George Soros Speech

>   
>   (email exchange)
>   
>   On Mon, Jun 21, 2010 at 6:31 AM, wrote:
>   
>   Soros’s recipe, FYI
>   much about bubbles,
>   also about how bad can be deficit reductions at this time
>   

I usually don’t read or comment on Soros, but comments below this one time only for you.

:)

George Soros Speech

Institute of International Finance, Vienna, Austria
June 10, 2010

In the week following the bankruptcy of Lehman Brothers on September 15, 2008 – global financial markets actually broke down and by the end of the week they had to be put on artificial life support. The life support consisted of substituting sovereign credit for the credit of financial institutions which ceased to be acceptable to counter parties.

As Mervyn King of the Bank of England brilliantly explained, the authorities had to do in the short-term the exact opposite of what was needed in the long-term: they had to pump in a lot of credit to make up for the credit that disappeared and thereby reinforce the excess credit and leverage that had caused the crisis in the first place. Only in the longer term, when the crisis had subsided, could they drain the credit and reestablish macro-economic balance.

Not bad, but he doesn’t seem to understand there is no ‘macro balance’ per se in that regard. He should recognize that what he means by ‘macro balance’ should be the desired level of aggregate demand, which is altered by the public sector’s fiscal balance. So in the longer term, the public sector should tighten fiscal policy (what he calls ‘drain the credit’) only if aggregate demand is deemed to be ‘too high’ and not to pay for anything per se.

This required a delicate two phase maneuver just as when a car is skidding, first you have to turn the car into the direction of the skid and only when you have regained control can you correct course.

It’s more like when you come to an up hill stretch you need to press harder on the gas to maintain a steady speed and if you get going too fast on a down hill section you need to apply the brakes to maintain a steady speed. And for me, the ‘right’ speed is ‘full employment’ with desired price stability.

The first phase of the maneuver has been successfully accomplished – a collapse has been averted.

But full employment has not been restored. I agree this is not the time to hit the fiscal brakes. In fact, I’d cut VAT until output and employment is restored, and offer a govt funded minimum wage transition job to anyone willing and able to work.

In retrospect, the temporary breakdown of the financial system seems like a bad dream. There are people in the financial institutions that survived who would like nothing better than to forget it and carry on with business as usual. This was evident in their massive lobbying effort to protect their interests in the Financial Reform Act that just came out of Congress. But the collapse of the financial system as we know it is real and the crisis is far from over.

Indeed, we have just entered Act II of the drama, when financial markets started losing confidence in the credibility of sovereign debt. Greece and the euro have taken center stage but the effects are liable to be felt worldwide. Doubts about sovereign credit are forcing reductions in budget deficits at a time when the banks and the economy may not be strong enough to permit the pursuit of fiscal rectitude. We find ourselves in a situation eerily reminiscent of the 1930’s. Keynes has taught us that budget deficits are essential for counter cyclical policies yet many governments have to reduce them under pressure from financial markets. This is liable to push the global economy into a double dip.

Yes, and this is an issue specific to govts that are not the issuers of their currency- the US States, the euro zone members, and govts with fixed exchange rates.

It is important to realize that the crisis in which we find ourselves is not just a market failure but also a regulatory failure and even more importantly a failure of the prevailing dogma about financial markets. I have in mind the Efficient Market Hypothesis and Rational Expectation Theory. These economic theories guided, or more exactly misguided, both the regulators and the financial engineers who designed the derivatives and other synthetic financial instruments and quantitative risk management systems which have played such an important part in the collapse. To gain a proper understanding of the current situation and how we got to where we are, we need to go back to basics and reexamine the foundation of economic theory.

I agree, see my proposals here.

I have developed an alternative theory about financial markets which asserts that financial markets do not necessarily tend towards equilibrium; they can just as easily produce asset bubbles. Nor are markets capable of correcting their own excesses. Keeping asset bubbles within bounds have to be an objective of public policy. I propounded this theory in my first book, The Alchemy of Finance, in 1987. It was generally dismissed at the time but the current financial crisis has proven, not necessarily its validity, but certainly its superiority to the prevailing dogma.

First we can always act to sustain aggregate demand and employment at desired levels across any asset price cycle with fiscal policy. No one would have cared much about the financial crisis if we’d kept employment and output high in the real sectors. Note that because output and employment remained high (for whatever reason) through the crash of 1987, the crash of 1998, and the Enron event, they were of less concern than the most recent crisis where unemployment jumped to over 10%.

Let me briefly recapitulate my theory for those who are not familiar with it. It can be summed up in two propositions. First, financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. This is the principle of fallibility. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times it is quite pronounced. When there is a significant divergence between market prices and the underlying reality I speak of far from equilibrium conditions. That is where we are now.

