"The Next Panic" by Boone & Johnson

Very worthwhile piece in the Atlantic by Peter Boone and Simon Johnson. Don't miss it. Johnson is former chief economist of the IMF; currently, he is at MIT. Boone is an economist and money manager.

The nub of their position is that the natural order of things, economically, is a series of booms and busts. These periodically wipe out financial institutions and creditors. We have been spared most of this since the Great Depression, but the tools used to moderate the cycle have run their course. The financial bacteria are, one could say, increasingly immune to antibiotics.

Here are some key sentences, lightly re-ordered, to bring out the thrust of their article:

The on-again, off-again euro turmoil has already proved immensely damaging to nearly all Europeans, and its negative impact is now being felt around the world. Most likely there is worse to come -- and soon.

[O]ur financial systems appear to be returning to their inherently unstable nature, which plagued the 19th and early 20th centuries. Financial institutions back then were not too big to fail -- they were too big to save. 

Devastating crises characterized the pre-war global financial system; these would typically raze banks and other institutions to the ground. 

Through the development of central banks and active fiscal and monetary policy, the rich world has managed to avoid serious depression for seven decades. Yet big finance -- which tends to grow ever larger when crises are rare and credit risks seem muted -- hides deep political flaws.... 

Bankers and politicians seem to enable the worst characteristics and behaviors of the other. The past few years have led us to focus on half of that phenomenon: the degree to which government guarantees have facilitated irresponsible risk-taking on Wall Street.

[J]apan illustrates the other half of the phenomenon -- the extent to which finance has allowed and encouraged politicians to make attractive short-term decisions that are eventually damaging. 

Those whom the gods would destroy, they first encourage to borrow cheaply. 

In recent decades, financial sectors throughout the rich world grew at historically unprecedented rates; now they are dangerously outsize relative to the rest of the economy. Changing that dynamic in any orderly way looks extraordinarily difficult. Yet history suggests it will change, and soon. The era of large-scale, uncontrolled financial booms and busts -- last seen in the 1930s -- is back.

I advise reading, sleeping on, and re-reading their whole piece.

Are they right about the return to old-style cycles? I don't know, but they are raising the right issue. The older I get, the more I appreciate a well-formed question. Often, that is the answer. If capital-N Nature is, at some level, chaotic, then a well-defined set of possibilities may be the most we can actually know.

It is difficult to manage financial assets in a world in which people seem, almost continually, to use overly-optimistic assumptions. My tool kit would work better in the world they say we are heading into. And occasional forest fires are better for all than decades with no fire, and then a huge one that burns completely out of control. So, in a sense, I actually like the gloomy things they are saying.

My guess is that we will have more volatility than we got used to before 2007. Sovereign balance sheets are weaker. I doubt it will be as wild as the booms and busts of the 19th Century, however. I suspect that, in the long run, fiat currencies drain off some of the boom-and-bust energy into slower growth, bouts of inflation, and, in weakened countries, currency crises. Some of the energy; not all.

[Reflects a few edits on 9/28/12]

An Economics Bestiary

Link here. Not to be missed. From Noah Smith, an economist whose blog I had not read before. HT Paul Krugman's blog.

There is a bit of political spin embedded in Smith's post, some of which is subtle, and some of which is obvious. I care not, it's smart stuff.

Nice Graphic Showing the Fed's Balance Sheet Expansion

Via the Cleveland Fed, here.

It brings to mind pictures of odd creatures at the bottom of the sea, where the pressure is many times that of the air on earth. Beautiful to the eye, and also, a bit scary.

Richard Fisher, the head of Dallas branch of the Fed, voiced his concerns in a speech two days ago at the Harvard Club in New York.

Simplicity is Good

Good piece in The Economist about the importance of simplicity and clarity in banking regulation. It summarizes a speech that Andrew Haldane, who is in charge of bank stability at the Bank of England, gave at Jackson Hole a few weeks ago. The title of the speech is, "The Dog and the Frisbee."

The basic idea is to use leverage ratios, rather than to risk-weight assets. I agree. After all, how risk-free were those zero-risk-weight bonds issued by European sovereigns?

From The Economist:

Mr Haldane uses the analogy of dogs, such as border collies, which are very reliable catchers of Frisbees without being aware of the complex calculations (wind speed, air resistance, etc) that might be involved. The rule which the dog’s brain has subliminally worked out is to run at a speed so that the angle of gaze to the Frisbee remains constant. 

