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US Economy


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We are not immune to the temptations to debase our own currency either, and were pretty enthusiastic proponents of doing this under "Trudeapia":


The Dollar and the Market Mess
January 23, 2008; Page A25

Lenin was surely right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.

-- John Maynard Keynes

Currency debauchment is a choice. Most governments don't want to debauch their currency -- it's just that they don't want to take the actions that might prevent it, because those actions are perceived to be intolerably painful. Thus it was that last fall, the Federal Reserve, the world's central bank, decided to "let the dollar go" because staying the course on interest rates might threaten the world's financial system (or so the argument goes).

Meanwhile oil prices are high, inflation is considerably above the Fed's own stated long-term targets, and the dollar is in danger of losing its reserve currency status. Should we care? Are saving the dollar and saving the global financial system mutually exclusive alternatives? And isn't a dollar decline necessary for "rebalancing" the U.S.'s external deficits? The answer to the first question is a resounding yes, and to the last two questions, resounding nos.

Why is a weak dollar bad for America? First of all, it directly pushes up oil and other commodity prices by paying the producers with a depreciating piece of paper (thus removing the incentive to increase production), while lowering local currency oil prices for the rest of the world (thus increasing oil demand at the margin). It is no coincidence that the world's two great oil shocks in 1972-73 and 2004-2007 both came after long periods of off-balance-sheet global monetary expansion and subsequent dollar weakness -- the growth of the eurodollar market in the late 1960s and 1970s, and the SIV and CDO expansion of the last several years.

Oil traders know this, and it is why the immediate consequence of the Fed's earlier 50-basis-point cut was to take the dollar down and oil prices up. One could write a separate essay on what a lower dollar and higher oil prices do to our strategic interests, such as propping up regimes like those in Iran and Russia.

Second, a lower dollar reduces the wealth of the U.S. consumer in global terms, immediately through the dollar's lower purchasing power, and longer term through the erosive impact of inflation. It hits retirees and those on fixed incomes particularly hard, and is a totally counterproductive policy for a potentially weak consumer.

Third, the weaker dollar accelerates the growth of our competitors. China may be growing at 11% or more in yuan terms, but their growth in U.S. dollars in 2007 was greater than 17%, and it is their dollar growth rate that is relevant for the rate of their rise in the world's economic hierarchy. Using Europe as another example, in 2002 U.S. nominal GDP was nearly 10% larger than that of the Eurozone 15. Today it is 14.3% smaller. Although Europe has been growing more slowly, its global economic power has been rising more rapidly than that of the U.S. because of our falling greenback.

Finally, if America were to lose its reserve currency status because of a continued loss of confidence in the dollar, the cost in terms of jobs and growth would be significant. The real economic benefit conveyed by the right to print the accepted global currency is called seignorage, which results in part from the lower capital cost we derive from foreigners' willingness to hold dollar cash. This country has taken for granted the benefits of our global seignorage for many years, and it is one of the reasons the U.S. has maintained a higher growth rate than the world's other mature economies.

But don't we need a lower dollar to "correct" our large trade and current account deficits? In the first place, our accounting deficits are largely with our own overseas subsidiaries (more than 50% of world trade is intra-company trade) and reflect an increasingly globalized world economy. Second, America is the shopping mall for the world. Because our distribution system is the world's most efficient, retail prices for the world's goods are lower here, and we have been the shopping destination for the world's consumers even before the dollar began its recent fall. These foreign purchases prop up retail sales (helping to explain the resilience of the U.S. consumer), depress our measured savings rate, and result in an underreporting of U.S. exports and an exaggerated measure of our imports (some significant share of our imports are actually bought by foreigners).

The ability of currency moves to correct trade deficits or surpluses depends on the elasticity of demand and supply. Because of increasingly specialized world trade, the elasticity associated with our exports and imports are very low. Thus a falling dollar is likely to increase the dollar amount of our imports (the infamous J-curve), and force the bulk of the adjustment to currency moves into the "income effect" that results from our higher bills (witness the impact of higher oil prices on the U.S. consumer). Moreover, our current account deficit for a year is equal to only a fraction of the dollar's foreign-exchange trades for a day. To say that one is either the cause or consequence of the other is almost laughable.