I’d say ‘equilibrium’ conditions are necessarily transitory at best under current institutional arrangements, including how policy is determined in Washington and around the world, and continually changing fundamentals of supply and demand.

Second, financial markets do not play a purely passive role; they can also affect the so called fundamentals they are supposed to reflect. These two functions that financial markets perform work in opposite directions. In the passive or cognitive function the fundamentals are supposed to determine market prices. In the active or manipulative function market prices find ways of influencing the fundamentals. When both functions operate at the same time they interfere with each other. The supposedly independent variable of one function is the dependent variable of the other so that neither function has a truly independent variable. As a result neither market prices nor the underlying reality is fully determined. Both suffer from an element of uncertainty that cannot be quantified.

Goes without saying.

I call the interaction between the two functions reflexivity. Frank Knight recognized and explicated this element of unquantifiable uncertainty in a book published in 1921 but the Efficient Market Hypothesis and Rational Expectation Theory have deliberately ignored it. That is what made them so misleading.

Reflexivity sets up a feedback loop between market valuations and the so-called fundamentals which are being valued. The feedback can be either positive or negative. Negative feedback brings market prices and the underlying reality closer together. In other words, negative feedback is self-correcting. It can go on forever and if the underlying reality remains unchanged it may eventually lead to an equilibrium in which market prices accurately reflect the fundamentals. By contrast, a positive feedback is self-reinforcing. It cannot go on forever because eventually market prices would become so far removed from reality that market participants would have to recognize them as unrealistic. When that tipping point is reached, the process becomes self-reinforcing in the opposite direction. That is how financial markets produce boom-bust phenomena or bubbles. Bubbles are not the only manifestations of reflexivity but they are the most spectacular.

Ok, also seems obvious? Now he need to add that the currency itself is a public monopoly, as the introduction of taxation, a coercive force, introduces ‘imperfect competition’ with ‘supply’ of that needed to pay taxes under govt. control. This puts govt in the position of ‘price setter’ when it spends (and/or demands collateral when it lends). And a prime ‘pass through’ channel he needs to add is indexation of public sector wages and benefits.

In my interpretation equilibrium, which is the central case in economic theory, turns out to be a limiting case where negative feedback is carried to its ultimate limit. Positive feedback has been largely assumed away by the prevailing dogma and it deserves a lot more attention.

Even his positive feedback will ‘run its course’ (not to say there aren’t consequences) for the most part if it wasn’t for the fact that the currency itself is a case of monopoly and the govt. paying more for the same thing, for example, is redefining the currency downward.

I have developed a rudimentary theory of bubbles along these lines. Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced.

Makes sense.

Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved.

I’d say it’s more like the price gets high enough for the funding to run dry at that price for any reason? Unless funding is coming from/supported by govt (and/or it’s designated agents, etc), the issuer of the currency, that funding will always be limited.

A twilight period ensues during which doubts grow and more and more people lose faith but the prevailing trend is sustained by inertia.

‘Inertia’? It’s available spending power that’s needed to sustain prices of anything. The price of housing sales won’t go up without someone paying the higher price.

As Chuck Prince former head of Citigroup said, “As long as the music is playing you’ve got to get up and dance. We are still dancing.”

This describes the pro cyclical nature of the non govt sectors, which are necessarily pro cyclical. Only the currency issuer can be counter cyclical. Seems to me Minsky has the fuller explanation of all this.

Eventually a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.

The spending power- or the desire to use it- fades.

Typically bubbles have an asymmetric shape. The boom is long and slow to start. It accelerates gradually until it flattens out again during the twilight period. The bust is short and steep because it involves the forced liquidation of unsound positions. Disillusionment turns into panic, reaching its climax in a financial crisis.

The simplest case of a purely financial bubble can be found in real estate. The trend that precipitates it is the availability of credit; the misconception that continues to recur in various forms is that the value of the collateral is independent of the availability of credit. As a matter of fact, the relationship is reflexive. When credit becomes cheaper activity picks up and real estate values rise. There are fewer defaults, credit performance improves, and lending standards are relaxed. So at the height of the boom, the amount of credit outstanding is at its peak and a reversal precipitates false liquidation, depressing real estate values.

It all needs to be sustained by incomes. the Fed’s financial burdens ratios indicate when incomes are being stretched to their limits. The last cycle went beyond actual incomes as mortgage originators were sending borrowers to accountants who falsified income statements, and some lenders were willing to lend beyond income capabilities. But that didn’t last long and the bust followed by months.

The bubble that led to the current financial crisis is much more complicated. The collapse of the sub-prime bubble in 2007 set off a chain reaction, much as an ordinary bomb sets off a nuclear explosion. I call it a super-bubble. It has developed over a longer period of time and it is composed of a number of simpler bubbles. What makes the super-bubble so interesting is the role that the smaller bubbles have played in its development.

