Wednesday, August 27, 2008

Know-nothings and the Current Systemic Crisis

Reporting from Jackson Hole, Wyoming, where the “leading banking policymakers” were concluding their annual meeting, The Financial Times wrote:
More than a year into the credit crisis, the world’s top central bankers admit that they are still in the dark as to what its ultimate impact on the global economy will be.
The governor of the Bank of Israel, presumably one of the world’s top central bankers, had this to say: “There is an enormous amount of uncertainty about where we stand at the moment”. A former deputy governor of the Bank of Japan, upped that and spoke of “exceptional uncertainty”.

So once again it was confirmed: the world’s top central bankers – and top fund managers and top regulators and top academics, in short all those who were top enough in finance to be invited to Jackson Hole – have absolutely no idea whatsoever as to what is taking place around them.

How do you proceed then, when you do not know where you are and what lies ahead? What guides you?

The answer, I suppose, is common sense that is rooted in the experience. Like this one, for example:
“If you’ve got a squirt gun in your pocket, you probably will have to take it out. If you have a bazooka in your pocket and people know it, you probably won’t have to take it out”.
The speaker is Treasury secretary Paulson in front of the Senate banking committee, making the point that to successfully manage the Fannie-Freddie crisis, he needs virtually unlimited resources (bazooka), as opposed to a finite sum (squirt gun). He then added:
The more flexibility we have on the credit facility [to make investments and loans to Freddie and Fannie], the more confidence you have in the market and the greater protection to the taxpayer because the less likely it will be used.
Note the two close-knit streaks underlining this practical wisdom. One is the Prussian “peace through strength” philosophy that is now the guiding principle of every military strategist and street-corner thug. It is the pulling-a-gun-when-the-other-side-pulls-a-knife philosophy, so that no one would “mess” with you. Peace through strength!

The other is the element of bluff: if you have no gun and no stomach for a fight, you pretend to be the madder and the “badder”. If your opponents believe that you have a bigger gun, or a bazooka, or no control over your car (in the game of “chicken”), they might back off. That is the subject of the so-called “game theory”: how to win against an opponent who reacts to your moves.

That Secretary Paulson thinks of Fannie-Freddie problems in terms of the chicken game is not surprising. This border-line fraudulent nonsense has so encroached economics and “modern finance” that its perpetrators are given the Noble Memorial Prize in economics. See how The Financial Times is using the same game-theory framework to report on the failure of Paulson's “bazooka” strategy:
By the start of last week, Mr Paulson’s theory was increasingly being undermined by the markets, as investors essentially called the Treasury’s bluff, not just by bringing down the equity prices but also by showing limited appetite for debt and preferred stock issued by Fannie and Freddie.
This is not the place to discuss the futility of resorting to escalating force. (That was the main point of the Rambo movie that many people missed, thanks to Hollywood’s perversion of the original script).

Let us also not dwell on the technical point of fitting a bazooka in a pocket. But I must absolutely insist on one critical point. The subject of finance is not people. It is capital in circulation. The capital in circulation, furthermore, has its own laws that operate independent of the will of the individuals in financial markets. More accurately, the sum total of self serving actions of individuals set in motion a force that has its own, independent laws of operation which, for that very reason, tends to frustrate the individuals’ efforts. That is why seemingly common sense “practical” solutions do not work. The problems in financial markets are real. No one needs to be aware of them for them to exist. They will not, likewise, disappear with bluff and threat.

Take, for example, this front page story from The New York Times, under the heading “U.S. and Global Economies Slipping in Unison”:
Economic trouble has spread far beyond the United States to major countries in Europe and Asia, threatening American businesses with the loss of foreign sales ... Only a few months ago, some economists still offered hope that robust expansion could continue in much of the world even as the United States slowed down ... Now, high energy prices, financial systems crippled by fear, and the decline of the trading partners have combined to choke growth in many major economies.
Why do global economies move synchronously with the US economy? Can we offer an explanation in terms of finance, one that would not involve “people”?

Here is what I wrote in Vol. 1 of Speculative Capital in 1999:
After arbitrage opportunities in the home market have been grazed, speculative capital sets out to find virgin markets outside the original national boundaries. This excursion begins with more developed markets. That is partly because they can more easily accommodate the large size of speculative capital. Also, the primary tools of speculative capital–derivatives–are more likely to be found in these markets. Gradually, even in these markets, the profit opportunities are arbitraged away ... So speculative capital sets out to seek even more virgin territories outside the developed markets and economies. When these markets are found, they become the “emerging markets.”

The specifics of how speculative capital links various international markets are, again, quite technical and vary from one case to another ... In all events, though, the end result of cross-border arbitrage is a replay of what takes place in national markets: the markets become coupled and their price movements synchronized.