Cassandras of the crisis: Krugman, Soros, Wolf and Shiller

Here’s a review essay I worked on in early 2009 which was published in the monthly. I’ve reproduced the review as filed rather than as printed as The Monthly needed to prune it back for reasons of space. The easiest way of doing so was to get rid of a great quote from Wolf, which you should read below.

These four short books are by Cassandras of the crisis who warned of doom, and hastened into print to join the collective puzzling and pontificating about our situation. The books neatly organise themselves into the Good (Krugman), the Bad (Soros) and the Ugly but thoroughly worthwhile (Wolf and Shiller). With the glorious exception of Krugman’s, these books are unsatisfying as books. All four authors have packaged up a range of ideas they’d articulated before the crisis and ‘re-purposed’ them with the crisis book trade in mind.

This is no insignificant detail when one considers that, as Berkley Professor and econoblogger Brad Delong has pointed out, this isn’t quite the crisis most doomsayers were expecting. The anticipated crisis was to be triggered by a plunging American dollar as the world woke up to the unsustainability of its borrowing and the international imbalances underlying it as discussed in Martin Wolf’s book. In fact the crisis erupted organically within the US financial markets – famously in the sub-prime residential mortgage market – and the resulting global crisis saw the US dollar rise as investors headed for (what they saw as) the safety of the international reserve currency. Old reflexes die hard.

Wolf has cobbled together a book by providing two introductory and two concluding chapters as bookends to a series of lectures he gave from 2005 in which he anatomises the growing foreign indebtedness of the Western – mostly English speaking – nations to Asian developing countries and oil exporters. As truly insightful as they are, with events moving as fast as they have been, the lectures – some of which are around four years old – sit uneasily next to the more contemporary chapters and frustrate the ardour of the reader’s search for explanations and answers to our current predicament.

Nevertheless Chapter Two – “The blessings and perils of liberal finance” – is as masterful an introduction and exposé of its subject as I’ve ever seen. Wolf expounds with regard to both the simplest first principles and the broad sweep of history, the profound significance of a financial system as a cultural, political and economic achievement. A financial system is a pyramid of promises. The trustworthiness of the state’s promises – in managing the monetary system and paying its debts – is the bedrock on which private promises can then, laboriously be built.

That’s why the take-off of modern finance dates to the late seventeenth century when Western sovereigns – in Holland and Britain – first became properly subject to the rule of law. The constraints this forced upon them rendered them creditworthy and so able to borrow vast amounts at modest interest. And, recent ideological enthusiasms notwithstanding, the central financial innovations of modernity were made by governments at around this time, most particularly bond markets, central banks and the legal infrastructure for joint stock companies. As Wolf explains, the resulting financial system “allows the creation of vast enterprises out of the combined capital, supplied at modest cost, of . . . millions of people; . . . it . . . reallocates risk; it allows people to time their spending . . . over their lifetimes; and it insures individuals against the big risks of life.”

Wolf counts US$145 trillion of financial promises held by the citizens of the world in 2005. And yet finance is beset by rottenness, indeed by all the failings and fragility of our species.

The purchasers of promises will know that the sellers normally know much more than they do about their prospects. The name for this is “asymmetric information.” They will also know that those who have no intention of keeping their word will always make more attractive promises than those who do. This is “adverse selection.” They will know that even those who are inclined to be honest may be tempted . . . not to keep their promises. The source of this is “moral hazard.” The answer to adverse selection and moral hazard . . . is to collect more information. But this too has a drawback: “free-riding”. . . Those who have made no investment in collecting ¹ can benefit from the costly efforts of those who have . . . . That will, in turn, reduce the incentive to invest in such information, thereby making markets subject to the vagaries of “rational ignorance.” If the ignorant follow those they deem to be better informed, there will be “herding.” Finally, where uncertainty is pervasive and inescapable – who, for example, knows the chances of nuclear terrorism or the economic impact of the internet? – the herds are likely both to blow and ultimately to burst “bubbles.”

This brief tour de force continues with a new paragraph beginning “Finance is a jungle inhabited by wild beasts.” So there you have it. A pyramid of promises, a miracle of sophistication and progress somehow delivered to us (are you feeling lucky?) on the back of wild beasts.

If you don’t fancy buying the book, read Chapter Two in a bookshop or library.

Robert Shiller’s The Subprime solution is a similarly flawed gem. It’s full of proposals that are ingenious and radical, and yet which pose no insuperable political difficulties. Many could be acted on with great profit but their elaboration doesn’t add up to a book. Like its weightier predecessor, The New Financial Order with which Shiller’s new book shares many ideas and proposals, much of the discussion in The Subprime Solution is strangely uncompelling and, despite its brevity, surprisingly repetitious. But don’t let that put you off.

