Being more of an empirical bent, I do not generally indulge
in the analysis of macroeconomic theory as thinking about it often causes me to
recall what I think was a quote by John Kenneth Galbraith something to the
effect that “Macroeconomics is like a religion, nobody truly knows what comes
in the hereafter.” More to the
point, I have to admit I find modern macroeconomic theory, policy and schools
of thought rather confusing having been raised in an undergraduate world where it was
simply Keynesian and Classical but I digress. Yet my curiosity has been piqued,
first by Nick Rowe’s January 1st blog piece “My simple theory about
why macroeconomists disagree” and then today’s piece by Paul Krugman on
“Ideology and Economics”.
I suppose that when one looks at whether there is agreement
or consensus amongst macroeconomists and views of the business cycle, it helps
to factor in the role of ideology or economic philosophy. I recall the classic first year text by
Parkin and Bade that helped me put this into perspective with the view that
when it comes to the role of government and economic policy, economists could
generally be classified as either “activists” or “passive”. Activist economists were generally
comfortable with discretionary government intervention in the economy because
markets were seen as often characterized by market failure and therefore
government could have a positive role in setting the economy straight. Passive economists believed markets
generally worked well, and therefore the role of government should be to
provide frameworks and policy rules rather than discretionary interventions,
which would either destabilize the economy or be ineffective at best.
Taking this basic continuum, one can then factor in the role
of fiscal and monetary policy. If
you are an “activist”, then both of these tools can be effective in addressing
an economic downturn though there may be debate as to which might be more
effective. If you are a “passive”,
generally you would not advocate fiscal or monetary discretionary intervention
but would stick with a more rules based approach and wait for the economy to
recover. Let me put this all in a
simple four-quadrant diagram with the continuum between “activist” and
“passive” on the vertical axis and the continuum between “monetary” and
“fiscal” policy on the horizontal axis.
Despite my earlier reference to macroeconomics as a religion, the fact
the diagram looks like a cross is purely coincidental. Let’s call it the macroeconomics policy
cross or MPC.
So with this MPC diagram, can we classify the various
approaches to macroeconomic theory and policy? Well, I’m not sure if I can but let me take a stab at
it. I would place old-style
Keynesians firmly in quadrant II – they are activist and firm supporters of the
use and effectiveness of fiscal policy.
I would place classical economists in quadrant IV – they are definitely
passive as to the role of government policy and I think their approach to
monetary policy would also be firmly passive. How about everyone else? A monetarist? I think quadrant IV.
If you are a “saltwater” macro-economist, I think you would be in either
quadrant I or II though the ultimate location would depend on views regarding
the efficacy or importance of monetary and fiscal policy. I would place them in quadrant II but
close to the border with quadrant I.
“Freshwater”economists? In either of quadrants III and IV but I think
more in IV. Real business cycle
theorists? I think a IV.
Anyway, in studying disagreements amongst macroeconomists,
I’m sure we will also disagree on how to classify them. However, my point is that while macro-economists
strive to be scientific in how they analyze issues and their focus on evidence,
they are also shaped by assumptions in how they approach empirical phenomenon
that reflect their economic philosophy or ideology even if they choose to refer
to it as theory. A macro-economist
who is fundamentally activist in outlook will have views and policy prescriptions
that differ from an economist who views the world from a passive perspective. The world and by extension the macro economy
are of course complex, with issues that require both activist and passive
responses. The real trick is to
know when to be an activist and when to be passive in your policy response. That part is a real skill and requires
the intuition of an artist.
Worthwhile Canadian Initiative 
And the Commodity Futures Modernization Act of 2000 was just hogwash then? Its clear intent was to state that OTC derivatives (the kind that caused oh so many problems) were not “securities” nor “futures” under federal law in the US, exempting them from the SEC and the Commodity Futures Trading Commission. The Act continued a 1992 policy which pre-empted state laws on gambling and insurance from applying to derivatives.
Sophisticated parties were individuals or corporations with assets greater than $5 million.
