by hilzoy
From the WSJ:
“Citigroup Inc. is nearing agreement with U.S. government officials to create a structure that would house some of the financial giant’s risky assets, according to people familiar with the situation.
While the discussions remain fluid and might not result in an agreement, talks were progressing Sunday toward creation of what would essentially be a “bad bank.” That structure would help Citigroup cleanse its balance sheet of billions of dollars in potentially toxic assets, these people said.
The bad bank also might absorb assets from Citigroup’s off-balance-sheet entities, which hold $1.23 trillion. Some of those assets are tied to mortgages, and investors have worried such assets could cause heavy losses if they land on the company’s balance sheet. Citigroup also has about $2 trillion in loans, securities and other assets on its balance sheet as of Sept. 30. (…)
Under the terms being discussed, Citigroup would agree to absorb losses on assets covered by the agreement up to a certain threshold. The federal government would cover losses beyond that level, people familiar with the matter said. One person said the new entity is expected to hold about $50 billion of assets.”
The NYT adds:
“If the government should have to take on the bigger losses, it would receive a stake in Citigroup. The banking giant has been brought to its knees by gaping losses on mortgage-related investments.
Regulators were debating various terms of the arrangement on Sunday, including whether the government would receive preferred stock or warrants, which are instruments that give holders the right to buy stock. Preferred stock would be more beneficial to taxpayers because Citigroup would pay dividends on those shares; warrants would be more attractive to Citigroup’s existing shareholders, since they would not immediately dilute the value of their investments as much as preferred stock.”
CNBC reports that the government has cold feet (h/t Calculated Risk). I suppose we’ll know sometime before the markets open tomorrow.
Question: is there some reason not to hurt the shareholders? My assumption throughout has been that it’s important to try to prevent moral hazard: we do not want people taking risks on the assumption that the government will step in and bail them out. When a bailout is required, we prevent the normal market response to dreadful management, namely bankruptcy or heavy losses. We therefore ought to try to impose costs on the people who could have and should have prevented it. This would include management, the board of directors, and shareholders. (Shareholders could not immediately prevent it, but they should not willingly invest in companies that are taking undue risks. One of Citigroup’s problems is that its stock is now below $4 a share; had investors priced its risk accurately to begin with, it might not need a bailout today.)
For this reason, I don’t see why hurting the shareholders is something we should be trying to avoid; offhand, I would have thought that mimicking the pain shareholders would feel if Citi went bankrupt was something we should actually aim for in constructing a rescue package. What am I missing?
***
Further reading: This piece from the NYT is a good explanation of how Citi got into trouble (though Brad DeLong disagrees.) This is a good rundown of some of the problems it’s facing, as is this. If you’re wondering why Citi needs to care about its stock price, here’s an answer. (Point worth noting: some institutional investors have to sell when stocks fall below $5. Institutional investors hold 64% of Citi’s stock.) Henry Blodget on ‘Six Ways Feds Might Bail Out Citigroup’.
And for an unrelated bit of gloom, here’s a piece wondering whether GE is in trouble too.
Enjoy!
In the course of researching this topic, did you come across a convincing explanation as to why a Citi failure would pose a systemic risk (i.e. create a much larger cascade of failures), such as what was used to justify the AIG bailout?
Because I haven’t seen any such justification yet, at least not one that I found convincing, and I’m wondering why we can’t just let them fail.
“While the discussions remain fluid and might not result in an agreement, talks were progressing Sunday toward creation of what would essentially be a ‘bad bank.'”
Bad Citi. No cookie.
One argument for not wiping out shareholders in a rescue is that a bank in some difficulty can raise additional capital by selling fresh shares. It is a lot harder to raise capital by selling equity if the prospective new equity holders face the serious prospect of their new investment being wiped out. Effectively by wiping out the shareholders in a rescue you make it more likely that a rescue will be needed by reducing the ability of the troubled bank to raise fresh capital.
Bad Citi. No cookie.
On that calculatedrisk thread, one of the commentors opined that the “bad bank” could go by the name of Shitibank.
ThatLeftTurnInABQ:
There are numerous reasons. First of all they are the counter party to trillions of dollars of swaps. Last I read it was about $40 trillion or somesuch. If they go down then there would be chaos in that market.
Also they have a gigantic amount of deposits, many of which are corporate and above FDIC limits, and 2/3 of which are international — many in countries that don’t have any insurance.
There are also hundreds of billions of dollars of bonds they have out, and who knows how much on swaps for those bonds.
I guess they could be taken into receivership and sold off, but their balance sheet is so bad that no place can handle all the bad assets so no one can buy them (plus everyone is out of money). They are even bigger than the US gov’t can hope to support…well unless we’re going to cancel everything else. So uh I think they are systemic risk but have absolutely no idea how things will be resolved.
We therefore ought to try to impose costs on the people who could have and should have prevented it. This would include management, the board of directors, and shareholders.
It may or may not be fair to penalize shareholders, but I think it is *not* particularly fair to penalize shareholders on the premise that they could have prevented bad decisions on the part of management and the board.
I’ll bet most Citi shareholders (as a percentage of the number of shareholders, not shares) are more or less unaware of the fact that they *are* shareholders. They’re probably shareholders through some investment plan, or through a mutual fund.
What I think would be fair would be a bailout of failing financial institutions that requires the resignation of the existing management, and possibly also the board.
With, of course, no golden parachute. You’re done, clear your desk and go home.
Management and the board will, of course, immediately say “No f*ing way!”.
Which then leaves them to explain to the actual shareholders why the value of their investment is about to become pennies on the dollar.
Thanks –
mikkel,
Do you have any links? I’d thought about the counterparty swap risk but I just can’t find anybody who is doing a convincing job of documenting them, at least not yet. Also, I assume that $40 T value you are quoting is notional value, which means that the actual cost of unwinding them might be in the 10’s of billions if they end up going the way the GSE and Lehman swap auctions came out, depending on what sort of swaps are involved.
$40T sounds like a large number but IIRC that is less than 1/4 of the notional value of the AIG swaps, and that was before we found out that AIG was also involved in helping European banks to evade their regulatory requirements on capital ratios (i.e. an AIG failure would have triggered a general bank failure across much of Europe).
As for the deposits, that is easy. The FDIC should be able to line up a buyer ahead of time and conduct a pass thru takeover like they did with Wachovia. I would think just about every other bank on the planet would kill to get their hands on those deposits right now.
As for the bond holders – well somebody’s gotta take the knife in their back. I’d just as soon see it be the Citi shareholders and bondholders, and let the US govt. keep the money for spending on soup kitchens at this point. Or spend it on converting abandoned McMansions into multi-family housing.
// Or spend it on converting abandoned McMansions into multi-family housing.//
This would violate a whole slew general plan, zoning and due process laws. There would be endless EIR’s and lawsuits as nimby’s joined with green folks to fight the affordable housing folks.
“Do you have any links?”
Sorry I searched and couldn’t find it, but I found something better! Here are loss estimates from swaps, which is far more important than the notional value. So it looks like it could double total losses.
Also about the notional, that’s why I tried to say that they were counterparty to that much and distinguish that from the size of the swaps on their debt. I’m not sure about the latter, but the counter-party is the big deal because when the counter-party fails that’s when the unwinding breaks and everything goes to hell.
Bear Stearns, AIG, now Citi…those are huge counter-parties and none of them has been allowed to fail for that reason.
And for the deposits: it’s not quite that easy. Deposits are the foundation for all the assets, so they can sell them to another institution sure, but that doesn’t make all the losses on everything else go away. What the government tries to do in theory is sell both the deposits and the assets to another bank as a whole, but since there are so many losses hidden every where then banks don’t want to bring that on. So what has been happening is that the government has been selling the deposits and then either explicitly agreeing to take the hit on bad stuff, or the Fed is taking it all on to their balance sheet under “temporary” liquidity measures. That’s why their balance sheet has more than doubled.
So yeah, all the miraculous last minute saves of banks that have sold them off has really fixed anything, it’s just hidden future losses somewhere: most likely on the government.
Or spend it on converting abandoned McMansions into multi-family housing.
You know what sucks? Lots of municipalities have laws on the books that make that illegal. Can’t have too many multi-family dwellings in town…if you do, then those people will move in and pretty soon the neighborhood will deteriorate to the point where you can buy good salsa at the corner store. Can’t have that now.
If you’re wondering why Citi needs to care about its stock price, here’s an answer.
I’m still wondering.
Your “answer” asserts that:
* The falling stock price will cause the stock price to fall more. So what.
* Creditors will balk, like at Lehman. Which didn’t have access to the Fed, as Citi does.
* Depositors will see a falling stock price and withdraw funds.
The last of the three is the only real issue, and if Citi is solvent on a long term basis, quickly and cheaply fixed by government intervention. If Citi is not currently solvent on a long term basis, then either you have a massive and horribly expensive bailout or you use the failure of the company to mark the beginning of the serious phase of the financial crisis.
Then again, Citi sent a notice saying they were raising the interest rate on my credit card from 8% to 17%.
Let ’em fail.
“Question: is there some reason not to hurt the
shareholdersRobert Rubin?”Yes. He has a long memory and friends in high places.
For Instance
“Prince Alwaleed bin Talal’s Kingdom Holding said Alwaleed will increase his Citigroup stake, his largest holding, to 5 percent. His holdings in Citi are currently less than 4%.
In his mysterious role at Citi as “Director and Senior Counselor”, since joining the bank n 1999, Rubin has pulled down $150 million in salary and bonuses.”
Wiping the shareholders is fine if you’re nationalizing. But if you want to get a return on at least some of the TARP loan money, you probably don’t want to poison the investment well.
What is a “bad bank” ? What would anyone put into a bad bank? What can be taken out of a bad bank? What is its purpose? Is it like a concrete sarcophagus? Is Chernobyl a bad power plant?
Here are loss estimates from swaps, which is far more important than the notional value. So it looks like it could double total losses.
Thanks!
I was a little bit disappointed with the brevity of the analysis at that link and the handwaving “it depends on the institution” ( ORLY? ), but hopefully I’ll have the time later to dig through the linked IMF paper.
For what it’s worth, here is the Q3 SEC statement for Citigroup, which on page 40 shows that as of Sept. 30th, out of $ 36.8 trillion in derivatives exposure, 26 trillion of that is interest rate swaps, 5 trillion is in Forex, and a paltry 3.3 is in credit default swaps (with a roughly 50:50 split as Guarantor vs. Beneficiary).
At this point I’m agnostic – I’d really like to hear from some of the heavy duty wizards out there in econ-blogistan and elsewhere pull apart these numbers to guesstimate what the likely fallout would be if these swaps have to be settled, before I make up my mind whether bailing out Citi is a good idea or not (which obviously depends on a lot of other details as well).
Events seem to be moving too quickly for that, so I’m not holding my breath.
Thanks again!
Is Chernobyl a bad power plant?
Well it’s certainly not a good one…
Is Chernobyl a bad power plant?
Well it’s certainly not a good one…
“$ 36.8 trillion in derivatives exposure, 26 trillion of that is interest rate swaps, 5 trillion is in Forex, and a paltry 3.3 is in credit default swaps”
I see…well I’m pretty proud I basically remembered a number I saw once 4 months ago, but they didn’t mention that.
It makes me wonder though, everyone is talking about CDS when it’s the forex and treasuries that have seen MASSIVE movements. Maybe everyone is focusing on the wrong thing and a lot of bad stuff is going on out of the public eye with all those moves.
Would someone please explain to me this “counterparty” business? If I bet you $1 million a month ago that Barack Obama would win the election, you were my counterparty. And I was yours.
Now, I got a piece of paper from you that says “IOU $2M if Obama wins”. I paid you $1M for that piece of paper. That “asset” has been “on my books” for a month. Maybe it has been on my books at a notional value of $1M (the price I paid for it), or $1.95M (reflecting Nate Silver’s estimate of Obama’s likelihood to win), or $2M (the payoff I considered certain enough to bet a million dollars on), but it has NOT been on my books at $0. Meanwhile, my $1M cash has been on YOUR books. Somehow, and this seems important to me, MORE THAN $1M has been on our combined books. Sure, your books showed a liability (your expected cost of settling the bet) but your “expected” cost was less than my “expected” gain — or you would not have made the bet.
A real $1M of cash assets that I used to own and you did not, became “assets” worth more than $1M that we, the counterparties, owned between us. How the hell could THAT happen is one question. But the real question, to me, is: how is the world’s overall wealth reduced if you now default on your counterparty obligation to me?
Sorry to be so dense, but I don’t get it. It’s as if you told me that a bunch of big players sat down to a high-stakes poker game, the pot grew to trillions of dollars worth of IOUs, the showdown came, and THEY ALL LOST.
–TP
Given the level of panic the collapse has instilled (Krugman seems on the verge of heralding the ecopocalypse), I’m prepared to tolerate a little moral hazard if it restores investor confidence.
But that’s just the terror talking.
I’m still waiting for someone to tell me why yet another Master Of The Universe Financial Firm can expect big dollars from Uncle Sugar, but General Motors has to endure endless mockery and the stiffarm from Congress.
The contrast is sickening. One firm makes … well, it trades … or something, and it, uh, guarantees interest … hmm. The other firm MAKES CARS AND TRUCKS YOU CAN DRIVE TOMORROW. Oh, and did a damned sight more to win the Second World War than any God-damned bank ever did.
turb
//You know what sucks? Lots of municipalities have laws on the books that make that illegal. Can’t have too many multi-family dwellings in town//
California has a law that makes it illegal to prevent affordable units from being put anywhere. However, there is no way to make a unit affordable without the the builder losing money unless they are relatively small units with alot of density. To achieve the density in a neighborhood that is not zoned for it is nearly impossible. You’d have to get a general plan amendment and a zoning change. You’d have to do an environmental impact report which might take a year. You’d probably have to upgrade the roads in the neighborhood and install a traffic signal. In my town, impact fees are about $35,000 per unit when you consider sewer connection, school fees, fire district fees, traffic fees, and park fees. Suppose you were able to buy a 3,200 square foot mcmansion at a foreclosure auction below cost with the object of converting it to four 800 square foot unit. You might pick it up for $480,000. You’d have to carry it for 1.5 years while you get approvals. Then you’d have to pay fees for the three extra units plus extra walls, bathrooms, kitchens, covered parking (which is required). It could easily cost an extra $65,000 for each of the three extra units. You’ll be out a total of $675,000 or $168,750 per unit (a year and a half from now). Meanwhile, you can buy a foreclosed 800 foot condo now for less than $150,000.