Shiller foregrounds the way New Deal institutions democratised housing finance – doing nothing more revolutionary or risky than having governments underwrite long term fixed rate loans, where home borrowers had previously been required to risk refinancing at least every five years. Shiller proposes numerous initiatives in the same spirit. Today’s markets offer no way for us to insure huge risks that we face – like our suburb falling out of favour in the property market, or our professional skills losing their economic value, or the economy falling into recession. And when you have a deposit on a house but need to finance the other 80-95 percent, existing markets will lend good risks the money, but won’t ‘partner’ with them in the way investors in financial markets become partners of firms by buying their equity (shares). Given that housing is the largest asset class – amounting to over $3 trillion in Australia alone – this is as remarkable as it is ridiculous.

Shiller wants to kick start progress in all these areas. Despite the freshness and apparent radicalism of his proposals, it wouldn’t require political heroics or even much foresight by governments to encourage such market developments – they could at least show some of the solicitude they have shown the incumbent behemoths, the big banks. While underwriting the banks’ solvency with guarantees and their liquidity with all manner of improvised short-term borrowing facilities, with scant requirements for reciprocal oblications from the banks, the authorities have offered only token support for the twenty percent plus of residential lending that had been funded through the global securitisation markets until their collapse with the crisis. In the banks’ rush to profit from filling this newly missing market, they have starved their corporate customers of capital, as some warned at the time and others are discovering now.

Just as Australia’s government pioneered the financial innovation of income contingent loans (something Shiller advocated in earlier books) a small Australian start up called Rismark has set up the world’s first fully functional private market for Australia’s homebuyers to, in effect, sell ‘shares’ in their house. Rismark charges no interest, but for each one percent of the value of your home it invests, it will take two percent of your capital gains when you sell. Rismark’s reward for the financial innovation it has pioneered has been years of delay and millions of dollars in legal fees to obtain regulatory approval. And while the major banks had much of their fund raising guaranteed and extended facilities to allow them to access liquidity against the collateral of their mortgages, Rismark has received no similar support for its attempts to raise funds and its struggles to establish liquidity in the market it is seeking to develop.

The house price index that Rismark has built will be the infrastructure used by the ASX to make Australia the second country in the world to develop a residential property futures market. Shiller argues that the market for shorting thus created could help contain housing bubbles. Perhaps. But, here as elsewhere, Shiller tends to overstate his case. Shorting didn’t do much to restrain the bulls driving the dot.com boom. Shiller’s more important point is the basic one that, unless there are good reasons to the contrary, market development can be presumed worthwhile – because it expands the available options from which people can choose. Derivatives in house prices will enable homebuyers, investors and financiers alike to insure themselves against bad luck in their choice of capital city.

Soros’s book is a complete contrast to Shiller and Wolf. It’s an engaging, easy reading mélange of diary, confession and manifesto. But the book left me wondering this: If this guy’s so rich, how come he’s not smart? Soros confesses his desire to be taken seriously – but as a philosopher and not just a celebrity investor. And so his book showcases his ‘theory of reflexivity’ which explains that markets are full of positive feedback where people’s expectations and behaviour depend on their understanding of the expectations and behaviour of others. This is not just a theory of the market you understand, but a theory of life itself.

I’m the first to agree that some of the nonsense that’s been peddled by the economics fraternity in recent generations has been self evidently silly, particularly some of the more extreme presumptions about the efficiency of markets. But a theory which announces the emperor’s nakedness doesn’t help him work out what to wear. If Soros had wanted to be taken seriously by economists he might have told us how his ‘theory of reflexivity’ differs from Keynes’ theory of the same thing (Keynes gets one offhand mention). And he might have shown us he was a philosopher by demonstrating a passing familiarity with at least some philosophers other than Karl Popper. Popper’s status as Soros’s long time pinup boy adds piquancy to the mix because Soros confesses his disagreement with Popper’s doctrine of the unity of method between the social and physical sciences – the foundation on which Popper built much of his demarcation between science and nonsense. I suspect Popper’s reaction to Soros’s ‘theory’ would be that it is unscientific nonsense because it is unfalsifiable.

All that said, this book is much easier reading than those of his other nine (!) I’ve dipped into in bookshops.

I took two lessons from the book. The first is that honesty – to oneself especially – is an unusually good way to make one’s way amongst the wild beasts of finance. Bringing to mind Warren Buffet’s annual confessions that his company has prospered “despite some colossal mistakes made by your chairman”, Soros willingly hands over the incriminating evidence – in this case quoting his son.

