I know I’m not much of a technical blogger, but every now and then I read something that tickles my fancy as an economist. So sharing with you guys. Fepsians reading this, you’ll remember the author, we studied his book for a year 🙂
The financial gods that failed
By Paul A. Samuelson Tribune Media Services
Published: August 21, 2007
And why not? Central bankers everywhere, finally given their “independence,” were raising and lowering their official short-term interest rates to stabilize capitalism’s old-time business cycles.
“Inflation targeting” was their mantra: Price level inflation of 1 to 2 percent per year was their tolerated and targeted band.
With stabilized price levels and worldwide free trade, economics seemed no longer to be “the dismal science.” Only geopolitical terrorism, environmental conservation, sociological drug abuse and unsafe sex cluttered our worry lists.
Since July, the skies have darkened markedly. Falling house prices had earlier been rising wildly under the pressure of over-easy lending and extreme leveraged borrowing. Lovely!
But once the real estate bubble bursts and house prices plummet downward, excessive past leveraging began to generate bankruptcies and loss of homes through bank foreclosures.
In a Shakespearean play, once an armed hero arrives to save the day, the tide of battle turns. So it was when the European Central Bank announced that it was pumping hundreds of billions of euros into the credit markets to prevent a credit bust.
Shame on Ben Bernanke, chairman of the U.S. Federal Reserve, to be left behind. Still, better late than never. Rising bankruptcies and defaults mandated similar open-market infusions of billions of dollars into the credit markets by the Bank of Japan. The Bank of Canada joined in such rescue operations.
The late Milton Friedman must be rotating in his grave. He had counseled firmly: Never, never bail out foolish people who have made grave, self-harming mistakes.
And not long ago, Governor Alwyn King of the Bank of England trumpeted: “Interest rates aren’t a policy instrument to protect lenders from the consequences of their unwise decisions.”
He may rue those words if the crisis deepens.
Whatever the causes of new macro swings in Main Street fundamentals, interest rates are indeed a policy instrument – the policy instrument – to try to stabilize the Ship of State.
Andrew Mellon, multimillionaire secretary of the Treasury for President Herbert Hoover, proclaimed after the Wall Street Crash in October 1929: “Liquidate! Liquidate! Liquidate!” – words that have gone down into the records of infamy. Evidence-based policy decisions can surely do a lot better than that.
When Rome is burning, Emperor Nero must not benignly stand by fiddling, lest those careless with fire be encouraged toward future indiscretions.
First things first. Teach lessons later. Later correct the bad regulating that encouraged and permitted excessively leveraged loans.
Speaking about lessons to be learned, what is the global financial turmoil teaching us about our wonderful new hedge funds, numbering already in the thousands? Like the wheel, the alphabet and the fermentation of wine, hedge funds sprung out of the brows of us academics.
They would reduce volatility of our nest eggs and, at the same time, boost our short-term and long-term risk-corrected returns. Never mind that their sage managers collected up to hundreds of millions of dollars in fees during good years, and in bad years still receive tens of millions of dollars. The good laborer is worthy of his hire, it says in biblical scriptures.
This is the summer of discontent for hedge fund managers so far. How come?
They employ new instruments of financial engineering – puts and calls and other such options, complicated swaps, etc.
Let’s look at the new “securitized mortgages.” No longer does a bank lend me my home mortgage money. Instead, just like good and bad cheeses, it packages debts into safe, risky and more risky packages. It sells off to almost anonymous others different packages: highest promised returns for the riskiest junk stuff; lower yields for the safest stuff. Hail this better way of calibrating riskiness and spreading it efficiently onto many different shoulders.
However, at the same time these new instruments for risk-sharing definitely encourage and tempt us to elevate our pyramid of leveraging twofold, fourfold . . . and maybe even 99-fold. My granddaughter can balance a small baseball bat on a windless day. But Hercules, Isaac Newton and Albert Einstein combined cannot balance a bat as tall as the Empire State Building. The dramatic 1998 failure of Long Term Capital Management taught us that hard lesson.
My phone rings around the clock as foreign journalists ask, what is going to happen in the coming years for America and the globe after the recent volatility indexes’ recent explosion?
My one answer is: No one can be sure. At best there is a one-third probability that (as Alan Greenspan earlier thought) there will be at least a mild recession by 2008.
Also there is a one-third probability that enough central bank infusions of cash will restore stability and restore those earlier optimistic outlooks for global growth.
That leaves still one-third probability that markets will be ricocheting up and down while inflation stays above the growth rates that central banks hanker for.
More than one reporter, receiving these Delphic wisdoms, goes on to ask: Professor Samuelson, which of those one-thirds do you like best?
My answer follows Gertrude Stein’s formula that “A rose is still a rose.”
I say one one-third is no worse than any other one-third. At your risk, take your choice.
Paul A. Samuelson, long-time professor of economics at the Massachusetts Institute of Technology, was awarded the Nobel Prize in Economics in 1970. Distributed by Tribune Media Services.