Nice thought but…it’s not going to work.
Tony P: you’re leaving out an important step, which is that both sides are making other investments assuming the counterparty is good.
Let’s say that instead of me owing you $2 million up front, the contract is to pay you over the course of a year. Well you won so you are expecting that money to come rolling in and it’s guaranteed, and then someone comes to you and says “I bet you $1 million that the Patriots are going to win the super bowl and if they do you owe me $2 million.” So you think oh that sounds good, at worst case I just lost what I made on Obama, but it sounds like a sure bet…so you make it.
Meanwhile I’ve gone to the track or something and bet all $2 million I had to give to you and lost it all. Well when the Patriots win and you expect to be ok because you can pay out from what I gave you, then you find out I lost it all and now you’re screwed too.
And that’s even without leverage. In reality, what was happening is that people said “oh there is only a 5% chance of any individual thing happening, so I can make bets that are worth 5x more than I have in aggregate because there is a 1 in a billion chance that all the things will go bad at once.” But that was the completely wrong assumption that they are independent and in reality the chance that lots more bad things happening becomes higher whenever one bad thing happens.
The leverage in the system is what creates value out of thin air and that’s what gets destroyed during deflation.
Of course the real life story was even more complicated because there are tons of different ways to bet on the same thing. So what people did was say “oh we can make money by making the same bet for and against something, but in a slightly different way and all the numbers will add up to a profit.” Then they assumed counter-party risk was good and are like “hooray we have zero exposure, we get free money.”
Everyone did that and so far fortunately it’s worked out, but NakedCapitalism suggested that part of the stock market going down and banks hoarding money was to make good on their payments…..and it is unclear whether they can keep finding areas that are liquid if things keep going down. That’s also why they aren’t lending.
Companies like JPMorgan, Bear Stearns, AIG, Goldman and Citi are the largest and if one of them defaulted then things would quickly spiral out of control because all bets would be up in the air. If even one of their counterparties defaulted they might be in trouble.
Tony P.
IIRC, J.Michael Neal (who sometimes comments here) at one point wrote a really good non-technical explanation of how the various flavors of swap derivatives work that was highly readable, but I just looked over the archives in his blog and couldn’t find it. With luck maybe he’ll stop in here at some point.
The leverage in the system is what creates value out of thin air and that’s what gets destroyed during deflation.
mikkel,
Breathing creates value out of thin air, but to say that anything else does is to expand the definition of “value”. That’s OK, as long the definition is clear enough to avoid self-contradiction or circularity.
For instance, consider your example of me betting on the Patriots what I won from you on Obama. You have not paid me yet, so I bet your IOU to me against some “asset” my counterparty holds — say, his own IOU from you. You and I and the Giants fan are a pretty incestuous bunch, obviously. We make bets with each other, covered by IOUs to each other, and side-bets on the bets, and so on. We each started with a million bucks, but at any given moment the total of the IOUs floating around amongst ourselves is a couple of billion dollars. All that “value” would vanish into the same thin air from which we “created” it, if any one of us defaulted. Value that ephemeral is hardly worthy of the name, is it?
Meanwhile, it’s worth asking what happened to the three million bucks we collectively started with. Maybe it had no value, either, since it was merely IOUs from people whose houses we financed. That is, we paid carpenters and plumbers up front to build those houses, and the homebuyers gave us IOUs. Those IOUs are backed by the homebuyers’ capacity to create value over time by, say, writing software to sell to carpenters and plumbers. What we paid up front to the carpenters and plumbers was money invested with us by, say, dentists who had fixed the teeth of the software writers in the past but did not spend their money on either software or houses immediately. Healthy teeth, houses, even computer programs have undeniable value. But that kind of value is not created out of thin air — it is created by the labor of people (who do, admittedly, breathe air) doing things and making stuff for other people.
How does this latter kind of value disappear when you and I and the Giants fan, being so smart that we outwit ourselves, manage to simultaneously all lose our bets against each other?
–TP
Lots of municipalities have laws on the books that make that illegal. Can’t have too many multi-family dwellings in town…
Which is of course nonsensical, because one of the reasons Canadian cities haven’t degraded in the way many American cities have is the vast prevalence of large Victorian-era mansions in the downtown core converted into multi-apartment dwellings. It’s not just scary ethnic families living in those apartments; it’s students and artists and young business go-getters and get-goers and people saving up to buy ludicrously expensive houses of their own (which, in order to afford the mortgage, they in turn convert into multi-apartment dwellings).
It means higher population density, more vibrant and successful local businesses, more money flowing around the downtown core, more community spirit, more of everything people generally like and approve of.
The leverage in the system is what creates value out of thin air and that’s what gets destroyed during deflation.
I second Tony P’s comment on this. What is created out of thin air are numbers, not value.
It seems to me that not recognizing this distinction gets to the heart of the overall problem.
An economy whose nominal assets are detached from any realistic notion of their actual underlying value is, more or less, a souffle made of numbers. That’s all good (sort of) until somebody slams the door.
Thanks –
Uh, Tony P…you’re not supposed to ask those questions. What you described is actually what goes on and if people realized it there would be mass chaos. There is actually very little “money” in the world, and most of what acts as money is just IOUs. Even the “money” doesn’t really represent anything anymore other than a promise that the government says that it does. [This is why I take the cynical view that fiat money is actually backed by military and political power.]
Our entire problem is summed up in forgetting that “But that kind of value is not created out of thin air — it is created by the labor of people.”
Russell, yes obviously, but it’s important to distinguish between “money” and “value”/”worth” because they both act very similarly. For instance, if you add up all the dollars in the world there is only a few trillion dollars…but that stock market was recently worth $18 trillion. And there is $42 trillion of private/business/government debt. So what happens is that everyone goes around acting like there is $60 trillion, even though it’s backed by something like $4-$6 trillion (it’s kind of hard to say).
But all values are based on future income streams…so when the stock market crashes and wipes out $9 trillion, everyone says that it has “lost” $9 trillion, but that’s not true…no money was ever lost. The perceived value of the stock market was cut in half.
Here is the important part: everyone runs around like chickens with their head cut off because there is a change in perception of value, and value is forward looking. This means that the vast bulk of worth in the system isn’t derived from stuff that exists, it is derived from future expectations that we will be able to create real stuff. That is why our economy must grow or everything falls apart.
A realistic view would say that for the last 20 years we vastly over predicted real growth potential and this is why everything is crashing. The reason why we over predicted is because most of what looked like increases in the economy was really just debt expansion (back to the point that we forgot about real worth) and also we weren’t accounting for resource and infrastructural constraints.
So far the government’s reaction is to not really paying much attention to the first and not realized how big of a problem the second is — although Obama has made a first good step, the last 20-30 years has been fueled by fantasy and we have to come to account for that, AND we’re still expecting the next 20-30 to be similar to the last.
What Obama Needs to Know About Geithner …Barry Rithholz. Setser admits that Geithner was a deficit hawk, and I think he will be again.
Geithner is certainly a major architect of the Citigroup “bailout” Check out what Krugman & Dean Baker think of last night’s deal. Or most anybody else.
And Christina Romer to CEA. God help us.
Oh I forgot. Greg Mankiw is deliriously happy about Romer.
Tim Congdon is an UK economist who just says the Neo-Keynesians should just cut the bull and admit they are Friedmanite monetarists.
Here’s a long Cut & Paste:
…Snowdon & Vane, Modern Macroeconomics, Edward Elgar, 2005
IOW the New Deal (SEC, SS, UI) didn’t help stabilize the economy Post-WWII. She looooves the 20s.
Her husband David is even worse.
Monetary Keynesians = Monetarists.
I am now sorry I voted for Obama.
I’m still waiting for someone to tell me why yet another Master Of The Universe Financial Firm can expect big dollars from Uncle Sugar, but General Motors has to endure endless mockery and the stiffarm from Congress.
That’s easy. The financials pay bigger bribes.
Seriously, since I believe in evolution, any society that allocates $300 billion to preserving pieces of paper but can’t allocate $30 billion to preserving one of it’s necessities deserves whatever happens to it.
“I am now sorry I voted for Obama.”
Dude, WHAT?!?!?!? Get a grip; remember the alternative.
All this reminds me of going to Confession, Ten Our Fathers and 5 Hail Marys…..wtf
Why only “most” of what acts as money? What are the circumstances under which money is not an IOU?
To stickler’s and TJ’s points, an excellent post by Yves Smith about the pro-finance mentality that has captured the thinking of U.S. media, academic, and political elites.
Nell. Yves’ post ends thus:
“The idea that the needs of the financial sector can trump those of the productive sector are dangerous and destructive to our collective well being, and need to be combatted frontally.”
Yep. Indeed.
the “bad bank” could go by the name of Shitibank.
Part of the restaurant and airline conglomerate of South Park’s Chinese entrepreneur… ;>
Having been a fan of Yves’ blog for some time now, I’m in danger of over-estimating the sagacity of her posts and I try to make a point of seeking out dissimilar viewpoints that make sense to balance things out.
But IMHO the main thrust of that post which Nell just linked to should be tatooed on the inside of the eyelids of our fiscal and monetary policy makers.
Also, Nemo just posted a pretty good (IMHO) breakdown of the terms of the Citigroup bailout. I’m still digesting the details. So far it reminds me of the AIG bailout – some modest effort has been made to protect our (taxpayers) interests, but in ways that depend on the details and I suspect will prove to be nothing but fiction (to put it politely) in the end.
Can somebody please make sense of this for me?
Fed Pledges Top $7.4 Trillion to Ease Frozen Credit
Note the “T”. h/t atrios.
Some excerpts:
….
….
Half of the GDP is pledged, in one way or another, to the credit markets and other private financial institutions.
The other half is probably imaginary to begin with.
And it doesn’t really sound like anyone has any f’ing clue about what a real solution looks like. They’re just throwing money around. Real money, that is going to come from your and my real wallet.
You know, a year or two back, a Chinese official responsible for public health was convicted of malfeasance and of taking bribes. They took him out back and shot him.
Here, you end up in the Cabinet.
I’m at a loss for words.
Thanks –
Here, you end up in the Cabinet.
I’m at a loss for words.
Just want to say that russell is a treasure. One of my New Year’s resolutions will be to work at being that concise.
Must go do a million put-off-until-the-last-minute pre-Thanksgiving-trip errands. Best wishes for a calm and festive holiday to all ObWingers.
Can somebody please make sense of this for me?
It is panic – quite possibly justified. They are trying to do what they think Hoover should have done before the Great Depression got well underway. Ben B. already told us that this is what he would do if we ever came to this, which is basically to drop money out of helicopters (hence his nickname ‘Helicopter Ben’).
They are trying to fight deflation by expanding the money supply, using quantitative easing (essentially waterboarding the banks with liquidity until they agree to start issuing loans again) because the other tool of monetary policy (lowering interest rates) has already failed and we are already basically at ZIRP (IIRC the effective Fed funds rate is at about 0.3 %).
One argument for not wiping out shareholders in a rescue is that a bank in some difficulty can raise additional capital by selling fresh shares. It is a lot harder to raise capital by selling equity if the prospective new equity holders face the serious prospect of their new investment being wiped out.
That’s a feature, not a bug. There’s a reason why no one wants to invest in insolvent companies.
Hilzoy,
There is something comically stupid about every article I’ve read about some bank’s woes like the NYTimes article you linked. Every one of them, at a certain points, breaks off and says something like:
What do you mean they never took into account the possibility that they were riding a housing bubble? If I were trading in mortgages, that would be the FIRST thing I would take into account. Besides, even if my a priori knowledge that if I am buying home mortgages then I should be concerned about the housing market doesn’t serve me well, the VERY FIRST THING I would have considered these past few years simply skimming the financial news was a housing bubble.
So there’s all this talk … grumble, grumble … about “experienced managers” and “There’s no way we could have known” and yada-yada and then, when explained, the problem is not enormously complicated, but rather enormously simple and stupid.
when the stock market crashes and wipes out $9 trillion, everyone says that it has “lost” $9 trillion, but …
… when it jumps 800 points in a day, nobody says, “WTF? How did a trillion dollars just materialize out of thin air?”
That asymmetry explains why most of our public economic discourse is incoherent babble.
Here’s another example, illustrated by two anecdotes. In the last couple of weeks, I have heard talking heads on TV opine that even if Michelle Obama has some kind of budget to redecorate the White House with, it would be unseemly to spend money that way in these hard times. And I’m sure we’ve all heard Congressmen berating the Detroit CEOs for spending money on private jets to fly them to DC, hat in hand.
Now let’s get something straight: “spending” is exactly what you want when business is slow and jobs are scarce. “Spending” is what money is for. In fact, money not spent is hardly “money” at all; it’s just a souffle of numbers, in Russell’s inimitable phrase.
I should make clear that I use “spending” in a slightly idiosyncratic way: hiring people and buying things to build a bridge, or a wafer fab, or a doghouse at 1600 Pennsylvania Avenue, is spending. Hiring private pilots, or butlers, or hookers for that matter, is spending. In plain English, more spending is all that “economic growth” amounts to.
Buying “financial instruments” is not spending. It is not even, in itself, “investment”. It is what you do with money you don’t want to “spend”, possibly because you already have everything a mortal human being could ever consume. Very, very, very few people fall into the category of already having everything they could possibly consume, but when those people own almost all the money, “spending” slows down and “the economy” — the actual trading of goods and services between human beings — goes into recession.
About 10 years ago, the CPI was flat and the Dow was surging. I observed at the time that inflation was not dead, it had merely moved to Wall Street. Little did I realize how truly awful inflation can be.
–TP
Ara,
There is a word which describes the problem you’ve noticed: group-think.
I just posted a comment at NakedCapitalism posing the question – how do we open up the Wall St. culture to a broader set of ideas so as to dilute their group-think? It will be interesting to see what response that draws.