The legal loophole of calling a spade a shovel (a security that isn’t a “security” or “insurance”) was IMO the real danger. It was regulatory stupidity to allow it and more importantly commercial stupidity to engage in this risky, unregulated activities.
Clarification: I am not a lawyer but Bob Smith is.
Smith: That doesn’t follow. What was the technology that was introduced in the early 1970’s, which didn’t exist before that time and which allowed Americans to put their money in London?
The fax machine was invented in 1964. Try signing a legally binding contract over a telegraph or telephone. Even better, try signing a twenty page legally binding contract over a telegraph. Or negotiating that contract….
The first transatlantic telephone cable was put in place in 1956.
The first transatlantic communications satellites were launched in the 1965.
Here is an interesting timeline……
http://www.corp.att.com/history/nethistory/milestones.html
Note that in 1970 was the first time you could place an international long distance call without an operator. Between London and Manhattan….. Hmmmmm……
The CFMA and SEC were set up so that the CFMA and the SEC would not regulate products, but rather to regulate issuers. The idea was that the products could be unregulated if you controlled issuers under banking and securities law. Since companies that traded CDS also traded securities, people didn’t worry too much about this. That was a bad idea.
No one worried about insurance companies since insurance companies in the United States have generally been under state law that prevents them from doing things other than insurance in their own states.
We could go through the messy details, but bottom line. AIG could not legally sell CDS in the United States. They could in England and Germany.
Securities law is extremely messy because you end up with a patchwork of regulations. Saying that something is or is not regulated is an oversimplification, because what the law says is that you can and cannot do X to Y in situation A for firm Z.
You end up with cracks and loopholes, but the people that write the laws at a national level usually can get rid of the worst loopholes. In the case of AIG, the law was successful at keeping AIG from selling CDS’s in the United States. It’s not regulated as a security, but there are other parts of the patchwork that kicked in and at a national level, it worked.
Once you have laws of different countries, what starts out as a small loophole becomes a huge deadly hole.
Also its important to realize that there was a demand element too. One reason AIG didn’t sell CDS in the United States is that US banks cannot use these swaps as reserve capital so they are useless to anyone in the US. Because US banks cannot use CDS as reserve capital, the idea was that if the CDS went bad, then so what?
Trouble was that German banks can use CDS as tier-one reserve capital. So when AIG went boom, it almost brought down the entire European banking system. When US regulators drafted CFMA, I doubt that anyone was thinking about the impact on the German banking system.
And the Germans weren’t total idiots either. The reason that German banks can use insurance products is that they are highly regulated….. In Germany.
I call that the “Maple Bond” problem. Maple Bonds are Canadian Dollar-denominated securities issued by a non-Canadian issuer in Canadian markets. They are restricted in Canada to “sophisticated investors” ($1 million net worth) and cannot be used as collateral in the banking or clearing system.
They may pay out in CAD, but they are still treated as “foreign” and iffy by regulators. Canadian banks sell them from their securities dealers but they are only useful as portfolio investments, not collateral.
Also you have to be careful about politicians. The standard speech is “I’m good. My opponents are evil, and it’s not my fault.” When someone listens to a politician they aren’t interested in a 100 page treatise on securities law, so a politician will simplify the situation. It’s just not true that CDS were “totally unregulated” and in fact that CFMA increased Federal regulation of CDS. CDS are not “securities” or “futures” but they were a new category of “securities based swaps” whose leaders could be regulated. However, because they weren’t banking or insurance products, securities regulators don’t look at things like reserve requirements.
CFMA did preempt state gambling law, but since AIG was an insurance company, it was still subject to NY State regulation. It’s just that NY State didn’t realize that what it was doing in Germany could bite them.
Correction: AIG was not prohibited from selling CDS in the United States by the Securities Acts of 1933 and 1934. The relevant law is the Investment Company Act of 1940. CFMA excluded CDS from the definition of security in the 1934 law, but the SEC asserts a different definition for the 1940 law.
