Friday, September 19, 2008

Down In The Slough

As you’ll have gathered, Tyler is up to his nethers in the Slough of Despond. True, his investments now seem to have regained a crumb of value, but the week has been a disaster for the cause of small government.

The markets have blown up. The Masters of the Universe have been revealed as not just greedy, but also highly dangerous - wild beasts who must be hunted down and dealt with.

Theoretically, markets take care of it themselves - they have their behavioural quirks, but the so-called "fundamentals" are eventually supposed to win out over reckless speculation before it gets out of hand.

Only that hasn't happened. Instead, big strong government has had to come to the rescue.

And now, just like the thirties, the message is up in lights: only big strong government stands between us and the abyss.

[Short medicinal pause while Tyler nips down to Cost Cutter to buy another litre of Albanian vodka]

The thing is, even those of us who believe in markets can see that something has gone seriously wrong. At the start of the week we thought the reeling markets would pull themselves together. After all, Lehman had been on the critical list for a while, and with its shareholders wiped out, its carcass would quickly get gobbled up by better capitalised banks. And once the central banks had pumped in some more Bagehotian liquidity, everything would settle back down again.

Nice idea. The trouble is, the markets were incapable of following the script.

And so we've had a week in which the US government was forced not only to take over their biggest insurer, but to promise the nationalisation of all their banks' problem debts. And that's on top of nationalising the major mortgage providers. Even Roosevelt would have blenched at such a precipitate lurch to socialism.

And the cost? Nobody knows what the final bill for taxpayers will be, but the numbers being tossed around are scaled in trillions (ie thousands of thousands of millions).

I turned to the Prof for comfort. Unfortunately, he has none:
"There is a long-standing argument that there is no real case for private ownership of deposit-taking banking institutions, because these cannot exist safely without a deposit guarantee and/or lender of last resort facilities, that are ultimately underwritten by the taxpayer...

That argument... can now be extended to include the new, transactions-oriented, capital-markets-based forms of financial capitalism.

The risk of a sudden vanishing of both market liquidity for systemically important classes of financial assets and funding liquidity for systemically important firms may well be too serious to allow private enterprises to play. No doubt the socialisation of most financial intermediation would be costly as regards dynamism and innovation, but if the risk of instability is too great and the cost of instability too high, then that may be a cost worth paying."

And if you took a poll right now, that's what virtually everyone would say. Especially once taxpayers cotton on to how much these bailouts are going to cost over the long-term. And what does it matter that financial deregulation has made it ten times easier to own your own home if a financial collapse triggers a depression and you can't afford the repayments?

Can we blame Gordo's mate Sir Alan Greenspan and his wretched put? It's tempting, and although he and many others argue there never was a put, market participants certainly thought there was. At the height of the equity market bubble in February 2000, PIMCO ,one of America's biggest investors, told its clients:

"Here at PIMCO, there is widespread support... as to the existence of an equity bubble. Almost to a person, we believe that Mr. Greenspan should quit giving away puts on the equity market.

At the same time, we also recognize that we must configure your portfolios not for a world that we think should exist, but for the one that does exists. For example, while I may think the case for a Fed hike in margin requirements on stocks is compellingly clear, it is also clear... it simply isn’t going to happen."

And they produced this little chart to show how the put worked during the 1990s:

Of course, the PIMCO statement coincided almost exactly with the top of the equity bubble, and it was downhill from there. And what did Greenspan do? Yup, he cut interest rates.

Today's FT article by David Blake lets rip (HTP Joan W):

"Mr Greenspan bears responsibility is his role in ensuring that the era of cheap interest rates created a speculative bubble. He cannot claim he was not warned of the risks. Take two incidents from the 1990s.

The first came before he made his 1996 speech referring to “irrational exuberance”. In a Federal Open Market Committee meeting, he conceded there was an equity bubble but declined to do anything about it. He admitted that proposals for tightening the margin requirement, which people need to hold against equity positions, would be effective: “I guarantee that if you want to get rid of the bubble, whatever it is, that will do it.” It seems odd that since then, in defending the Fed’s inaction, he has claimed in three speeches that tightening margins would not have worked.

The second incident stems from spring 1998 when the head of the Commodity Futures Trading Commission expressed concern about the massive increase in over-the-counter derivatives. These have been at the heart of the counter-party risk in the crisis. Mr Greenspan suggested new regulation risked disrupting the capital markets."

And later, as the US property market inflated its own gigantic bubble, Greenspan dismissed it as a little local "froth".

There seems little doubt that Greenspan was far too complacent about the risk of asset bubbles. And that isn't hindsight, as the PIMCO quote from 2000 underlines.

But I dunno. Was he really such a bad guy?

Coming out of the roller-coaster 70s and 80s, his principal job was to keep the economy on an even keel. And in that, on most traditional tests, he succeeded spectacularly - only one year of negative growth, and only one year with inflation over 5%. Your average punter quite understandably sees him and his fine tuning Fed as a success.

Of course we sophisticates can see he made a serious mistake. But actually, the mistake was to have too much confidence in the ability of financial markets to correct themselves. The very same mistake that Tyler made earlier this week.


I'm afraid to say, we're facing much more regulation.

And much more government.

And much less willingness to trust markets.

We're in the Slough.


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