Paul Seabright on The Imaginot Line
January 17, 2011 6:26 AM Subscribe
Why we're still fighting yesterday's economic war Above all, like historians assessing the Maginot Line, we must avoid comforting ourselves with the judgment that the [financial] system's architects were naive and that therefore we might hope to do much better. Far more important is to be aware that defenses are vulnerable precisely where they are strongest and to be prepared to respond creatively and calmly when they fail, as they surely will again.
I liked David Harvey's comment on blithe ignorance of risk:posted by Abiezer at 6:57 AM on January 17, 2011 [4 favorites]
Interesting article, I like the analogy with the Maginot line. I'm not academically invested in this debate though, I just want to know why banks appear, to the average consumer, to have gotten away with a spectacular fraud of the general public. Germany was forced to pay reparations after World War II, while bankers are this year collecting record bonuses.
posted by londonmark at 7:26 AM on January 17, 2011 [4 favorites]
posted by londonmark at 7:26 AM on January 17, 2011 [4 favorites]
It seems to me that the very regulations meant to address the moral hazards were systematically weakened in the last three decades. It's not a failure of the 1930s model of economic control, it's a dismantling of it that is at fault here.
posted by Mental Wimp at 8:08 AM on January 17, 2011 [10 favorites]
posted by Mental Wimp at 8:08 AM on January 17, 2011 [10 favorites]
In other words, we tore down the dike and now we're drowning oh my god nobody could have predicted thiiiiiiiiiiiis
posted by Pope Guilty at 8:20 AM on January 17, 2011 [6 favorites]
posted by Pope Guilty at 8:20 AM on January 17, 2011 [6 favorites]
Wow, what happened here? I mean, we really need to assess this situation and figure out what happened. Who could have possibly known that money + concentration of power = disaster? This is an entirely new situation that we haven't been aware of for the past 1,000 fucking years.
The only way to fix this going forward is to spread the power around. Either we break things up, or we'll get hammered again.
posted by Benny Andajetz at 9:11 AM on January 17, 2011
The only way to fix this going forward is to spread the power around. Either we break things up, or we'll get hammered again.
posted by Benny Andajetz at 9:11 AM on January 17, 2011
gary gorton gets a mention, but i think he's worth reading more fully cuz it helps to understand new institutional evolution.
also btw...
-New Rules for the Global Economy
-Back to the Sixties
-Capitalism at a Crossroads
-Algorithmic trading and market-structure tail risks
posted by kliuless at 9:16 AM on January 17, 2011 [1 favorite]
also btw...
-New Rules for the Global Economy
-Back to the Sixties
-Capitalism at a Crossroads
-Algorithmic trading and market-structure tail risks
posted by kliuless at 9:16 AM on January 17, 2011 [1 favorite]
Not only were existing regulations stricken or under-enforced, regulators - at the behest of their masters and their ideology - failed to regulate new instruments and systems. Of course, that's exactly why those instruments and systems were created, to avoid regulation and maximize profits. It's a game of regulatory mission creep and whack-a-mole enforcement.
The problem is that financial institutions will always seek to put as much money as possible into unregulated practices. Regulators will always be behind, even in administrations that favor heavy scrutiny.
posted by Xoebe at 9:21 AM on January 17, 2011
The problem is that financial institutions will always seek to put as much money as possible into unregulated practices. Regulators will always be behind, even in administrations that favor heavy scrutiny.
posted by Xoebe at 9:21 AM on January 17, 2011
What? WHAT? They put the wolves in charge of the hen-house and you have the giant hairy balls to ask, "how could we not have seen this coming?!" I have no time for your balls or your swimming-pool sized navel gazing.
posted by seanmpuckett at 9:36 AM on January 17, 2011
posted by seanmpuckett at 9:36 AM on January 17, 2011
Best act quickly before Golden Sacks finishes turning Facebook into an investor Farmville.
posted by srboisvert at 10:01 AM on January 17, 2011
posted by srboisvert at 10:01 AM on January 17, 2011
londonmark,
Let me start by warning that I am not a banker or particularly educated in finance. But it seems to me that if you want to know why banks appear to have gotten away with fraud, it's because they have gotten away with fraud.
Now, if you want to know why they got away with fraud here is my uneducated take. Modern banking requires customers to overlook two scary realities. The first scary reality (FSR) is that they don't, ever, have every depositors' money on hand. Typically, they have enough money reserved for withdrawals by some depositors, but never from all depositors. Let's set aside the positives about this arrangement, the negative is that banks would be threatened if mass numbers of people felt the need (or desire) to withdraw money.