As to where the current group-think came from and how it operates, I’ve posted this link before but if you haven’t see in, it’s worth a read because I think it sheds some light on those questions: Interview with a Hedge Fund manager.
Also, I think we are suffering the consequences of memories from the last great systemic shock fading away. The old timers on Wall St. who remembered the Great Depression are almost all gone now.
But, but… This just begs the question of where money does come from. Seriously. It’s not a rhetorical question. The thing I was trying to get at in my earlier question was that money does indeed originate out of thin air, in the same way that statements and promises originate out of thin air.
Money is a signal, not a resource. It’s information, not stuff. It’s an IOU, not a consummation. Models which treat money as a resource are inaccurate not because a few independent variables have slightly incorrect values, but because those models are inherently wrong. Wrong as in epicycles rather than wrong as in estimates of the pre-colombian human population of North America.
Hmmm, I stop paying attention for one weekend, and suddenly we have another enormous bailout.
My default position is skeptical.
My position on bailing out the bank to the extent the stockholders avoid harm is VERY SKEPTICAL.
TLTA: I don’t think it’s group-think, to be honest. I think it’s short-run incentives. And the priority gap between management and ownership. Everyone profited handsomely while the roulette wheel was turning, with bonuses and so forth. I wonder if incentives were as skewed as a lot of hedge funds’, where the managers don’t lose on bad years and break the bank in good ones.
I honestly think many people saw it coming, knew it was coming, and are only doing butt-covering now. People benefited from the bubble while it was going on. And they didn’t want to be left out of the gold rush. Competitively, they couldn’t let themselves be let out while other firms were posting soaring profits.
But I don’t think this many people were really this stupid about the consequences of an asset bubble. Please.
how do we open up the Wall St. culture to a broader set of ideas so as to dilute their group-think?
Financial decimation.
Get a list of all C-level management in any financial institution receiving federal bailout money.
Pick every tenth guy and take all of his or her bonus money for the last 18 months. Just take it, all of it.
You will receive their full attention.
Thanks –
Tony P @ 1:51: …I have heard talking heads on TV opine that even if Michelle Obama has some kind of budget to redecorate the White House with, it would be unseemly to spend money that way in these hard times…
I learned something from your follow-on thoughts about the usefulness of “spending” at a time like this, but as a bit of a quibble from someone who knows nothing about economics, I would point out that those thoughts (yours) don’t address the phrase (also yours) that I’ve put in bold: “that way.”
That phrase implies not so much that the money shouldn’t be spent as that it shouldn’t be spent on the White House. Maybe it could be spent, for instance, on buying/building some basic necessities for people who have nothing much. Or something like that.
I’m not making the proposition, or even suggesting that the talking heads you’ve heard are making it, I’m just pointing out that saying “money shouldn’t be spent that way” isn’t the same as saying “money shouldn’t be spent.”
Russell — why not the A and B level folks too? 😉
But all values are based on future income streams…so when the stock market crashes and wipes out $9 trillion, everyone says that it has “lost” $9 trillion, but that’s not true…no money was ever lost. The perceived value of the stock market was cut in half.
To put a little pedantic flesh on this:
What is lost is not “money” but wealth, which is more or less the present value of a future income stream. By the “present value” I mean the amount of money you could get today for that future income stream.
That’s what happens when you buy a security. You are buying a future income stream. Stocks and bonds are not money. They are assets like apartment buildings or manufacturing equipment. Like those hard assets, their value can change.
Say you own a factory, and make something and sell it at a profit. You have income. The factory is wealth. Now say the factory is destroyed. You have lost wealth. Your income steram is no more, but no money has disappeared. Suppose instead suddenly consumers stop buying what you make, and you can’t easily start making something they do want. Again, you have lost wealth, but no money has been destroyed.
Now say you only own a small fractional interest in that factory – like a few shares of stock. The same thing happens, except you bear 1 millionth of the loss or something, and not the whole amount.
What happens when the market drops is that people’s willingness to buy future income streams drops. That can be because they lower their estimate of how much income there will be, or because they see it as suddenly riskier (even though the average doesn’t change), or their own tolerance for risk goes down. It can also be because everyone decides that consumption today is worth more relative to consumption tomorrow than it was, so the future income stream, even if identical, is worth less.
Of course, it all works in reverse, too, making the market go up, or in different ways, making it go who knows where.
You will receive their full attention
Short, simple, to the point.
I like it.
It scans more elegantly in the original French however, or so it seems to me:
Too bad about that due process of law thingee. Perhaps we should all start cultivating our gardens instead.
We may need the vegetables.
“When a bailout is required, we prevent the normal market response to dreadful management, namely bankruptcy or heavy losses. We therefore ought to try to impose costs on the people who could have and should have prevented it. This would include management, the board of directors, and shareholders.”
hilzoy, are you serious?
Penalize sharehoders? For what? Participating in captialism gone amok.
As russell said, many shareholders probably don’t even know they are shareholders, such is life in putting your finances in a mutual fund and/or mutual-fund manager you trust. I may have shares, however teeny-tiny, of Citi in my 401K.
Actually, I am not sure it would be possible to impose costs on management and boards — unless they did something illegal.
The government allowed these entities to play fast-and-loose with the rules — and now that same government is going to impose fines on those same entities?
I like russell’s bailout penalty: Throw out the CEO, board and top management. (Who gets to pick their replacements? I guess that would be the new Bailout Czar.)
I think the financial term for all of this is, we are in a pickle.
—
Frank asked: “What is a bad bank?”
Answer: One that taxpayers are forced to support.
—
GE in trouble? If that’s not a reflection of how bad the economy is, I don’t know what is.
What ara said.
Pul-eeeze.
I’m just pointing out that saying “money shouldn’t be spent that way” isn’t the same as saying “money shouldn’t be spent.”
You’re right, JanieM. My point is that spending money “that way” is better than not spending it at all.
Incidentally, you know the current GOP talking point that it was not FDR’s New Deal which cured the Great Depression, but “the great public works project known as WW2” that did so. People who talk like that ought to be asked this question:
Where the hell did the money to pay for the great public works project known as WW2 come from, if the whole country was broke before that?
–TP
Bernard Yomtov explained perfectly why it’s so wrong when people said our national savings rate is inconsequential because of the increase in wealth. We are in so much trouble because people confused wealth with money.
“Money is a signal, not a resource.”
Actually that’s not entirely true on one level. If you are looking at economic dynamics between money and wealth/debt, then it is a resource. The crisis is a result of too much stuff being built on too little of a resource.
This is why economists are in favor of expanding the “resource.” On this level, it is true that they’ve forgotten it’s a signal. I don’t understand how very smart people like Krugman and Summers can overlook this, and realize that it doesn’t matter if they expand money supply because still have the problem of consuming too much relative to how cheaply we can extract it from the earth.
It is kind of funny, pre neo-classical economics focused on physical constraints and ignored internal economic dynamics. Hence mercantilism and such. Then, we got the industrial and petrol revolution, where physical constraints mattered far less and everyone focuses on internal dynamics…forgetting that it represents physical constraints.
Where the hell did the money to pay for the great public works project known as WW2 come from, if the whole country was broke before that?
When the economy is in a deflationary funk, the Govt. can just arbitrarily declare “we have more money” (technically the Central Bank does this and then just hands the trillions it so happily found hidden under the sofa cushions over to the Govt. to spend), and then go ahead and spend it.
Under more normal circumstances this would be highly inflationary and not something to try at home. During wartime (at least for a big war like WW2) there are all sorts of things to prevent runaway hyperinflation, like wage and price controls, rationing, and basically a socialist command economy for the duration.
So the short answer is: a benign form of national socialist economics.
The trick is getting back to a more normal economy after the war ends. Truman had a fun time doing this, which was one of the contributing factors to his popularity being so low when he left office.
Of course this only works if the economy is not critically dependent on imports, or at least nothing that we can’t command more or less at gunpoint (which helps when establishing favorable prices).
Get a list of all C-level management in any financial institution receiving federal bailout money.
Something like this has happened. I have a friend who (used to) crunch numbers for a big name Wall St bank. He had done some analysis in 06 and 07 and concluded that mortgage backed securities were going to be a real problem (obscene default rates for starters) and had sent some nasty memos upstairs (as in “help, we’re on fire”). No one did anything of course. When belts had to be tightened, management wasn’t really interested in sorting out who was good and who wasn’t, so they essentially fired people at random. Technically, they just announced that most people would get zero bonus, which amounts to cutting their salary by over 50%. People took the hint and quit since many of them couldn’t afford to make their own mortgages after taking a 50%+ pay cut. The funny thing is, they lost a bunch of people who either saw the whole thing coming or were really good at making obscene amounts of money in unrelated ways. Not smart. But you already knew that.
Something like this has happened
Just for the record, in case it’s not clear…
By “C-level” here, I mean folks whose title begins with a big capital C.
CEO COO CFO
Not third-tier-in-the-org-chart guys.
First-tier-in-the-org-chart guys.
Thanks –
Ara expressed just outraged over this NYT observation — as he said, a sort of disclaimer that seems to be in all of these stories:
“Citigroup’s risk models never accounted for the possibility of a national housing downturn, this person said, and the prospect that millions of homeowners could default on their mortgages. Such a downturn did come, of course, with disastrous consequences for Citigroup and its rivals on Wall Street.”
And so, for not doing its job, Citigroup gets a bailout.
I’d like to see more outrage from the Democratic Congress, from Obama, before these guys keep getting blank checks.
TLTiA, who almost always gets it right, told ara: “There is a word which describes the problem you’ve noticed: group-think.”
No, LeftTurn, the word is bullsh!t.
Sometimes good first-page comments seem to get lost in the “next-page” shuffle.
Like:
“I’m still waiting for someone to tell me why yet another Master Of The Universe Financial Firm can expect big dollars from Uncle Sugar, but General Motors has to endure endless mockery and the stiffarm from Congress.
“The contrast is sickening. One firm makes . . . well, it trades . . . or something, and it, uh, guarantees interest . . . hmm. The other firm MAKES CARS AND TRUCKS YOU CAN DRIVE TOMORROW. Oh, and did a damned sight more to win the Second World War than any God-damned bank ever did.”
Then again, maybe stickler was being too much of a stickler.
And I hate to break it to you, stickler, but one of our esteemed posters, Sebastian, thinks General Motors makes useless things (see the “Something’s Better Than Nothing” thread).
Anybody know which bank will get the next no-questions-asked bailout? Surely, there will be another.
Nope. See, now you’re doing it too. But just because you and Paul K and just about everybody keep saying it, that still don’t make it so.
There’s a qualitative difference between some agent insisting on some particular form of money which some other agent happens not to be “in possession” of, and that form of money actually being a finite resource. That difference means that there are no impediments to all of the parties to a monetary transaction agreeing to another transaction which is thermodynamically identical except that it uses no money, or uses twice or ten times or a million times as much money, or a different currency, or whatever.
Whenever it’s possible to change how the bookkeeping is done while leaving everything else the same, you can be quite sure that the bookkeeping is just information. Not stuff.
The only exceptions are situations in which the “money” is eventually used as something other than a medium of exchange or a unit of account. Unless one of the parties is a jeweler who melts a coin down to make earrings, it never matters whether the coin is made of gold, or silver, or cow patties. Which is why money is, for practical purposes, always a signal and not a resource.
No, LeftTurn, the word is bullsh!t.
I’ll take compliments whenever I can get them, so thanks btfb for your endorsement of my attempts to get things somewhere in the same zip code as “right” (present topic excepted, apparently).
Here’s why I lean toward stupidity (e.g. group-think) rather than just pure malice and deceit as an explanation for what went wrong with the risk modelling on Wall St.:
Anybody who understood what was really happening had a chance to get very, very rich. Not just standard issue ripping off clients and skimming off the bubble rich, but far beyond that. Because enormous shifts in a market like what we are seeing now are where you have a chance to make highly leveraged bets with only small amounts of money, and hit the jackpot of a lifetime.
That holds both at the level of specific firms, and in terms of repuations made by individual traders working at these firms. You don’t hear too many stories about folks who did that right now.
There are a few of them, like the article that Eric Martin linked to back in the Nobody Expects the Spanish Inquisition thread several days ago on this blog.
There is also very little evidence that any of the Wall St. firms did much to hedge their risk against what has happened (the obvious and terribly self interested thing to do if you knew the risk models were bad), with the notable exception of some stories about Goldman Sachs telling their clients one thing with regard to buying bonds while trading the other way behind their backs, back in 2007.
That is about it. That’s not much, considering the opportunities which were out there for smart people with access to the best information money could buy. If any of the large investment banks or hedge funds had known what was going to happen with any degree of probability, they could have made a killing and would be gobbling up the competition right now. I don’t see that happening, although again GS is doing better than most.
We also have stories about lower level analysts smelling something rotten in Denmark and trying to get the attention of somebody higher up (like the story Turb mentions above). Those stories are coming out of the woodwork now, all over the econ-blogosphere. I have yet to read such a story where the reaction the Cassandra received was along the lines of “ssshhh! keep it a secret. We don’t want anybody else to find out what we are up to”. Instead the reaction you read about in these stories is more of an incredulous brushoff – “The models can’t be wrong, look at how well they’ve worked so far. Now run along and play and stop bothering me”.
To my ear, that is the voice of group-think talking.
Thus I just don’t see much evidence to indicate that for the majority of Wall St. this was anything other than a ocean liner hitting an iceberg that they did not expect to be there. That they are scrambling now to make sure that they get the best seats on the lifeboats and leave the rest of us to swim, does not I think prove that they saw it coming, rather it proves that they have a well developed sense of self preservation once it became clear that the ship was going down.
That at least is how I evaluate their motivations during the inflationary phase of the bubble. The deflationary phase (i.e. since mid/late 2007) is a different story. I think we are being told all sort of lies right now, and that probably goes back at least a year, maybe more [see sinking ship and lifeboats analogy, above].
