18 April 2009

Capitalism's Greatest Vulnerability:~ Nolan

The great Hyman Minsky postulated that Capitalism was “flawed.” Over the years I’ve taken exception with this particular view, countering that Capitalism is more appropriately described as “vulnerable.” As part of this line of analysis, I have used the analogy of the human eye. We would not think of its delicate nature and susceptibility to injury as some “flaw” in our eye’s design. Instead, this inherent vulnerability is fundamental to the nature of this important organ’s functionality. We worry much less about our elbows, but they’re not going to do an adequate job detecting light and transmitting visual signals to our brains.

I have argued over the years that an extraordinary backdrop has beckoned for keen focus in order to protect our Capitalistic system from its inherent vulnerabilities - just as one would don sun glasses on a sunny beach or ski slope or insist upon tight-fitting safety goggles before entering a metal-working shop. One must first recognize inherent vulnerabilities and then take more aggressive preventative measures as necessary in response to riskier environments.

We, as a society, failed to take preventive action. Now, Capitalism as we have known it is under fierce attack from many directions and on various levels. At the same time, there is regrettably scant indication that we now possess any clearer understanding of the nature of Capitalism or its inherent vulnerabilities. We’re still entwined in Mistakes Beget Mistakes.

But there’s lots of blame being bandied about. Many pinpoint “Wall Street greed.” The securities firms, reckless traders, hedge funds, rank speculation and egregious leverage are viewed today as the major culprits. Executive pay and Wall Street bonuses are pilloried for fomenting dangerous excess. Others trumpet the failure of regulation and corporate governance. Some attribute the mess to the Asian propensity to save. There’s a more sensible case that flawed banking and Wall Street risk models played an integral role in the fateful Bubble. Many that participated in the bountiful upside of the speculative Bubble these days posit that the rating agencies were at fault for garnishing “AAA” ratings on Trillions of risky securities and debt instruments. And a very strong argument can be made that hundreds of Trillions of derivatives played a fundamental role in the near financial implosion. But how could it be that so many things went so wrong all at the same time?

I have over the years expressed disdain with the “free market ideologues” for their steadfast refusal to even contemplate the possibility that “Capitalism” could possess vulnerabilities of need of recognition and corrective action. Yet, economic history is replete with boom and bust cycles, along with a bevy of post-Bubble writings providing us fertile ground for cogent analysis of system vulnerabilities. Contemporaneous analysis during the Great Depression focused clearly on the acutely susceptible U.S. Credit system that emerged from “Roaring Twenties” lending and speculative excesses. During the forties, fifties and even into the early sixties there was some adroit analysis of the Credit system’s role in the boom and subsequent depression. This entire fruitful line of analysis was, however, stopped dead in its tracks with the emergence of a revisionist view of the twenties as the “Golden Age of Capitalism” needlessly terminated by post-crash policy blunders.

The Great Depression and today’s turmoil expose Capitalism’s vulnerabilities. And as easy (and accurate) as it would be for me to write that the problem lies first and foremost in the “Credit system,” I have come to believe that it is vital to dig deeper to get to the root of the problem: Capitalism’s Greatest Vulnerability lies with Risk Intermediation.

The essence of Capitalism is one of a predominantly private system of allocating resources based on market price signals. A private Credit mechanism is fundamental to financing the economic system in a manner that effectively allocates both financial and real resources. And we can stop right here and recognize potential pitfalls. First, Credit flows may be inadequate to finance sound investments or to sustain economic activity. Second, there may be too much Credit. I have for some time argued that Credit excess (“Credit inflation”) is the Bane of Capitalism. Credit excesses distort the various costs of finance throughout the system, while inflating asset prices and fostering distorted spending and investing patterns (among other effects). And, importantly, Credit inflation inherently fosters self-reinforcing Credit inflation through asset price, economic, and speculative Bubble dynamics. In short, “Credit excess begets Credit excess,” with its subtle but corrosive effect upon pricing mechanisms.

But how on earth does the always-existing nature of “Credit Begetting Credit” somehow morph into the history’s greatest Credit Bubble? One way: Unfettered Risk Intermediation.

I often referred to “Wall Street Alchemy” - the process of various methods of intermediation (Wall Street securitization structures, myriad Credit insurance and financial guarantees, liquidity arrangements, dynamic hedging, explicit and implicit government backing, etc.) transforming risky loans into coveted instruments perceived by the marketplace as safe and liquid (“money-like”). I have also theorized that a boom predominantly financed by, say, junk bonds would never run too far before the market loses its appetite for the inflating quantity of (conspicuously) risky debt. In contrast, our recent Credit Bubble was financed by endless Trillions of “AAA” debt instruments (GSE debt, MBS, ABS, CDOs, CP, “repos”, auction-rate securities, top-rated guaranteed muni debt, Treasuries, bank deposits and such) ran to unmatched excess.

