The Prodigal Catholic Blog



Crisis economics shows that far from being the exception, crises are the norm, not only in emerging but in advanced industrial economies. Crises are hardwired into the capitalist genome. The very things that give capitalism its vitality – its power of innovation & its tolerance for risk – can also set the stage for asset & credit bubbles & eventually catastrophic meltdowns whose ill effects reverberate long afterward. Crises follow consistent trajectories & yield predictable results. They are commonplace & relatively easy to foresee & to comprehend, call them white swans. While history rarely repeats itself, it often rhymes. Many of the most destructive booms-turned-bust have gone hand in hand with financial innovation, causing a particular asset to rise far above its underlying fundamental value going hand in hand with excessive accumulation of debt & supply of credit for investors to buy into the boom. Demand rises & outstrips supply; prices rise. At some point, bubble stops growing, when supply begins to exceed demand. Just as a fire needs oxygen, a bubble needs leverage & easy money, & when those dry up, prices begin to fall and “deleveraging” begins. Just as prices exceed their fundamental value during the bubble, prices fall well below their fundamental values during the bust. The elements of a boom & bust are remarkably predictable. Crisis economics is the study of how & why markets fail. Much of mainstream economics, by contrast, is obsessed with showing how & why markets work – and work well. Stock prices exhibit far more volatility than the Efficient Market Hypothesis can possibly explain. Capitalism is not some self-regulating system that hums along with nary a disruption; rather, a system prone to “irrational exuberance” and unfounded pessimism (extraordinarily unstable). Clearly the best way to understand crises is to see them as part of a broader continuum of causes & effects, extending long before & long after the acute phase of the crisis. “The whole world has become a city.” “Capital account crises” – in emerging market economies, all had one thing in common: unsustainable current account deficits that were financed in risky ways, by relying so heavily on short-term debt—and on debt denominated in foreign currencies—these countries set themselves up for a catastrophic fall. When foreign investors panicked & refused to roll over short-term debts, overvalued local currencies collapsed. Worse, as the relative value of local currencies declined, the real value of debts denominated in dollars & other foreign currencies soared, making default all the more likely, with the cost of bailing out the economy ending up on the backs of taxpayers plunging millions of taxpayers into poverty in the ensuing contraction. Issues with crisis – what made a difference was not the magnitude of greed but new structures of incentives & compensation that channeled greed in new & dangerous ways. Securitization was the name of the game – illiquid assets like mortgages could now be pooled & transformed into liquid assets that were tradable on the open market. “Originate and distribute” replaced “originate and hold.” Easy money policies from Greenspan would help foster unsustainable credit & housing boom. Moral hazard is someone’s willingness to take risks – particularly excessive risks – that he would normally avoid, simply b/c he knows someone else will shoulder whatever negative consequences follow if not bail out those who took risks. The bonus system in financial firms encouraged short-term risk taking & excessive leverage. Principle-agent problem is in large-scale capitalist enterprises, the principals (shareholders & board of directors) must hire other people such as managers (agents) to carry out their wishes & mind the store. Unfortunately, the agents know more about what’s going on than the principals and can pursue their own self-interest to destructive effect. An asymmetric information problem forms when the principal knows less than the agent. Shadow banks are financial institutions that look like banks, act like banks, and borrow and lend and invest like banks but are not regulated like banks. They mostly borrow in short-term, liquid markets, then invest in long-term, illiquid assets. Shadow banks lead to regulatory arbitrage: the purposeful movement of financial activity from more regulated to less regulated venues. USA borrowing: The USA borrows from abroad in its own currency. The potential depreciation of the dollar doesn’t increase USA liabilities. Instead, that currency risk is transferred to foreign creditors. At some point, the foreign creditors will demand real assets – ownership stake in American companies. Central bank in the USA can monetize the debt by printing new currency to pay off debt which would send inflation soaring wiping out the real value of the debt & transferring wealth from creditors to the gov’t. The Coming Crisis – financial crises have a funny way of making radical reforms seem reasonable. The concentration of financial powers has created a system that is too interconnected to fail. We need greater transparency in derivatives & other financial instruments, greater accountability in the financial firms by reforming compensation to focus on long-term growth, regulating securitization, changing the system for the rating agencies by forbidding them to consult or model for anyone while adding more competition into the rating agency field – have a solution that all institutional investors pay into a common pool that would be administered by regulators. The rating agencies should exist for 1 purpose – to assign a rating to debt instruments. We need a 21st century version of the Glass-Steagall legislation of 1933 (separate commercial banks from investment banks) to create a # of new firewalls b/c right now, the breakdown of barriers allows banks with access to deposit insurance & lender-of-last-resort to support high risk activities (proprietary trading should be left to hedge funds). Only commercial banks should have access to deposit insurance & a gov’t safety net. Current account balance: is its “external balance,” a measure of how its economy compares with those of other countries at any given time. Current account adds together the difference between exports & imports (balance of trade) and the difference between income earned on foreign assets & payments made toward foreign liabilities (“net factor payments”) and a 3rd component of one-sided transfers of money across national boundaries for foreign aid and such. Money flows from countries that have current accounts surpluses (China) to those than run current account deficits (USA). A country’s current account balance also represents the difference between its “national savings” & its “national investment.” Capital account is the change in the country’s private foreign assets minus its foreign liabilities – is equal to the change in the reserves of the central bank. Economic theory holds that emerging markets should have a current account deficit while advanced economies have a current account surplus. But, the USA has gone from the worlds biggest creditor to biggest debtor nation. China, the world’s biggest creditor has sunk hundreds of billions into low-yield US Treasury bonds in order to keep its currency low & exports affordable. ................
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