YMMV, and please keep up the comments. I miss your voice of common sense when you aren’t around.
radish: all the different forms of economic thought have demonstrated that money obeys the same rules of supply and demand that real resources do. In order to be a resource, it just depends on it being scarce. It doesn’t matter whether it is a natural or artificial limitation. Different monetary systems act differently depending on scarcity: that’s why some people think we should go back to the gold standard instead of having a completely arbitrary limit. However it still does act like a resource. Also, by changing the system by having more or less money, things don’t all scale identically and inflation/deflation has different effects across different asset classes.
I don’t quite get your point completely, but by saying “thermodynamically identical” I assume that you are saying that money is just a theoretical placeholder for real stuff and it’s stupid to limit ourselves based on it rather than direct measurements of energy and resources. In that case you’re talking about a non-monetary based system entirely and I guess you are a proponent of energy accounting or somesuch. (Either that or you are talking about a barter economy with a non-universal means of exchange.)
I can’t say I entirely disagree, but it’d be a completely revolutionary way of looking at things that no society has tried. So I still say that for “practical” purposes money is a resource because it acts like one and is what all our society is constructed to use. If we made a society that paid more attention to thermodynamic resources and that became our mode of exchange, then yes from that point of view money is not real.
Ara: here’s my best stab at it.
I have noticed, over the course of my life, that I am pretty good at predicting crashes, and not just that one will happen, but why it will happen. The trouble is that I always start predicting them at least three years early. Thus, by 1996 at the latest, I thought that the dot com boom had gone nuts, and that there would be a serious implosion of tech stocks. I think I was predicting a major meltdown, starting in subprime but spreading into the rest of the economy via collapsing housing prices taking away people’s refi piggy banks, by 2005 at latest.
This doesn’t take much acuity; it just takes a willingness to say: wait, this is insane. But the problem is: if I were investing, by being systematically early, I would do much worse than a lot of other people. I would have missed the prime years of dot com, and some pretty decent years of this bubble as well. So mine is not, I think, a winning strategy.
There is something that props up markets for several years after they reach the point at which I think: this is insane. I don’t know what. But I don’t understand it — it is invisible and incomprehensible to me. And not understanding it would really harm me if I were investing or managing money. (Or: it would let me avoid big harms, but it would also mean that I missed most of the gains.)
Whatever this something is, I think that it pays, in the short run, for people who invest money either to see and understand it or, failing that, to believe in it in the absence of evidence. It really does. That people believe in it is not, I think, just groupthink; in a lot of situations, believing in it will actually pay off, and will probably be encouraged in one way or another.
If only I knew what “it” was, this comment would be more helpful. But as I said, it is invisible to me. Fwiw, “it” is also keeping the markets from being considerably lower, I think.
This is what I dispute. People treat it as though it were a resource, to the extent that they believe it represents resources, and no further. That’s very different from it actually being, or even “acting” like, a resource. So what you say is true only in the same sense that the earth “acts” flat because people routinely treat it the same way they would if it really were flat.
Yes, I think that’s money’s primary purpose. Isn’t that the consensus view even among economists?
No, I’m saying almost exactly the opposite, really. The use of money is (for the most part) an excellent and efficient way to measure (and allocate, and model the distribution of) energy and resources (as evidenced by the success of populations using it).
But money is not, itself, a form of energy or a resource.
I’m saying that all of the things which people commonly refer to as “economies” or “markets” function as abstractions of some other ecological and material landscape. They are maps, and only maps, although generally drawn at a scale which defies the comprehension of any particular individual. Money is no more nor any less “real” than a promise, or a map, or an algorithm.
The information-ness of money takes a while to get used to, but it’s perfectly sound physics, perfectly sound information theory, perfectly sound biology, and entirely compatible with the observed behavior of both markets and individual market agents. Thermodynamics isn’t just about matter and energy, it’s also about information and entropy.
ara,
Lots of truth in your 3:38 comment. For support, try reading John Kenneth Galbraith’s A Short History of Financial Euphoria, one of many books on the general subject. Note that the book was written in 1990, but much of it could have been written yesterday. I can’t find an online version, but it’s short, cheap, entertaining, and extremely instructive.
You might also look to Keynes, particularly his chapter on investment.Some selections:
“Economics,” someone once said, “is a branch of the biological sciences.” This is useful to remember.
I think this conversation is edging toward an area I’ve been thinking about and on which I’ve been wanting to put some questions to the commenters here – namely, deriviatives. Do derivatives have any function in terms of wealth creation, that is, directing capital to worthwhile endeavors, beyond simply making money in a zero-sum way like gambling does?
I can understand the value of futures markets for people who need predictablity in the sale or purchase of commodities, and I can even accept credit default swaps to manage risk for those actually holding debt instruments.
But is there any valid argument whatsoever for purely speculative CDSs or, say, short selling? Is it anything other than gambling? Is anything of value more likely to be created because of these things?
Just wondering.
Bedtimeforbonzo: “And I hate to break it to you, stickler, but one of our esteemed posters, Sebastian, thinks General Motors makes useless things”
If you spend tens of thousands of dollars making large SUVs that aren’t selling, you think that is perhaps useful?
You should note that I did not say that GM workers were useless. Just that it is a waste to try to save their jobs *at GM*. If we are going to spend enormous amounts of government money with respect to these workers, I’d rather spend it employing them to do something productive. At this point, building GM cars is vastly less productive than doing lost of other things. It is in fact less productive than paying them their salaries to stay at home–at least that way we aren’t wasting steel and electricity which could be better used on productive projects.
I’m opposed to the bailout of the General Motors company. That isn’t at all the same as saying that I’m interested in just seeing the workers cut adrift.
All three of the Detroit automakers have been having serious trouble for decades, punctuated by small and very short term successes.
I’m not sure what I think about *a* Citibank bailout in theory, but I’m pretty sure I don’t like the actual one in practice. The bailout should be structured to keep regular banking activities going(structuring loans, taking and giving deposits, helping businesses deal with internal and external cash flow). I don’t care about Citibank itself as a company. I’m not pleased that the bailout seems to keep the investors of Citibank safe from losing much of the money they really should lose.
Like a GM bailout, it is *possible* that for some reason we need to save the company in order to save the people I care about. But I haven’t seen a good explanation of that in either case.
btfb,
The argument for, say, futures exchanges and the like is that they provide liquidity for those wanting to hedge, and eliminate the need to find a counterparty. The speculator steps in and fills that role. Sometimes, where there is no exchange, like with CDS, banks or other institutions can act as intermediaries, taking both sides of a deal for a small spread.
Is the tail wagging the dog? Entirely possible. See the second quote from Keynes in my comment above.
Mikkel, value is *NOT* forward-looking. Value doesn’t look; it just is. Perceptions of value are forward-looking, valuations that get put on financial institutions’ books are forward-looking, but value either is or isn’t *in the present*. You’ve just demonstrated the very conflation of money with value that Tony P and others were talking about.
hairshirt,
Poker is the paradigm of a zero-sum game. If five of us sit down at a poker table, what one of us loses someone else wins. The money we collectively brought to the table is the money we collectively take away. The churning of chips back and forth among us during the game does not in any way grow their value. All of this is obvious because a poker game lasts a few hours at most, usually with the same players from beginning to end.
The stock market is a permanent poker game. Its beginning is lost in history, its end is not visible in the future. Old players withdraw, new players come in, generation after generation. The money “in the market” is brought in by buyers and taken out by sellers. The only reason anybody thinks of the stock market as NOT a zero-sum game is because nobody can watch the game from beginning to end.
With that as preface, let me say that short sales are just sales. You can’t sell short unless someone buys. The buyer’s cash becomes your cash, your (borrowed) shares become the buyer’s shares. If you actually own 1000 shares of XYZ Corp. and sell them at $10 today in the hope of buying them back at $8 tomorrow, you are not called a short seller, but you are gambling in exactly the same way as a short seller. “The market” may move against you whether you sold stock that you borrowed or stock that you owned. Your stake gets reduced either way. Your cash becomes someone else’s cash. What you lose, some other gambler wins.
Now, you might have been gambling with borrowed money. But you can BUY stock with borrowed money, too. The buyer you sold short to might have paid you with borrowed money. Gambling with borrowed money is very risky, whether you’re playing poker or speculating in the stock market, though it’s also potentially very rewarding. But long or short you can’t win more than someone else loses, and vice versa. If you lose so much that you can’t pay back your creditors, that means your creditors’ money became someone else’s money. The overall game is still zero-sum.
Derivatives are side bets on the poker hands. You make your bets with actual money, but so does the fellow you’re betting with. His money becomes yours, or vice versa. Still zero-sum.
Does it help the real economy that this zero-sum gambling goes on? Yes, I think. But I have a vague recollection of Warren Buffett once pointing out that the airline industry as whole had been a net loss to its investors from the invention of the airplane until the date of his comment a few years ago. Let’s say that’s true. Would it indicate that the stock market also MISdirects capital sometimes?
–TP
LeftTurn: I am in complete agreement with ara here. I think writing off Wall Street’s failure to recognize a housing bubble as stupidity is too kind. Greed took over and, I suspect we will find out in the future, so did deceit and malice in some quarters. (Not to say there wasn’t some element of your group-think premise.)
Bernard: Correct me if I’m wrong, but I think you mistakenly addressed your 1:47 comment to me when you were actually addressing hairshirt’s 12:14 post.
Thanks, Tony P. and Bernard (I think you were responding to me, Bernard, though you addressed BTFB), but what I had in mind was more the distinction between (some)derivatives and more direct investments. As I wrote, I can see the value in, say, futures markets for the people who are buying a selling commodities because futures allow the market to function better by allowing people, who otherwise could not assume whatever level of risk, to participate. I also wouldn’t normally think of buying and selling stocks as a zero-sum game aside from that portion of it that is purely market speculation. I don’t think of value investing as zero-sum, only because wealth can be created and economies can truly grow. So my question really gets down to this: Do we really need many of the existing derivative instruments out there to get capital where it needs to go? On balance, are they more destructive than truly purposeful? I know I’m being rather broad with these questions and that these sorts of things need to be considered on a case-by-case basis, but I wouldn’t mind a discussion of, say, whether there is any value, on balance, to having CDSs available, particularly purely speculative CDSs. I really can’t see how my being able to bet that my next door neighbor will default on his mortgage, when I’m not holding the mortgage, does anything to create real wealth and spur real growth.
radish: OK points taken. Let me see if I sort of see where you’re going with it. I am thinking about writing an article about how our monetary system represents utilization of natural resources and have found some economic papers to help provide context.
In general the thesis is that by vastly increasing the money supply there are two possible outcomes based on whether consumption increases or not. If it doesn’t increase, then there will just be a lot more money chasing fewer products and that’s textbook inflation (or in this case most likely hyperinflation). If it does increase enough that there isn’t hyperinflation, then what happens is dependent on how efficient we produce things from our natural resources.
The most likely scenario would be that real GDP increases would arise from a massive increase of natural resource consumption and this would lead to scarcity, destruction of the environment and eventually massive economic consequences. I’ve found a paper that looks promising as it has a model for how real GDP increases are related to resource consumption and if you assume that the resources are renewable, gives a model for determining the sweet spot of sustainability and GDP increase.
I say that increased utilization of resources is the most likely outcome because I find it very unlikely we will be able to boost efficiency as much as it would need. It goes back to Greenspan’s observation that real productivity increases seem to cap out at 3% per year. Productivity is both a technological and cultural phenomenon, so it’s possible that even if we were to develop renewable energy quickly, we’d still be in deep trouble.
I guess I accept your definitions of what money is but still don’t see what you are arguing that implies. Is what I just talked about sort of it?
hairshirthedonist:
It’s my understanding that most derivatives are used for hedging purposes. Also, because most of the writers only keep enough money to pay a fraction of their obligations, it is a nice way to increase leverage in the system. This is what Roubini refers to as the “shadow banking system” where much of our current leverage was not created by banks through fractional reserve lending, but through derivative contracts and the like.
I guess the answer to your question is whether the increased leverage is being used for investing in sustainable growth or whether it is just masking a debt bubble. I think the answer for our current predicament is obvious.
//Sebastian: “If you spend tens of thousands of dollars making large SUVs that aren’t selling, you think that is perhaps useful?”//
That GM is still making large SUVs doesn’t unto itself make the company or the product it is making useless.
There is still a market for SUVs — just not one as large as it was three or four years ago, when that’s what the majority of domestic-car buyers wanted.
To ignore that market — when GM makes arguably the best all-around SUVs for the money — would be bad business.
But where GM failed terribly was showing an alarming lack of vision and foresight in thinking that this was the ONLY market worth going after. Just as Wall Street got drunk on first the dotcom bubble, then the housing bubble, Detroit preferred to think its high-margin SUVs would forever be the goose that laid the golden egg.
So they lost precious years and market share to Toyota and Honda in the hybrid arena.
And similarly, they lost focus on producing good-looking, good-gas cars in the non-hybrid arena (we are a long, long way off before everyone is driving a hybrid, I think we can stipulate that).
Playing catch-up, GM has been succcessful with its redesigned Malibu, unveiled in 2007, and which I linked in the “Something’s Better than Nothing Thread.”
The re-designed Impala isn’t doing as good, but has been a huge improvement on its predecessor. The Aveo and Cobalt would not be given a look by someone who can afford a Prius, but for blue-collar workers looking for a decent, cheap gas car, their $12-15,000 price tags work.
SUVs aren’t going away, so even gas-guzzling GM is offering them with hybrid options. What they are selling more of right now are Tahoes that can go from 8 cylinders to 4 cylinders in the blink of an eye.
And unless we become a society that doesn’t make a damn thing, I don’t think pick-up trucks are going away. Toyota’s Tundra is a great pick-up, but Ford and Chevy offer one that is just as good (some would say better) — and cheaper.
For the moment, market forces — i.e., the credit crisis — have conspired to make none of this important. The auto business is either dying, very sick or, even in the case of Honda and Toyota, plain-old sick (also cited with links at “Something Better than Nothing”).
Do we help the dying patient or let it die?
If Citi, AIG and the like deserved government intervention, so does GM.
(I think we both agree that the government’s bailout plan of Wall Street contains too many holes, that the 8 percent worth of shares in Citi should have been larger, and top management changes should have been mandated. My guess is Detroit will get a bailout of some kind — just not a here-it-is, take-the-money-and-run handout that Wall Street got; that gets into class-warfare issues that I also addressed in “Something Better than Nothing.”)
