Back to Keynes II

Greg Mankiw seems to agree with me about the current relevance of Keynes. So does Tyler Cowan. He is creating a discussion of the General Theory at Marginal Revolution.

Morgan Stanley and Short Selling

This article in the Wall Street Journal reports on short selling regarding Morgan Stanley in September. Recall that CEO John Mack attacked short sellers for what happened to the stock price, and was instrumental in getting the SEC to initiate the short selling ban. The interesting tidbit in the article is that hedge fund clients of Morgan Stanley reacted by pulling their funds out as revenge:

But within days, more than three-quarters of Morgan Stanley's roughly 1,100 hedge-fund clients had put in requests to pull some or all of their assets from the firm, according to a person familiar with the operation. Even though most kept some money at the firm, Morgan Stanley couldn't process all the withdrawal requests at once, adding to market fear.

As Felix Salmon argues the notion of a bear raid on Morgan Stanley does not hold water. The cost of insuring against Morgan Stanley default increased because investors needed to hedge, not because of a bear raid. Two months later the cost of insurance is down but the stock is still in the doldrums. As Salmon notes:

Even now, after yesterday's massive rally and a further uptick this morning, Morgan Stanley stock is trading at less than $15 a share. Clearly the stock price is not being driven down by manipulative speculators taking advantage of an illiquid CDS market to sour sentiment.

What I wonder about is how much the loss of business caused by the attack on short sellers cost Morgan Stanley.

Back to Keynes

It is hard right now not to think about the economics of John Maynard Keynes. We appear to be in an environment where the lessons of the General Theory are once again relevant.

Given the developments in macroeconomics in the last 25 years it is a bit hard to type those words. Yet is surely seems to ring true today. After all, our current economic crisis is not the result of some external shock -- indeed, the boom continued while oil prices sky-rocketed. The crisis is related not to external events but to the unraveling of a bubble. In essence, it is essentially a failure of coordination. As investors fear for the future they rush for security. T-bill rates fall to near zero, lending to the private sector decreases dramatically, and income and employment start to spiral downwards. That is why so many now call for a severe dose of fiscal stimulus (see, for example, this article by Paul Krugman).

As my colleague Neil Wallace mentioned to me today, what is striking about our current situation is that unlike, say, Katrina -- which had serious, real destructive effects for both capital and labor but had little impact on the overall economy -- our current dilemma seems to stem directly from fear and expectations. Fear of the future has had very serious real effects. "Animal spirits," or the lack thereof, is the important factor. Investment is on strike right now and we seem to be in a liquidity trap where credit expansion is ineffective at combating the slump.

The return to the economics of Keynes at this moment makes me think about the "corridor hypothesis" that my former teacher Axel Leijonhufvud proposed. He argued that in normal times the market system works well to bring us back to equilibrium. Within the corridor of stability it is like a thermostat -- a negative feedback device. The problems that Keynes wrote about occur when we are outside the corridor. Then we cannot rely on the market to automatically restore equilibrium. That is where the economics of Keynes is relevant. Unfortunately, for us, we now appear to be in that situation.

I suppose that during a long period of stability it is not surprising that we ignore the lessons about effective demand failures. The lessons seem archaic. Now the same lessons seem very relevant. Good fortune allowed us to ignore the economics of Keynes for a while. Perhaps the consequence of assuming that those lessons were no longer applicable is the reason that we recklessly created an environment that caused us to leave the corridor.

Citigroup's Descent

The failure to adequately manage risk is the theme of this article in the NYTimes. One of the highlights concerns Citigroup's analysis of the risk of its mortgage holdings:

...when examiners from the Securities and Exchange Commission began scrutinizing Citigroup’s subprime mortgage holdings after Bear Stearns’s problems surfaced, the bank told them that the probability of those mortgages defaulting was so tiny that they excluded them from their risk analysis, according to a person briefed on the discussion who would speak only without being named.

Another amazing item is that Citigroup mainly relied on ratings agencies rather than its own risk managers to assess the risks from assets like CDO's. One might understand this if Citi was just selling the assets to gullible investors (which it did), but it held huge slices itself, and it is the losses on the assets it retains that have caused such large losses.

It is amazing to read how a company could lose $220 billion in market value in just two years. As Brad DeLong emphasizes, however, the losses in market value dwarf the announced losses on CDO's and other real estate loans. DeLong's argument is that the risk premium on holding Citi equity has risen as the crisis worsened. After all, the probability that the government will dilute the shares in a takeover has increased dramatically. He takes the rise in the risk premium as the major factor causing the value of Citi's shares to decline so dramatically.

DeLong's analysis is based on the observation that banks are institutions that trade on reputation and trust. The borrow short and lend long. Hence, they are always on the edge in a financial crisis. The risks bank take that are sensible in normal times appear insane in rough times.

Rescue package soon to follow.

Zimbabwe Hyperinflation

According to calculations from Professor Steven Hanke, the annual inflation rate in Zimbabwe has reached 89.7 sextillion percent (89,700,000,000,000,000,000,000%). On the bright side, it is only about 79.6 billion percent per month. If you go to this site you can see a table that shows its massive acceleration.

Frightening Picture of the Day

Frightening picture of the day. This is the corporate cost of borrowing in real terms, from Paul Krugman. Inflation expectations are taken from the difference between 20 year Treasury bonds and 20 year TIPs. You can really see the sharpening of the crisis. A key part of this is the decline in inflation expectations.



A related piece of information is that the spread between high yield bonds and Treasuries rose to 18.6% on Wednesday. The spread was only about 8% in August.

Agency

I've said before that the key problem that led to the crisis was agency. Incentives for financial decision makers encouraged risk taking. An article in today's Wall Street Journal provides some evidence, in the form of earnings of top executives in finance and home-building over the last five years. A key finding:

Fifteen corporate chieftains of large home-building and financial-services firms each reaped more than $100 million in cash compensation and proceeds from stock sales during the past five years, according to a Wall Street Journal analysis. Four of those executives, including the heads of Lehman Brothers Holdings Inc. and Bear Stearns Cos., ran companies that have filed for bankruptcy protection or seen their share prices fall more than 90% from their peak.

Of course such earning filtered all the way through the financial system. Bonuses and earnings were high at investment banks because the risk taking led to high current earnings, and because insufficient attention was paid to the associated risks that the decisions that produced those earnings implied.

The key point is that these people were obviously not stupid, and the crisis is not due to stupidity, but rather to a system that rewards current performance without attention to risk. To paraphrase James Carville, "it was the incentive system stupid."