Importantly, there was a direct relationship between our contemporary system’s capacity to intermediate Credit risk and the expanding scope of the Bubble. Over years, risk was in varying degrees distorted, camouflaged, or deceptively concealed to the point that it was no longer even possible to monitor, analyze or regulate it. Worse yet, the risk intermediation process was self-reinforcing instead of self-adjusting and correcting. Wall Street “alchemy” was the true source of this period’s “easy money.”

Our Credit system’s capacity to intermediate Trillions of mortgage and consumer debt into “money-like” instruments was instrumental in fueling real estate and asset Bubbles throughout. It was the capacity of Credit system intermediation to create Trillions of instruments (chiefly Treasuries, agency debt, MBS, and “Repos”) perceived as safe and liquid by our foreign trading partners that accommodated our massive current account deficits (and attendant domestic and international imbalances). It was contemporary risk intermediation at the heart of a historic mispricing of finance for, in particular, mortgages and U.S. international borrowings. And it was the potent interplay of contemporary risk intermediation and contemporary monetary management/central banking (i.e. “pegged” interest rates, liquidity assurances, and asymmetrical policy responses) that cultivated unprecedented financial sector and speculator leveraging.

Most historical analyses of busts (going back about 300 years to John Law!) focus on banking ineptness, negligence, excesses and nuances. Banks, creating “money-like” (i.e. deposit) liabilities in the process of intermediating loans, have historically been at the center of boom/bust cycles. Contemporary finance – with its focus on marketable debt instruments - took intermediation risk to a completely new danger level. For one, traditional bank capital and reserve requirements no longer provided any restraint on the quantity of Credit that could be extended and intermediated (in the “market” or “off balance sheet”). Furthermore, the marketable nature of these instruments (created in the intermediation process) cultivated speculative demand for leveraging higher-yielding securities (i.e. hedge funds buying collateralized debt obligations that had acquired private-label subprime MBS). Cheap finance literally flooded the riskiest sectors of the economy

All of this led to extreme systemic distortions in the pricing of risk - along with the attendant massive over-expansion of Credit and the economy-wide (and global) misallocation of real and financial resources. Buyers of intensively intermediated instruments (say “AAA” senior CDO tranches or auction-rate securities) in many cases could not have cared less with regard to the type of underlying loans being financed. Elsewhere, the buyer (leveraged speculator or trade partner) of agency securities could not have been less concerned with GSE balance sheet issues or California home prices. This entire process of contemporary (marketable instrument-based) intermediation developed an overwhelming propensity for financing asset-based loans instead of real economic wealth-producing investment (unlimited supplies of mortgages were viewed as a more appealing asset class than limited amounts of corporate loans). It is not only in hindsight that this process of risk intermediation should be viewed as central to system asset price distortions and economic maladjustment.

I am tempted to write “I am as tired writing about the previous Credit Bubble as readers are reading about it.” But I’m not tired. And this topic is not as much about rehashing the past as it is about providing a perspective as to why I believe the current course of policymaking will inevitably end in failure. Why? Because of the very complex and unresolved issue of Risk Intermediation.

Wall Street “finance” self-destructed in the process of intermediating Trillions of risky loans. It was the quantity of Credit and the nature of resulting spending patterns (resource allocation) that both doomed this endeavor and ensured a deeply maladjusted economic structure. This terribly flawed financial structure has morphed into a system where our government has stepped forward to supplant Wall Street as predominant risk intermediator. Basically, the Fed and Treasury are in the process of intermediating risk on a system-wide basis – to the tune of tens of Trillions – with little possibility of extricating themselves from this endeavor going forward.

This development may be welcomed by Wall Street and the markets - and it certainly goes a long way toward getting the Credit wheels rolling again. It would be expected to help spur some level of global economic “recovery.” I would argue, however, at the end of the day we will see that it has only exacerbated the problems of risk mispricing, Monetary Disorder, financial and real resource misallocation, and economic maladjustment.

Our Capitalistic system has been severely injured. I don’t expect meaningful structural recovery until there is some semblance of restoration to our Credit system’s mechanism for the pricing and allocation finance. This, I believe, will require our system to wean itself both off of its dependence on enormous Credit expansion and away from Washington’s newfound role of chief system risk intermediator and allocator (the “Government Finance Bubble).


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