Not that it would have mattered. If the SEC had regulated CDS with traditional securities regulation, things would have still blown up with the internet. Also there is another intersection with technology, and the real reason why people wanted CDS excluded from the definition of securities.
The thing about “securities” is that you have to register them with the SEC. Even if the SEC rubber stamps them in a week, this means that you can’t take a computer and automatically program to generate massive numbers of contracts in ten seconds.
“Taking this basic continuum, one can then factor in the role of fiscal and monetary policy.”
Livio, by fiscal policy do you mean create more gov’t debt and by monetary policy do you mean create more private debt?
Wow!!! Now that you mention that the roots of Canadian banking are Scottish, a lot of things make sense…
Something that is very interesting is that there is no British financial system. The English and the Scottish systems are very different, and as any Scot will remind you, Scotland is a different country from England. The legal systems are different and the commercial culture is also very different, much more risk averse. The founder of the modern English financial system is Margaret Thatcher, who is pretty universally loathed in Scotland.
The one bank/one corporation system is interesting. The dream of every megabank CEO in the United States is to be one stop shopping, but one-bank/one-corporation won’t work under US banking law. Even after the investment banks and commercial banks were put under the same umbrella, by law, they have to be separate and there are special “anti-tying” rules to keep a commercial bank for offering investment services to its customers. Which means that a company has to deal with different vendors.
One thing about US banks is that there are thousands of banks, and there is a wide diversity between banks, but not within banks. Because there is a lot of diversity between banks, there is a lack of diversity within a bank since what happens is that a bank will specialize in one particular market. Except for the megabanks, the banks are too small to diversify and they try to keep the megabanks from diversifying too much because they don’t want to get kicked out of business.
One other problem is that US megabanks are pretty new so you don’t have the level of “deep trust” that you have with banks in other countries where you deal with the same bank as your father or grandfather. The megabank might have a sign out that says “since 1850” but usually that was one small part of the megabank that they bought out in 1995.
The Bank of Montreal has been in business since 1817. I look forward to its bicentenary. I’ve banked with them since I was six.
The interesting case is Royal Bank of Scotland and Royal Bank of Canada. Both were the same size in 1990, had similar histories and had similar cultures. But RBS “modernized” under Thatcher, went on a leverage binge and in the end went bust and was nationalized. RBC kept to its knitting and is ranked as one of the ten safest banks in the world.
The US has also developed a strong “letter of the law” evasion culture in business and regulation. Canada is all about “principles” and evasion will be struck down if it appears to contradict the principle. The BMO tried to offer an income product a year ago that was in essence a life annuity and the OFSI said to stop it. I have insurance training and I agreed wholeheartedly with OFSI. The BMO thought its lawyers did a legal bypass but OFSI would have none of it and that was that. Life Insurance is for ,life insurance companies and Canada still maintains a ban on selling insurance in branch (rightly IMO).
Life Insurance, properly sold, involves a comprehensive discussion of health issues, which is very variable and very personal. A teller or branch staffer is culturally unable to tell a customer straight on that they will have to have a needle in their arm for a blood test, and since that is a crucial part of insurance advice the ban should stand.
In Canada the retail banks are the investment banks, the OFSI’s rule is that the investment side must not engage in activities that may endanger the retail side and the whole entity is therefore regulated. It works.
Three things:
1. Underlying credit bubble as the real cause, Lehman /AIG just as a little icing on the toxic cake
2. GIPSIs
3. German banking
1. Underlying credit bubble as the real cause, Lehman /AIG just as the icing on the toxic cake
I think we talk here a lot about the US banking / ABS (asset backed securities, more important than CDS) aspect here, which is for me a pretty minor side show, the sub prime too.
There is a book from Warren Brussee “The second Great Depression, 2007 – 2020” printed in 2005, based on data until 2003, where he makes the prediction for the US, that the US consumption bubble, based on ever increasing private credit will pierce in 2007. The data for the size he took from Japan 1990. There is no mentioning of structured products, sub prime, not even housing, also the HELOC credits were already going strong. The thesis is extremely simplified, it does not take into account the humungous debt load of Japanese corporations at that time, and the price bubble.
