect depositors, and reimburse taxpayers with whatever remains? Let the rest of the banks fend for themselves -- working out their bad loans with their creditors. As to AIG, well, that's a complete basketcase. Put it out of its suffering. Take it over, sell its assets, protect policy holders (you'll need to create a big co-insurance plan with every other major insurer in the world), then get out.

Want a cigar?

 

[vimothy]

Macroeconomic imbalances and the financial crisis

Over the past decade a combination of diverse forces has created a significant increase in the global supply of saving--a global saving glut--which helps to explain both the increase in the U.S. current account deficit and the relatively low level of long-term real interest rates in the world today. The prospect of dramatic increases in the ratio of retirees to workers in a number of major industrial economies is one important reason for the high level of global saving. However... an important source of the global saving glut has been a remarkable reversal in the flows of credit to developing and emerging-market economies, a shift that has transformed those economies from borrowers on international capital markets to large net lenders.

Ben Bernanke, speech to the VEA, March 10th 2005

The current financial crisis has its roots in the series of crises that preceded it over the last decade and a half: Mexico (1994), Asia (1997), Russia (1998), Brazil (2000), Argentina (2002). The crises altered the preferences of many developing nations, who went from being net borrowers, importing capital to fund development, to being net savers, lending money to the developed world. This was, in some ways, surprising, because importing capital to fund development makes sense in that, if you are growing rapidly, you can borrow now, keeping investment and consumption high, and pay back when you are richer. In another way, this was the natural outcome of the experience of banking and currency crises. Central banks, once burned, kept current account surpluses, large foreign reserves, and intervened in foreign exchange markets.

What this meant in practice was a lot of money with nowhere to go. Furthermore, the massive run-up in petrol prices created more excess capital in the developing world, in particular in the Middle East. Most of this excess ended up in the USA. Reinhart and Rogoff state that the series of US current account deficits that tracked this shift, "at their peak accounted for more than two thirds of all the world’s current account surpluses". The flip side of excess saving was that long-term interest rates around the world fell. The global economy was deep into the "Great Moderation" of economic volatility. Central banks bought treasury bills. The Fed kept rates low. In search of yield, investors moved into residential mortgage backed securities, CDOs and the like. Oh yeah, and credit was cheap so they took on a lot of leverage. Which bid up asset prices, which could be drawn again on as increased collateral, which pushed up prices further. Just like the housing market.

The whole world has been falling over itself in a mad dash to lend America money, and America has spent the lot in a binge: the global consumer of last resort. China subsidises its export sector in American markets (internal demand in China is weak) by bidding up the value of the dollar against the renminbi, and lends the dollars it has bought back to the US, which are then spent on Chinese imports. Its a strange relationship. If there is a lot of inflation in the US in the near future (and that is surely unavoidable), China will lose a large amount of money.

 

[Mr BoShambles]

advancing the META dissensus project

Apologies if this is OT but it seems relevant, in an abstract sense, given that change is at the heart of this discussion [and pretty much every other on Dissensus).

In this peice, Mowles, Stacey and Griffin argue that 'rather than portraying social interaction as rational, linear and predictable' we should adopt an alternative perspective which seeks to 'describe a web of human interactions... predicated on the power relationships and interdependencies of the actors.'

They argue that:

Because of the scale and complexity of the game being played by these actors, it can only result in unpredictable and unexplained consequences no matter how clear and logical the strategy pursued by any actor. This is a paradoxical world where we are forming and being formed by the web of interactions both at the same time. Our knowledge of the game we are playing is imperfect, and we only realise this as we play the game and reflect on the consequences of having played it. Rather than displaying an ‘if. . .then’ causality, our understanding of the temporality of what we are involved in is cyclical: we act in the present, informed by the past and in anticipation of the future, and our understanding of that past is constantly revised as a result of our acting.

This argument can be grounded in the emergent sciences of complexity (i.e. quantum theory, non-linear mathematics, biotechnology, micro-biology, cybernetics) as well as the sociological works of Pierre Bourdieu, Norbert Elias, and others.

Here is Elias' (1991: 62) take on the complexity of human networks:

The interweaving of the needs and intentions of many people subjects each individual among them to compulsions that none of them has intended. Over and over again the deeds and works of individual people, woven into the social net, take on an appearance that was not premeditated. Again and again, therefore, people stand before the outcome of their own actions like the apprentice magician before the spirits he has conjured up and which, once at large, are no longer in his power. They look with astonishment at the convolutions and formations of the historical flows which they themselves constitute but do not control.

 

[vimothy]

The feedback effects are everywhere. Most notably, the contraction in the financial sector is causing a contraction in the real economy, which is then causing further contractions in the financial sector; and the contraction in the US economy is causing contractions in other economies round the world. In previous recessions over the last twenty to twenty five years, the US consumer's spending (and remember the US consumer's role in the global economy over the last couple of decades) barely dipped (stats in this paper), but now it has fallen off a cliff.

 

[josef k.]

A further question/angle on this problem is the technological one. Richard Sennet points out:

The growth of communications technology meant that information could be formulated in unambiguous and thorough terns, disseminated in its original version throughout a corporation. E-mail and its derivatives diminished the mediation and interpretation of commands and rules verbally passing down the chain of command. Thanks to new computer tools for mapping corporate inputs and outputs, information on how projects, sales, and personnel were performing could pass up to the top, instantly and unmediated. In the auto industry in the 1960s, the time lag of getting an executive decision on to the shop floor was, by one estimate, five months, an interval that today has been dramatically cut to a few weeks. In sales organization, sales reps' performances can be mapped in real time on home-office computer screens.

**

And there is the way - noted lately by John Stewart - in which 24 television news has exacerbated the game-show aspect of the market. To what extent, I wonder, is the new rapidity of information a cause in the current economic collapse?

 

[Mr BoShambles]

So a ‘Newtonian’ mechanical worldview – i.e. one based on linear chains of cause and effect - is clearly flawed. Rather than viewing the world as a clockwork machine made up of many different basic parts; instead we need to see it as a holistic organism – a unified whole made up from the many relations between its parts. So the emphasis is shifted from the study of objects to the study of relations and processes – cyclical patterns of information flows, feedback loops, non-linear interconnections, self-emergent properties etc.

Question is though: what potential value does complexity thinking hold for policy advisors, managers, regulators and researchers who work on issues of change and reform in any social sector? If actions 'can only result in unpredictable and unexplained consequences no matter how clear and logical the strategy pursued by any actor', and the effects of any action resonates ever more rapidly through the system because of the IT revolution, then what hope for macro planning our way out of "problems"? We're always playing catch-up with an ever-evolving world, armed only with imperfect knowledge/models....

 

[vimothy]

Here's a piece of technology with a lot to answer for:

And of course, advacements in technology became one of the reasons justifying why the bubble was not really a bubble, why it was different this time around: just in time supply-chains meaning that inventories will not fluctuate, mitigating the business cycle, e.g.