“Built to Fail”

At last, a brief article on the financial crisis that goes behind the facade to look at some of the deeper structural issues.

The author is Satyajit Das and the article (“Built to Fail “) was published in the latest Monthly. He sees the principle cause as excessive debt:

The most important lesson of the financial crisis may be that the current economic order was built to fail, for the global economy used debt and financial engineering to enhance growth, requiring ever more stimulus to maintain performance. The spike in debt globally caused a spike in growth rates. As much as $5 of debt was required to create $1 of growth. Approximately half the recorded of growth in the US over recent years was driven by borrowing against the rising value of houses (that is, mortgage-equity withdrawals). As the level of debt in the global economy decreases, attainable growth levels also decline.

This is now a fairly widely held view. More interesting, I think, is the beautifully simple fashion in which he goes on to consider the real-world impact:

The world economy used debt to accelerate consumption. Spending that would normally have taken place over many years was squeezed into a relatively short period because of the availability of cheap borrowings. Business over-invested, misreading demand and assuming that exaggerated growth would continue indefinitely, creating significant over-capacity in many sectors.

Until household balance sheets are restored, a significant portion of demand is quite simply gone and hence the capacity created to meet it is of questionable value. It’s a brute fact that can’t be easily papered over; it will take time, and considerable pain, to make the necessary adjustments. It’s also why all the frantic efforts to reflate, to get the credit machinery running again, to encourage consumption, may more often than not fail to gain purchase:

The current initiatives of governments and central banks are a hair-of-the-dog treatment. The problems they seek to address can be traced to the high levels of debt accumulated by banks, companies and consumers. In effect, this is now being replaced by government debt and, simultaneously, the debt-fueled consumption of companies and consumers is being replaced by debt-funded government expenditure. Yet adjustment in the level of debt and asset prices is part of the process through which the global economic system will re-establish itself. Like King Canute, central bankers and finance ministers cannot hold back the tide.

Nevertheless, they all feel they must try and already the severity of the crisis has created a “Whatever It Takes” attitude. This is (arguably) all very well if it works, but if it doesn’t it risks utter disaster. Not only economically, but in terms of social stability and trust in the political system.

We better hope they’re right.

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vanaalst.robert
vanaalst.robert(@vanaalst-robert)
12 years ago

I think “utter disaster” is over the top. If we’re bogged down in bad debt for years (like Japan) or have higher levels of inflation for a reasonable amount of time (like the 70s), it might not be the land of milk an honey, but it’s hardly utter disaster.

Johnboy
Johnboy
12 years ago

Hey Conrad,

Obviously you have bought your plasma TV. I haven’t. It is an utter disaster!

Richard Tsukamasa Green
Richard Tsukamasa Green(@richard-green)
12 years ago

Whilst not questioning the general validity of the premise, I do wonder about the “too much debt”, often vulgarised into “living beyond our means” in the context of a global recession.

After all, the net debt of the world economy is 0, just as it had always been, unless Roswell’s visitors were financiers or the worst nightmares of David Icke are true.

I guess this can be clarified into “too much poor debt”, but that ends up being more a regulatory problem, and less a morality tale.

(This isn’t about Das’ article specifically though I should add)

vanaalst.robert
vanaalst.robert(@vanaalst-robert)
12 years ago

Perhaps we have different definitions Ingolf. When I think of “utter disaster”, places like Sudan come to mind, where it really is an utter disaster. I can’t see how Australia would get even close to anything like that.

I guess an alternative way to look at it is to try and predict the worst possible scenario that could eventuate. On this note, let’s say that the Australian dollar falls to 25c to the US dollar and we get an 18% unemployment rate. That would surely be bad, and we’d have a huge cut in living standards. However, it still wouldn’t be the end of the world — we’d have to save for a few months to buy consumer goods like we did for most of the 20th century, people would have to start riding scooters about like most of the world, and the actual percentage of the population employed wouldn’t be too different to a lot of the 20th century either (it’s just there would be more unemployed males). That’s certainly bad compared to now, but, at least in my books, it isn’t an utter disaster.

Tel_
Tel_
12 years ago

Hopefully I can recycle http://mises.org/story/3194 from a few months back:

the downturn is a period of readjustment, when misallocated resources are channeled back into more appropriate lines, consistent with consumer preferences and technological realities. When the government steps in and tries to prevent this readjustment, it simply maintains an unsustainable deployment of scarce resources.

And in reply to Richard Green:

After all, the net debt of the world economy is 0, just as it had always been, unless Roswells visitors were financiers or the worst nightmares of David Icke are true.

