Friday, July 17, 2009

Bleeding the 'Real' Economy to Support the Financial System

I am in the highly unusual position of agreeing with Krugman (or at least in part), the Nobel winning economist who writes in the New York Times. He has just recently written an op-ed on the subject of the huge profits being achieved by Goldman Sachs ($US 3.4 billion), and says the following:

The huge bonuses Goldman will soon hand out show that financial-industry highfliers are still operating under a system of heads they win, tails other people lose. If you’re a banker, and you generate big short-term profits, you get lavishly rewarded — and you don’t have to give the money back if and when those profits turn out to have been a mirage. You have every reason, then, to steer investors into taking risks they don’t understand.

And the events of the past year have skewed those incentives even more, by putting taxpayers as well as investors on the hook if things go wrong.

Inevitably, the massive bonuses that Goldman are about to distribute are a major point of the controversy. However, whilst this is all good populist material, the focus should be on a system in which the banks were bailed out in the first place. As Krugman identifies, it is a case of 'heads they win, tails other people lose'. Krugman, I recall, was in favour of 'saving' the financial system, as were many others. What we are now seeing is the result of the 'salvation' of the system. The banks that took huge bad bets are now appearing to make large profits.

Regarding Goldman Sachs as the evil in the machine, the populist mantra of the day, I will not criticise them. Provided that they act in the law, their duty is to do the best possible for their shareholders, and also their employees. Goldman Sachs are simply doing a very effective job within a framework that allows them so much leeway. They are no different from GM in holding out their hand for government support, but are simply more effective at doing so. Goldman Sachs are just a symptom, and are certainly not the cause of the problem. It is not their role that should be subject to criticism, but the government and the Federal Reserve - it is the state that is the problem. It is the state that is at the root of the appearance of the bumper profits and bonuses at Goldman Sachs.

I say 'appearing', as there are real question marks over how 'real' these profits actually are. The bailout of AIG has been linked to an indirect bailout of Goldman Sachs, for example by the bane of Goldman Matt Taibbi of Rolling Stone magazine. On top of AIG, it is not clear how much Goldman has been bailed out by the various programs that have been enacted to remove toxic assets from the balance sheets of banks, as the recipients of such bailouts is shrouded in secrecy. There are also the changes in accounting rules have allowed banks to do some extraordinary accounting tricks:

During the financial crisis, the market prices of many securities, particularly those backed by subprime home mortgages, have plunged to fractions of their original prices. That has forced banks to report hundreds of billions of dollars in losses over the last year, because some of those securities must be reported at market value each three months, with the bank showing a profit or loss based on the change.

Bankers bitterly complained that the current market prices were the result of distressed sales and that they should be allowed to ignore those prices and value the securities instead at their value in a normal market. At first FASB, pronounced FAS-bee, resisted making changes, but that changed within a few days of a Congressional hearing at which legislators from both parties demanded the board act.

This is just one example. In other words, as a result of the bailouts and the changes to the accounting rules, it is nigh on impossible to work out exactly where any real profits might lie. Quite simply, nobody but the banks themselves and the Federal Reserve, and perhaps other arms of the government, can untangle the real state of the banking system. However, it is almost certain that the sudden profitability of the banks is rooted in the various bailouts and accounting tricks. Whilst it is quite plausible that many parts of the Goldman operations are profitable, the overall genuine profitability is buried in the accounting and the bailouts. Krugman identifies the complete opacity of the situation as follows:
I won’t try to parse the competing claims about how much direct benefit Goldman received from recent financial bailouts, especially the government’s assumption of A.I.G.’s liabilities. What’s clear is that Wall Street in general, Goldman very much included, benefited hugely from the government’s provision of a financial backstop — an assurance that it will rescue major financial players whenever things go wrong.
Under such conditions, it is no wonder that so many commentators are calling 'foul' over the massive bonuses that are going to be paid out by Goldman Sachs to their employees. However, the underlying problem remains as to why all of this has taken place. Why have the changes to the accounting rules taken place, and why are toxic assets being taken off the hands of the banks, thereby transferring risk from the private sector to the state sector?

The argument has been that certain financial institutions are 'too big to fail', but the reality is that the various government measures to support the situation is entrenching the system in which the large financial institutions threaten the financial system. With each bailout, with each measure, they undermine the market forces which might discipline the banks, creating ever more public exposure to private risk taking. In doing so, they simply embolden the banks to take further risks.

As was identified at the start of the process of the bailouts, there is an inherent moral hazard in bailing out banks, in that they cannot lose. They become a one way bet, and that will, however much oversight is applied, eventually lead to complacency, and excessive risk taking. It is now apparent that, under the current system, profit is guaranteed by public institutions. The worst case scenario for the major banks is that they might have a few quarters of poor or no profits, but there is an implicit guarantee that the government will do whatever is necessary to engineer a return to profitability. There will be no more Lehmans in the future, as the new regulatory regime will never allow another major bank failure for fear of a repeat of this crisis. One way or another, the 'too big to fail' banks will be immune from any major losses.

The solution given by many, like Krugman, is more supervision and regulation. However, if a bank is 'too big to fail', with proposals for special levels of supervision as a result, it will become to be seen as the 'safest' kind of bank. If a bank is seen as 'safe', it will offset any measures such as stronger capital adequacy requirements through being able to raise finance more cheaply, and through the state guarantee will win more business, and the result will be to just get bigger, and consolidate ever more risk into a small number of institutions. The crisis has already seen a consolidation in the number of major banks, and this process is likely to continue.

The problem is that the same regulators who failed to see the risks in the current system will be responsible for regulation under any new system. Whilst they might (possibly) be able to spot the kind of risks that caused the current financial meltdown, what is to say that they will be able to spot the risks that arise in the next particular set of economic circumstances? The difference is that, next time around, it is more likely that there will be even more concentration of risk in a few major institutions, and therefore even greater system-wide risk.