Bedtimeforbonzo, I disagree with your assessment. GM is not producing enough cars that people want to make a profit. It has no clear and likely business plan to make a profit in the next few years.
The auto business as a whole may have problems, but GM has the worst of pretty much all of the problems. If the auto business is sick, a large part of that is that it has too many people doing too much for to little of what is needed. It is virtually certain that there are too many people working in the auto business. That means that people are going to have to lose their jobs in the auto business for a healthy economy because there are currently too many of them working for too few needed jobs. GM is one of the weakest of a weak industry. Its business has been problematic for 30 years, during which time it has taken cash infusions from the capital markets enough to have purchased Toyota AND Honda outright.
That is an enormous waste of money, and throwing more money into that pit is not wise.
We can take care of the workers, and help them transition to productive jobs (which is to say jobs with a positive net outcome rather than the current negative net outcome) without saving GM. And we can almost certainly do that cheaper than saving GM.
Tony P.,
I disagree that the stock market is zero-sum. Since the values of equities have grown fairly consistently over time it is pretty clearly positive-sum, at least in modern economies.
I think you may be thinking in terms of individual transactions. If I buy stock from you and it goes up you’ve lost, somehow, and I’ve won. But that’s not true. I’ve won, and you’re even (or possibly ahead, but leave that for now). That is, if you take the money I paid you and put it in a mattress, you are no worse off than you were the moment before you sold.
hsh,
Yes, I was responding to you. Tony is right. Derivatives are side bets. Their original purpose was to hedge various risks, as you say. They’ve been around for centuries. The newer more exotic types are still intended to hedge risk in complex ways. Whether they ultimately accomplish anything useful for the real economy I don’t know. An easy answer is that they must have some value, since they are, after all, just voluntary contracts between (presumably) highly knowledgeable people.
But count me among the unconvinced. They seem to have value, since people make an awful lot of money dealing in them. But maybe this comes from being able to offload risk onto society in general.
Alternatively, I also wonder whether the huge private rewards available aren’t drawing bright people to Wall Street in excessive numbers, so we get into a “winner-take-all” mode that isn’t a great thing for the economy.
The fact is, I don’t know enough to answer your questions. CDS have always seemed a little strange to me. If you’re worried about the bond you own why not just buy a safer one? I guess there are reasons. Still, it’s easier to do that than it is for the farmer to switch from wheat to pineapples if wheat prices drop.
Sebastian: Ultimately, we must decide if standing by and watching GM die will prove beneficial — free-market forces at work — or if its death will impact the already-sagging economy in a way that makes helping it is necessary (the same argument that has been made for saving the financials).
I think where you stand is clear.
However, I think you are underestimating, among other things, the impact on the economy that a million or so more workers instantly out of work would have on a growing unemployment problem (see hilzoy’s “Poverty” post).
I think you are underestimating the impact of a GM death on the economy because some of its impact is immeasurable. I know one Hyundai store, for instance, that would not survive without its Chevy anchor, and I am sure there are many dealerships nationwide in a like position. (And I would not be surprised if our owner sold the Nissan store — currently not selling as many units as our Chevy store for the third straight month — down the street if he lost his 83-year-old flagship.)
If Citigroup and AIG were going to cause an untold negative cascade in their industry, GM carries the same burden — unless you have an answer for an unemployment explosion and you’re OK with an automotive industry that is down to Honda and Toyota and a precious few.
“I think you are underestimating, among other things, the impact on the economy that a million or so more workers instantly out of work would have on a growing unemployment problem”
This is garbage. GM would go into Chapter 11, and if the unsupported fears about it being unable to get interim bankruptcy funding prove true (I would guess that these fears are wrong) the government could cover THAT funding for much less and get to the good outcome of GM ceasing operations of wasteful areas while continuing the areas that you believe are profitable.
That isn’t anything like a million jobs gone. If it is true that there are lots of profitable areas, all of those will survive and continue on after Chapter 11. If that isn’t true, your whole argument falls apart, so I don’t think you’ll be claiming that. In neither case does GM as a whole need to be saved. And the government can help workers who are displaced by Chapter 11 move on to something useful.
None of this requires that we bail out GM.
And I see the same treatment as being wise for Citibank. So there we are. There are almost certainly too many people working in the financial sector. Those excess jobs are going to have to transition to something more useful. Government would be wise to ease that transition, but stopping it is just going to cause problems.
AIG is different than GM in that so far as I can tell it has a perfectly good business model as soon as a couple of months from now, and certainly a year from now. It also doesn’t have 30 years of obvious problems to make me skeptical of it.
“and you’re OK with an automotive industry that is down to Honda and Toyota and a precious few.”
This on the other hand just alludes to something I don’t agree with at all. There is nothing whatsoever wrong with a world where all of the Detroit workers are working at productive non-auto jobs and there is no ‘American’ automotive industry in the sense of it be mostly owned by an American chartered corporation.
One reason Citi and GM need a bailout is because they need to get “lean-and-mean” — which should be mandated as part of any taxpayer assistance, although I’m afraid the government has been lax in this area on the financials.
Perhaps Bernard Yomtov or mikkel or TLTiA or others who have checked in on this post and other economic-themed posts can answer why Chapter 11 wasn’t seen as a good option for Citi. It may have been — I don’t know.
In theory, I like the idea of Chapter 11 giving us a leaner-and-meaner GM. One result, I think, would be at long last to force GM to disband its redundant brands. No more GMC since Chevy would be left to handle the truck and SUV market. No more Pontiac or Buick since Chevy could offer a Pontiac-flavored sports version of its existing cars and they could make a Lacrosse or Lucerne to keep Buick buyers happy because, frankly, there are older buyers who won’t consider anything other than a Buick. Saturn would have to go, too; little-known fact: It’s been good PR for GM, but has never made a profit. So Chevy would remain a competitive force, with a possible game-changer in the Volt on the way, and Cadillac could be teamed with the Saab brand.
I hope these are some of the ideas CEO Rick Wagoner brings to the table when he goes back to Congress in December — admittedly, I’m not counting on it.
But if Congress dishes out a handout, I don’t see why they can’t impose some of these conditions.
As for the reality of a Chapter 11 working for GM, I mentioned in the “Something Better than Nothing” thread that a car company — already facing a challenging environment — is not likely to survive the stigma of bankruptcy.
What’s more, are you OK with the suppliers and creditors whom GM owes being left out in the cold?
Also, if you’re OK with an exclusive Honda-Toyota car industry, I’d have to ask how big of a fan you are of Wal-Mart. As someone mentioned in the other thread, it’s not too far-fetched that we’d see the Wal-Martinization of the auto industry.
Smiley faces for everyone.
And a half tank of gas with your new-car purchase.
Admire those factory-fresh tires, too, shoppers — you’ll get a good 24 months out of them.
bedtimeforbonzo:
I guess bankruptcy laws are written in a way that makes it basically impossible that important financial companies can go bankrupt. I know basically nothing about it except for this post on NakedCapitalism.
But yeah you are 100% correct that Citi — and the financial sector in general — needs to dramatically reduce in size. Yves has made this point time and again but I have no idea how it’s possible without mass deflation and she hasn’t really provided any insight into that.
why Chapter 11 wasn’t seen as a good option for Citi
Somebody on one of the comment threads at NakedCapitalism made what I thought was a very perceptive observation, which is that the powers that be have not yet figured out a way to return the pricing of the asset backed securities and all the other overly leveraged crappy paper being held by the banks back to true mark-to-market values without taking down the entire banking system, and for that reason none of the major holders of those securities can be allowed to see the inside of a bankruptcy court.
To expand this a little bit:
Fundamentally the entire banking sector both globally and at the level of the USA specifically, is insolvent. And they will stay that way until they suck up enough new capital to get their balance sheets back under control. Which the Treasury and Fed are trying to help them do by any and all means necessary, from bailouts to steepening the yield curve and paying interest on reserves.
But until such time as the banks are close to solvent, correct valuation of their dodgy paper is a figurative Pandora’s Box which nobody wants the lid lifted on. And for that reason, not a single major investment bank, not even one of them, can be allowed to go into bankruptcy, because doing so would force an evaluation of the actual current market value of their paper, and since everybody else is all holding the same kind of paper it would force a global re-valuation of everybody’s paper.
Which means that every last one of them would fail.
All more or less at the same time.
And in fact this came very close to actually happening when Lehman went bankrupt. Pandora’s box was opened just a crack, but they managed to slam the lid shut quickly enough to prevent the general across the board markdown which is now thought to be lurking inside that box.
So what we are doing right now is playing the game of everybody pretending not to notice that the Emperor is not actually wearing a stitch of clothing, because the entire court is naked. And it is essential to preserving this fiction that none of them gets hauled into a bankruptcy court where the ugly truth will be exposed. So instead we are getting all these weird bailouts and extremely complex liquidity vehicles from the Treasury and the Fed, which are designed both to recapitalize the banks and to provide some measure of reorganization of their debt structures, the latter being a form of Chapter 11 reorganization in disguise, but without the price discovery function which would trigger a general mark-to-market meltdown.
From mikkel’s NakedCapitalism link about Chapter 11 being feasible for GM but not Citi: “Now why can’t we do that for financial firms? In some cases, you get the run on the institution syndrome, which is what happened to Bear Stearns.”
Hard to argue with that argument.
Nowhere in that otherwise solid piece on how an automaker in a dire economic environment would be further hampered by the stigma of bankruptcy — not having the customer’s trust that a warranty would be rock solid, for example.
The post does make the point that the Bush administration and Republicans in general feel no real need to support an industry whose workers don’t vote their way.
Bankruptcy would force GM to become a meaner-and-leaner company, as I noted upthread is vital to its success, and economists in the NakedCapitalism post basically say must be forced upon the venerable carmaker.
I’m hoping General Motors CEO Rick Wagoner does not decide to play a game of chicken with Congress and presents them real changes (like the ones I outlined earlier) that would be better for the long-term health of his company and likely win a bailout.
Otherwise, I could not fault Congress for saying, “Sorry. Do not pass Go. Do not collect your bailout.” And we will all see if Sebastian and others are right in regard to bankruptcy being the only option, and a workable one, for GM.
AIG is different than GM in that so far as I can tell it has a perfectly good business model as soon as a couple of months from now, and certainly a year from now
The certainty of central planning.
The certainty of central planning.
Is investment banking as practiced over the last several years (or perhaps a decade or so) actually all that different from central planning?
I mean my understanding is that at a information theory level markets are better than central planning because they harness the computational power of a vastly larger number of decision makers (the wisdom of crowds), most of whom are closer to the local conditions that need to be taken into account. Thus you have a system for making price setting and resource allocation decisions which is many times larger in its capacity to process information than a mere bureaucracy.
But does that really hold when mergers and acquisitions combine the substantial majority of our financial decision making processes into a handfull of mega-corporations, who in turn are subject to herd like behavior. How much difference is there really between a Ministry of Finance in one big marble clad building and the equivalent number of people working in 6 or 7 steel and glass towers who all think the same?
Isn’t part of the problem of the last decade that Wall St. went all communist on us (so far as central planning by apparatchiks is concerned that is) and nobody noticed?
Bernard,
If you buy my 1000 shares of XYZ at $10, I have your $10K and you have a nice, fancy certificate. You can’t eat the certificate. What you can do is sell it for $12K to some other buyer. The net result of both transactions is that my shares became your buyer’s shares, and his $12K became $2K in your bank account and $10K in mine.
Let those shares change hands as many times as you like; let their price at each sale vary as much as you like. The final buyer owns the shares. The cash he and every other buyer paid adds up to, say $1M. The cash every seller (including XYZ Corp in its IPO) received is perforce also $1M. Some people bought low and sold high. They netted cash from the people who bought high and sold low. That’s what I call zero-sum.
The final buyer might have paid only $5 a share — or $50. It doesn’t matter. He’s the “final” buyer because he holds the shares until XYZ Corp. goes out of business. If that’s a good long time, during which XYZ earns profits and pays him dividends, he “wins” or “loses” depending on whether the net present value of the dividends (plus proceeds of the liquidation) ends up being higher or lower than what he paid for the shares.
Had that final buyer bought the shares at the IPO and held them to extinction, his investment might have been wise, or not. But if holding forever were his intention, he could have invested in XYZ privately — no need for all that zero-sum buying and selling in a stock market. His investment’s success would be measured as above: total future dividends reduced to present value and compared to his investment. That’s an uncertain calculation before the fact, but perfectly straightforward after the fact. If he “makes money”, it’s because his capital was put to good use by XYZ Corp., not because of any wealth-generating property of the stock market.
That a lively stock market provides liquidity to investors is certainly true. That this liquidity makes it easier for investors to provide capital to industry is not in doubt. But within the stock market itself, all that happens is a zero-sum game.
That’s my simple-minded picture, anyway.
–TP
Isn’t part of the problem of the last decade that Wall St. went all communist on us
No, the problem is that it went all capitalist on us. The problem with communism is communism, that problem with capitalism is capitalists.
I mean my understanding is that at a information theory level markets are better than central planning
There’s a difference between “markets” and “free markets”. Communism is a market. Free markets don’t exist. The great victory that libertarians have won in the culture wars is that all markets, in your everyday average normal argument, are assumed to be free, when in reality, there are zero instances of a free market.
Well then I’d like a refund, because that means it has failed to work as advertised.
Sort of. I wasn’t going for any particular implications, but I don’t disagree with any of your observations either. I just find it slightly bogglesome that economics as a discipline has managed to remain focused on the mercantile model for so long. It’s been 60 years since Claude Shannon, 40 years since Ilya Prigogine, almost 30 since Robert Axelrod… What’s it going to take to trigger a paradigm shift in economic theory? When do economists plan to enter the late twentieth century? Imagine if Planck and Einstein had done their bits on time, but the hot topic in physics in the 1980s was still Newtonian mechanics.
That said, there are plenty of implications. The big one being that whenever we talk about “markets” we are quite literally (and without apology to Gary Farber 😉 discussing massively parallel computers using meat-based CPUs to calculate the answer to a very difficult nondeterministic polynomial problem: “how much of each resource should be used in order to maximize aggregate efficiency?”