But eerily accurate.
Now the US housing bubble was a relatively short affair. When you look at the Case-Shiller Index, it basically started in 2000, people looking for some safe invest as alternative to the dot.com bubble.
Running up in 7 years, by a factor of a little more than 2, and normalizing within less than 2 years, starting in earnest begin 2007 (technically 8/2006), hitting bottom in Spring 2009.
This cracking has come, independent of Lehman / AIG, the end probably a little more drawn out.
Unemployment down to less than 8%, about 2 % above the new / old normal. Some Feds want to end quantitative easing. Kind of the worst is over, the End is in sight. Raising rates in 2014.
2. GIPSIs
The situation in the Euro GIPSI states is very different. They had a long boom from 1990 or even earlier, being still in a catch up phase, 4 % or more real growth rates typical (Greece 26% of EU GDP per capita in 1985 to 93% in 2007 !)
House prices in Ireland going up by a factor of 6, fueled by much lower interest rates, due to the Euro, the old credit rules (calibrations) not working anymore, and especially the gut feeling rules of the normal people. Do the old current account deficit rules still apply? And why should a politician care? A good paying, safe government job for your idiotic brother, many more building permits for your sister, the real estate developer. Build it, and they will come. And buy a new, bigger BMW for yourself, in 2 years you earn 20 % more, and can pay it off with ease. Most of the credit decisions of Spanish Casas looked reasonable at that time, I am pretty sure, and they are only cracking up now, 4 years later.
Yes and no. I don’t think that credit derivatives and securitization caused the bubble. I do think that credit derivatives and technology made the result much, much worse that it otherwise would have been. There are two fundamental causes:
1) technology moved faster than regulation
2) technology allowed for regulatory arbitrage. Securities regulators and banking regulators have vastly different outlooks on financial regulation. If you lose all your money in a checking account, some bank regulator is going to get very, very angry. If you lose all your money in the stock market, the regulator is going to see if you were defrauded, and if you weren’t, then they say that they are sorry but life is tough. Securities regulators check for fraud, but they don’t tell companies how to run their business, and if a business goes bankrupt, that’s life.
The problem is that you had a situation were you could use technology so that investment bank became unreserved commercial banks. Now people didn’t think this was bad, because you didn’t own liabilities of the investment bank. The investment bank was just a custodian of securities which you owned, so if it goes under, who cares? Perfectly safe. As long as you have your stuff in safe securities, the investment bank could do stupid things, because who cares if it goes under. Except that if an investment bank goes under, you can no longer convert your securities to cash.
One thing that might have helped Canada is that Canada has no national securities regulator which means that the whole system is seen with a banking regulators eye. Also one thing that is odd is that consolidation in the US probably helped the situation because the investment banks that were under the control of commercial banks had to answer to banking regulators.
grummel, I am pretty sure I had posted that already.
3. German banking
This somehow shows up very prominently in the argumentation of twofish, and it bewilders me. Germany was hit by much larger amounts of the US sub prime / AIG complex than other European countries, but WE do not have the problems now, we have full employment. The problems in the GIPSIs are of their own making, and not the US. If the US banking would have been the central problem in Europe, Germany would be the one suffering now.
It is true that the Landesbanken sector was hit by the sub prime, first the IKB, then the Saxonian, but all the US stuff did cost less than 50 b. The 102 b Euro, the HRE disaster caused in Ireland, was more significant. Since they had bought the Depfa, some old German covered bond institution, and incorporated in Ireland, they were systemically relevant for us, but subject to the lacking oversight in Ireland. Together with some other 50 b, all that added some 7% GDP to our national debt, but since we had kept discipline before, we can carry that, and absolutely nobody doubts that we can and will pay it. To provide some perspective, this would have been a 1 trillion $ loss, and not just guarantees, for the US. And to add some more color, allegedly they “found” some 55 billion of that last summer, in Ireland.