If you doubt what I am saying, take a look at one of the key policy makers discussing the state of housing and the financial system pre-crisis. I found this video of pre-crisis statements by Bernanke on Reddit recently. For the many out there calling for more regulation, you will need to think about how the regulators might be able to identify risk, when the record of policymakers is so abysmal. Quite simply, the policymakers who will formulate the regulation are clowns dressed up in important titles, armed with mechanistic formulae and jargon.

Whilst all of the shenanigans continue in the financial sector, the 'real' economy in the US continues to bleed. At some point in time, it is the real economy that will have to pay the price of the salvation of the 'financial system'. Again, I find myself agreeing with Krugman:
The bottom line is that Goldman’s blowout quarter is good news for Goldman and the people who work there. It’s good news for financial superstars in general, whose paychecks are rapidly climbing back to precrisis levels. But it’s bad news for almost everyone else.
The fact is that, one way or another, the 'real' economy will eventually be paying for the profits at Goldman and the massive bonuses, and that 'real' economy is already suffering extreme pain. In the meantime, it is not apparent that the 'salvation' of the financial system has translated into salvation of the economy. For all the talk of 'green shoots', the US economy continues on a steady descent, with all the pain that means for those working in the 'real' economy.

The panic engendered when the financial crisis hit is now over. I argued against the bailouts at the time that they were taking place, at that moment of panic. I argued that the resource being poured into the banks would be needed whilst the economy restructured. I argued that the bailouts would continue on from those that were proposed at the start, and that is what has taken place. And.....every single $US that has been poured into the rescue of the financial system will one day be repaid in taxation from the 'real' economy. I argued against the bailouts on this principle.

All of this, hidden in opacity, has led to a point at which insolvent banks are now able to make a 'profit'. Exactly why has this massive bleeding of resources into insolvent banks been allowed to take place? Where exactly is the salvation of the real economy, the pot of gold at the end of the rainbow of the financial system? Like the pot of gold and the rainbow, if we just go a bit further.....we might just find the pot of gold.

In this terrible mess, the point that is forgotten is what a financial system is actually really for. It only exists to allocate accumulated capital and provision of insurances; the financial system should be a support to the real economy, by efficiently allocating capital. It is entirely unclear how pouring trillions of dollars into insolvent institutions, capital which will eventually be taken out of the 'real' economy, might facilitate this. The 'real' economy is now expensively supporting the financial system, rather than the financial system supporting the real economy. It seems that this is the exact opposite of what a financial system actually should be doing. It is simply beyond any reasonable explanation.

It is the same policymakers who are supporting the financial system at the cost of the economy who will be formulating the new regulatory framework. It is the same policymakers who failed to see the risks inherent in the financial system that will be overseeing and regulating the future risks in the financial system. It is the same policymakers who have overseen the consolidation of the banking system into fewer hands, who are engineering a system in which banks will be ever more concentrated. It is the same clowns who were responsible for the current mess in the financial system, who have engineered that insolvent institutions make profits, that will suddenly have the wisdom to create a 'safe' financial system in which major risk is banished.

It is not an encouraging prospect.

Note: The use of the term 'real' economy is a convenience, as the financial system is actually part of the real economy. As such it is used simply as a way of saying that I am referring to the provision and exchange of services and goods outside of the financial sector.

34 comments:

  1. Just after posting this, I found an article on Reddit which is titled 'Has Paul Krugman Become an Austrian?' Bearing in mind I have finally found some points of agreement with Krugman, I was interested to see what it said. The link is as per below, and leads to an article on Lew Rockwell:

    http://www.lewrockwell.com/anderson/anderson259.html

    On reading the article, I found the author quoting Krugman as I have done. It seems that I am not the only one finding some common ground here. However, for the Austrians to find some common ground is really quite novel. Krugman will probably go into shock.

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  2. This just proves that a Swedish-Style bank bailout was needed all along

    The effects of the absurd bailout of creditors are predictable enough, as other commentators have observed.

    Some points:

    Krugman, I recall, was in favour of 'saving' the financial system, as were many others. What we are now seeing is the result of the 'salvation' of the system

    Though I am not sure what kind of bailout Krugman supported, there were plenty of people who condemned the present bailout, but wanted to see the financial system saved.

    The financial system could have been saved by a completely different solution: a Swedish-style bailout of banks that was used in 1992.

    In Sweden, financial deregulation in the 1980s caused a flurry of real estate lending by Swedish banks. When the bubble popped in 1991/1992, there was a major financial crisis. Here is the solution as described in the New York Times:

    “Sweden took a different course than the one now being proposed by the United States Treasury … Sweden did not just bail out its financial institutions by having the government take over the bad debts. It extracted pounds of flesh from bank shareholders before writing checks. Banks had to write down losses and issue warrants to the government. When distressed assets were sold, the profits flowed to taxpayers, and the government was able to recoup more money later by selling its shares in the companies as well.
    That strategy held banks responsible and turned the government into an owner. Sweden told its banks to write down their losses promptly before coming to the state for recapitalization. Facing its own problem later in the decade, Japan made the mistake of dragging this process out, delaying a solution for years ….
    By the end of the crisis, the Swedish government had seized a vast portion of the banking sector, and the agency had mostly fulfilled its hard-nosed mandate to drain share capital before injecting cash. When markets stabilized, the Swedish state then reaped the benefits by taking the banks public again …. Soon after the plan was announced, the Swedish government found that international confidence returned more quickly than expected, easing pressure on its currency and bringing money back into the country.”