Fraud was a major, exaggerating element in the latest go round, conspicuously absent from this analysis.

The prevailing trend in the super-bubble was the ever increasing use of credit and leverage. The prevailing misconception was the believe that financial markets are self-correcting and should be left to their own devices. President Reagan called it the “magic of the marketplace” and I call it market fundamentalism. It became the dominant creed in the 1980s. Since market fundamentalism was based on false premises its adoption led to a series of financial crises.

Again, a financial crisis doesn’t need to ‘spread’ to the real economy. Fiscal policy can sustain full employment regardless of the state of the financial sector. Losses in the financial sector need not affect the real economy any more than losses in Las Vegas casinos.

Each time, the authorities intervened, merged away, or otherwise took care of the failing financial institutions, and applied monetary and fiscal stimuli to protect the economy. These measures reinforced the prevailing trend of ever increasing credit and leverage and as long as they worked they also reinforced the prevailing misconception that markets can be safely left to their own devices. The intervention of the authorities is generally recognized as creating amoral hazard; more accurately it served as a successful test of a false belief, thereby inflating the super-bubble even further.

‘Monetary policy’ did nothing and probably works in reverse, as I’ve discussed elsewhere. Fiscal policy does not have to introduce moral hazard issues. It can be used to sustain incomes from the bottom up at desired levels, and not for top down bailouts of failed businesses. Sustaining incomes will not keep an overbought market from crashing, but it will sustain sales and employment in the real economy, with business competing successfully for consumer dollars surviving, and those that don’t failing. That’s all that’s fundamentally needed for prosperity, along with a govt that understands its role in supporting the public infrastructure.

It should be emphasized that my theories of bubbles cannot predict whether a test will be successful or not. This holds for ordinary bubbles as well as the super-bubble. For instance I thought the emerging market crisis of 1997-1998 would constitute the tipping point for the super-bubble, but I was wrong. The authorities managed to save the system and the super-bubble continued growing. That made the bust that eventually came in 2007-2008 all the more devastating.

No mention that the govt surpluses of the late 90’s drained net dollar financial assets from the non govt sectors, with growth coming from unsustainable growth in private sector credit fueling impossible dot com business plans, that far exceeded income growth. When it all came apart after y2k the immediate fiscal adjustment that could have sustained the real economy wasn’t even a consideration.

What are the implications of my theory for the regulation of the financial system?

First and foremost, since markets are bubble-prone, the financial authorities have to accept responsibility for preventing bubbles from growing too big. Alan Greenspan and other regulators have expressly refused to accept that responsibility. If markets can’t recognize bubbles, Greenspan argued, neither can regulators–and he was right. Nevertheless, the financial authorities have to accept the assignment, knowing full well that they will not be able to meet it without making mistakes. They will, however, have the benefit of receiving feedback from the markets, which will tell them whether they have done too much or too little. They can then correct their mistakes.

Second, in order to control asset bubbles it is not enough to control the money supply; you must also control the availability of credit.

Since the causation is ‘loans create deposits’ ‘controlling credit’ is the only way to alter total bank deposits.

This cannot be done by using only monetary tools;

Agreed, interest rates are not all that useful, and probably work in the opposite direction most believe.

you must also use credit controls. The best-known tools are margin requirements

Changing margin requirements can have immediate effects. But if the boom is coming for the likes of pension fund allocations to ‘passive commodity strategies’ driving up commodities prices, which has been a major, driving force for many years now, margin increases won’t stop the trend.

and minimum capital requirements.

I assume that means bank capital. If so, that alters the price of credit but not the quantity, as it alters spreads needed to provide market demanded risk adjusted returns for bank capital.

Currently they are fixed irrespective of the market’s mood, because markets are not supposed to have moods. Yet they do, and the financial authorities need to vary margin and minimum capital requirements in order to control asset bubbles.

Yes, man is naturally a gambler. you can’t stop him. and attempts at control have always been problematic at best.

One thing overlooked is the use of long term contracts vs relying on spot markets. Historically govts have used long term contracts, but for business to do so requires long term contracts on the sales side, which competitive markets don’t allow.

You can’t safely enter into a 20 year contract for plastic for cell phone manufacturing if you don’t know that the price and quantity of cell phones is locked in for 20 years as well, for example. And locking in building materials for housing for 20 years to stabilize prices means less flexibility to alter building methods, etc. But all this goes beyond this critique apart from indicating there’s a lot more to be considered.

Regulators may also have to invent new tools or revive others that have fallen into disuse. For instance, in my early days in finance, many years ago, central banks used to instruct commercial banks to limit their lending to a particular sector of the economy, such as real estate or consumer loans, because they felt that the sector was overheating. Market fundamentalists consider that kind of intervention unacceptable but they are wrong. When our central banks used to do it we had no financial crises to speak of.