An implication related to your GDP/money supply comment is that any market which identifies an exponential tendancy without damping it — whether that process is resource depletion or population overshoot or any other cumulative externality — is a market that has already “failed” in the traditional economic sense of market failure (even if it doesn’t collapse altogether).
Also, there’s the implication that TLT in ABQ’s question raises…
In theory it’s pretty different even if the outcome seems alarmingly familiar. Investment banking (finance generally) is coupled to the rest of the economy via the value of currency, while central planning isn’t.
In info theory terms the “natural” purpose of purely financial transactions is to provide “short-cuts” to conclusions that the marketplace as a whole (the “productive” economy so to speak) would take much longer to reach, and possibly have to keep confirming over and over, the slow, painful, one-transaction-at-a-time way.
This isn’t necessarily a good or a bad thing, any more than it’s bad to flinch instinctively when you see something coming at you out of the corner of your eye. Ninety times out of a hundred it’s not a big deal either way. A few times it saves you from bruises or a concussion. Once or twice it may save your life.
Then there’s the time when it’s just a nerf ball, but you still crack open your skull on the cabinet that you forgot you were standing in front of, and start bleeding all over the kitchen floor. Then it’s bad. And the more “efficient” you are (i.e. the faster your reflexes) the more likely you are to overreact.
Whereas proper central planning is more like Parkinson’s disease, or a constant series of muscle spasms… You may well be able to function, but efficiency isn’t really an option.
@now_what 12:38am
IMHO you are misreading the point I was making in that 11:38pm by removing the qualifiers which contain most of the semantic content of the argument and focusing almost entirely on that last piece of snark about Wall St. and communism that I threw in for entertainment value. Let me try again.
It seems to me that the failure to correctly price asset backed securities and the resulting misallocation of resources which took place on Wall St. during the asset bubble represents a conspicuous market failure – in other words a much stronger than usual deviation from theoretical free market behavior. The market is never a perfect free market but in this case the degree to which it acted differently from how a free market would have behaved was much greater than usual.
Why did this happen? I’m suggesting that it is because the price discovery process which is one of the functions of a market failed because the information needed to correctly price those securities was concealed from or ignored by the market into which they were sold, instead pricing was established largely by fiat, by a relatively small number of actors. For example a key role was played by the rating agencies and the monoline insurers who together presented mortgage backed securities as AAA grade paper when in fact they were nothing of the sort.
I’m suggesting that between them the rating agencies, monolines and major investment banks effectively established pricing on these securities on a technocratic basis rather than letting a functioning market set the price, in a manner analogous to the way that central planners set prices in a planned economy. This is what can happen in a capitalist economy when there is too much centralization (a consequence of the wave of mergers and acquisitions which preceded this crisis) of firms who play a key role in the way our markets operate. Rather than acting as a clearing house for information, the banks and their partners acted as an information sink.
It seems to me that this line of thinking is worth pursuing because it provides an additional argument against letting very large financial firms exist (because of the potential for information capture), above and beyond the moral hazard problem which comes from them being “too big to fail” and thus capable of blackmailing the rest of us into bailing them out.
Well, props to Sebastian for consistency. But, to answer his proposal for a world with no native U.S. car production, here is my syllogism:
In the very near future, the U.S. trade imbalance is going to zero, whether we like it or not. (I’m going with Roubini on this).
To do this, we must make all our own shit and preferably export some extra.
The three things most people everywhere want to buy are food, energy, and transport.
Therefore, the U.S. better have the capability to produce food, energy, and transport.
You may choose to believe that we can trade pieces of paper to other nations for goods indefinitely, but I strongly disagree.
If he “makes money”, it’s because his capital was put to good use by XYZ Corp., not because of any wealth-generating property of the stock market.
Therein lies the rub, at least for me. Well, maybe. I would suggest that the stock market facilitates the investment of capital, allowing XYZ Corp. to put it to good use, thereby generating wealth. Whether that constitues a “wealth-generating property of the stock market” or not, I’m not sure. But I’m also not sure it matters and that any argument over it wouldn’t be an argument strickly about how to describe something and not really about what that something actually is or what it actually does.
TJ, you are misunderstanding the implications of “trade imbalance is going to zero” even if it is in fact in our immediate future.
“To do this, we must make all our own shit and preferably export some extra.”
The second half of this doesn’t make sense on your own terms. If it is true that globalization forces are going to push all general trade imbalances to zero, we won’t be exporting something extra.
The first half, misunderstands what trade imbalance at or near zero means. It means that the value we trade OUT will be at or near the value we trade IN. Interpreting that as a need to trade nothing IN so that we don’t have to trade anything OUT, is to completely pervert what Roubini says about trade.
Do you have trouble buying TVs? Have you noticed a huge markup on that cathode ray tube television lately? Or do you notice that what actually happened was that we shifted to a better technology AND the prices went down for comparable TVs? Those aren’t made in the US. That isn’t a bad thing. When the last major US TV manufacturer went down, what horrible thing happened to our economy?
The horrible thing is for smart and able workers to be working in a bad company that doesn’t make good things when those smart and able workers could be working for a good company that makes good things.
A good government will help transition those workers from the bad company to a good one by letting the bad company go under without letting the workers go into free fall.
A bad government will keep pumping the bad company and many of the workers will never get to a good company.
I’m fairly confident that GM is an example of the second case.
Tony,
On a cash basis you’re right. If you buy $10K of stock in an IPO you have $10K less, the company has $10K more. if I buy them from you for $12K I am down $12K, you are up $2K (which, BTW, is no more edible than a stock certificate), and the company is still up $10K. Adds to zero.
And you are also right that the wealth comes from the underlying business activity. But you can’t divorce the two. The market makes cash available to businesses. As hsh says, If it weren’t there the business couldn’t generate the wealth. So surely that means the stock market generates wealth, since in its absence the wealth wouldn’t be there.
In fact, you could make the same argument about a bank. It only generates wealth because the borrowers make enough money to pay back the loans. The argument applies broadly to all sorts of financial organizations. Yet without them we would be vastly poorer.
Even restricting ourselves to the stock market, there are other ways in which it generates wealth. By letting me diversify my investments it lets me improve the returns I get for a given amount of risk. I can make a number of small investments with very low transaction costs.
If I show up in Redmond with $2000 to invest in Microsoft I won’t get very far. But I can buy 100 shares quickly and easily in the market, and can spread my money around among lots of companies I couldn’t invest in directly, at least not without a lot of trouble.
I may have misunderstood your point. It’s clear that what you are describing amounts an accounting identity that is correct by definition. If that’s all you intended you probably didn’t need this response. But if you claim that the market and the financial system in general do not generate wealth then I do think you are mistaken.
You may or may not be arguing over a semantic point.
Tony, do you believe that the stock market facilitates the creation of wealth which otherwise would not happen but are reluctant to label that as DIRECT wealth creation?
In other words are you objecting to the framing of the stock market as creating wealth because you believe it is important to distinguish the direct wealth creation of companies that are making things and directly providing services from the indirect wealth creation which is done by facilitating the direct wealth creation?
I sort of think that is an important distinction to keep in mind because one would suspect that if the indirect wealth creation sector of the economy gets too big compared to the direct wealth creation sector, that things could be problematic–this is in fact the conservative critique of quite a bit of government spending.
But on the other hand, it is really difficult to firmly classify ‘primary’ producers from ‘facilitators’. What is FedEX for example? What is an electric company? What about an IT support company? Is a copier manufacturer a primary producer, or secondary since really a copier is all about making everyone else’s jobs easier?
Emphatic, wholehearted endorsement of TLT’s view of How The Bad Thing Happened and What We Might Want To Learn From It.
P.S. I had completely forgotten about the earlier mark-to-market conversation. Funny how Paulson didn’t do what he said he was going to do, so we’ll never know what would have happened if he had, but we are still being told that we need to throw yet more money at the problem, and as a result the Fed is printing up another $800b (let’s call it .5% of GDP) which lacks even fractional liens as a backing commodity.
@Sebastian:
Well, one thing that happened is that a bunch of people who used to make TVs in the US lost their jobs, and a bunch of people who used to do something else somewhere else started making TVs. The point being that you can’t answer questions like this without first deciding which jobs you want to export and which you want to keep.
It does no good to say that you want to let “the market” decide where to put those jobs, because “the market” in question is demonstrably non-functional. The global market in TVs does not currently fulfill the normal, primary, cost-discovery function of a marketplace. This isn’t an ideological observation — its a function of the flow of price information between a particular producer in (say) China and particular consumer in (say) the US.
That’s something that can actually be measured with a reasonable degree of accuracy if you feel like putting some effort into it, but you don’t have to bother with years of rocket-science research unless you care about the details. To the extent that the value of the yuan is artificially coupled to the value of the dollar the “bandwidth” for cost discovery between the two economies is reduced. Period.
Just ask Claude Shannon. It’s Very Hard Rocket Science to calculate the actual numbers (which is why it generally works better to have the market do it), but the nature of the relationship between currency coupling and the propagation of cost discovery is a stone cold mathematical certainty.
“Well, one thing that happened is that a bunch of people who used to make TVs in the US lost their jobs, and a bunch of people who used to do something else somewhere else started making TVs. The point being that you can’t answer questions like this without first deciding which jobs you want to export and which you want to keep.”
Did those TV making people cease working? The unemployment rate of the US in the 1990s (the time in question) suggests, ‘no’. They went on to work in other companies.
Furthermore Toshiba, Mistubishi and Sony are all very mechanized companies with most their production in Japan itself (so cheap labor isn’t the big deal, and especially wasn’t at the time.)
Why do you have to decide the winners and losers at the government level? You could instead decide that when businesses go under because they can’t compete that we have systems that will help them find other jobs.
“The global market in TVs does not currently fulfill the normal, primary, cost-discovery function of a marketplace. This isn’t an ideological observation — its a function of the flow of price information between a particular producer in (say) China and particular consumer in (say) the US.”
What in the world are you talking about? The TV market doesn’t work well? What doesn’t work about it? TVs are getting both better and cheaper for consumers as a function of competition among TV manufacturers. There is no monopoly among TV manufacturers. Having TVs made in Japan (Sony manufacturing is 50% in Japan and only 10% in China, so labor costs are not the major driving factor anyway)
Did those TV making people cease working? The unemployment rate of the US in the 1990s (the time in question) suggests, ‘no’. They went on to work in other companies.
Did they?
Doing what?
What do they earn in their new jobs?
Thanks –
Not so much other companies as other industries. Other sectors.
This is the post hoc view of markets which I find puzzling and have taken to describing as mercantilist. Is an observation that TVs are getting “better and cheaper” enough to prove that there’s a functioning market? Whose observation is sufficient? How many? Why wouldn’t somebody else’s observation that tractors kept getting “better and cheaper” in the Soviet Union prove the utility of Ten Year Plans? Heck, why would I ever bother to calibrate an instrument before using it?
Lemme put it this way. Building better and cheaper TVs means building worse and more expensive [something else], right? If you decide ahead of time that TVs are more important than [something else] then you’re doing central planning. If a population of agents makes that decision individually then those agents must be able to compare the costs of TVs from different sources in order for the market to work its magic.
Okay, now the TV manufacturers are using a different currency than the purchasers. The buyer and seller are no longer using the same unit of account, so the “price signals” between consumers and producers must pass through the “lens” of the exchange rate. Tariffs, pegs, reserves, politics… All the stuff in Paul Krugan’s lovely New Trade model comes into play, and more besides.
At this point, even if distortion through the “lens” were constant (which it isn’t), agents can no longer compare the local cost of a transaction which crosses the boundary to the local cost of transaction that doesn’t. People at the endpoints have no realistic way of knowing what impact the exchange rate is having on the local price of a particular resource.
The mercantilist argument is that this doesn’t matter because (or as long as) the exchange rate itself is governed by a currency market at the boundary between the two economies. In my view this does not help. It simply confirms that “exchange rate” signals which have nothing to do with resource allocation at the endpoints can degrade, alter, or even drown out any “local utility” signal between endpoints, without either producer or consumer being able to tell what happened. It also means that controlling an exchange rate can be as “valuable” as controlling the issuance of currency. And we all know what happens when humans control the issuance of currency.
What you really have here is not one, but three distinct markets (consumer, producer, currency). The local price at one endpoint of a transaction chain may have little to do with the local price at the other end. There is no unit of account in which both prices can be measured. There is no single “market” in the technical sense.
There are various ways around this problem, but none of them apply to TVs sold in the US.
Oops. Addendum for technical consistency:
If a population of agents makes that decision individually then those agents must be able to compare the costs of TVs and [something elses] from different sources in order for the market to work its magic.
//Sebastian: “When the last major U.S. TV manufacturer went down, what horrible thing happened to our economy?”//
I think the larger point is that we are fast becoming a country that makes nothing.
My inner Paul Krugman tells me that is not a good thing.
Our economy is built on information technology, entertainment, the service industry and financials. All have their place, but I think there is something to be said for making tangible things.
What horrible thing could happen?
We have just witnessed the financials run amok, drive our economy into recession and have our leaders throwing money around in the hope of staving off Great Depression II.
//TJ: “You may choose to believe that we can trade pieces of paper to other nations for goods indefinitely, but I strongly disagree.”//
TJ’s point made me think of what CNN’s David Gergen was saying last night, that China is propping up our banking system — a predicament that could undermine Hillary Clinton and her team at State.
Never easy to put your banker in place.
—
//Sebastian: “A good government will help transition those workers from the bad company to a good one by letting the bad company go under without letting the workers go into free fall.”//
GM workers can rest much easier this Thanksgiving. Alas, they work for a bad company but will be saved by a good government.
Bernard and hairshirt,
You’re both right that I am saying something obvious (stating an accounting identity) when I call the stock market a zero-sum game. And you’re right that the stock market serves the useful (even essential) function of optimally allocating money to industry so that industry can generate wealth. So where do we disagree, if at all? Perhaps only in emphasis.
Lots of people make lots of money “in the stock market”. I’m thinking of hedge fund managers and investment bankers and financial advisors, not just the people who scurry around the floor of the NYSE. People should make lots of money for providing a valuable service, and “creating wealth” is certainly a valuable service. The more we emphasize the idea that the stock market creates wealth, the more justified those people’s gains seem — and the more palatable government intervention to preserve those gains appears.