    Carter Dougherty, “Stopping a Financial Crisis, the Swedish Way,” New York Times, September 22, 2008
    http://www.nytimes.com/2008/09/23/business/worldbusiness/23krona.html?em

    The crucial factor was the eventual cost of the bailout in Sweden: the final cost to Sweden ended up being less than 2 percent of its G.D.P. Some officials say they believe it was closer to zero, depending on how certain rates of return are calculated.

    Nouriel Roubini has made the same point:

    In the Scandinavian banking crises (Sweden, Norway, and Finland), which are a model of how a banking crisis should be resolved, there was not government purchase of bad assets. Most of the recapitalization occurred through various injections of public capital in the banking system. Purchase of toxic assets instead -- in most cases in which it was used -- made the fiscal cost of the crisis much higher and expensive (as in Japan and Mexico).

    Thus the claim by the Fed and Treasury that spending $700 billion of public money is the best way to recapitalize banks has absolutely no factual basis or justification. This way of recapitalizing financial institutions is a total ripoff that will mostly benefit -- at a huge expense for the U.S. taxpayer -- the common and preferred shareholders and even unsecured creditors of the banks.


    Nouriel Roubini, Bailout benefits only banks and their unsecured creditors, Sunday, September 28, 2008
    http://www.gata.org/node/6688

    Yet another bailout plan was proposed by James K. Galbraith, A Bailout We Don't Need
    Thursday, September 25, 2008

    http://www.washingtonpost.com/wp-dyn/content/article/2008/09/24/AR2008092403033.html

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  3. As was identified at the start of the process of the bailouts, there is an inherent moral hazard in bailing out banks, in that they cannot lose … One way or another, the 'too big to fail' banks will be immune from any major losses … The solution given by many, like Krugman, is more supervision and regulation. However, if a bank is 'too big to fail', with proposals for special levels of supervision as a result, it will become to be seen as the 'safest' kind of bank.

    The solution to “too big to fail” banks is to permanently nationalize them. The issue of moral hazard is in fact addressed by alternative types of bailouts: the fundamental issue is that creditors and bondholders should not be bailed out.

    Fred Moseley proposes a plan that addresses the issue of moral hazard:

    – The federal government would become the owner of any “systemically significant” bank that asks for a government rescue or goes into bankruptcy proceedings. The value of existing stock would be wiped out, as it would be in a normal bankruptcy.

    – The government would itself operate the banks. Top management would be replaced by government banking officials, and the managers would not receive “golden parachutes” of any kind.

    – Most importantly, the banks’ long-term bonds would be converted into common stock in the banks. This would restore the banks to solvency, so they could start lending again. The private common stock would be subordinate to the government preferred stock in the capital structure, which would mean that any future losses would be taken out of the private stock before the government stock. Bondholders could also be given the option of converting their stocks back to bonds at a later date, with a significant write-down or discount, determined by bankruptcy judges.

    The bondholders lent their money and signed contracts that stipulated that if the banks went bankrupt, they might suffer losses. Now the banks are bankrupt and the bondholders should take the losses.


    Fred Moseley, Time for Permanent Nationalization
    If the big banks are “too big to fail”' they should be public.
    http://www.dollarsandsense.org/archives/2009/0309moseley.html

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  4. The problem is that the same regulators who failed to see the risks in the current system will be responsible for regulation under any new system ... For the many out there calling for more regulation, you will need to think about how the regulators might be able to identify risk, when the record of policymakers is so abysmal.

    That’s why current regulators and policymakers afflicted with fantasies like the efficient market hypothesis of financial markets should be thrown out and replaced by people who actually believe that financial markets need to be properly regulated.
    The present policymakers didn’t even believe this. It’s like appointing a creation scientist to teach evolution.
    Moreover, Joseph Stiglitz identified the risks of financial deregulation ages ago. Appoint people like him to be chief policymakers.

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  5. It seems so obvious but then I remember I'm trained as an engineer, a profession that uses science and empirical validation in conjunction with human knowledge and experience in applying science to create functioning system that do what is needed and avoid what is not needed. And I have an MBA, which I got after spending 20 years in business first.

    And I remember economics as commonly practiced in the financial and academic community is largely the very, very opposite of all of this.

    What comes to mind is your example of moral hazard and the effect of consolidation on risk.

    This is classical feedback theory (wherein if you run "open loop" without true feedback you start to run into the weeds and are strictly "out of control" as a system.

    Removing the one critical and large feedback loop means the short loop of greed and cognitive limits will dominate and we already know it is a positive feedback loop rather than a negative feedback loop. The former are provably unstable while the latter are provably stable. Further, the positive feedback loop is demonstrably aiding the wrong things necessary for the system infrastructure itself to survive

    This is like asking for an amplifier with a finite gain and power supply, and demanding an arbitrarily large signal to build - it either stops dead when the laws of physics come knocking or it catches fire and the whole apparatus fails catastrophically.

    This is also classical reliability design theory, wherein you use diversity in time, space and phenomenology to reduce the total system failure probability.

    This is pretty much what portfolio theory is about as well; it uses the same idea of exploiting the independence of individual quanta of risk in your favor by making the total probability the product of individual independent probabilities rather than the total sum of cross-dependent probabilities. One gives infinitesimal overall risk results and the other doesn't even give a system risk that is better than any worst-case component risk.

    Thus first you have to be sure the underlying events really are independent for any of the risk reduction to even work. That is not what industry consolidation can *ever* achieve - it does just the opposite.