A simple example: you come to my place once a week to swap tomatoes for a pig, we both get something useful, transactions are completed instantaneously and no debt ever exists. One day you bring your tomatoes and I take the tomatoes but I don’t have a pig, “Sorry, big pig next week,” I say in the efficient manner spoken by the man on the land. Now you go home empty handed, and a debt has come into the world. There are no new real pigs in the world, but there is one extra imaginary pig that you believe is coming to you.

Should I come good with the promise, the debt is cleared and we are all happy. Should I fail to deliver on time I can either promise more (and hope for a patient audience) or we start a longstanding neighbourly Feud and teach our sons to hate. The US economy has been exchanging promises for larger promises for many years and the audience just got impatient.

I guess this can be clarified into too much poor debt, but that ends up being more a regulatory problem, and less a morality tale.

I would say, in colloquial terms, a lot of people felt they were promised something and now they discover that the promise ain’t gonna happen. Is it immoral to make a promise that you can’t keep? Maybe it was all just an unfortunate misunderstanding. My point is that the total debt in the world can be non-zero, and it is all in the form of imaginary goods that people believe they will get at a future date.

As a regulator, the ideal thing would be to make it impossible for anyone to promise anything unless sure that the promise will be kept, but we all know this simply cannot be achieved. All debt comes with some component of risk because we cannot fully control the future. The next best thing the regulator can do is ensure that the person taking the risk understands the true nature of this risk and has a fair assessment of what that is. I suspect that this is also not achievable, but in this particular case the regulators made not the slightest effort to inform anyone which is a morality tale in itself.

Once the promise has been broken, the regulator can give the promise-breaker a good old fashioned country thrashing; which won’t create the missing goods, but it might serve to encourage caution next time round. The trouble in this case is the highly interwoven nature of the transactions makes it difficult to figure out exactly who was the promise-breaker (but most people have their eyes on the banks).

Patrick
Patrick(@patrick)
12 years ago

Ingolf, I agree that there is a lot of monetary blame to lay. From one perspective even that is a regulatory problem as well. I do agree there is a greater regulatory problem. For one thing, a great many of these ‘toxic’ assets are really regulatory arbitrage, and that this went on to such a scale without the regulators realising that the rules were being leapt through like fountains on spring break suggets a pretty big problem. Warren Buffet famously made the point with respect to Fannie Mae and Freddie Mac:

OFHEO has over 200 employees now. They have a budget now that’s $65 million a year, and all they have to do is look at two companies. I mean, you know, I look at more than two companies.

(and repeated it, p17)
~ ~ ~

Tel, at least you should be happy that I think the US officially abandoned the fractional reserve banking you are complaining of sometime last year (I doubt it has resumed since).

More to the point, are we sure that promises are being broken? I would have thought not many. Rather, you promised Dick, not a pig, but pig as described in this 50 page document. Dick collected 1000 such promises and promised Jane a particular set of income streams and risks from those 1000 promises, as described in this 300 page document. Jane then used that promise as collateral to support her promise to Harry.

When someone twigged that Dick’s pigs were rather malnourished, and might not contain as much bacon as thought, a cascading stream of devaluations went through the chain of promises. So Dick’s promise to Jane was now worth less than Harry had thought, so Harry was entitled to ask for more collateral to support her promise. But Harry wouldn’t accept such vague promises this time, so Jane had to use other, more traditional, promises to support her promise to Harry.

And her promise from Dick became ‘toxic’, because it was no longer acceptable collateral at any ordinary rate. So in effect her net stock of promises was sharply reduced, and thus her ability to make credible promises to people.

At this point the government stepped in, assumed a massive promise on behalf of our children to pay taxes, and gave Jane a big bundle of very simple promises so that she could start making promises again.

Or so I understand it, and I apologise for the length, but the point is that the pig is still there, but we know realise that we didn’t really establish what kind of a pig it was and how much lipstick it was wearing. The promise wasn’t broken, we just didn’t really know what it was.

(And then, yes, you were sacked, and you did break your promise to Dick, and you are now bankrupt with no assets, and that cascades through the system too, but this is really as much an effect as cause).

To (finally) make my point, which I hope marries your concerns with Ingolf’s, I will paracite JKG (I can’t find the original, maybe I am making it up), whom I dislike and generally disagree with but has a point on this:

It is often said that our financial system is one based on trust. I would have thought the exact opposite should be the case.

pedro
pedro
12 years ago

Yes the story does sound like the Austrian heresy. ;-) Still, Richard’s point is correct in that each loan has a lender and a borrower, and tel, lenders don’t spend money they have lent to other people so you fractional reserve extra dollars are not all down at Harvey Norman at the same time. As Keating pointed out, consumption in the US and other places (like us) has been partly funded by the Chinese not consuming, so the Chinese (and others) have been under consuming. The problem is not overconsumption generally, but a bubble created by too much lending by the Chinese. CDOs and CDSs just made it a bigger knot and the fricitional damage will be worse as a consequence.