In the US, this threat has been mitigated by federal deposit insurance. But if you think about it, the US government isn't sitting on cash waiting for a banking crisis...in fact the US government is in debt and has an annual budget deficit. So, should people take out their money and should the banks call in a claim on their deposit insurer, the effect would be to add to the debt of the country. Hence the phrase, "socializing the losses".
The second scary reality (SSR), and this one took a long time to wrap my brain around, is that the banks make money. Let me say that again...the banks make money.
Sure, the Treasury prints money. But the amount of printed money is only a fraction of the total amount of money in circulation. There is a whole lot more money in bank accounts (which is to say on a ledger or accounting book or computer) than there is cash. Which is to say, don't think that the Treasury printing press is all that meaningful in the US (now, Argentina in the late 80s may be another story).
Ok, back to the SSR. Banks make money. Like out of thin air, sort of. This is related to the FSR. Let's say Alvy deposits $100 in a bank. We said above that the the bank is allowed to lend out a fraction of that money, let's say $80 worth. Now, Brandon comes along and needs an $80 loan. The bank lends out the money. Ta-daa! The money was created. What do I mean?
Well, the banks still owes Alvy $100. On the other hand, Brandon has got to come up with $80. Between Alvy, Brandon, and the bank, there is $180 in the "system", $180 of money someone owes someone else. This is how the idea of "Money as Debt" makes sense.
Finally, we get to the crisis. This also has two parts. Part A, let's say that Brandon spends his $80 in something that will help him make money like tools for his carpentry company. In time, the hope is that the new tools will lead to faster work which will lead to more money for Brandon. The hope is that the tools will "pay for themselves".
Alternatively (note - we are still in Part A), let's say that Brandon decides to buy an $80 flower because lately high-priced flowers have been getting resold at a higher price than their original selling price. Now, Brandon still thinks that the flower will "pay for itself". And it might. But the reality is, this whole flower re-selling thing is quite weird and at some point someone is going to say "No, I won't buy your $80+ flower and, in fact I won't even pay the $80 to the original vendor".
Now, Brandon is stuck with an overpriced flower that even he doesn't want, as well as an $80 loan he will have trouble re-paying because he doesn't have the carpentry tools he needs to do his job quickly. But the truth is, no one cares about Brandon's troubles. Not Alvy. Not the banks. Not the government. Not Rick Santelli. No one. In fact, Brandon himself feels pretty awful about this whole thing despite this type of weird behavior being predictable and reproducible in a lab setting. What everyone cares about is that $80. If it isn't repaid, it's a problem. There is still $180 worth of debt in the "system" and only $20 to cover it.
Now for Part B. What if instead of lending out $8 for every $10 they had, the bank leant out $30 for every $1* they had? So let's say Brandon actually took out $3,000, meaning that there is $3,100 worth of outstanding debt in the system (that was a really expensive flower). The problem is this...how will the $3,100 be covered? Well, the bank has the first $20 (yay?).
In the US, the strategy that was selected was to help the bank and not Brandon. If I had to guess, this is because:
1. The bank is super powerful and gets the attention of people in power (political economy reason)
2. Caring about Brandon means socialism...ahhh, run for the hills! (cultural reason).
So, you've sat with me through all of this here is the finale. The way to help the bank is to tilt the scales in its favor. How? Ok, we noted that the bank is out a lot of money. I mean, a LOT of money. But, by picking a strategy of supporting the bank, we need the bank to do its bank thing. It needs to take deposits and lend money.
Now, the bank really, really doesn't want to make loans. Why? Um, because it has no money to lend. Plus, its super risky now to lend out money in this economy, too (forget for a moment that the bank itself is the reason why its super risky to lend out money at this moment). But a bank has got to be a bank. So the central bank of the US says to our example bank, "I will lend you the money you need to give out the loans". What's more, the central bank promises not to charge interest.
So what happens? Well, the central bank providing the cash means that the bank is operating as usual. So, if the bank made a profit lending money before, it is making a profit now. And the bank needs to make a profit now, because being profitable is how it will deal with the threat that that large debt poses.
But, in the process of being profitable, the bank's employees will also make money, earn bonuses, etc.. And since the crisis actually caused other banks to falter, our surviving bank was able to buy some other smaller/less healthy bank accounts with the money they made. Our example bank actually got stronger relative to what is was before, thanks to the central bank intervention and other bank failures.