    There were two articles on Reddit today to point these out rather more nicely:

    https://www.adbusters.org/magazine/84/creative-destruction-neoclassical-economics.html

    And:

    http://videolectures.net/ccss09_sornette_fbreb/

    I've been watching the deconstruction of productive economic models by displacement of financial services over the last 20 years and it's been hell being the Cassandra about it. Now that an actual academic is saying the same thing maybe folks will listen. Too bad it may be too late to matter now - well, not too late if you consider 10-20 more years of the same stuff we're going through or worse "nothing important". :-p

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  6. Lord Keynes:

    The current crisis is not Sweden. The big question that is not addressed in your comment is quite how severe the problems of the banks actually are in this case. As I point out in my article, with all of the opacity, it is simply an unknown.I suspect that the scale of the problem is of a degree that quite simply dwarfs the problems encountered by Sweden, but there is no way to make such an assertion with any certainty.

    In the meantime, the only way of the rescuing the banking system must, one way or another, mean taking the liabilities of the banks into the public sphere. Exactly how much of the resource of the 'real' economy should be utilised to bail out, for example, overseas creditors who took their risks by investing through the US banks and lost?

    The real problem is that the government has offered an implicit guarantee, and is now paying the price for that guarantee. Your solution would make the guarantee absolute. During the build up to the crisis, US savings rates were in negative territory, or extremely low. As such, we can safely assume that a considerable portion of the losses are actually for overseas investors. Overseas institutions poured money into the US economy, and they face the loss of that money.

    Why should the 'real' economy in the US pay for such losses? Are the government saving the US economy or the banks? I would suggest that they are saving the banks......at the cost of the real economy (which in any case would have problems enough).

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  7. The big question that is not addressed in your comment is quite how severe the problems of the banks actually are in this case. As I point out in my article, with all of the opacity, it is simply an unknown.

    Of course, a thorough auditing and examination of the banks would be a first part of a serious bailout. Finding out the extent of debt to foreigners is a first step.

    In the meantime, the only way of the rescuing the banking system must, one way or another, means taking the liabilities of the banks into the public sphere.

    Not if they are allowed to go bankrupt first, and then the government writes off or re-structures the debts, and then nationalizes them and runs them.

    During the build up to the crisis, US savings rates were in negative territory, or extremely low. As such, we can safely assume that a considerable portion of the losses are actually for overseas investors. Overseas institutions poured money into the US economy, and they face the loss of that money.

    Then most of them should also lose that money! And under an alternative bailout, most of the overseas investors would be burned, because as shareholders and bondholders, they would lose their money. There is no reason why most of those debts can’t be written off or re-structured.

    Even China has already taken massive losses because of the sub-prime and financial crisis. It wasn’t US treasury bonds that caused them the huge losses, but investments in private equities.

    China’s sovereign wealth fund, the State Administration of Foreign Exchange (SAFE), began diversifying its money out of Treasuries early in 2007, and by July 2008 had moved well over 15% of its $1,800bn reserves into riskier assets, including equities and corporate bonds. But now they have taken massive losses on these investments, like everyone else.

    See “China sovereign wealth fund diversifies into a massive loss”
    http://www.creditwritedowns.com/2009/03/china-sovereign-wealth-fund-diversifies-into-a-massive-loss.html

    Once the banks are nationalized, their lending practices can be reformed from within: no more destructive asset bubbles for a start, and investments in the real economy.

    The real problem is that the government has offered an implicit guarantee, and is now paying the price for that guarantee. Your solution would make the guarantee absolute.

    How is firing management, and letting most shareholders, bond-holders, and other creditors take a loss giving an “guarantee absolute”?

    Why should the 'real' economy in the US pay for such losses? Are the government saving the US economy or the banks?

    But under an alternative bailout plan, the real economy would not. The bailout cost to the public would be minimized.

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  8. James Galbraith explains the problems of the present bailout here and his solution:

    http://www.youtube.com/watch?v=eKb_5w0YqnQ

    There should be rigorous audit of all the banks that are insolvent. Those banks that are insolvent should be handed over to the Federal Deposit Insurance Corporation (FDIC). They then replace the management, make private risk capital (common and preferred equity and subordinated debt) take the first loss, re-organize the banks, separate solvent parts from insolvent parts, and re-open them.

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  9. Lord Keynes: If I have understood you correctly, then it is good to see that you agree that overseas creditors should just have to accept their losses.

    However, where we sharply diverge is in having the government run the banking system. It would not be long at all before the banks became subject to every whim of the politicians, whether for corrupt purposes or their 'noble' pet projects.

    I will give an example of how that policy translates into practice, which is the idiocy of wind power - supposedly a noble project.

    A long while ago I posted on energy reform, and pointed out that, near as not worth quibbling about, every MW of potential power output generated by wind power would require the back up of 1 MW of alternative generating power. In other words, wind power is next to useless, and horrendously expensive.

    http://cynicuseconomicus.blogspot.com/2008/11/reforming-energy-policy.html

    The idiocy of wind power has been encouraged and subsidised by government. The government claims that it is the 'future' and will create jobs. Instead it just makes energy more expensive and the UK less competitive, thereby destroying jobs.

    Fortunately I was reminded of the wind power example by an article today in the Times. It is the first time I have seen such doubts expressed in the mainstream media.

    http://www.timesonline.co.uk/tol/comment/columnists/dominic_lawson/article6719142.ece

    The article identifies exactly the same points that I made in my article. Quite frankly, nobody in their right mind would support wind power, but plenty of politicians, lobby groups and the media have seen a massive expansion in this lunacy (for those that object to my point about this, read my post and the Times article).

    Is it not bad enough that this idiocy is taking place with subsidies and other generous concessions? Imagine what would happen if government laid its hands on the nation's stock of capital! Every pet project, however idiotic would be fully funded according to populist whims, and the latest fads, and near term electoral success.

    And 'no', the banks could not be run by independent boards, as some kind of patronage would eventually come to dominate such appointments.