But if we put any emphasis at all on the accounting identity, then those gains are part of the zero-sum calculation. If those gains were smaller, somebody else’s gains would be bigger. The stock market does not only allocate capital to industry, it also allocates the wealth generated by industry among the market’s participants. Some of them win, some of them lose. The losers, as well as the winners, play a role in the “wealth creation” aspect of the stock market. They play a slightly different role in the “zero-sum” aspect. Their losses, within the stock market, mostly just add to the gains of the winners.
So, to summarize: “the stock market” funds “wealth creation” outside of itself and distributes wealth in “zero-sum” fashion within itself. Not a profound observation, but worth airing once in a while.
You’ve probably heard the old saying that the optimist feels we live in the best of all possible worlds, and the pessimist fears this may be true. I say this as a pessimist: maybe there’s no better way to maximize the output of “industry” than to let “the stock market” allocate much of the gain to its own big players. The “financial services industry” is, after all, industry too 🙂
Happy Thanksgiving all,
–TP
One problem I have with Sebastian’s anti-GM stance is his argument is too broad and inflexible, the last speaking for itself.
As for being too broad, what are these “systems” we have in place that will find jobs for the displaced workers and where is this “good government” that will transition them into these new jobs?
And where are these new jobs?
I don’t have an opinion one way or the other about GM except that if they get anything there should be lots and lots of strings.
I wish to speak up for the notion that it is important to have low skill jobs that pay a living wage. The manufacturing sector used to supply such jobs.
Why is it important? Well first human decency. It is immoral, in my opinion, to regard fellow citizens as disposable or superfilous. If a person is willing to do a job well then they should be able to make a living. Not everybody has the kind of brain or talents that get rewarded by a technological/financial economy; that doesn’t make those people worthless and it doesn’t make their time or their effort at a job worthless.
Secondly, pragmatics: if those uneducated people go off and work at a living wage they will have money to spend and taxes to pay which makes them contributors to the rest of the economy. If they make a bare subsistance or no income at all, then they have no choice but to be a burden and might become criminal as well.
So there is a virtue in being the kind of country where people earn a living by making things, provided they get a union wage for it.
“Not so much other companies as other industries. Other sectors.”
Yes productive sectors. Is this a problem?
There are limited resources in the world. If you prop up a nonproductive industry you are by necessity taking labor and capital away from productive industry.
“Did they?
Doing what?”
Is this honestly a question or are you just being silly? They clearly did, the unemployment rate has been astonishingly low by 1st world standards for decades.
“What do they earn in their new jobs?”
We know that on average they weren’t doing much/any worse because depending on what standard you use the pay rates have been no worse than flat over the time in question.
You know all this. Why are you asking questions that don’t even help you?
–Thanks
Radish, I have no idea what you think your point is.
First I’m pretty sure you are using the term mercantilist to mean something other than what it actually means. And the way you are using it doesn’t make sense to me.
“Lemme put it this way. Building better and cheaper TVs means building worse and more expensive [something else], right?”
No. That is completely wrong. It looks like a lot of your economic confusion flows from this. More efficiency in one area doesn’t magically create less efficiency in another area. Building better TVs doesn’t cause cars in Detroit to be built like garbage.
It does mean that relative to other expenditures it is easier to make TVs than it used to be.
“If you decide ahead of time that TVs are more important than [something else] then you’re doing central planning. If a population of agents makes that decision individually then those agents must be able to compare the costs of TVs from different sources in order for the market to work its magic.”
I’m not sure this quote makes economic sense at all. Individuals are comparing the costs of TVs *to everything else they might potentially buy*.
Pretty much, no.
Americans typically buy things in dollars.
Between two 1st world economies it is definitely true that it doesn’t matter. So at the case in hand yen to dollars is irrelevant. Between a 1st and 3rd world economy there can be a distortion, but it can’t last long. But at the case in hand, Japan to US, you aren’t making any sense.
Ok, that is your view. And I think you are misusing mercantilist again. But it certainly isn’t a view of any major economist I know of. And it doesn’t seem well supported by the facts. And further the exchange rate between yen and dollars is not controlled by anyone. So your whole ‘control’ thing sounds like a conspiracy theory more than an economic analysis.
“What you really have here is not one, but three distinct markets (consumer, producer, currency). The local price at one endpoint of a transaction chain may have little to do with the local price at the other end. There is no unit of account in which both prices can be measured. There is no single “market” in the technical sense. ”
You use ‘may’ to do a lot of work. For TVs and yen and dollars I see no reason whatsoever to think your supposition is correct. Yen and dollars exchange quite freely. Yen denominated purchases of raw materials compete with dollars on a regular basis and vis versa. TVs purchased in dollars compete with everything else a consumer might purchase using dollars. That is pretty much a single market in a very classic sense. There are exceptions to how general market forces work, but you haven’t given any reason to think that this is one of them.
What precisely is the problem that you believe American consumers have in understanding price differences between TVs, and computers, and bedding, and silverware, and lamps, and books, and washers, and automobiles, and cleaning services? You seem to assert by saying the word ‘yen’ at some point in the process, everything necessarily breaks down. Why do you make that assertion and where do you get that idea?
More efficiency in one area doesn’t magically create less efficiency in another area. Building better TVs doesn’t cause cars in Detroit to be built like garbage.
Well, what does “cause cars in Detroit to be built like garbage”?
I mean, I don’t know if it’s true today, but it certainly was true back when Detroit built the 1978 Plymouth Volare I used to own. Of course, it’s not like 1978 Datsuns or VWs were automotive gems, either, but let that pass. Assume that cars in general got better in the last 30 years, but foreign-branded (not necessarily foreign-made) cars got more better. Why do we think that happened?
Could it be that Detroit was unwilling to pay for enough product and manufacturing engineers? Maybe because American engineers could make more money in other, more “efficient” industries?
–TP
“I think the larger point is that we are fast becoming a country that makes nothing.
My inner Paul Krugman tells me that is not a good thing.”
But that is false. We make plenty of lots of things. And Krugman doesn’t buy into the idea that it is bad for one country to make things that aren’t made here. So don’t drag him into the argument as if he is on your side.
“GM workers can rest much easier this Thanksgiving. Alas, they work for a bad company but will be saved by a good government.”
I honestly don’t know what to say to this type of thing. If you are going to invoke bad government, why is the government controlled bailout good? They do in fact work for a bad company. That is pretty much indisputable by anyone of good faith. Whether or not the government can help them is yet to be determined.
Tony, I think we may have very different views of the world. A question like “Well, what does “cause cars in Detroit to be built like garbage” seems completely wrong to me. I don’t think excellence is the natural state of things. Lots of businesses are poorly run and make crappy things. They often survive because they can politicians to lock out their competition or to help them out.
Detroit car companies seem to feel entitled to their position. They don’t feel they have to be excellent to succeed. They just need to have enough politicians in their pockets.
It would appear that you’re living on a planet where resources are not constrained. Where I live, resources devoted to the construction of more and better TVs are not magically also available to build more and better cars. What we try to do over here is devote more resources to areas that people happen to care more about, and reduce resources devoted to areas that people care less about, though of course that’s not the same as not reducing resources anywhere. The need to make difficult and moral-hazard-prone multivariate decisions about where to allocate scarce resources is why we have these things called markets.
Yes. That’s why I thought I should clarify that that’s what I meant.
Yes. Which means that when Americans buy something that was manufactured in Japan, or China, or anywhere else, the manufacturer was very likely paid in some other currency. Which in turn means that some distinct intermediate transaction took place in which yen were exchanged for dollars, or vice versa. Which means that the exchange rate between yen and dollars is one of the factors regulating the ability of a consumer in the US to convey their resource allocation preferences to a producer in Japan.
So I’ve heard. As a proponent of that view, perhaps you would be so kind as to explain how I would go about measuring the intensity and duration of such a distortion?
There’s no doubt at all that this disproves it conclusively.
I am now wondering why I went to the trouble of explaining that the exchange rate is typically “controlled” by a currency market, when you don’t seem to have read that part.
Yes. But only in the aforementioned currency market. That market has a profound influence on the dollar-price of your television, and many other things. And yet, you have no idea what your TV might cost in yen, nor any easy way to find out, nor any easy way to buy it using yen instead of dollars, nor any way to get paid in yen. If these currencies are so easy to exchange why can’t you do any of those things? Possibly because it’s so much “cheaper” to think in local currency and let somebody else do the calculations that it didn’t even occur to you? You don’t find this puzzling or counterintuitive, and do not believe that it supports a multiple markets hypothesis. I do, and believe that it does.
I make that assertion because I regard money as a signal rather than a resource, and know a tiny little bit about signals generally. If I ask you to tell someone that I am going to Papeete, and you tell them that I am going to French Polynesia, that signal has been degraded. By the same token, if I tell the market that I think a particular TV is worth $100 and the market tells the producer that the TV was worth ¥10k, then that signal has been degraded.
Money as a signal is not actually a controversial opinion, it’s just not expressed very often. But I’ve found that you don’t have to press an economist too hard before they allow that yes, money is information, and who cares. What’s unusual about my views is mostly that I happened to have already been acquainted with signaling and dissipative structures and whatnot before I started taking an interest in economics. So I take the info theory aspect a bit more seriously.
To you, this position is (apparently) too sparse and poorly explained. To me, unilateral decisions of the form “the market is working because TVs are better and cheaper” are tautological and represent a denial of path dependence, among other problems. How would you know if these better and cheaper TVs represented a “misallocation” of resources? Or is that simply not possible?
“It would appear that you’re living on a planet where resources are not constrained. Where I live, resources devoted to the construction of more and better TVs are not magically also available to build more and better cars.”
You are having a serious problem with the difference between ‘efficiency’ and ‘resource’. Efficiency is about reducing the amount of resources required to do a task or create a product. You absolutely can increase efficiency in one area without having any effect on efficiency in another area.
“Where I live, resources devoted to the construction of more and better TVs are not magically also available to build more and better cars. What we try to do over here is devote more resources to areas that people happen to care more about, and reduce resources devoted to areas that people care less about, though of course that’s not the same as not reducing resources anywhere.”
Yes and that is what prices help allocate. RESOURCES that are scarcer get higher prices.
“Yes. Which means that when Americans buy something that was manufactured in Japan, or China, or anywhere else, the manufacturer was very likely paid in some other currency. Which in turn means that some distinct intermediate transaction took place in which yen were exchanged for dollars, or vice versa. Which means that the exchange rate between yen and dollars is one of the factors regulating the ability of a consumer in the US to convey their resource allocation preferences to a producer in Japan.”
Correct. And you claim that systemically this is some sort of enormous problem. But you support that claim like a creationist: I’ve said something is a general problem therefore it is a general problem. You’ve done nothing to show that it *is* a general problem in the modern economy.
” But it certainly isn’t a view of any major economist I know of.
There’s no doubt at all that this disproves it conclusively.”
No but it puts the onus on YOU to provide at least some small amount of evidence for your view. Something other than “I’ve seen bad things in the world therefore my explanation must have merit”.
In a purely in-country, dollar denominated market, how many TVs does a bed cost? How many batteries does a fan cost? How many shirts does a book cost? How many pens does a knife cost? How many cardboard boxes does a couch cost? How much corn does a house cost? How much wheat does a car cost? How many cars does a skyscraper cost?
That is EXACTLY the question that prices answer.
Now how many yen does a dollar cost?
It is exactly the same question.
“I make that assertion because I regard money as a signal rather than a resource, and know a tiny little bit about signals generally.”
This isn’t the source of our confusion. Of course money is a signal, does anyone who knows anything at all about economics think otherwise? Our problem is that you think efficiency CONSUMES resources. Which is just weird.
“By the same token, if I tell the market that I think a particular TV is worth $100 and the market tells the producer that the TV was worth ¥10k, then that signal has been degraded.”
But no more so than the fact that TVs aren’t denominated in wheat either if you buy both electronics and food. That is what you don’t seem to understand because you seem to accept price signals for food and electronics but not yen.
There are thousands of steps between the in-country, dollar-denominated price of wheat and the in-country, dollar-denominate price of a GM car. Yet on average the price alone is an excellent signal about the overall consumption of resources in the two products. Both are distorted by the US government policies on the margin, but the price is still a very good indicator. For some reason, among those thousands of steps, you object to the currency step. So either you don’t accept prices as a good signaling method (to which my response is that we shouldn’t be abandoning it until you provide a demonstrably better one) or you are being oddly focused on one of the signal steps without understanding its incredibly small place compared to the other ones.
“To you, this position is (apparently) too sparse and poorly explained. To me, unilateral decisions of the form “the market is working because TVs are better and cheaper” are tautological and represent a denial of path dependence, among other problems.”
Speaking of degraded signals, you’ve overgeneralized. You are mixing up the price allocation part of the market with the competition driving innovation and efficiency driving part of the market. Even if your critique of price signals were accurate, you haven’t even touched the innovation/efficiency side. My statement was that cheaper prices show that the innovation/efficiency side of the market worked for TVs. This is definitely true unless you think the material inputs for TVs have gone down. Commodity price differences from 1980 to 2000 don’t explain the price and quality differences at all, so I would be surprised if you took that route.
“How would you know if these better and cheaper TVs represented a “misallocation” of resources?”
The real question if you don’t believe in prices is “How would YOU know?” Do you just intuitively feel it?
//”I wish to speak up for the notion that it is important to have low skill jobs that pay a living wage. The manufacturing sector used to supply such jobs.”//
Sebastian, I would like you to address wonkie’s point.
Without the manufacturing jobs she describes, I think the gap between the haves and have-nots will continue to widen. The middle class will continue to disappear.
Folks working on a Wal-Mart salary are going to have a hard time saving for that down payment that is now required for a car or home.
To wonkie’s point, my late father was an ironworker worker all his life when it was still a thriving industry. He built bridges and buildings all over the East Coast, New York, Philadelphia, Baltimore. He worked his way up to foreman and, when we became closer late in his life — not a smoker, cancer killed him at 56 — I am so glad he took me to some of his job sites, particularly NYC. I had no idea how respected and revered he was by his men. He never gloated, but Dad knew how to read blueprints better than the young hotshots out of college he trained; I sold one of them a Trailblazer a few years ago, and he was in awe of how self-taught his teacher was.