True. What the govt creates it can regulate and/or take away. Public infrastructure is to serve further public purpose.

But both dynamic change and static patterns have value and trade offs.

The Chinese authorities do it today, and they have much better control over their banking system. The deposits that Chinese commercial banks have to maintain at the People’s Bank of China were increased seventeen times during the boom, and when the authorities reversed course the banks obeyed them with alacrity.

Yes, and always with something gained and something lost when lending is politicized.

Third, since markets are potentially unstable, there are systemic risks in addition to the risks affecting individual market participants. Participants may ignore these systemic risks in the belief that they can always dispose of their positions, but regulators cannot ignore them because if too many participants are on the same side, positions cannot be liquidated without causing a discontinuity or a collapse. They have to monitor the positions of participants in order to detect potential imbalances. That means that the positions of all major market participants, including hedge funds and sovereign wealth funds, need to be monitored. The drafters of the Basel Accords made a mistake when they gave securities held by banks substantially lower risk ratings than regular loans: they ignored the systemic risks attached to concentrated positions in securities. This was an important factor aggravating the crisis. It has to be corrected by raising the risk ratings of securities held by banks. That will probably discourage loans, which is not such a bad thing.

My proposals, here, limit much of that activity at the source, rather than trying to regulate it, leaving a lot less to be regulated making regulation that much more likely to succeed.

Fourth, derivatives and synthetic financial instruments perform many useful functions but they also carry hidden dangers. For instance, the securitization of mortgages was supposed to reduce risk thru geographical diversification. In fact it introduced a new risk by separating the interest of the agents from the interest of the owners. Regulators need to fully understand how these instruments work before they allow them to be used and they ought to impose restrictions guard against those hidden dangers. For instance, agents packaging mortgages into securities ought to be obliged to retain sufficient ownership to guard against the agency problem.

One of my proposals is that banks not be allowed to participate in any secondary markets, for example

Credit default swaps (CDS) are particularly dangerous they allow people to buy insurance on the survival of a company or a country while handing them a license to kill. CDS ought to be available to buyers only to the extent that they have a legitimate insurable interest. Generally speaking, derivatives ought to be registered with a regulatory agency just as regular securities have to be registered with the SEC or its equivalent. Derivatives traded on exchanges would be registered as a class; those traded over-the-counter would have to be registered individually. This would provide a powerful inducement to use exchange traded derivatives whenever possible.

There is no public purpose served by allowing banks to participate in CDS markets and therefore no reason to allow banks to own any CDS.

Finally, we must recognize that financial markets evolve in a one-directional, nonreversible manner. The financial authorities, in carrying out their duty of preventing the system from collapsing, have extended an implicit guarantee to all institutions that are “too big to fail.” Now they cannot credibly withdraw that guarantee. Therefore, they must impose regulations that will ensure that the guarantee will not be invoked. Too-big-to-fail banks must use less leverage and accept various restrictions on how they invest the depositors’ money. Deposits should not be used to finance proprietary trading. But regulators have to go even further. They must regulate the compensation packages of proprietary traders to ensure that risks and rewards are properly aligned. This may push proprietary traders out of banks into hedge funds where they properly belong. Just as oil tankers are compartmentalized in order to keep them stable, there ought to be firewalls between different markets. It is probably impractical to separate investment banking from commercial banking as the Glass-Steagall Act of 1933 did. But there have to be internal compartments keeping proprietary trading in various markets separate from each other. Some banks that have come to occupy quasi-monopolistic positions may have to be broken up.

Banks should be limited to public purpose as per my proposals, here.

While I have a high degree of conviction on these five points, there are many questions to which my theory does not provide an unequivocal answer. For instance, is a high degree of liquidity always desirable? To what extent should securities be marked to market? Many answers that followed automatically from the Efficient Market Hypothesis need to be reexamined.

Also in my proposals, here.

It is clear that the reforms currently under consideration do not fully satisfy the five points I have made but I want to emphasize that these five points apply only in the long run. As Mervyn King explained the authorities had to do in the short run the exact opposite of what was required in the long run. And as I said earlier the financial crisis is far from over. We have just ended Act Two. The euro has taken center stage and Germany has become the lead actor. The European authorities face a daunting task: they must help the countries that have fallen far behind the Maastricht criteria to regain their equilibrium while they must also correct the deficinies of the Maastricht Treaty which have allowed the imbalances to develop. The euro is in what I call a far-from-equilibrium situation. But I prefer to discuss this subject in Germany, which is the lead actor, and I plan to do so at the Humboldt University in Berlin on June 23rd. I hope you will forgive me if I avoid the subject until then.