Our external deficits are largely measures of Federal Reserve and banking-system liquidity creation, just as the dollar's exchange rate is a function of foreign trust in holding dollar cash or near-cash balances as a monetary store of value (these balances are the lion's share of our so-called foreign debt). Thus, our deficits will only be ameliorated by a slowdown in liquidity creation itself. Just such a slowdown is likely now underway as a result of the mortgage crisis as we enter 2008, but any attempt by the Fed to ease at the expense of further dollar declines will likely snatch defeat from the jaws of victory, and risk a global inflation of significant proportions over the next several years.

Doesn't a failure to respond aggressively to the credit crisis by cutting rates too slowly risk a recession, or a Japan-like breakdown of the world's financial system? Unfortunately the recession risk is high, but not because of high interest rates (which are currently negative in real, after-tax terms). The recession risk is high because of a breakdown in the absurd system that developed for the packaging and underwriting of debt, and the excess liquidity that developed from the combination of that system and a highly stimulative monetary policy.

The Fed took a gamble on inflation to ward off what was perceived as a deflationary threat in 2001-02. The inflationary consequences of that gamble are now here, with the petrodollar monetary merry-go-round fueled by the weaker dollar. Those consequences will be much easier to deal with now, rather than later. Unlike Japan, where the capital-markets risk was concentrated in a handful of thinly capitalized large banks, the very growth of the credit-derivatives market that is the source of the current crisis in the U.S. has also resulted in a wide dispersion of risk in the financial system, and any recession will likely be mild and short.

While we might see a number of hedge funds and some isolated banks fail, the pool of distressed asset buyers waiting in the wings would result in a needed consolidation of the financial-services industry, without systemic failure. In the meantime, the systemic risk posed by the failure of one or more of these institutions is minimal compared to the moral hazard and longer-term inflation risks we incur from their bailout.

Sadly, the dimensions of the Fed's great dilemma would be much less acute had the Fed and Treasury officials not taken such a cavalier approach to the U.S. dollar over the past eight years. Our "strong dollar" (wink, wink) policy has never been articulated by either institution with any real conviction, and markets have rightly sensed that maintaining employment, growth and stock-market happiness has begun to take precedence over maintaining the value of money. In a world of fiat currencies, where trust is your most powerful policy tool, dollar strength is a far better indicator as to the appropriate stance of monetary policy than "core" inflation.

Any further loss of confidence in the U.S. currency will cost us dearly in terms of both price stability and jobs in the long run, as it will imply a higher level of interest rates to maintain a given monetary stance. A convincing elevation of the dollar in the policy priority list for both the Fed and the Treasury would be the single greatest step that either institution could take in restoring health to the financial system.

Mr. Wilby is a former head of equities at OppenheimerFunds.
This is a very good discussion of the topic.  I am not sure I see a clear successful conclusion, here, or in other things I have read, elsewhere.  I would be interested in reading ideas, from members here, about what could be a successful conclusion in the years to come.

boxseats said:
This is a very good discussion of the topic.  I am not sure I see a clear successful conclusion, here, or in other things I have read, elsewhere.  I would be interested in reading ideas, from members here, about what could be a successful conclusion in the years to come.

A clear, successful conclusion in what sense boxseats??

I'm not sure I'm getting your meaning. Everything and everyone is always evolving -- what is a clear & successful conclusion today -- may not be tomorrow. Nor may you and I have the same "basis" for determination of what clear & successful entails.

I see many sucessful and clear conclusions in many things, including threads on this forum. Yet, if I choose to go about looking for those that are unclear & unsuccessful -- I will find those too.

One usually finds what they are looking for ... quite often at the expense or detriment (or ignoring) of threads etc that do not support their own "conclusions" or definition of "success." That is the greatness of democracy. One can discuss things without fear of reprisal because their definitions and opinions differ from another.
ArmyVern said:
A clear, successful conclusion in what sense boxseats??

I'm wondering the same thing. Economies have their ups and downs. The US economy has recovered from some serious dipd in the past and will recover from this as well.
CDN Aviator said:
I'm wondering the same thing. Economies have their ups and downs. The US economy has recovered from some serious dipd in the past and will recover from this as well.

Good.  Confidence in the US economy.  Very good.  See, Thucydides, nothing to worry about regarding debasing the CAD.  There are ups and downs in the past and will {sic} recover from this, too. 

