Links for today

Ned Phelps has an interesting article in the FT that criticizes both Keynesians and neoclassicals. He blames speculation for the housing crisis, not incentives.

The WSJ has an article (subscription required) on John Geanokopolos's work on leverage. I think that theorists will be interested to learn that they were on the margins:

Mr. Geanakoplos is among a small band of academics offering new thinking about those cycles. A varied group ranging from finance specialists to abstract theorists, they are moving to economic center stage after years on the margins.

Hard to see what margins they were on, but then we also learn that traditional macroeconomics had been relegated to second class status:

Traditional macroeconomics, such as practiced by John Maynard Keynes and Milton Friedman, was relegated to second-class status.

So I guess any comment about economics is possible in the WSJ. But despite these complaints, the article is interesting.

Everyone wants to make their work seem more revolutionary than it was, and reporters need it to be so, else why report it.

Insolvency versus Illiquidity

Emmanuel Derman has an interesting post about how we got into the present mess. His argument is essentially that the bubble created a class of assets that were way overvalued and holders are insolvent, and that this spilled over into other asset classes that people could not judge the quality of. So you have insolvency in some classes inducing panic that causes illiquidity in other classes.

As everyone fled the insolvent and illiquid securities they lost confidence in the economic future and stock prices fell, and people felt poorer and spent less and companies projected less future profits and fired people who then spent less money and so they drove other companies that depended on them to do badly and so on and so on.

The administration is trying to cure insolvency and illiquidity with stimulus, but stimulus is mostly a cure for illiquidity. They are using a medicine for living people to revive the dead. The best thing would be to ring fence and restructure only the insolvencies and to stimulate the illiquidities. The desperate effort to treat insolvency with stimulus and the Chicken-Little warnings about the consequences of not doing so detracts from the confidence necessary to restore liquidity.

I find this argument very insightful. But there is another point to remember. That is the change in leverage. As we go from 30-1 leverage to 2-1 leverage assets that were not toxic now seem to be. Risk aversion leads to this loss of leverage and to the flight from these assets. So there is a point to the argument that some of these assets may become viable if confidence is restored. Derman's point, however, is that this will not be possible if we don't bury the dead. That is an important point to remember.

Bank Bailouts and Losses

Representative Barney Frank and many others complain that recipients of TARP funds have hoarded funds rather than issue new loans. I find this argument perplexing. If there was a huge demand for credit that is going unfulfilled, perhaps it makes sense. But as we spiral into a Keynesian recession the demand for credit, at least by able borrowers, has fallen significantly. De-leveraging is taking place because banks are not sure if anybody else is credit-worthy. Since the banks got in trouble by lending too much it is not surprising that they hold reserves to maintain some semblance of solvency.

And then we read, in today's Post for example, that unexpectedly large bank losses are complicating the federal government's rescue plans. As they note:

The problems are intensifying the pressure on the incoming Obama administration to allocate more of the $700 billion rescue program to financial firms even as Democratic leaders have urged more help for distressed homeowners, small businesses and municipalities. Senior Federal Reserve officials said this week that the bulk of the money should go to banks.

This should hardly be a surprise. Given the massive de-leveraging we are experiencing, and the fact that a new wave of foreclosures are coming. Moreover, it is not clear that all of the troubled banks have recognized their losses yet. Under these conditions would you lend?

Nature of the Financial Crisis

Axel Leijonhufvud has a very insightful article on the causes of the financial crisis. The basic point of departure is the difference between positive and negative feedback systems. Typically markets display negative feedback: when demand exceeds supply price tends to rise. This restores equilibrium. A thermostat is a negative feedback system, it stabilizes the temperature in your house. Positive feedback systems can lead to bubbles. Leijonhufvud explains how the monetary system and the financial system took on features of positive feedback.

Leijonhufvud also has important things to say about the process of deleveraging. His conclusion is not rosy:

American households are also fairly highly levered at this time and virtually the only way for them to reduce debt is to increase their saving. The fall in business investment combined with the increase in attempted saving by households will, under present financial conditions, produce the kind of recession that John Maynard Keynes theorised about. The automatic adjustment tendencies of free markets are peculiarly ineffective in producing a recovery from a recession of this type.

Leverage

This article in the Economist illustrates how leverage is complicating adjustment. Financial institutions are highly leveraged. As their equity falls liquidity falls much faster.

Even if markets can be stabilised this week, the pain is far from over—and could yet spread. Worldwide credit-related losses by financial institutions now top $500 billion, of which only $350 billion of equity has been replenished. This $150 billion gap, leveraged 14.5 times (the average gearing for the industry), translates to a $2 trillion reduction in liquidity. Hence the severe shortage of credit and predictions of worse to come.

Leverage bolsters profits on the way up. It is dangerous to forget that what goes up can come down. Galbraith's book "The Great Crash" has a great discussion of what happens when leverage applies in reverse.

Putin I and Putin II

You hear a lot of discussion recently about Russia's new assertiveness (sometimes a different description is used!). And it is obvious that high oil prices have a lot to do with it. But this picture produced by my colleague Cliff Gaddy puts it neatly in perspective. He compares Russian government foreign debt with its foreign exchange reserves.

In the Putin I regime, Russian government debt was much larger than foreign reserves. In Putin II we have more than a complete reversal (though I should note that foreign debt of state-affiliated companies would add to government debt -- presumably if Rosneft cannot pay its Eurobonds the government will). In the Putin I regime the west had lots of leverage on Russia. Now that leverage is gone.