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37 Responses to George Soros Speech

  1. davver says:

    ‘Monetary policy’ did nothing and probably works in reverse, as I’ve discussed elsewhere. Fiscal policy does not have to introduce moral hazard issues. It can be used to sustain incomes from the bottom up at desired levels, and not for top down bailouts of failed businesses. Sustaining incomes will not keep an overbought market from crashing, but it will sustain sales and employment in the real economy, with business competing successfully for consumer dollars surviving, and those that don’t failing. That’s all that’s fundamentally needed for prosperity, along with a govt that understands its role in supporting the public infrastructure.
    ________________________________________

    I hate two problems with this.

    1) If incomes are increased (or sustained) won’t that increase or stabilize asset prices, which are serviced with incomes? A higher income allows one to service a higher debt. For instance, we could cause housing prices to rise by sending every American a check for $50k. It would also cause other prices to rise if incomes rose without the production of good rising. And yes, I have my doubts about how big the output gap is and what potential goods the output gap really represents – GDP is made up of real things and the output gap only represents what goods the unused resources can produce, not just generic GDP. An unemployed real estate agent can’t provide us with health care just by paying him money.

    2) Just because the government can THEORETICALLY spend money wisely doesn’t mean it is LIKELY too. They used to teach political economy in school, because politics and economics are intertwined. If we pass another stimulus bill it is most likely to be a top down giveaway to special interests, just like the last one. This doesn’t even have to be because politicians are evil or greedy (though they certainly are), it could simply be a part of the limitations on the efficiency of central decision making (think Hayek).

    I think a flat payroll tax deduction would be your best bet to maintain aggregate demand, but its not very popular on the left in congress (or various Keynesian economists who think it has a bad multiplier or other such nonsense). Sadly, they want to use “stimulus” as a way to get spending for government programs in the door knowing full well that today’s stimulus becomes tomorrows recurring budget item, whether we return to “full employment” or not.

    Reply

  2. anon says:

    “bank capital is endogenous”

    I don’t know what that means exactly, but it doesn’t seem to be consistent with the idea that banks are capital constrained:

    http://bilbo.economicoutlook.net/blog/?p=9075

    “However, capital requirements do place a limit on the expansion of a commercial bank’s balance sheet at any point in time.”

    If capital is “endogenous”, why does Bill make a point of banks being capital constrained?

    Reply

    Jim Baird Reply:

    Capital constrains “a” bank’s ability to loan, not the banking system in general. A loan from one bank will move through the system to become part of another bank’s capital.

    Reply

    Ramanan Reply:

    No it doesn’t move into another bank to become a part of its capital.

    Reply

    anon Reply:

    Thanks, but with all due respect, I’m quite certain that explanation is not correct.

    Both individual banks and the banking system as a whole are capital constrained in the sense in which Bill Mitchell described it.

    Reply

    Bx12 Reply:

    Ratio of loans to own fund is constrained. But “own fund” must come from someone’s loan. So obviously, as long as loans in the system continue to grow, a bank can also grow its capital and therefore, in turn, its loans. The capital ratio therefore puts a limit on the speed of loan creation.

    Am I rehearsing trivialities here?

    Matt Franko Reply:

    anon,
    MMTers often mention the capital levels to contrast it to the maintstream (incorrect) view that looks at reserve levels as the throttle point for lending at a bank.

    I interpret WMs point that capital is endogenous as meaning it is provided to banks from ‘within’ the non-govt sector pretty readily, but at a certain price. Soros seems to be making the point that adjusting the minimum capital ratio will act to stop the greed factor. WM seems to be stating that is not necessarily enough as more capital can come piling right in if the investors think the juicy returns are there. Resp,

    Reply

    anon Reply:

    An increase in capital requirements means more private capital must be supplied to back a stated level of risk. That improved capital backing means that the taxpayer is less at risk, other things equal.

    I don’t know what is meant by “endogenous”. I dislike the word. But it’s an over simplification IMO to suggest that all credit worthy borrowers will be able to borrow because capital is effectively unlimited in supply. Banks judge alternatives in deploying capital – they don’t just respond to every opportunity that is “credit worthy”.

    This is particularly the case in wholesale banking, where deals are presented that may be accepted or rejected. Sometimes banks say – not interested – without even pricing the deal.

    Capital does not grow on trees.

    Reserves do, or just about.

    Reply

    Matt Franko Reply:

    anon,
    The mmt framework is one of ‘stocks and flows’, ‘sectors’, and the lines of demarcation that define the boundaries of such constructs, so words that mean ‘from within’ or ‘from without’ have helped me visualize the mmt framework when analyzing things if you see what I mean.

    btw, you give bankers too much credit…all they do is lend against property and autos in reality…big deal…and they dont even do that very well now do they? Resp,

    anon Reply:

    And the existence of the credit crisis emphasizes the point.

