Pure Pedantry

Economy Update

I have been a bit lax on the blogging, but here is what I have been reading on the economy.

Tyler Cowen attributes the financial bubble to three main causes:

The current financial crisis comes from a conjunction of three major trends, common to many countries and to a wide variety of financial institutions.

The first trend was a positive one: an enormous growth in wealth that needed to be moved into investments. Before he became chairman of the Federal Reserve, Ben S. Bernanke wrote of a “global savings glut,” particularly from Asia. Furthermore, over the last 20 years, many countries have modernized their financial systems and created new channels that linked savings and investment. In Spain, Iceland, Ireland and Britain, the real estate boom was without recent precedent.

Of course, more wealth is a good thing over all, but the question is whether that wealth has been invested in an effective and prudent way.

This leads us to the second trend, the greater willingness of both individuals and financial institutions to take on risk. This trend has shown up in many areas, including real estate, derivatives markets, loans to companies like the American International Group, and overpriced equities. Heavy debt, particularly in financial institutions, created a low margin of error for many of these calculations.

Greater risk-taking was driven by investor hubris and collective delusion. Banks and other financial institutions bet against the possibility of bad times and in the short run those bets paid off handsomely. But in the long run they were disastrous.

For a simple analogy, imagine betting against a sports underdog every year. You may win consistently for a while but eventually you will lose all your money when the odds turn against you. In essence, banks were betting against extreme volatility, which sooner or later does arrive.

In the United States, loose monetary policy in the previous decade encouraged this misplaced optimism, while in Europe there was giddiness from the benefits of economic integration. People pursued profits rather than prudence because their minds and emotions were geared to expect further rewards.

The third component has been weak governance and oversight. That includes inadequate control and monitoring by shareholders, regulators, creditors, accounting systems and ratings agencies, among others. Most people, including informed insiders, simply did not understand the systematic risk that financial institutions were accepting.

Keeping to the story of lax regulation, the Economist has an excellent history of regulatory changes in the world financial markets that may have contributed to the meltdown:

The idea that the markets have ever been completely unregulated is a myth: just ask any firm that has to deal with the Securities and Exchange Commission (SEC) in America or its British equivalent, the Financial Services Authority (FSA). And cheap money and Asian savings also played a starring role in the credit boom. But the intellectual tide of the past 30 years has unquestionably been in favour of the primacy of markets and against regulation. Why was that so?

Each step on the long deregulatory road seemed wise at the time and was usually the answer to some flaw in the system. The Anglo-Saxon economies may have led the way but continental Europe and Japan eventually followed (after a lot of grumbling) in their path.

They do make two important points, however. One, in many cases politicians were complicit in deregulation. This was not something inflicted on them by greedy bankers. The politicians wanted easier credit for their constituents. Two, deregulation did have many benefits. Whether those benefits outweigh the costs over the long-term is another question.

Having read the background, I can only conclude that the problem is not necessarily deregulation, but bad regulation. And this meme of regulation vs. antiregulation is self-destructive. What we need is effective but flexible regulatory agencies staffed by professional and relatively apolitical regulators. If the emphasis in this debate is about whether or not to have regulation — if it is that black and white — it won’t get to the core issue of which regulations are effective and which are not. I remain skeptical that any regulatory agency can police that world economy effectively, but I would rather this debate not rapidly devolve into ideological opinions about regulation in general. Sadly, that is exactly what I think it will do.

What’s a man to do then? Well, Warren Buffett has a suggestion. He is buying American — stocks that is. After reading his piece, the phrase regression towards the mean springs to mind. Buffett — with his mantra, “Be fearful when others are greedy, and be greedy when others are fearful.” — has been exploiting this concept successfully for decades. Sometimes the old tricks are the best tricks…

Oh, and speaking of money. This is some sad shit.