The Landesbanken were some typical German mixture of public/private, which made sense a 50 or 100 years ago, but today these constructs are weird, and the EU insisted on a clear separation, and that caused some last minute buying panic of people there, who just believed they can be global players too.
A lot more of their follies could be said, they are now most in devolution. But the important thing here, their troubles didn’t and don’t have significant impact on the financial functioning of Germany!
And the one relevant private Bank , the “Deutsche Bank” survived the whole thing pretty unscathed. They did not even take an emergency loan from the government! It was a social democrat finance minister Peer Steinbrück at that time, who tried to force it on them, with the openly stated reason, to then get his hand on their credit decisions.
My understanding is, that all German banks have to play by international accounting rules IFSR, Basel II and III, what counts how to which reserve ratio, since at least 10 years, and twofish’s argumentation just sounds weird. (reaction to twofish’s regulation arbitrage will follow)
Just to make that clearer. Last year we reactivated Soffin II, sized with 490 b Euro exactly the size of the whole German banking sector. It can take over the whole sector over a weekend, if need would arise.
The ESM has 700 b firepower, the ECB can buy unlimited on our nod. I think we have made pretty sure that it is not hedge funds and Wall Street who are calling the shots here around.
One last thing just coming to my mind. When we are so reluctant in Germany to do any of these Stimulus stuff, a complaint which comes on a regular basis from US politicians since the 70ties, this is not ideological, but because we have already tried everything: – )
What did we try in Germany: ?
Kurzarbeit
ABM
Infrastructure
Science push
Beschäftigungsgesellschaften
Arbeitszeitkonten
Treuhand
1-Euro Job
Ich-AG
Gründerzuschuss
What stays: Kurzarbeit, Arbeitszeitkonten
3 short questions for twofish:
1. What is the explanation for the size of the derivatives market
(http://www.bis.org/statistics/otcder/dt1920a.pdf) of about 600 trillion $?
Global GDP is around 80 t$ (https://www.cia.gov/library/publications/the-world-factbook/geos/xx.html) , of this about 5% = 4 t$ agriculture.
Trade about 18 t$, of this about 20% cross currency, of which about half may need hedging = 2 t$,
Together 4+2 = 6t$ “legitimate” hedging needs. Where do the other 99 % come from? Or other comments to this simple kind of calculation ?
2. Your US statement
“As long as you have your stuff in safe securities, the investment bank could do stupid things, because who cares if it goes under. Except that if an investment bank goes under, you can no longer convert your securities to cash.”
I think, that this somehow happened with MF Global Corzine people in 2012. But I am curious, how this worked out with customers of AIG and Lehman in 2008. Supposed I had an account with them, and in this account some 1000 GE stock, just as an example. At what point in time would I or wouldn’t I be able to trade / transfer that?
3. European equivalence
Since twofish makes a lot of statements about the situation here in Europe, this question: My understanding is, that even if European ING-diba, just as an example of a cross-Europe discounter universal financial service (ATM, credit card to knock-out derivatives, life insurance, mortgage, auto, ) would have gone bankrupt, every single stock in my name would have staid that, the ATM (within FDIC like limits) might not have functioned for a few weeks. But finally the bank operates under new management, and pays out everything within my accounts.
Comment ?
If a big bank becomes insolvent, the practice of what happens next depends on the policies of the regulator handling the problem. The FDIC in the US, since they are the most practised, experienced and professional at this are the benchmark.
The FDIC practice is to “shutter” an insolvent bank on Friday evening after the close of business. They have already selected a takeover partner. The takeover partner takes all the good assets and the FDIC covers the residual loss to depositors, who are a liability to the bank, the bank owes them money. The same branch opens under a new name on Monday morning.
In really big failures the failed bank will get continuation funding to honour depositors until they can be merged into a health bank.