    Capital is not binary in supply.

    Reply

    warren mosler Reply:

    Bill says at any one point in time, which is correct.

    In the next period, however long, capital can be higher or lower.

    Endogenous means it comes from within the non govt sectors.

    Reply

  3. warren mosler says:

    bank capital is endogenous and will ‘arise’ to fill any demands for credit deemed credit worthy at some ‘competitive’ risk adjusted rate of return.

    Yes, the adjustment is not instantaneous, but it’s usually pretty quick.

    You will rarely see the banking system capital constrained for long.

    Market forces operate such that borrowers will face interest rates sufficient to drive the process that attracts needed capital.

    Reply

  4. anon says:

    Krugman SocSec analysis:

    http://krugman.blogs.nytimes.com/2010/06/21/zombies-have-already-killed-the-deficit-commission/

    Reply

    Tom Hickey Reply:

    Good one. Krugman is really putting an edge on it. The best way to finish over an idea is to riducule it. Alan Simpson isn’t going to like that at all.

    But real zombies in this kabuki dance are the president and his advisors who thought up this commission in the first place. What did they think was going to happen considering the zombies they put on it?

    Reply

    Mosler for OMB Reply:

    It’s all too much comedy, when the deficit commission wanted a budget increase. Orszag resigning – who will succeed him – Warren Mosler – why don’t you try and get this job?

    List of potantial OMB candidates to follow peter orzsag – none seem MMT educated.

    http://voices.washingtonpost.com/federal-eye/2010/06/who_will_succeed_peter_orszag.html

    Reply

  5. anon says:

    “The quantity is affected because of creditworthy demand for bank loans, not due to shortages.”

    That’s a nice (MMT) theory, but it’s not the way banks actually work.

    Ever hear of the credit crisis?

    Reply

    Jamisia Reply:

    “The quantity is affected because of credit worthy demand for bank loans, not due to shortages.”

    That’s a nice (MMT) theory, but it’s not the way banks actually work.

    Ever hear of the credit crisis?

    Yes, it does. Creditworthiness of customers, however, was ignored. Banks loaned to customers (whichever) entirely unworthy of the credit they received (unworthy as in: in no proportion to income).

    Anon, what do you think is (now) more important in the credit crisis: demand for credit or it’s supply?

    Reply

    anon Reply:

    prior to the crisis, end credit supply was free flowing from non-banks that weren’t subjected to bank capital standards

    capital supply became an issue after banks lost about $ 1 trillion of it; it’s still an issue due to the uncertainty of regulatory overhaul

    capital supply is not digital – it’s not unlimited in good times and not zero in bad times

    Reply

    Ramanan Reply:

    Yes credit crisis also end up in lack of demand.

    As Warren mentioned below capital is endogenous and adjusts easily to absorb any demand.

    The recent credit crisis is really an exception. It depends on how one starts describing. For example instead of saying that for a theory of production, supply is constrained, one says that as demand increases, inventories move fast and entrepreneurs start producing more to meet the demand. Of course this description doesn’t mean that there can’t be supply shocks. However its a much nice description. It means that even though there is a fixed supply at one point plus inventories to take care of demand surprises, the adjustment is quick.

    Reply

  6. Ramanan says:

    Anon,

    The quantity is affected because of creditworthy demand for bank loans, not due to shortages.

    Bank capital is of course not unlimited but enough to support all creditworthy demand for bank borrowing.

    Yes banks refuse loans because of lack of animal spirits but not due to shortages of funds.

    Price is of course affected. When the demand increases, banks may want to increase the rates – though its purely discretionary instead of happening with any market clearing. However, when they start earning, they can reduce rates. The banking system can take huge shocks in demand.

    Banks should be looked at as not asset allocators strictly. The banks have become complex, so its better to look at them as banks + asset allocators.

    So think of the banks lending to the asset allocator part plus the part which runs the activity banks are supposed to carry out.

    Banks’ undistributed profit adds to its “own funds” isn’t it ? The way I understand is that the own funds of one period is the sum of (i) own funds in the previous period (ii) undistributed profits (iii) proceeds from equities issued (iv) negative of non-performing loans occurred.

    The restriction banks should satisfy is that the ratio of the own funds to (risk weighted) assets should be greater than the capital adequacy ratio. In reality there are various categories such as under-capitalized etc which prevents banks from distributing dividends etc.

    However, because of banks’ forecasts, it can make sure that this condition is always satisfied by setting the rates on lending – its main activity – so that it doesn’t become under-capitalized and in fact to be far from it.