    Furthermore, as a general point, every business would be sniffing around the government seeking favour for special preference in the allocation of capital. It is a recipe for corruption, and collusion between government and big business. The government will be the honey pot, and the bees will soon be buzzing around that pot.

    Many already have reasonable concerns about such cosy relationships, for example in defence contracting. Spread to the wider economy.....????

    Overall, you seem to hold a belief that government might be technocratic and might approach the economy and economic development with an independent and well thought out plan for industrial development. The things you do not factor into such a picture are ambition, spite, greed, political advantage, patronage, plain stupidity, corruption and so forth.

    Introduce these very human elements into your picture and you may come to a different conclusion. The world is made up of fallible humans, filled with weakness and stupidity, and politicians are perhaps more prone to fallibility.

    Regarding your point about China's losses, should they not take the full brunt of their losses, not have some of their losses offset by the US taxpayer? They took a risk and lost - end of story.

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  10. It would not be long at all before the banks became subject to every whim of the politicians, whether for corrupt purposes or their 'noble' pet projects ... Imagine what would happen if government laid its hands on the nation's stock of capital! Every pet project, however idiotic would be fully funded according to populist whims, and the latest fads, and near term electoral success.

    I don’t think so. Democratic elections of political parties that make their spending and investment decisions public before entering government will encourage rigorous public and private scrutiny of their plans. Since their investment choices are highly public, as opposed to the secret and opaque investment decisions of private banks in exotic financial instruments and unregulated financial markets, the public and organizations of academic and private sector experts will be able to actively oppose stupid investment decisions in a far more effective way. You can’t vote out the management of Goldman Sachs, but you can vote out a spendthrift and corrupt government at the next election. In fact, a government is far more accountable than a private sector bank.

    Given that private investment decisions have brought our financial system to the point of bankruptcy, I don’t see why private sector investment is in any way inherently superior than a system with a large input from the public.

    The major problem, anyway, is that investment has been going into useless asset bubbles over the past 20 years. Establish a legal system in which the government is absolutely and legally bound to prevent asset bubbles from occurring and also putting money into the real economy, and you already have a system that is much better than the current one.

    You can take your choice: a private system that bankrupts the West or a public system that occasionally invests in stupid things like wind power, but with plenty of good investments in the real economy.

    I'll take the second, thank you - and with the option of voting out that government spending my money on wind power at the next election.

    Overall, you seem to hold a belief that government might be technocratic and might approach the economy and economic development with an independent and well thought out plan for industrial development

    And yet South Korea and Japan demonstrate beyond any shadow of a doubt that governments can do precisely this.

    The things you do not factor into such a picture are ambition, spite, greed, political advantage, patronage, plain stupidity, corruption and so forth.

    Public corruption is easily punished: through criminal prosecution and at the ballot box. Also, there would be a role for intense public oversight of the government’s investment policies. As for ambition, spite, greed, patronage and plain stupidity, we have just seen how the private sector suffers from the same problems. I don’t see why it’s superior at all.


    Regarding your point about China's losses, should they not take the full brunt of their losses, not have some of their losses offset by the US taxpayer? They took a risk and lost - end of story.

    Naturally their private sector investment should be written off.

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  11. "It is not [Goldman Sachs's] role that should be subject to criticism, but the government and the Federal Reserve - it is the state that is the problem."

    I got this far and did a facepalm.

    1) You've ignored the obvious infiltration of GS employees into all the upper echelons of the US government.

    2) You clearly don't understand the history, structure, organization and _significance_ of the Federal Reserve of _New_York_.

    Bone up and you'll then realize why I did a facepalm, and perhaps you'll join me.

    I'll try to read the rest of your post now...

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  12. Anonymous:

    I am fully aware of the problems with the revolving door between Goldman and the state. However, that is still the problem of the state, not Goldman. I could go into a big discussion about the fundamental problems that underlies this situation, but that would be more than one post can stand.

    I hope you note the comments in response to Lord Keynes regarding the honey pot. Well, just such a honey pot exists in the system that now stands, and the result is Goldman Sachs.....

    However, much more could be said on the subject....

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  13. JSG: Thanks for an interesting commentary, and the links.

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  14. Financial hyper-profits pre-crisis were built largely on asset bubbles. Will a new bubble be created deliberately, so that such profit levels can be regained?

    Whilst consumers and companies are paying off accumulated debts - which presumably will take years - they can't be saving or investing that money. So productivity growth will be slow, so growth in the 'real economy' will be slow for several years, unless deliberately-created high inflation devalues debt and re-creates the illusion of rising wealth.

    If the real economy grows slowly, and there isn't a new asset bubble, financiers can only keep their incomes rising fast by charging the rest of us more and more.

    So either 'the markets' will insist that the government creates high inflation or the entire financial sector will raise the charges it levies on everyone else. In doing this, they'll be protected from competition, because new regulations will serve (maybe even be designed) to hamper or exclude all lenders except those who are 'too big to fail'.

    Putting it together, the financial system is going to kick us when we're down, but hopes there will be high inflation so we don't notice.

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  15. Anonymous:

    The whole point of all of the actions of the state is to rebuild the bubble. They are trying to restore the US economy to some magical point pre-crisis. That this magical point was a bubble economy still eludes them. They have forgotten about the notion of sustainable wealth generation...and are seeking to replace lost debt fuelled consumer spending with government spending and printing money.

    However, I am struggling to see how the state might continue to engineer the system. I suspect that they are losing all control, as their models simply do not work. Their engineering diagrams for the economy are lopsided.

    However, your premises about higher charges etc. are already taking place. The banks are using the 0% from the fed, whilst hiking fees in every area. In doing so, they might eventually come back to a point where they can stand alone, but only at the cost of the rest of the economy. Not to mention that banks such as Goldmans have seen a large part of their competition disappear, allowing them to reap the rewards of less competition by hiking fees.