My Dad gave us entry to the middle class, allowed me to be the first in my family to go to college. (I so wish he was here today to mentor my son, who shares his engineering brain.)
There are untold thousands upon thousands of middle-class kids whose fathers — and mothers — built things, allowed them to go to college and make a better life. For this to continue, I’d rather rely on good manufacturing jobs than those “systems” that you say government will use to transition these workers.
Transition them into what?
P.S. You are right. I confused my economists, and should have invoked Robert Reich, who I quoted rather liberally in the “Something Better Than Nothing” thread. I will gladly join his side in this argument.
I’m kind of confused about what radish is trying to say about currencies. It is actually beneficial that currencies are a different information source as it provides another dimension to stabilize trade. The problem is that China/Japan and the US have a relationship where the governments “artificially” control currency valuation through treasury bond buying and selling. Of course the Chinese are trying to directly peg, but our government is guilty for having policies that encourage decreases in manufacturing for export and increases in imports. That has way more of an effect on trade than whether our government gives domestic industry money.
For my two cents, I think it’s obvious that specialization and trade increases efficiency (meaning cheaper and better products) but I’ll play devil’s advocate and claim that too much efficiency is actually a bad thing. From a systems theory standpoint, it leads to the overall system becoming too sensitive to external changes. There has been a lot of good commentary about how the financial system has been a victim of this, but even the real economy has seen it.
For example, a lot of developing countries specialized their crops (or stopped growing as much food and went to other industries) based on growing efficiency and it increased export value more than they had to pay for the increased importing of other food. Unfortunately, when there was the system shock of spiraling oil prices, entire nations almost collapsed because they were stuck with a bunch of specialized supply. Fortunately for them that was a blow off top as a result of debt but there is a good chance that transport is going to get much more expensive over the next 20-30 years. Likewise, the energy producing countries are facing collapse now because they relied too much on a single source of income.
So the primary concern about being overspecialized is that if trade is disrupted for whatever reason (war, politics, energy shortfalls) then you can be hung out to dry very quickly. It is more robust to accept a bit of inefficient production that can meet baseline needs. In fact, I’d go so far as to say that the US is in the best overall shape based on our mix of natural resources, industry and demographics/land usage. If we had more high tech manufacturing I’d say we could just default on most of our debt and see relatively little damage compared to the rest of the world. I’m not saying we should, I’m just saying that it is a mistake to assume geopolitics will always be favorable.
One last time. My argument is that if “market” is defined in a strict technical sense rather than an anecdotal or post hoc sense, then the currency step takes place in a different market. The yen which you (indirectly) purchased in order to buy your Japanese-made TV were “priced” in a market, but it was not the same market as the one in which you purchased the TV. This produces the effect of a lens, or diffraction boundary. I cannot explain it any more clearly than that in under 2000 words.
WTF? I lay out a set of views about the relationship between price discovery and resource allocation from scratch and you wonder whether I “believe” in prices?
When I point out that some particular products being produced more efficiently does not allow you to infer the existence of a functional market — because that is incompatible with a rigorous definition of “market” — your response is to accuse me of being some sort of economic creationist?
Your replies have been mostly a stream of unwarranted condescension and straw men. If you’d bothered to read without that chip on your shoulder you might have realized that what I’m saying is unusual but not particularly controversial, and that it derives quite cleanly from the premise that “money is a signal.”
All the same though, Happy Thanksgiving…
That’s what I get for trying to respond to a critique of some other argument that I didn’t make. I’m not making any grand radical statements, honest. All I’m really saying is that there are many external factors distorting the prices of products or services that are sold internationally, and since none of us have any idea how significant that distortion is, let’s not blindly assume that it’s trivial.
It seems like a pretty unexceptional thing to say, somewhere along the lines of “hey, look, the pope is wearing a funny hat.”
That’s an interesting proposition. I wish I weren’t half asleep, so I could think about it 🙂
Why do you assume it is a ‘different’ allocation market?
Actually that may not have been clear enough. You assume that the currency step was priced in a ‘different’ market. But you don’t seem to have a serious problem with wheat being in a different allocation market from cars. They clearly are, and they may very well be more separate than cars in the US vs. cars in Japan. Why are wheat purchases in Iowa balancing against Broadway tickets in New York OK with you just because they are all in dollars, but TVs in Japan vs. TVs in the US aren’t because they have to cross a currency?
So again, what makes the currency step so amazingly different from all the other steps?
“If you’d bothered to read without that chip on your shoulder you might have realized that what I’m saying is unusual but not particularly controversial, and that it derives quite cleanly from the premise that “money is a signal.” ”
No, it is pretty controversial. And the problem is that you don’t seem to be understanding that the signal degradation you are worrying about takes place every single time there is a non-barter step. Yet strangely prices do an amazingly good job of juggling all that. You want to focus on one particular part of the juggle, but have offered no reason why that piece is so much more suspect than all the other pieces. And you seem to ignore the fact that the potential for trouble in that area has gone down over time not up, as countries have lost control of currency pegs and the like. And Japan especially hasn’t been able to control it in the past decade which ought to give you at least some pause in applying your conjecture to the real world case that we were discussing of why US automakers can’t compete against Japan.
Sebastian this isn’t nearly as difficult as you’re making it out to be. If you have a dollar, and you wish to compare pineapples from Honolulu with opera tickets from Chicago, you can very easily compare the value — to you — of these two very dissimilar items. This is why economic systems can converge on a single nominal unit of account even before they converge on a single medium of exchange.
If, OTOH, you wish to compare a Sony Model 10 TV in Tokyo with a Sony Model 10-USA TV in Honolulu, you have to go to the extra trouble of deciding whether the exchange rate is favorable, even if you are comparing two almost-identical items. The problem is compounded when you compare dissimilar items, and it does not go away simply because you pay — or trust — some other agent — principal or otherwise — to compare items for you. In fact, if you trust an agent (Sony Electronics for example) who has preferences which are at odds with yours the problem gets worse!
Okay, fine, again.
When you buy (or sell) wheat or tickets or pineapples you are trading money for stuff (or labor, but let’s not go there). When you buy yen, you are trading one kind of money for another kind. You make that sound like that’s such a trivial thing that anyone can do it anytime they want. But if anyone can do it anytime they want then why does my employer refuse to pay me in euros even though I would prefer euros, and euros, not dollars, are my employer’s reserve currency? Why can’t I buy a TV uing yen? Why don’t people just accept other countries’ currencies?
Assuming that you accept that money is a signal, the two types of transactions (money:stuff vs money:money) are mathematically distinct. Why is it inconceivable that they might also be qualitatively different in practice? Why must both types take place in a single market with a single population of agents?
Maybe, maybe not. When was the last time someone you know personally traded currency other than for a trip?
This part of the argument — that going through a currency step is (still) more likely than not to introduce significant levels of noise into the channel between buyer to seller — is a lot more complicated, and debatable, and apparently totally incomprehensible to anybody who is unaccustomed to thinking of economics as an exercise in signal processing.
I’m very grateful that you’re making me refine my argument, but it seems that the argument I’m making is, from your point of view, an opaque black box labeled “how signals work.” And I (apparently) will not be able to explain it without opening the box unpacking the contents, and demonstrating their use. If this is going any further we will need to talk about it in terms of some process which you agree is purely communicative (like radio messages).
Tony P.,
Thanks for the clarification. I see what you’re getting at.
“Assuming that you accept that money is a signal, the two types of transactions (money:stuff vs money:money) are mathematically distinct. Why is it inconceivable that they might also be qualitatively different in practice?”
No. This only seems true to you because you think ‘stuff’ is a single category. It isn’t.
Money:wheat
Money:paper
Money:computers
Money:batteries
Money:paintings
Money:light bulbs
Money:ThermaCare Back Heating Pads
Money:cell phones
Money:Oil
Money:Gold
Money:Copper
Money:Tin
Money:other types of money
“Maybe, maybe not. When was the last time someone you know personally traded currency other than for a trip? ”
If you know anybody in Finance for even a medium size international corporation you know people who trade currency without going on trips. And any corporation that buys and creates stuff in Japan and sells it in the US has to do it.
Which is where the price gets folded in to the US currency system in most cases.
And unless you think that Sony is controlling the dollar:yen exchange rate, you’re going to be getting information every bit as good as you do out of fluctuating LCD crystal prices.
“If this is going any further we will need to talk about it in terms of some process which you agree is purely communicative (like radio messages). ”
We already are. We are talking about prices.
Wait. You’re disputing the value of a categorical distinction between signals and resources? You insist on rebuilding signal theory and ontology from the ground up?
Sebastian, the whole point of having a “single unit of account” is to facilitate comparisons between the utility of dissimilar kinds of “stuff” (like tickets and wheat) without having to take into account whether one can actually be traded for the other. How do you think money works exactly? If “stuff” isn’t useful as a single category, then “money” can’t be a useful category either, because paper currency is different from specie is different from contracts is different from accounting!
This is like saying that categories like “mammal” and “reptile” are irrelevant because every species of mammal and reptile has distinct characteristics.
* Dollars:tickets :: iguanas:cats
* Dollars:wheat :: iguanas:dogs
* Yen:tickets :: geckos:cats
* Yen:wheat :: geckos:dogs
* Money:wheat :: reptiles:dogs
* Money:other money :: reptiles:reptiles
* Dollars:Yen :: iguanas:geckos
The fact that “cats are not dogs” and “geckos are not iguanas” does not mean that there are no useful categorical differences between mammals and reptiles.
What I was asking was whether you know people in finance. I work at a brokerage, so we, as an institution, don’t speculate or trade internationally (though we do exchange euros for dollars in order to pay expenses). In fact we (not me personally) are working on offering a forex service. I was pretty jaded about finance already but it’s still been an eye-opener.
No. See, this is not how signals work. The “quality” of the price signal (the “every bit as good as” part) can be very low even if the dollar:yen rate is set by a market, and very high even if Sony “controls” the dollar:yen rate. The limiting factor is the degree of coupling between two variables; “US:Japan balance of trade” and “dollar:yen exchange rate.” The coupling between those variables limits — by definition — the quality of the price “signals” which can be transmitted between the US and Japanese economies. Period. Full stop.
This is much easier to understand when you talk about radio signals, but in any case it’s the current degree of coupling that defines the upper limit of signal quality at any given time. The factors influencing that coupling can vary predictably or randomly. They can be be “controlled” or “uncontrolled.” Homeostatic or exponential. It doesn’t matter.
If the two variables are kept tightly coupled — for whatever reasons — then the signal quality can (but still might not) become very high. If they are kept loosely coupled — for whatever reasons — then signal quality will be correspondingly low. In either case the limit has nothing to do with whether the coupling is controlled by a free market or the phase of the moon. It only has to do with what the level of coupling actually is at any given time. That part is not negotiable unless you want to negotiate it with the ghost of Claude Shannon.
The only thing that’s negotiable here is, as I have previously suggested, exactly how closely coupled those variables are, and by what mechanisms.
And you *speculate* that they are not well coupled, but the market in forex suggests that there is plenty of information in the 1st world country currency markets to make them work out at least as well as the wheat:television signals.
“Wait. You’re disputing the value of a categorical distinction between signals and resources?”
Again this makes no sense. You seem to believe that signals can be transmitted across dollars ABOUT wheat and televisions. But you can’t believe that signals can be transmitted across dollars about yen. I’m not denying that you CAN make a distinction. I’m denying that your distinction is usefully meaningful.
Or rather that is useful in THIS discussion about for example whether or not we can get useful information about resources and televisions created in Japan (a 1st world country with a floating exchange rate) and the US (another 1st world country with a floating exchange rate).
You have offered no evidence that there is any serious distortion in price that should make us believe that you can get significantly less pricing information across a yen/dollar market. You have also not provided any particular reason why the pricing information isn’t incorporated by SONY, which after all has to buy many things in yen and sell them in dollars.
There are only so many ways that I can explain that this is not about the quality of the “signals about yen” which are “transmitted across dollars” but about the quality of the “signals about wheat and tickets” which are “transmitted across both dollars and yen”.
I looked it up, and assuming that BIS and US Census Bureau data are about right, USD/JPY transactions run at an average of about 697:1 currency to trade (US$397320m to US$570m). That suggests that the dollar:yen signal is driven roughly .14% by actual purchases of TVs or wheat or whatever and 99.86% by all other factors, including the views of a few thousand people whose day jobs consist of placing Very Large Bets on how that .14% will shake out. To me that doesn’t sound like a marketplace that has much to do with TVs proper. YMMV of course, and you are encouraged to do your own napkin doodles.
I think at this point I will assume that you’re having some other argument with some other person altogether, and let you and them continue it uninterrupted.
” looked it up, and assuming that BIS and US Census Bureau data are about right, USD/JPY transactions run at an average of about 697:1 currency to trade (US$397320m to US$570m). That suggests that the dollar:yen signal is driven roughly .14% by actual purchases of TVs or wheat or whatever and 99.86% by all other factors”
I hope that is the source of your confusion because it is easy to fix. It suggests no such thing.
You are only counting direct yen to dollar transactions as having a large effect on the price of yen and dollars. You aren’t counting the bidding of yen and dollars on every other product that both are used to buy. A noticeable component of that for example would be steel. Steel can be purchased with yen or dollars. If the exchange rate is not reflecting supply and demand properly (if the signal is weak as you posit) than steel sellers will shun purchases in yen or dollars, whichever isn’t signaling properly.
Oil is another case. It will drive up the currency transaction numbers because most oil is sold in dollars, with some in euros, and almost none directly in yen. But if there was a lot of arbitrage to be had in the exchange rate, the Japanese (and certainly the Americans if the arbitrage went against them) would buy from someone who would take the yen directly.
Yen and dollars compete for hundreds of thousands of physical goods. That is the signal that drives a floating exchange rate up and down. Many of those goods are not shipped between the US and Japan. They are from Saudi Arabia and then sent to one of the two countries and will never show up in the trade figures you quoted.