    A single bank may face a constraint – for example if someone starts a bank with $1m, he is obviously constrained in lending. But the banking system as a whole is not – though I am not saying they will never be or never have – during 2008/2009, they went through a crisis.

    There is a debate in PKE – horizontalists vs structuralists on such things.

    Reply

    RSJ Reply:

    Nothing prevents the government from seizing banks, converting bondholder claims to equity claims, and voila — you have tons of capital available to lend.

    Or the government can start new banks. This is easily solved, from the business/accounting view, but not so easily solved from the political power relations view.

    There are plenty of bondholder claims to absorb all losses and sufficiently recapitalize the banks.

    Reply

  7. Floccina says:

    Warren, IMO you are right, bubbles are human nature. What we need is a monetary system that is robust to bubbles. A system that can keep employment high during a collapsing bubble.

    Reply

    Tom Hickey Reply:

    Hyman Minsky’s financial instability hypothesis lays it out, and others have developed his ideas. The way to prevent dangerous financial bubbles from forming involves eliminating the final stage of financial cycles that Minsky described as Ponzi finance.

    While regulation and oversight are important tools, regulators can be captured, and the big players also have a bevy of lawyers to find loopholes in the regs that they can drive trucks through.

    A key element has to be incentives. Greed is a powerful incentive that makes people do foolish things. Greenspan got it wrong about industry self-discipline and self-policing. The GFC shows conclusively how incentivizing greed in the financial sector — “where the money is” —is at the root of the problem.

    Even a former head of GS is complaining about the current incentives in the industry. It makes no sense to allow a non-productive sector to extract what it can from the economy — well in excess of what it contributes.

    However, trying to get politicians who are beholden to Wall Street for campaign financing is not going to be easy. Their strong inclination is to pass a bill with a fine sounding name that makes a show of “doing something,” and that’s it, unless voters ignite some fear in them.

    Reply

    Floccina Reply:

    “Even a former head of GS is complaining about the current incentives in the industry. It makes no sense to allow a non-productive sector to extract what it can from the economy — well in excess of what it contributes.”

    Yeah but you must avoid too much command in control the above argument could also work for other industries. The gambling business comes to mind. Further when you think of Wall Street in the context of gambling you have to admit that Wall Street like gambling provides enjoyment and hope (and at far lower cost than state lotteries).

    There was a study, linked to by Tyler Cowen at Marginal Revolution, that concluded that bubbles are welfare enhancing. (BTW there were two famous investors who treat stocks not like gambling but rather like investing Warren Buffet and Jim Rogers and both stopped buying stocks for 10 years during the bubble, ten years!) I rather agree with Warren Mosler let Wall street go crazy just make the system robust to the crash. If employment were to stay high in a crash then you could let the bubbles run.

    Note Cuba and North Korea have avoided all bubbles but have rather had a long slow decline so maybe bubbles are not so bad maybe they are welfare enhancing.

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    Tom Hickey Reply:

    Floccina, to the best of my knowledge, and I have looked, there is no economic definition of “bubble.” But there is of “Ponzi finance,” which is what Minsky wrote about and others have developed. Since Ponzi finance characterizes the late stage of a financial cycle, preceding a crash and likely a debt deflation. It involves a massive market failure, and it is NOT welfare enhancing, unless one means that the automatic stabilizers kick in and maybe government has to intervene even more strongly to support the broken system. In this crisis a lot of the “welfare” has been corporate.

    Floccina Reply:

    Tom Hickey,
    This is from the wikipedia article on financial Financial crisis:

    for Ponzi finance, expected income flows will not even cover interest cost, so the firm must borrow more or sell off assets simply to service its debt. The hope is that either the market value of assets or income will rise enough to pay off interest and principal.

    So if that is an accurate description of Minsky’s definition of Ponzi finance you would need to make it illegal for a firm or individual to borrow more money than they can cover the interest for. Difficult perhaps the Wikipedia article does not give your definition for Ponzi finance. If so what is your definition.

    Tom Hickey Reply:

    Here is a summary of Minsky’s three stages, the last being dominated by Ponzi finance.

    The “Ponzi borrower” (named for Charles Ponzi, see also Ponzi scheme) borrows based on the belief that the appreciation of the value of the asset will be sufficient to refinance the debt but could not make sufficient payments on interest or principal with the cash flow from investments; only the appreciating asset value can keep the Ponzi borrower afloat. Because of the unlikelihood of most investments’ capital gains being enough to pay interest and principal, much of this type of finance is fraudulent. If the use of Ponzi finance is general enough in the financial system, then the inevitable disillusionment of the Ponzi borrower can cause the system to seize up: when the bubble pops, i.e., when the asset prices stop increasing, the speculative borrower can no longer refinance (roll over) the principal even if able to cover interest payments. As with a line of dominoes, collapse of the speculative borrowers can then bring down even hedge borrowers, who are unable to find loans despite the apparent soundness of the underlying investments.