When the Royal Bank of Scotland became insolvent the UK Government stepped in with emergency funding to continue to honour depositors, over and above the statutory deposit insurance scheme. The intent was that accounts were honoured.
genauer: German banks
I’m looking at this from a US/Asia point of view, and I wouldn’t be surprised if the Landesbank after being bailed out didn’t have that much impact on the German economy. Basically in bailing out the Landesbanks, the Fed was bailing out the US and Asia.
As far as your other questions:
In the popular press, the size of the derivatives market is usually expressed in notational terms, which wildly overstate the amount of derivatives out there. For example, a typical swap would have me pay you $1000 a day, and that you pay me back $1000 +/- interest rate times $10. Now if you add up all of the $1000 in the contracts, then you end up with a meaningless number, because that’s a bookkeeping number….
Now you might ask what the risk of that contract in fact actually is. That’s a good question.
2) But I am curious, how this worked out with customers of AIG and Lehman in 2008. Supposed I had an account with them, and in this account some 1000 GE stock, just as an example. At what point in time would I or wouldn’t I be able to trade / transfer that?
The moment the clerk at the bankruptcy court stamped the bankruptcy petition, which happened at 1:45 A.M. on 15 September 2008. Funny story. There was a bank that did a swap transfer with Lehman. It sent Lehman $500 million and then the next day, Lehman would send back $500 million +/- a few million depending on the interest rate. Unfortunately, someone didn’t run the computers right so it sent Lehman the money before the bankruptcy, which meant that it didn’t get it back after the bankruptcy.
Genauer: But finally the bank operates under new management, and pays out everything within my accounts.
The trouble is that most people can’t survive a month if all of their accounts are frozen. What’s worse, what happens to your employer if his or her accounts are frozen. How are you going to eat. Worse yet, how is the supermarket going to get it’s food if it has no cash?
This is something people in commercial banking are familiar with so what people do when a commercial bank goes under is that they send in bank regulators Friday night. They have a very quick auction and Monday morning, the bank opens and nothing changes except that there is a sign that says “this bank now run by X”. In the case of WaMu, the CEO got on the plane and when he got out, he was informed that he was no longer CEO and his bank had now been sold. In that case, FDIC seized the bank on Thursday, because they would not have made it through Friday.
The other problem is that the money isn’t some cash in boxes. If the bank has $1.5 million in deposits, but $1 million in assets, it can’t operate. The bank has to get some funds from somewhere. It could be the government, but that assumes that the government has authority to fund the bank. What most people don’t realize is that money is just a “video game.” There are rules about what can and can’t be done. If one set of numbers exceeds another set, then the rules say no colored bit of paper get sent out. To adjust the numbers, you have to have people in fancy rooms take votes and to through some rituals.
Determinant: The FDIC practice is to “shutter” an insolvent bank on Friday evening after the close of business. They have already selected a takeover partner. The takeover partner takes all the good assets and the FDIC covers the residual loss to depositors, who are a liability to the bank, the bank owes them money. The same branch opens under a new name on Monday morning.
There’s a problem though. What FDIC usually does is that it takes a small bank seizes it, and then it gets eaten by a bigger bank. There’s a standard operating procedure for that. Now what happens if a really big bank has problems? Well, this was when we got into “make up rules as we go along” but it involved a cash infusion by the Fed. What the Fed has forced the biggest banks to do is to write “living wills” but that was post crash.
One thing that that FDIC and the Fed ended up doing was to guarantee all deposits for all banks and to also guarantee all money market funds.
Also in the US you have the division into bank regulators and securities regulators. The philosophy is very different. If the SEC doesn’t tell people how to run their business. If you are starting a new venture selling pork brains over the internet, it might be a stupid idea that will lose you and all your shareholders their money, but as long as you aren’t committing fraud, the SEC will let you be stupid.
This turns out to be a terrible philosophy for running a commercial bank.
One reason I think that Canada did well is that Canada doesn’t have a federal securities regulator, so that it looked at the system from banking viewpoint.