    The trouble is that they are still exposed to the real economy, and that will mean ongoing losses in many areas of their businesses....and there must come a point where there the bailouts take the state and $US over the cliff.

    As for inflation, I think that we will all notice when it finally emerges....the question then will be how it will be spun....and the argument that will then explode is difficult to predict.

    I hope a coherent reply, as I need to rush away.

    Lord Keynes: A discussion of military procurement that has conveniently been published recently. It does not quite illustrate my points, but it is a start...

    http://online.wsj.com/article/SB124787043032160493.html

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  16. Cynicus - I think you are quite correct in your suspicion that the state is losing all control. But they will mindlessly go on rearranging the deckchairs till Nemo swims up their trouserleg, rather than accept our economic model is broken and we must seek radical change. I am deep into John Ralston Saul's "The Collapse of Globalism" at present. He crystalises my thoughts so eloquently, I can do no better than quote from his discussion of the pseudo-inevitability with which globalism has been presented:

    "The belief that we do not have choices is a fantasy, an unfortunate indulgence in abdication. And so the curious thing about inevitability is that it tends not to last very long. The more the true believers in a reigning theory of truth insist that its growth is inevitable and therefore eternal, the faster the rest of us, who have a bit of distance, tend to decide that we do have the power of choice. And all things considered, we would rather choose some other approach.

    "The true believers and sophisticated managers go on riding their great wave ever more relentlessly and with remarkable but increasingly meaningless skill, while a growing percentage of the citizenry draw ever further back on the shore in a precautionary manner. To those up on the crest, so intent on manoeuvring their surfboards, we must appear an unsympathetic lot, uninterested in their efforts, disengaged, strangely irritable, annoyed, alienated, dispirited cynical...

    "But most of us just seem to be disconnected, waiting for the wave to crash. We are waiting with the cruel, experienced eye of a citizenry that has lost respect for its leadership in general, yet hasn't quite worked out what to do about it and so waits for them to self-destruct."

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  17. On Military Spending

    Military pork barrel spending is a special problem in the US largely because the US is an empire, with a network of military bases everywhere, endless wars and a powerful defense lobby.

    That's the cost of empire.

    The same issue isn't a big problem in, say, Sweden or Denmark.

    The solution is a greater public role in decisions over allocation of government money (that is, more democracy) and steps to cut off the link between corporate lobbyists and their flow of money to elected officials.

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  18. Economic Development and State Allocation of Investment

    I noted above that South Korea, Taiwan and Japan are text-book examples of rapid and highly successful economic development caused by state intervention and a role for government allocation of investment.

    It should be noted that in fact Singapore can be added to this list as well:

    Linda Y. C. Lim, "Singapore's Success: The Myth of the Free Market Economy," Asian Survey, Vol. 23, No. 6 (1983), pp. 752-764.

    A Sample:


    The [Singapore] government is also the major actor in the capital market, given its
    large direct participation in the financial sector. Its Central Provident Fund
    and Post Office Savings Bank hold a majority of large direct participation in the financial sector. Its Central Provident Fund
    and Post Office Savings Bank hold a majority of national savings, while the
    Development Bank of Singapore is a major commercial bank which holds
    deposits and grants loans ...
    The government also influences the private allocation of investment
    funds by various investment incentive schemes administered by the Economic
    Development Board, which grants tax exemptions, write-offs, other
    subsidies and allowances, state equity participation, and low-interest loans to
    desired investments.

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  19. Like Anonymous JULY 18, 2009 10:57 PM I was slightly disappointed with this article.
    The core argument seems to be that governments are bad and big business are a benign / morally neutral force. This is too simplistic to be useful and to my mind fails CE’s mission to describe reality. The divisions between State and global corporations have blurred to insignificance in the areas that really matter. Aside from that, systems of government are part of society rather than above / separate to it. (“we get the government we deserve etc…”).

    I am not a fan of Glen Beck nor am I a conspiracy theorist, but here he maps out the human relationships between the Fed and Goldman Sachs with rather alarming clarity.
    http://www.youtube.com/watch?v=_wVQ3_ZaYB4&eurl=http%3A%2F%2Fwww%2Eyoutube%2Ecom%2Fuser%2Fpatriotsandheroes&feature=player_profilepage

    We can ignore the $ numbers he quotes, but his short presentation speaks volumes of human impulses toward greed mixed with more positive ones of helping comrades in tough times. Economic models inherited from Marx or Smith do not adequately explain or cope with this.As democracy is highly imperfect in curtailing political excesses “rational markets” are unreliable in keeping corporations honest.

    Level of stupidity and corruption within governments are as variable as they are within corporations.( I would rather live in a society run say by the Swedish government than by Goldman Sachs (as America now appears to be). I think CE lives in new Zealand where ideas of community still linger in ways that have largely collapsed in the US /UK (IMO.

    Thatcher’s self-fullfilling statement that “there is no such thing as society" have helped create the hell-holes Britain and the US seem bent on becoming (yes New Labour are also responsible etc etc etc).
    My opinion again, but the UK is only livable for the wealthy few.

    The fact is that if no-one has any responsibility beyond adhering to the law we create societies where the only sensible course of action is to fleece the state / taxpayer for everything you can. This logic permeates the society from top to bottom whether you're a Wall Street Welfare Queen or on a sink Estate in Salford.

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  20. Josiah Stamp's GhostJuly 20, 2009 at 12:19 PM

    Goldman Sachs are scum. So says Max Keiser:

    www.maxkeiser.com/2009/7/16/video-max-keiser-takes-offense-to-goldman-sachs-oligarchy/

    Spot on he is too. Worth watching.

    ps. im i the only one who can;t copy and paste into the comments box? I had to type that link in...