Thucydides said:
We are not immune to the temptations to debase our own currency either, and were pretty enthusiastic proponents of doing this under "Trudeapia":

Whew!  And to think I had been wondering about this, including debasing of currencies, for years and what would happen in the classical economics framework that did not include the debt structures that are in place now, as the wsj article mentioned.

....  system that developed for the packaging and underwriting of debt, and the excess liquidity  ....

boxseats said:
Good.  Confidence in the US economy.  Very good.  See, Thucydides, nothing to worry about regarding debasing the CAD.  There are ups and downs in the past and will {sic} recover from this, too. 

Uhmmm, perhaps I'm missing something here --- or you are seeing something that isn't there??

I didn't see Thucydides worrying about debasing the CAD, nor did I see him expressing a lack of confidence in the US economy. He simply posted a news article, or do you just take his simple posting of such as an expression of a lack of confidence in your economy? If that's the case, you're stretching it. I think his comment accompanying the posted article ... actually expresses the opposite view in that this is a normal event which occurs in economies, which eventually recover.
The one thing i will say about the curent goings-on in the US economy and sub-prime mortgages :

"Banks, you should have seen the crissis coming, you caused it"
The thrust of the article was the dangers of allowing a currency to become debased, something which can happen when politicians persue short term goals without reference to "classical economic structures". This is the root cause of the so called "Sub Prime" crisis; excessive monies pumped into the housing market through US government subsidies, creating a housing bubble.

Since politicians tend to be rather timid by nature, and often fail to challenge the status quo, it is quite possible or even probable that a nation can move into this position by default. Imagine the press reaction if President George W Bush had actively intervened in 2005 by pulling federal dollars out of the housing market to prevent the possibility of a meltdown..........
I think the subprime market exists not because of the politicians (including the Federal Reserve Bank monetary policies), but because of the private banking and capital markets players, outside the government.  The ability to create derivative products and synthetic debt instruments to such a degree is way beyond what classical economics structures postulate.  Derivatives, and as they have grown, started only in the 1980’s with a simple interest rate swap.  But now all the successor instruments play a pivotal role in the capital markets.  These are from the private or publicly traded financial firms, not public or quasi-public sector influences.

Of course, I can see an argument for  linking powerful private sector interests with powerful political influences.  But, I think the political influence is just a “derivative”. 
The private sector can create almost anything; the problem is the government using the powers of the State to meddle in the economy. If the US government hadn't pumped billions of dollars into the housing market, the crisis may still have happened, only on a smaller scale and without economy wide (and indeed global) implications.
Jerry Pournelle on the crisis:


The Fed is pumping more money out in the hopes of restarting the housing boom and bringing it down a bit less abruptly. In so doing they tax fixed income and retirement savings.

Clearly the government hates people who save money, and will do anything it can to tax those economic traitors. Or perhaps it's simple greed?

Not, I hasten to add, that I quite know what to do about the economic disasters we have engineered for ourselves. The country is going to have to take an economic dose of salts, and clear out the system.

We know this. The market is still the most efficient allocation system for putting resources to work. It satisfies what people want. On the other hand, the market is amoral, and tends to the worst: left to itself it will sell anything, from its grand daughter's virtue to human flesh for stew. The unregulated market does not produce a country that many will die to defend. Few ever charged up a hill to preserve a standard of living, and the only greater fool is one who dies to preserve someone else's standard of living. For a man to love his country, his country ought to be lovely, and the market, unrestrained, can't do that; it will sell anything that anyone, no matter how perverted, will buy.

We also know that the closest thing we have to a true middle class in this country are the home owners. Sure: there are some who have incomes reasonably independent of the government and economic conditions, but most Americans are only a short step away from utter dependence on government. They don't have savings enough to live for a few months, much less for a year or more. We can't let the market wipe out all those who were enticed into what they thought were investments in housing. Yet we don't want to protect all those who took advantage of the government's interference in the market to make silly loans in hopes of shuffling the risk of onto someone else before everyone caught wise. And for that matter, the financial institutions that didn't bother to look at the quality of the "investment grade" paper they were buying from the money lenders don't have much of a break coming -- not in an ethical world, anyway.

So we have to climb down, carefully, from the precipice we dashed up to; and that's going to take a lot more than rhetoric or food stamps or demagoguery. It's going to take economic skills of a high order, and I don't see one single candidate from any party who has the faintest idea of the magnitude of the problem, much less a solution.