Fred Argy
Fred Argy(@fred-argy)
12 years ago

What Das is suggesting is a “do nothing policy”. In my view (as I argued in Response to Turnbull, that it is the surest way to build up government debt. It would create so much unemployment and a fall in profits that public debt would have to rise.

Indeed we would end up with a fall in economic growth and a big rise in government debt.

So what he has achieved?

Patrick
Patrick(@patrick)
12 years ago

Pedro, I don’t see how CDS made anything worse at all. CDOs perhaps yes, because they are the kind of generic instrument I described. But if Jane had bought protection on Dick’s promises with a CDS, then most likely, Jane would have been better off. At that point it really would have come down to collateral, and whether Jane, who didn’t have enough alternative promises to wholly replace the CDOs (multi-packed promises) she was holding, might have had enough alternative assets to post as additional collateral on the CDOs as they downgraded.

So CDS might not have saved her, but they would have given her a much better shot. They certainly wouldn’t have made it worse.

Fred, I realise that you know a lot more than me about this. But are you sure that a do nothing policy even could build up as much debt as the US seems hell-bent on taking on? Or is your answer that they will get back a lot of their money so the debt isn’t as bad as it seems?

Fred Argy
Fred Argy(@fred-argy)
12 years ago

Patrick,

I know for sure that public debt will need to increase as economic activity declines. What I don’t know is how much US pump priming will increase debt, but it will certainly be at a lower level of economic activity, even if it is not proportional.

I do happen to believe that the large government debt will take a few years to run off but it will do alot of good in the meantime.

Patrick
Patrick(@patrick)
12 years ago

Fred I can agree in the Australian context, I have no problem with the Gruen/Argy public-debt-is-not-as-bad-as-it-is-made-out-to-be-at-least-in-Australia school, indeed I think it is almost common sense, but I am interested in whether you think this is applicable to the US where the figures are such an order of magnitude higher at the best of times and are a couple orders of magnitude higher now, even expressed relative to GDP.

I would prefer that we factor in a smashingly conservative $15trillion in unfunded medicare and federal pension entitlements (I have seen 36tr touted for Medicare alone) and that is ignoring the States. With US GDP of 13 trillion and Aust of 1, we would have to be borrowing 2 trillion to catch up with Medicare, TARP, and all the rest.

Do you think that would be sensible? Do you think it is sensible for the US, or do you think that the US is sufficiently ‘different’?

Fred Argy
Fred Argy(@fred-argy)
12 years ago

Don’t know for sure. I would hate to see it decline sharply, as it is an economy which once it takes of, is likely to rebound quickly.

pedro
pedro
12 years ago

Patrick, I think CDSs contribute to the problem by the sense of security they provide, thus increasing the appetite for more of the problem debt.

I think govt spending now (and thus debt) is only justifiable to the extent is eases the adjustment process that Das is talking about. For example, I can’t see much point in supporting jobs in consumer retail because we almost certainly face a contracted retail sector for years. But the do nothing school has to answer the objection that doing nothing will lead to a big overshoot downwards as each stage of the developing recession causes new problems.

Patrick
Patrick(@patrick)
12 years ago

I liked this paper on CDS, it seemed consistent with my expectations and understanding. It attemps to address, in particular, your complaint about the OTC market.

Where we differ is that you are probably hopeful that new regulation will be positive (for example you are a fan of banning OTC CDS) whereas I am certain that the costs will outweigh the benefits.

But I also do agree with Pedro’s statement about adjustment. My mind literally boggles at the money given to GM. Imagine if that money had been divided amongst the workers, even including those of the supplier networks, as retraining and relocation subsidies. Anyone who believes that the money given to GM/Chrysler was a loan should be paying face value for sub-prime RMBS.

pedro
pedro
12 years ago

I am with Patrick in fearing the new round of regulation. My view after many years as a lawyer is that regulation to protect people from their own stupidity has high and unforeseen costs and little effect. I often wonder if the existence of ASICs and so forth make the problem worse by disguising that fact that securities investment can be a leap into a bear-pit.

If we accept that too big to fail is a political necessity then perhaps the best regulation is to limit the number of too-bigs? I really don’t like mucking around with the market, but it is impractical to pretend that moral hazard problems can be avoided by political will, so we only have the regulatory environment to help in that respect.