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  21. Lord Sidcup and others:

    I am not defending GS in the sense that you think, but rather pointing out that they are doing what they can within the system that is available.

    If we think of traditional corruption, a person can only corrupt if the person offered the wad of cash accepts it. Having lived in China, I despise corruption, but understand the necessity for a company to do business by bribery if they wish to survive. Being good at it, does not alter the dynamics.

    In the same way, the banking system and GS can only do what they do, because the system allows it. They can only seek gain, if gain is on the table. I think the question here is where the corruption starts and ends. I can only see the start being a person being willing to be corrupted, and a system that allows such corruption.

    If it were not so, then the attempts to corrupt would be rebuffed. This is the case with traditional corruption in, for example, Scanidinavia, where it barely exists. A corrupt company used to corruption might go there, attempt to corrupt officials, and find themselves in trouble for doing so. The system does not support them corrupting, and it is therefore nearly impossible.

    The problem with GS is that they are simply good at playing a corrupted system. It does not absolve them entirely from their actions, as they could take the moral high ground and not act as they do. However, as for a company within China, there is an understandable drive for using the system to their advantage.

    I knew when I wrote the 'offending' paragraph that it would upset many. However, I would rather identify the real driver of the problem which is a system that allows this, and possibly encourages it.

    In such a system, those who play it best will prosper.

    This is a rushed answer, but I hope that my point is clear. GS are a symptom, not the cause. I can no more condemn them than I can a company in China that pays off a local official, who makes such a payment the price of doing business.

    Businesses are only corrupt where it pays to be corrupt. As I said, a rushed answer.

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  22. Josiah Stamp's GhostJuly 20, 2009 at 1:40 PM

    Another good read about Goldman Sachs:

    www.rollingstone.com/politics/story/29127316/the_great_american_bubble_machine

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  23. Cynicus

    you might find this interesting

    its being emailed to UK businesses by BOE

    http://www.bankofengland.co.uk/monetarypolicy/pdf/qe-pamphlet.pdf

    Regards
    Smiley

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  24. You know what's scary?

    From: http://newsfrom1930.blogspot.com/

    Here's what the Federal Reserve chairman said on July 21, 1930:

    “there is food for serious thought in the fact that, under our excellent banking system ... we nevertheless came to the brink of a collapse, had to resort to heroic action to prevent a panic, and were not able to avoid ... severe liquidation and what appears to be a business depression. Is this unavoidable? Is it necessary for this country to go through periods of reckless exuberance, accompanied by enormous credit expansion and fantastic levels of money rates that profoundly disturb the financial structure not only here but all over the world?”

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  25. "This is like asking for an amplifier with a finite gain and power supply, and demanding an arbitrarily large signal to build - it either stops dead when the laws of physics come knocking or it catches fire and the whole apparatus fails catastrophically."

    JSG, it is good to see a fellow engineer here. The above statement goes to the heart of the problem. If you look at the whole of world economy, you realise that the system is unstable. You may get long periods of everything running smoothly but it is doomed to fail sooner or later.

    Zed

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  26. “I am not defending GS in the sense that you think, but rather pointing out that they are doing what they can within the system that is available. “

    Exactly, so perhaps we could agree that the system is not fine (being conducive to and allowing abuse)? The GS example seems a fairly clear contradiction of your earlier stated belief that “the underlying system works.”

    I would argue that GS are a both a symptom and a cause (as are the idiotic governments most of the Western World is lumbered with).

    CE and Krugman agree that Goldman Sachs act rationally and legally towards their own self-interest and the results are disastrous for society.

    Could we see clearer rebuttal of the idea that provided one of the best-known rationalisations for unregulated markets etc? (I think you yourself have quoted it also).
    This one:
    ““by pursuing his own interest, the individual frequently promotes that of the society.”
    Adam Smith, Wealth of Nations, 1776.

    (The corporation has the legal status of an individual in the US, so I think the comparison stands).

    Different kinds of societies encourage and accept different behaviors: for example in Agrarian /early industrial societies it might have been lunacy to not to help your neighbours with their work, given that you could expect their help at other times when needed.We move forward a few hundred years and have new environments where for example, Corporations and modern politics encourage ruthless competition between and WITHIN organizations and thus make co-operation an extremely stupid strategy towards success. These are new environments where rational self-interest can be a destructive force in the wider society.

    I realize I’m a bore on the subject but CE’s arguments are shaky when built on his ideological assumptions (which no doubt seem obvious truths to him) rather than getting to core by analyzing reality.

    How many commenters on this blog agree with CE that there is “no real problem in a system built around consumption”?.

    Adam Smith and Karl Marx described a world which longer no exists. Economic models and analyses built on their ideas can only fail.

    ReplyDelete
  27. Lord Sidcup:

    You seem to be suggesting that in my previous post on consumption, I was suggesting that everything in the current capitalist system is fine. This entire blog is devoted to pointing out the many flaws in the current system, and in places offering suggestions to how it might be fixed.

    In previous posts I have shown how the banking regulation contributed to the crisis:

    http://cynicuseconomicus.blogspot.com/2008/12/banking-regulation-buyer-beware.html

    I have consistently argued against any bailout of insolvent institutions.

    In your comments you say this:

    'CE and Krugman agree that Goldman Sachs act rationally and legally towards their own self-interest and the results are disastrous for society.'

    I have argued consistently that banks should not be bailed out. I have argued consistently against the kind of regulation and system that allows such a thing to happen, as has happened with GS. This is not the fault of free markets, but government intervention in free markets. No government interference, no bailout of GS.

    I do not make ideological assumptions. There is no problem in a system built around consumption. However, there is a problem when government loads the dice in determining who will be wealthy, and who will not be. GS is an example of this, not of a problem with consumption as a driver of the economic system.