Remember, a bank is going to be a bank. It is always going to lend out a fraction of the money that is deposited. It now gets to earn a profit on money it borrows, interest-free, from the central bank. It will still keep Brandon on the hook for his debt (plus interest, plus fees) despite the help it is getting from the central bank. It is going to make money. It will acquire. It will pay out record bonuses.
I think this is the answer to your question. I look forward to any responses which correct errors in this stupidly long comment.
*Note - If I understand correctly, only investment banks had 30-1 leverage ratios, not the banks normal people would deposit to or take loans from. But if I understand correctly, it doesn't really matter since the investment banks were tied into the commercial banks so tightly in terms of the cash flows stemming from MBS. What's more, the ability of investment banks to, nowadays, be treated like commercial banks in terms of access to central reserve money, seems to make the this all moot. But as stated above, this is all gleaned little-by-little from the news, not from school or from professional exp.
posted by Hypnotic Chick at 10:13 AM on January 17, 2011 [12 favorites]
Let me start by warning that I am not a banker or particularly educated in finance. But it seems to me that if you want to know why banks appear to have gotten away with fraud, it's because they have gotten away with fraud.
Now, if you want to know why they got away with fraud here is my uneducated take. Modern banking requires customers to overlook two scary realities. The first scary reality (FSR) is that they don't, ever, have every depositors' money on hand. Typically, they have enough money reserved for withdrawals by some depositors, but never from all depositors. Let's set aside the positives about this arrangement, the negative is that banks would be threatened if mass numbers of people felt the need (or desire) to withdraw money.
In the US, this threat has been mitigated by federal deposit insurance. But if you think about it, the US government isn't sitting on cash waiting for a banking crisis...in fact the US government is in debt and has an annual budget deficit. So, should people take out their money and should the banks call in a claim on their deposit insurer, the effect would be to add to the debt of the country. Hence the phrase, "socializing the losses".
The second scary reality (SSR), and this one took a long time to wrap my brain around, is that the banks make money. Let me say that again...the banks make money.
Sure, the Treasury prints money. But the amount of printed money is only a fraction of the total amount of money in circulation. There is a whole lot more money in bank accounts (which is to say on a ledger or accounting book or computer) than there is cash. Which is to say, don't think that the Treasury printing press is all that meaningful in the US (now, Argentina in the late 80s may be another story).
Ok, back to the SSR. Banks make money. Like out of thin air, sort of. This is related to the FSR. Let's say Alvy deposits $100 in a bank. We said above that the the bank is allowed to lend out a fraction of that money, let's say $80 worth. Now, Brandon comes along and needs an $80 loan. The bank lends out the money. Ta-daa! The money was created. What do I mean?
Well, the banks still owes Alvy $100. On the other hand, Brandon has got to come up with $80. Between Alvy, Brandon, and the bank, there is $180 in the "system", $180 of money someone owes someone else. This is how the idea of "Money as Debt" makes sense.
Finally, we get to the crisis. This also has two parts. Part A, let's say that Brandon spends his $80 in something that will help him make money like tools for his carpentry company. In time, the hope is that the new tools will lead to faster work which will lead to more money for Brandon. The hope is that the tools will "pay for themselves".
Alternatively (note - we are still in Part A), let's say that Brandon decides to buy an $80 flower because lately high-priced flowers have been getting resold at a higher price than their original selling price. Now, Brandon still thinks that the flower will "pay for itself". And it might. But the reality is, this whole flower re-selling thing is quite weird and at some point someone is going to say "No, I won't buy your $80+ flower and, in fact I won't even pay the $80 to the original vendor".
Now, Brandon is stuck with an overpriced flower that even he doesn't want, as well as an $80 loan he will have trouble re-paying because he doesn't have the carpentry tools he needs to do his job quickly. But the truth is, no one cares about Brandon's troubles. Not Alvy. Not the banks. Not the government. Not Rick Santelli. No one. In fact, Brandon himself feels pretty awful about this whole thing despite this type of weird behavior being predictable and reproducible in a lab setting. What everyone cares about is that $80. If it isn't repaid, it's a problem. There is still $180 worth of debt in the "system" and only $20 to cover it.
Now for Part B. What if instead of lending out $8 for every $10 they had, the bank leant out $30 for every $1* they had? So let's say Brandon actually took out $3,000, meaning that there is $3,100 worth of outstanding debt in the system (that was a really expensive flower). The problem is this...how will the $3,100 be covered? Well, the bank has the first $20 (yay?).