Re: Scottish banks / bankers. The Canadian banks benefitted from the bankers wanting to adhere to the traditional scottish banking sterotype, whereas the problems of the Scottish banks RBS and BoS came from the new confidence and attitude in a post-devolution Scotland, that of “we’ll show the Bloody English we’re better at it tham them” for any definition of “it”.
It is also possibly disengenuous to place the blame for the English real-estate bubble and associated banking failures on a former-PM who was no longer in office and their party was no longer in power.
Anecdote from my personal history.
When I started my career in 1996 there was no way I could get a mortgage even though I could afford the repayments, this all changed when in 2001 the FSA came into being. Sudenly the sound judgement of the lender was no longer valued, only have you ticked all the regulatory boxes mattered. This is how I was able to get a 105% LTV mortgage from Northern Rock (the caring sharing bank that started the whole avalanche rolling in 2007 – I remember heading off for a weekend camping in September 2007 listening to the news reports of people lining up outside branches to withdraw thier money).
It is not so much the de-regulation that was the problem as as far as I can tell the FSA brought in more mortgage regulations, but it was the type of regulation that was the problem. It was the proscriptive type of regulation so beloved of politicians who need to be able to point to something they’ve done; as opposed to the more sane descriptive type of regulation that allows for flexibility both to allow and deny activities that wouldn’t/would be allowed under the proscriptive, letter-of-the-law regime.
Going off at a tangent, I have experienced equivalent phenomina in product safety and software testing. A lot of product safety issues and even more software problems can be explained by the failings of the scripted “tick all boxes” proscriptive regime. See http://kaner.com/pdfs/ValueOfChecklists.pdf for a far better explanation than mine.
On the other hand, “tick the box” type regulations do work in some fields. The reason that securities regulators are very strictly procedural is that for some types of business you don’t want the regulators interfering. For example, 90% dot-com companies were doing very stupid things, but if you ban that sort of stupidity, then you also end up banning the 10% or even 1% of companies that by some mix of luck or genius, end up changing the world.
The basic problem is that the type of regulation that works well in high tech stocks works horribly when it comes to checking accounts. Most people do not realize what a sophisticated highly dangerous instrument a checking account is.
Part of it was that there was a hidden flaw in regulatory assumptions that wasn’t obvious until 2008. If I invest my money into a high-tech startup, and I lose all my money, then tough luck. I can deal with this by not investing my money in a high-tech startup, or not investing any of my money in anything that has to do with a high-tech startup.
However…. There’s a problem. Big businesses in the US investment their cash in things called repurchase agreements. I buy something like US Treasuries from you, you agree to buy them back in a week with some interest. This is cool because, if you go bankrupt, I still have your Treasuries, the agreement is cancelled, and I can sell your Treasuries. Now you would think that in that situation, I don’t have to regulate you very heavily, if you go bankrupt, then nothing bad happens to me. So let’s see how that worked…..
Big business does a repo agreement with Lehman. Lehman goes bust. No problem, I have Lehman’s collateral which I put somewhere else. I’m good. All I have to do to get cash is to sell that collateral. But….. The trouble is that you just can’t sell $10 million in Treasuries in some parking lot. You have to find some broker. But no one is willing to trade. So I’m running out of cash, and I start converting anything that I can to cash. Once the brokerage system starts to unravel, then people that aren’t Lehman start getting hit. Suppose, I have my stuff in 100% safe, non-stupid, bank, but I suddenly realize that I can’t convert to cash, what do I do? I pull out my money, and it’s the nature of banking that if everyone pulls their money out at exactly the same time, things fall apart.
At which point you have a massive bank run, which adds to the panic. This part of the crash ended when Ben Bernanke showed up and said, I’ll buy your Treasuries.
The bad assumption was that if you didn’t invest money into a risky venture, it didn’t matter if that venture goes bust so there is no point is caring if they were doing something stupid. The trouble is that I care if the telephone and power companies are doing dumb things not because I have money in phone and power stocks. I care that they are doing stupid things because I might need a telephone or power in an emergency.