Libertarianism is a vector, not a position. In general, in a Republic, that government that governs best governs least. That's not to say it shouldn't govern at all. Pure unrestrained capitalism ends up with the winner being the one who can hire the most efficient mercenaries -- which is to say, those who can set up a state under a different name. Economic recovery is going to take economic freedom; but pure economic freedom has the seeds of its own destruction. Political power isn't just economics. Men do not fight and die for economic power - although there are plenty who will send men to die for economic power.

(An aside to think about: The pure theory of politics: A tells B to do something, and B does it. Why? De Jouvenal wrote on the subject, but his books are largely unavailable. He also said that a nation of sheep would soon beget a government of wolves.)
As usual, the regulatory failure which brought on this mess is being ignored and market capitalism is being attacked and blamed. Please note which US president is responsible for the sub prime mess to begin with......


Road to heaven still paved with free markets

Terence Corcoran,  National Post  Published: Thursday, March 20, 2008

When financial markets are gyrating and economic turmoil hits, declarations of pending cataclysm are frequently at hand. At such times -- junk bond crash, Asian currency crisis, Enron collapse, tech meltdown -- we are either said to be at the brink of the end of capitalism, brought down as Marx predicted by its own rampant greed and ritual lurches toward self-destruction, or we are set to plunge into some kind of replay of The Great Depression of the 1930s.

So it's no surprise there's a lot of this kind of talk around. The current star gloomster is Nouriel Roubini of New York University's Stern School of Business. He made an appearance on these pages two weeks ago under the headline "The coming financial pandemic." Mr. Roubini is now a household name among readers of Financial Times, where he is being lionized by Martin "The Mother of All Meltdowns" Wolf, and the Socialist Worker, which yesterday explored the "Shocking instability that is built into capitalism" by citing Mr. Roubini's scary estimate of global financial losses exceeding $6-trillion.

And now my good friend Michael Bliss has emerged from retirement to announce that the current U.S. subprime credit crisis marks the end of an era, the collapse of the "capitalist game" of the last few decades and the beginning of a return to regulation on a scale not seen since the Great Depression.

First, whether we -- Canada, the United States, the world -- are heading into some kind of economic cataclysm I cannot say. Alan Greenspan wrote the other day that the current financial crisis in the U.S. is "likely to be judged in retrospect as the most wrenching since the end of the Second World War." While that's bad, it's a far cry from the economy-wide devastation of the Great Depression. It lasted 10 years, economic output fell 8.6% in 1930, 6.4% in 1931 and 13% in 1932. Unemployment hit 25%, wages fell 42% and world trade dropped 65%.

Unless we plunge into that kind of economic hell, it's hard to imagine a return to what Mr. Bliss calls "massive new regulation of business, massive new taxation of wealth and sustained vilification of the values that have driven Wall Street and Bay Street." How likely is it that Americans (or even Canadians) will insist on a an explosion of state intervention against business? Mr. Bliss cites Capital One's TV commercial portrayal of bankers as greedy vermin to be exterminated. It would be a mistake, I think, to blow an ad campaign into a political movement against banks -- especially since everybody knows Capital One is a bank.

At this point, I'm not sure whether Mr. Bliss is being predictive or prescriptive. He certainly seems convinced there's been an "awesome failure of free enterprise," and the state needs to step in "to protect us all from the havoc wreaked by greed and incompetence." And he adds: "My good friend Terence Corcoran will find his way to heaven still blaming accountants and regulators for the crack-up."

I always thought Mr. Bliss would be joining me in heaven, but now I'm not so sure. He seems to be taking far too much glee in the idea that politicians, bureaucrats and regulators will -- and should -- be called in to overthrow free market capitalism.

Whatever the real failings of the capitalists whose risk detection systems failed -- to their own peril and at massive loss to themselves -- it's not as if they operated in a deregulated free market unfettered by bureaucratic and political interference. Banks have been subject to elaborate controls for years. Fresh accounting and bank capital rules are newly imposed at regular intervals. Post-Enron regulations blanket all public corporations and their employees.

But let's take a look at one of the bigger non-capitalist boondoggles behind the current credit crisis.

Where did the U.S. subprime mortgage boom come from? In the early 1990s, the Clinton administration asked the U.S. department of housing to come up with a National Homeownership Strategy. Working with private and public institutions, the strategy was to "achieve an all-time high level of homeownership in America within the next six years." Plans included innovative schemes to streamline transaction costs, bring in creative financing rules, ease land assembly and get money for mortgages into the hands of people who had no money.