My father will sit down and give you theories to explain why he does this or that. But I remember seeing it as a kid and thinking, Jesus Christ, at least half of this is bullshit. I mean, you know the reason he changes his position on the market or whatever is because his back starts killing him. It has nothing to do with reason. He literally goes into a spasm, and it’s this early warning sign.

If you’re around him long enough you realise that to a large extent he’s driven by temperament. . . . And he is living in a constant state of not exactly denial, but rationalisation of his emotional state. And it’s very funny.

The second lesson is about the capriciousness of the market, or rather the ways in which one can lose money even when one’s analysis is mainly right: Soros anticipated the crisis but miscalculated various details of the precise form it would take and so lost money through the crisis.

The Return of Depression Economics by Paul Krugman stands out even from this mostly illustrious crowd. Alongside his work on trade and geography that has just won him a Nobel Prize, Krugman has always taken an interest in what turns out to be a much more practically useful subject – financial crises. And he’s been warning, at least since he studied Japan’s ‘lost decade’ of stagnation in the 1990s, that it can happen anywhere. Now it has, he’s issued an updated version of this originally courageous and thus duly ignored book. Its central assertion is that Keynes’s great subject – the upside down world that characterises an economy in depression, where the vice of profligacy is virtue and the virtue of saving is vice – has not gone the way of the steam engine, a victim of increasing knowhow. As Krugman puts it elegantly in his conclusion

Depression economics . . . is the study of situations in which there is a free lunch, if we can only figure out how to get our hands on it, because there are unemployed resources that could be put to work. The true scarcity in Keynes’s world – and ours – was therefore not of resources, or even of virtue, but of understanding.

Of all our Cassandras, Krugman would have been the least surprised about the shape the crisis took, having warned of the capriciousness and dangerousness of financial crises for a decade or more. Krugman’s book is a model of his pathological clear headedness and simple, compelling style. Using the simplest explanations and examples, like his set-piece story about the Washington baby sitting co-op that issued its own coupons – a brilliant allegory on the challenges of monetary policy – Krugman entertains and informs lay readers and experts alike. Whether they’re broadly chronological as the early chapters are, or thematic like the later chapters, each works as might the chapters of a children’s book, as an episode in an unfolding story, setting the stage for the next. Krugman explains that the IMF’s draconian demands on countries it has helped ‘rescue’ arise from the pressures its own limited resources put on it to maintain the confidence of financial markets at all costs. Having thus exculpated the IMF he concludes, “which is not to say that there were no villains in the plot”. The next chapter’s subject is hedge funds. It’s title: “Masters of the Universe”.

I recommend Krugman’s book unreservedly. It certainly got me thinking afresh about the constraints on Australia. Ironically Krugman’s book makes me nervous that his own recipe for responding to the crisis – and that of other American and European economists leading the way – as appropriate as it may be for their own circumstances, will be simply transplanted here at our peril. Temporary deficits are sensible, even if they’re large and even if it’s entirely possible that in this case ‘temporary’ means quite a few years. But much of Europe does not depend on attracting large amounts of net capital investment from other countries, while the US is in the privileged position of issuing the world’s reserve currency, which continues to give it extraordinary leeway.

Our most recent fond hope – running into the sand as I write – is that China’s growth will shield us from the crisis. Our last remaining hope is that, as with the US, the markets will choose to treat Australia kindly, and not punish us as they have other counties – whether these are countries we look down upon (Argentina, Brazil, Indonesia), countries we’re not so sure about (Thailand, Malaysia), or even countries we suspect are more enticing investment destinations than our own (Hong Kong, South Korea). That’s why this passage in The Return of Depression Economics gave me the willies.

After all, Indonesia’s current account deficits had been nowhere near as large . . . as its neighbours’ – at less than 4 percent of GDP, Indonesia’s . . . deficit was actually smaller than, say, Australia’s.

Australia’s current account deficit last year was around six percent of GDP and this year may be around half as big again. Market sentiment may give us less leeway to spend our way through the crisis than we seem to be thinking. As a result, more of our response should be directed towards increasing investment in and the production of traded goods and services – something that will be a lot easier said than done at a time when profits and foreign demand are collapsing.

Published in March 2009 edition of The Monthly (somewhat inexplicably) as “For a few dollars more”.

Robert Shiller, The Subprime Solution: How Today’s Global Crisis Happened and What to Do about It, Princeton University Press, Princeton and Oxford. 196 pp.

George Soros, The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What it Means, Scribe, Melbourne. 176 pp.

Martin Wolf, Fixing Global Finance, Johns Hopkins University Press, Baltimore, 230 pp.

Paul Krugman, The Return of Depression Economics and the Crisis of 2008, Norton, New York and London, 193 pp.

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