I have always like the 4 pillars policy because overly large banks are a systemic danger.

We should not forget that the greatest cause of the present problem is the amount of money being lent and the low interest rates that encouraged the borrowing.

Patrick
Patrick(@patrick)
12 years ago

Be careful Pedro you will be a free banker soon!

Ingolf, you have hit a real issue. What did GE, AIG, Citibank and RBS all have in common? They leveraged the stability, cashflows and, crucially, credit rating, of one business (diversified manufacturing, insurance, deposits and mortgages) to give them a competitive advantage in another business (financial products/speculation).

I don’t even know if this is good or bad. Bear Stearns and Merrill Lynch went arse-up without any such balance sheet arbitrage. Goldman Sachs and even eg Macquarie are still going also. But I can’t help but wonder if there is a problem created when one entity can price an identical transaction differently because of their related entities’ credit ratings. Do credit rating agencies have any real idea what kind and size of implicit call is extant on a given company’s rating?

pedro
pedro
12 years ago

Patrick, I think free banking is one of those ideas where it sounds good at first, but nagging worries set in and you can’t quite sell yourself on the idea. I think maybe some things have moved on since the 19th century.

Arnold Kling on the financial regulation chess game:

http://www.finreg21.com/lombard-street/the-chess-game-financial-regulation

“Regulatory systems break down because the financial sector is dynamic. Financial institutions seek to maximize returns on investment, subject to regulatory constraints. As time goes on, they develop techniques and innovations that produce greater returns but which can also undermine the intent of the regulations.”

and

“Instead of trying to make the regulatory system harder to break, we might think in terms of making it easier to fix. ”

and

“The best way to make our financial system easier to fix would be to reduce the incentives for high leverage. We promote home ownership by subsidizing mortgage indebtedness. It would be better to provide subsidies and encouragement toward saving for a reasonable down payment. Likewise, in the corporate sector, our tax structure tends to penalize equity finance and to reward debt finance. Changing the system to tilt more in the direction of equity finance would go a long way toward reducing the vulnerability of our economy to crises at banks, insurance companies, and investment banks.”

pedro
pedro
12 years ago

“Do credit rating agencies have any real idea what kind and size of implicit call is extant on a given companys rating?”

Reliance on ratings agencies is the same problem as that I alluded to in comment 19. And do we detect the protective hand of government in the glorification of the ratings agencies?

It’s easy to be an anti-government cynic when, you know, there’s so much to be cynical about.

Tel_
Tel_
12 years ago

Steve Keen (and maybe other people) have explained the problem with the CDOs in attractively simple terms. It goes a bit like this:

If I have a single investment, with some smallish percentage chance of failure then I stand to potentially lose the lot. If I have a great many small investments, each with the same smallish chance of failure then the chance of losing the lot is vanishingly small, because multiplying all the small probabilities together results in a rapidly shrinking chance of total failure. Right?

Wrong, actually.

The statistical analysis that was used to get estimated for CDOs was based on a presumption of non-correlated failure modes (i.e. each investment was an unrelated, independent random variable). However, what actually happened was that default on housing payments (and credit cards, and similar loans) turned out to be highly correlated to a downturn in the market (and worse, when the defaults added up they caused further downturn). The high correlation of these “random” failures implied that the CDO was absolutely no protection at all.

In terms of the larger market stability, the CDS system has exactly the same problem as the CDOs but it is more difficult to visualise. Let’s consider that a CDS is really just an insurance contract, and the insurance company maintains a certain amount of liquidity to ensure they have enough to cover the random fluctuations in the risk that they are underwriting. The insurance company is quite safe so long as random events happen as independent random variables, they are foobar in the face of highly correlated failure modes (i.e. a market downturn). When the insurance company runs out of liquidity is exactly when the CDS is most needed and the buyer finds that the insurance company can’t keep their promise. Thus the CDS is also absolutely no protection at all.

Should the people calculating the risk have been aware that correlation was going to screw with their results? In the cold light of hindsight (and having it explained to me), it does seem bleedingly obvious. I’ll be quite honest and say that I doubt I would have spotted the problem in the heat of a boom time, but then again I’m not paid even a fraction of the income of the people who were paid to check this stuff out, so presumably they earned that money doing something?

pedro
pedro
12 years ago

Ingolf, I’m not suggesting a move to laissez-fair, just a lot more deliberation and humility in making regulations.

pedro
pedro
12 years ago

Very constructive steps, and all with out regulatory help from Big Brother it seems. Funny that. If I remember correctly, the market had called out Enron well before the regulators got to the scene of the crime.