In the US, the strategy that was selected was to help the bank and not Brandon. If I had to guess, this is because:
1. The bank is super powerful and gets the attention of people in power (political economy reason)
2. Caring about Brandon means socialism...ahhh, run for the hills! (cultural reason).
So, you've sat with me through all of this here is the finale. The way to help the bank is to tilt the scales in its favor. How? Ok, we noted that the bank is out a lot of money. I mean, a LOT of money. But, by picking a strategy of supporting the bank, we need the bank to do its bank thing. It needs to take deposits and lend money.
Now, the bank really, really doesn't want to make loans. Why? Um, because it has no money to lend. Plus, its super risky now to lend out money in this economy, too (forget for a moment that the bank itself is the reason why its super risky to lend out money at this moment). But a bank has got to be a bank. So the central bank of the US says to our example bank, "I will lend you the money you need to give out the loans". What's more, the central bank promises not to charge interest.
So what happens? Well, the central bank providing the cash means that the bank is operating as usual. So, if the bank made a profit lending money before, it is making a profit now. And the bank needs to make a profit now, because being profitable is how it will deal with the threat that that large debt poses.
But, in the process of being profitable, the bank's employees will also make money, earn bonuses, etc.. And since the crisis actually caused other banks to falter, our surviving bank was able to buy some other smaller/less healthy bank accounts with the money they made. Our example bank actually got stronger relative to what is was before, thanks to the central bank intervention and other bank failures.
Remember, a bank is going to be a bank. It is always going to lend out a fraction of the money that is deposited. It now gets to earn a profit on money it borrows, interest-free, from the central bank. It will still keep Brandon on the hook for his debt (plus interest, plus fees) despite the help it is getting from the central bank. It is going to make money. It will acquire. It will pay out record bonuses.
I think this is the answer to your question. I look forward to any responses which correct errors in this stupidly long comment.
*Note - If I understand correctly, only investment banks had 30-1 leverage ratios, not the banks normal people would deposit to or take loans from. But if I understand correctly, it doesn't really matter since the investment banks were tied into the commercial banks so tightly in terms of the cash flows stemming from MBS. What's more, the ability of investment banks to, nowadays, be treated like commercial banks in terms of access to central reserve money, seems to make the this all moot. But as stated above, this is all gleaned little-by-little from the news, not from school or from professional exp.
posted by Hypnotic Chick at 10:13 AM on January 17, 2011 [12 favorites]
Best act quickly before Golden [sic] Sacks finishes turning Facebook into an investor Farmville.
It is so sadly obvious (to anyone but a 'professional economist') that they're inflating another Dot Com Bubble. Because that's what they do. The sequel to "The Social Network" will be totally like "The Empire Strikes Back" and there will be no third, because the wolves will move on to another henhouse.
But I had a front-row seat for the Junk Bond Bubble twenty years ago, saw who profited from the collapse and started to come to accept that inflating and deflating bubbles was how the American (and now the World) Economy works. The only problem with the Housing Bubble was that it involved something people really needed - homes. That's why they've gone back to bubbling ethereal entities like "social media".
posted by oneswellfoop at 10:28 AM on January 17, 2011
It is so sadly obvious (to anyone but a 'professional economist') that they're inflating another Dot Com Bubble. Because that's what they do. The sequel to "The Social Network" will be totally like "The Empire Strikes Back" and there will be no third, because the wolves will move on to another henhouse.
But I had a front-row seat for the Junk Bond Bubble twenty years ago, saw who profited from the collapse and started to come to accept that inflating and deflating bubbles was how the American (and now the World) Economy works. The only problem with the Housing Bubble was that it involved something people really needed - homes. That's why they've gone back to bubbling ethereal entities like "social media".
posted by oneswellfoop at 10:28 AM on January 17, 2011
I don't have the link handy but the New Yorker recently ran a piece with a title something like 'Do We Need Banks' or similar, that I thought was depressing, and relevant.
posted by newdaddy at 10:51 AM on January 17, 2011 [1 favorite]
posted by newdaddy at 10:51 AM on January 17, 2011 [1 favorite]
I hate analogies to the Maginot Line because they're rarely accurate as to the purpose and failure of the Maginot Line. A better analogy describing the state we're in is the Cold War, which is to say that we live in an age when metaphorical nuclear war could destroy us all. Our globalized, integrated economy means that the wrong series of missteps now will destroy everything that everyone has built, but we can't turn back the clock. Moreover, we can't settle back into a safe passivity, just as the U.S. couldn't afford to not be involved in Africa, South America, and Central America in the 50s and 60s--doing so would have ceded those continents to the Soviet Union.