@ twofish
1. Landesbanks impact on the German banking /credit market.
Since my state Saxony was actually hit hardest, I looked up the numbers and timing (http://de.wikipedia.org/wiki/Sachsen_LB) for you (and maybe some other folks interested) and post it, because it also gives some general impression
The Sachsen LB was founded in 1992, after reunification, and in the old times was supposed to serve for the state debt distribution, and the connection of the local little “Sparkassen” credit unions to the larger world. On the 17th of August 2007 it became clear, that their “conduit” in Ireland signed stupid ABS contracts, and that the whole Sparkassen organization had to bring up a credit line of 17 b.
They did so only under the obligation that the Sachsen LB is absorbed by some larger organisation (with a competent management). On the 26th of Aug 2007 this suitor was found, the Suebian LB (LBBW), and the bank sold for a positive amount (>= 0.3 b : – ). In the subsequent followup, everybody involved got fired, the clowns calculating and signing the deals, the sector managers, the CxOs, the board. The finance minister stepped down end of September.
They didn’t have any retail consumer contact. The local business client business was separated into the “Sachsen Bank” 100% owned by the Suebians, of which the headquarter operates just one remaining floor, probably less than 300 square meter office space, less than 1 kilometer from me (I took a picture of it today, if anybody is interested). The little clowns were actually somewhat surprised, that they had to fulfill their contracts for 3 – 6 months longer, because the public servant supervisors were not familiar with the technicalities of all those structured products. There were some rumors that some of them wanted to negotiate some “stay on” bonus. Funny people, aren’t they?
The whole episode was finished 1. April 2008, when the Sachsen LB was formally completely dissolved and the Saxonian prime minister stepped down (he was finance minister at the wrong time, and good riddance anyway).
JUST HALF A YEAR LATER COMPLETELY MOPPED UP, and HALF A YEAR BEFORE LEHMAN brothers happened.
Impact on banking sector or the real world economy in Germany: ZERO.
Not too bad, keeping in mind that we didn’t have any precedence cases.
My state “Sachsen” has just 1500 Euro per capita debt, probably about half of that from this event, well, still being the lowest in Germany : – )
http://www.spiegel.de/wirtschaft/soziales/bundeslaender-ranking-bremen-ist-deutschlands-groesster-schuldensuender-a-750126.html
Not strutting around, just keeping score : – ) Last October (2012) Sachsen offered a 1.2% coupon 5 year bond, basically demanding an upfront 5% fee (after inflation and tax) for storing safely the useless green money of folks in our beautiful free state. The Bavarians are able to extract 0.3% / year more storage fee (negative real interest) : – )
2. Size of the derivatives market
I don’t see a “legitimate” market for more than the 6 t$ notional or 1 % of todays volume. But I am open for arguments. Until then we want a financial transaction fee (FTT) on each and every transaction of lets say 0.1 – 0.5 %. This is no problem for somebody buying harvest or currency fluctuation insurance. But if you have a different view, please tell me.
3. Size and relevance of the financial sector
At present that is more than 10 % in countries like US, UK. A factor of 3 too much, from our perspective. We say they are SUPPORT function, and not CONTROL of the real economy, and have forgotten a little about that.
And their “freedom to innovate” ends where it costs my money.
There is broad social consensus here, from the Boss of the largest private corporation, Bosch, 300 k employees to our cutie communist leader, Sahra Wagenknecht, a freshly minted economics PhD : – )
4. Tick-off boxes (mentality)
Check lists are good for doing this every day on a boring routine job, and enhancing the likelihood to catch some things, which do not come immediately to mind. There are more diligent, elaborate versions out there, for example FMEA, for less than trivial and less than completely known environments. But just like ISO 9000 certifications, if organizations just care about the ticking of boxes, run, RUN AS FAST AS YOU CAN.
Twofish has a comment stuck in spam.
Hi Nick:
I went through the last three days of the spam filter on this post and I think all of the Twofish comments are now posted. Livio.