    I have provided a link to the original post. You have quoted it a few times as if it is a defence of the current system. It is not. It is a defence of allowing individuals to choose how they might spend the value of their labour, and showing how consumption can create many benefits for all of us.

    http://cynicuseconomicus.blogspot.com/2009/03/capitalism-and-consumption.html

    In this post, I argue against the ways in which government has encouraged debt fuelled consumption. This is not the free market, but government manipulation of markets.

    I really do not understand your critique. I am pointing out that there is a system in which the government is wrongly interfering in markets, by supporting the profitability of banks. You are using this interference as a critique of my free market ideology. However, this is not anything to do with an underlying free market system. It is quite the opposite.

    ReplyDelete
  28. Reply to Lord Sidcup continued:

    I will end this with a quote from the relevant post, where there is some context around the quote of the 'underlying system works'. It is not a substitute for the original post, where it will be clear that Lord Sidcup is misrepresenting my views (though I am sure with no negative intent).

    ----------

    'Whilst it would be foolish to heap all of the blame for the model of economic growth based upon credit expansion, there can be little doubt that governments have contributed significantly to the problem.

    The answer to Lemming's question, and perhaps the questions of others, is that there is no basic problem in economic growth, and no real problem in a system built around consumption. The benefit of capitalism is the provision of goods and services to meet the needs and wants of individuals, and it has consistently delivered on that promise, and provided the many innovations that arise from such a system that benefit us in a myriad of ways. Whilst some point to over-consumption as a bad thing, it is hard to separate out what is good, and what is bad consumption, what is good growth, and what is bad growth. On the other hand the encouragement of consumption built upon the encouragement of debt is certainly not good for individuals, or for the wider economy. This illusion of economic growth should not be confused with economic growth built upon using savings or income for purchase of goods and services.

    In other words, the underlying system works. There are broader questions about how we might sustain such economic growth in the face of finite resources, and how the marketing of goods and services might ignite a desire to consume more than we would otherwise do. However, the problem arises as to how we might restrict consumption without making moralistic judgements, and how such consumption might be restricted in a way that is fair or just. If I wish to use money for all of the consumption necessary to use the Internet, then I would feel aggrieved if someone told me that this was unacceptable. Twenty years ago, the majority of us would not have even owned a computer, but we now all accept them as items we want, and which are useful to us.'

    --------------

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  29. Cynicus Economicus' Economics and the "Neutrality of Money" Concept

    I have a question.
    I am interested to know whether Cynicus Economicus accepts the idea of the "neutrality of money."
    This is a fundamental concept in neo-classical economics:

    neutrality of money is the idea that a change in the stock of money affects only nominal variables in the economy such as prices, wages and exchange rates but no effect on real (inflation-adjusted) variables, like employment, real GDP, and real consumption ... Money neutrality holds that the central bank does not affect the real economy (e.g., the number of jobs, the size of real GDP, the amount of real investment) by printing money. Any increase in the supply of money would be offset by an equal rise in prices and wages.

    http://en.wikipedia.org/wiki/Neutrality_of_money

    I wonder do you accept this idea, Cynicus?
    Is it part of your assumptions about money?

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  30. "There are broader questions about how we might sustain such economic growth in the face of finite resources..."

    In the end, did we ever establish whether growth is a requirement for our economic system to work?

    Some people use the term as though it is a 'nice-to-have': it is nice if your children have a better life than you do, and a continuously-improving standard of living is obviousy a good thing. But we could obviously survive quite comfortably if the economy shrank steadily.

    I don't think I received a satisfactory answer to a series of questions I asked a while back, about whether the economy as currently constructed can actually function without growth. Whether this problem is a side-effect of the way we issue money in a 'debt-based' economy, or a central one of the economy being, in essence, a giant Ponzi scheme is not important.

    Is it the case that growth is mandatory for our economy to work? If so, how can we change it in order to make it work in, say, the 'Peak Oil' scenario? (where we don't run out of oil, but the rate of supply levels off)

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  31. Dear (want to be) Cynicus...

    It is really sad that you stare the truth in the eye and you fail to understand it for what it is.

    Your problem is the definition of growth.

    Growth is a good thing, isn't it?
    Let me give you an example...

    Let's say I'm a scientist and tomorrow I design a motor that instead of gas, it uses water.

    My motor is so good, that it uses a litre of regular sea water to produce the same work that a litre of gas produces in the best today's motor. And it is cleaner than anything we ever designed.

    Is this good for your definition of growth???

    NO,IT IS NOT...
    It is the death of a huge sector of the economy. Millions of people will be unemployed. States will go to complete anarchy. Your loving indexes will crumple.

    That scientist will probably end with a bullet on his head.

    Promote innovation my arse...

    See the NASA and ESA budgets. Capitalism promotes profit, nothing else. Your new iPhone probably has the same budget with a probe to Mars. Is your iphone innovation?

    It is. It is a new marketing way to make you feel that you cannot live without it. Take a look at your house. How many innovations in there are simply marketing?

    Do me a favor and take that cynicus out of your blogname.

    Make it TroubledEconomicus and go to bed with your Adam Smith.

    Your Troll,
    ZED

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  32. I think I can simplify my question on the necessity of economic growth by asking:

    Why do we have to have growth?

    *SPECIFICALLY NOT* "Why is it nice to have growth?"

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  33. Lord Keynes now has a blog

    For anyone who wants to look, please go here:


    http://socialdemocracy21stcentury.blogspot.com/

    ReplyDelete
  34. Yes seems I have misrepresented your words on that specific point so apologies for that.

    However, I think your fundamental argument that markets. . . eh never mind.

    ReplyDelete

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