We have to engage the global financial system, or find ourselves at the bottom of the pile; but engaging it means furthering the conditions that risk destroying us all. We can't opt out of the deadly game.
posted by fatbird at 11:01 AM on January 17, 2011
We have to engage the global financial system, or find ourselves at the bottom of the pile; but engaging it means furthering the conditions that risk destroying us all. We can't opt out of the deadly game.
posted by fatbird at 11:01 AM on January 17, 2011
A better analogy describing the state we're in is the Cold War, which is to say that we live in an age when metaphorical nuclear war could destroy us all.
So can we look forward to glastnost and demokratizatsiya at some point?
posted by Hoopo at 11:11 AM on January 17, 2011
So can we look forward to glastnost and demokratizatsiya at some point?
posted by Hoopo at 11:11 AM on January 17, 2011
Thanks Hypnotic Chick. Of course, I was on some level being rhetorical but your explanation of the failure did help explain a few things. Not why nobody is holding banks to account for their incompetence, though.
posted by londonmark at 11:51 PM on January 17, 2011 [1 favorite]
posted by londonmark at 11:51 PM on January 17, 2011 [1 favorite]
oneswellfoop The only problem with the Housing Bubble was that it involved something people really needed - homes. That's why they've gone back to bubbling ethereal entities like "social media".
Would that this were the case, but they're also bubbling food, which is actually more needed than housing, and metals, which are essential for almost all modern industry. The problem is that money is fungible. You buy a house, food, shares on the stock exchange, and the vote of a politician with the exact same currency. I have no idea how to fix that problem.
posted by aeschenkarnos at 1:03 AM on January 18, 2011
Would that this were the case, but they're also bubbling food, which is actually more needed than housing, and metals, which are essential for almost all modern industry. The problem is that money is fungible. You buy a house, food, shares on the stock exchange, and the vote of a politician with the exact same currency. I have no idea how to fix that problem.
posted by aeschenkarnos at 1:03 AM on January 18, 2011
londonmark: ...explain why nobody is holding banks to account...
i think that was her "political economy reason" and "cultural reason".
im not trained in economics either but it seemed obvious to me that instead of big cash handouts the government should have bought up the worthless banks shares, and the FDIC should have taken over control just like theyve been quietly doing with 350 smaller banks until they could have been sold off again in some years time.
what is it about the Federal Deposit Insurance Corporation that was inadequate to protect depositers while at the same time letting the investors (Goldman et al.) eat their shorts?
we nationalized GM and its now a functioning if not a profitable investment (november IPO at $33, shares are now $38, government paid $53).
and yeah, i dont think my fellow americans are well-enough informed to actually understand and vote for their own interests in this type of disaster: we've been peddled alot of Fear, Uncertainty and Doubt and believed much of it (ala Hank Paulson).
posted by dongolier at 3:14 AM on January 18, 2011
i think that was her "political economy reason" and "cultural reason".
im not trained in economics either but it seemed obvious to me that instead of big cash handouts the government should have bought up the worthless banks shares, and the FDIC should have taken over control just like theyve been quietly doing with 350 smaller banks until they could have been sold off again in some years time.
what is it about the Federal Deposit Insurance Corporation that was inadequate to protect depositers while at the same time letting the investors (Goldman et al.) eat their shorts?
we nationalized GM and its now a functioning if not a profitable investment (november IPO at $33, shares are now $38, government paid $53).
and yeah, i dont think my fellow americans are well-enough informed to actually understand and vote for their own interests in this type of disaster: we've been peddled alot of Fear, Uncertainty and Doubt and believed much of it (ala Hank Paulson).
posted by dongolier at 3:14 AM on January 18, 2011
like the original article, i agree that fixing the current mess is actually alot easier and straightforward than preventing a future one which is... well... depressing.
posted by dongolier at 3:25 AM on January 18, 2011 [1 favorite]
posted by dongolier at 3:25 AM on January 18, 2011 [1 favorite]
this post deserved a little more attention, and hypnotic chick's comment makes it indisputably worthwhile.
posted by es_de_bah at 6:24 PM on January 18, 2011
posted by es_de_bah at 6:24 PM on January 18, 2011
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