A dog can catch a Frisbee because it uses a simple rule. If it tried to do the math -- obviously, it can't -- it would fail.

Haldane's bio is here.

David Layzer

I never had a better teacher than David Lazyer. He is a cosmologist and taught a seminar I took in college, "Chance, Necessity and Order," about three decades ago.

Humane, brilliant, and generous with his time and spirit. What more do you want? It is all in this profile, which is from a 1991 newspaper article. It is completely accurate and true to my recollections (including his taking walks with undergrads, like me, who did not know how to dress for the cold). I took the course my freshman year, and I was one of his course assistants when he offered it again in my junior year.

I actually started to write this post about banking regulation, and the idea that simple regulation is better than complex. Simplicity being a hallmark of truth is an idea I first heard from Prof. Layzer. He attributed it to Einstein, and maybe to earlier thinkers as well.

I cannot bring myself to making Professor Layzer a mere footnote in a piece about banking! That would be awful. He deserves his own post, and much more. I will make my point about banking regulation in an upcoming post.

Robert Rodriguez on QE3: "All in!"

Rodriguez is a very interesting money manager, and his candid opinion pieces are always worth reading. Here, he reacts to last week's aggressive quantitative easing announcement by the Federal Reserve. He mixes a little of his politics with his analysis. Depending on your own views, you may wish to filter that part out. His main point: the Fed is, at some level, trying to force investors to take risk. Investors will need to remain disciplined, and this will be difficult.

I would add that one tough question is, to what extent does discipline mean holding fixed-income like U.S. Treasury bills, when the currency is at risk of depreciating if the printing keeps going? What makes this question so difficult is that it is hard to know at what point the huge expansion of the monetary base that has taken place since the 2008 crisis will actually show up as serious inflation. On this matter, it is a lot easier to pose the questions, like Socrates, than it is to give an answer.

El-Arian Nuggets on the QE Announcement

Good FT piece by PIMCO's Mohamed El-Arian (registration required) on the Fed's announcement today of yet another round of quantitative easing. Key sentences from El-Arian:

Through both its actions and what it refrained from doing, the Federal Reserve confirmed on Thursday that it is operating in policy purgatory: incapable of delivering the good economic outcomes it desires, yet unable to exit from an experimental policy stance that risks a widening array of collateral damage and unintended consequences.

...Like the ECB, its Frankfurt-based European counterpart, the Fed cannot by itself secure the results that so many desire – high growth, robust job creation and financial stability. At best, it can keep buying time in the hope that other government entities will get their act together....

AIG, Yves Smith, Sorkin, Barofsky

Yves Smith correctly points out an uncharacteristically weak piece of reasoning by the usually-insightful NYT reporter Andrew Ross Sorkin.

In question: how much the bailout of AIG did, or did not, cost the U.S. Sorkin busts on the claim by former TARP plan inspector general, Neil Barofsky, that AIG will prove a big loss, if properly accounted for.

In a nutshell, the bailout of AIG cost more than Sorkin says it did. It is unclear why Sorkin chose to try to discredit Barofsky on the matter. Smith is right to point out Sorkin's mistake here.

I read Barofksy's book, Bailout, eagerly this summer, and enjoyed it. Barofsky has an abrasive personality, which comes through in almost everything he does. People may not like him. It is only because he is telling the truth!

I like Sorkin's reporting. He happened to make a mistake here. I wish we had more prosecutors and inspectors willing to take on the kind of thankless tasks that Barofsky did. There is a wiff of politics in this matter, but I think Sorkin, Barofsky, and Smith are all Democrats, or at least, more supportive of Democrats than Republicans. My point is only about the math.

Again?

Real estate is getting hotter. One recent article in the Nashville press speaks of bidding wars in Green Hills, where I live. The other is about a shortage of houses here for rent (even though the end of that piece suggests that some houses are not selling as fast the first article says). Bottom line, supply appears to have gone down, while demand has gone up.

What happens with the real estate in a city Nashville's size does not mean much (even if it is home to one of the the coolest musical communities in the world). However, I sent these links to a friend of mine who studies real estate markets very closely, nationally, and he tells me that these Nashville stories are typical of the pickup that he is seeing in most areas of the country.

I expressed some "Here we go again" concern to him. He said he is not worried about a new bubble because lending standards have stayed strong. Buyers are putting 20% down again. I am partially (though not wholly) reassured.