    It’s not just firms, Floccina. The GFC began when the residential mortgages on which the MBS were based began to fall apart. When the supply of borrowers ran out at the inflated prices. prices then stalled out and began falling, bursting the RE bubble. That was the catalyst that began the crash that paralyzed the financial system and spread to the real economy as demand plummeted in the face of the disappearing wealth effect and the massive overhang of debt that had been accumulating.

    It could have been any number of other things that were “Ponzi finance” in that the debt could not be serviced other than by refinancing based on a rise in equity due to ever increasing prices. As Chuck Prince said, it was a game of musical chairs. The global economy got left standing up when the music stopped, as the people who profited disappeared into the shadows or were protected due to their influence.

    The underwriters of those mortgages knew or should have known that the terms were unsustainable by the people to whom they were extended. This began a process of debt-deflation as other borrowers counting on ever-increasing prices were put under the gun. There is still a lot of deleveraging yet to come, and it will either be stretch out over time, resulting in stagnation, or else quickly, sparking another leg down in the GFC. Given current behavior, it seems like the latter may be in the cards.

    Floccina Reply:

    It involves a massive market failure, and it is NOT welfare enhancing, unless one means that the automatic stabilizers kick in and maybe government has to intervene even more strongly to support the broken system. In this crisis a lot of the “welfare” has been corporate.

    BTW a lot of homes were built that should drive down the cost of housing for the poor. Employment was high during the bubble also.

    The underwriters of those mortgages knew or should have known that the terms were unsustainable by the people to whom they were extended.

    I agree but I still think that it is tough to make a law that would prevent those loans from being made. I would rather see the monetary system not dependent on debt for money creation. A bubble burst would then not cause enough drop in demand to cause unemployment.

    For example I think that a FICA holiday could IMO restore enough demand to keep employment up.

    Tom Hickey Reply:

    BTW a lot of homes were built that should drive down the cost of housing for the poor. Employment was high during the bubble also.

    Instead, government is acting to prop up the market to maintain asset values so the banks retain at least the appearance of solvency. That’s the problem with debt-deflation. The government has decided to save the banks.

    I agree but I still think that it is tough to make a law that would prevent those loans from being made.

    According to the people who investigate this kind of thing, like Bill Black, the laws were already on the books. They were not enforced and they should be now.

    Floccina Reply:

    Instead, government is acting to prop up the market to maintain asset values so the banks retain at least the appearance of solvency. That’s the problem with debt-deflation. The government has decided to save the banks.

    We agree here but difficult to address. I have no reason to expect the median to get money in the near term.

    According to the people who investigate this kind of thing, like Bill Black, the laws were already on the books. They were not enforced and they should be now.

    Do you have a link where I can read those laws?

    Tom Hickey Reply:

    William K. (Bill) Black is where to start if you want to research the crime involved in the GFC.

    http://neweconomicperspectives.blogspot.com/search/label/William%20K.%20Black

    Jim Baird Reply:

    My reading of Minsky is a bit more cynical. He said that there really isn’t any way to avoid periodic financial crises, because people gradually forget about the last one. No matter how bulletproof you make the financial system, as the decades roll on without a crisis, the laws will be repealed and it will start all over again. In the long run, we are all dead.

    Reply

    Tom Hickey Reply:

    Yes, in the long run we are all dead. But the long run is a series of short runs. It’s up to each generation to be vigilante. All the present generation can do is take care of the short run.

    Right now, the GFC is a giant crime scene and that’s not being addressed. When rampant cheating is permitted and even reward through bailouts, then what to say?

    Marshall Auerback sums it up in Where Have All the Investigators Gone?

  8. Mike Norman says:

    “Again, a financial crisis doesn’t need to ’spread’ to the real economy. Fiscal policy can sustain full employment regardless of the state of the financial sector. Losses in the financial sector need not affect the real economy any more than losses in Las Vegas casinos.”

    That last sentence is beautiful! You need to incorporate that into your talks all the time!!

    Reply

  9. anon says:

    Bank capital is not unlimited.

    Neither is retained earnings as a source of capital.

    Banks make choices about where to allocate capital.

    Banks hold back on capital allocation particularly in times of uncertainty. It’s a matter of risk management.

    Both price and quantity of credit are affected.

    Reply

  10. Ramanan says:

    I assume that means bank capital. If so, that alters the price of credit but not the quantity, as it alters spreads needed to provide market demanded risk adjusted returns for bank capital.

    Good point Warren. Plus when demand increases and is going north-east incoming interest payments and higher retained earnings improves banks’ capital

    Reply

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