To fulfill the American Dream it advocated, among other things, "financing strategies, fueled by the creativity and resources of the private and public sectors," to help home buyers who lack cash to buy a home or get income to make down payments. By the Bush years, the program had ballooned to encompass dozens of initiatives, including the American Dream Down Payment Fund and the Home Investment Opportunity Program.

The strategy worked, says Joseph Mason, associate professor of finance at Drexel University LeBow College of Business. "It worked really well. Some might say too well." U.S. home ownership rose to record highs by 2007. But it was a strategy that promoted risk, and when coupled with financial engineering wizards, the risks multiplied.

If there's a backlash to come, maybe it will hit business. But maybe it will turn--as it should--against the massive regulatory regimes that already exist.


Oh, and an explanation as to how this happened (quite funny in a sad way): http://docs.google.com/TeamPresent?docid=ddp4zq7n_0cdjsr4fn&skipauth=true&pli=1
A view of how America is doing:


Globe essay
A turning point in the U.S.?


From Saturday's Globe and Mail

March 29, 2008 at 12:00 AM EDT

Americans are a proud and patriotic people. They live in the world's only superpower. They have the highest standard of living in the world, measured by per-capita income. Today, however, they are perplexed, anxious.

Powerful countries expect to control many events, not have events control them; the most powerful country expects to control all events, and to respond to the unforeseen in dramatic, conclusive ways. Smaller countries accept that they are takers of world events, and use whatever influence they can, with others, to mould them.

Americans seem to have lost control of their ability to make decisions that will produce satisfactory results. Their deep faith in and love for their country remains unimpaired; their belief in its ability to get a grip on domestic and international problems has been shaken.

For some years now, basic problems have gone unaddressed and have worsened in the United States: fiscal and trade imbalances, unfunded liabilities for health care and Social Security, and the design and execution of a foreign policy that has sent U.S. prestige to

It was not supposed to be this way after the Cold War ended. Supreme militarily, untroubled economically, the U.S. sailed through the 1990s. Russia was down, out and friendly. China was only beginning its spectacular rise. Terrorism had struck, but far away: in Africa and the Middle East. Afghanistan, having thrown out the Soviets, seemed out of sight, in hand.

The United States could reduce its defence budget (the "peace dividend") and pick and choose its spots to intervene militarily (Rwanda, no; Bosnia, no and yes; Haiti, a little), enjoying a soaring stock market, the high-technology boom, rising housing prices and a balanced budget.

Today, according to Pew Center polls, 70 per cent of Americans are dissatisfied with the direction of the country. Eight-one per cent believes economic conditions are "fair or poor." New, depressing economic news arrives almost daily. President George W. Bush's approval rating stands at 33 per cent; that of the Democratic-controlled Congress at 21 per cent.

A staggering 80 per cent say they want "change." This share of voters far eclipses the share who wanted change after eight years each of presidents Ronald Reagan and Bill Clinton.

The terrorist attacks of 9/11 were the most evident manifestation of events being out of control. The sense of vulnerability, even fear, does not guide Americans in their daily lives, but it has become part of the country's political discourse and shapes its spending priorities. In addition to the immense bureaucracy of the Department of Homeland Security, the airport searches and passport requirements, the curtailment of civil liberties, the torturing of prisoners, there was also the invasion of Iraq, the linchpin of the Bush administration's "war on terror."

The invasion and occupation were supposed to be easy, like a half-hour on the treadmill for a seasoned athlete. Instead, the U.S. is pinned down, caught between two broad options: to maintain or intensify military deployments with as many as 160,000 troops, for a long time, hoping for political stability; or to withdraw from Iraq with the possibility, or likelihood, of sectarian violence and civil war.

Afghanistan was supposed to be cleared of the Taliban, the friends of al-Qaeda, the murderers of Americans. Instead, the insurgency there has returned with a vengeance in certain parts of the country. Pakistan was supposed to be a reliable ally in the "war on terror." Yet the country has become the most dangerous in the world: unstable, nuclear-armed, run until recently by a dictator, incapable of exerting serious pressure against religious fanatics in its own territory.

Russia has returned to the world stage in a truculent fashion, featuring the return of 19th-century Great Russian chauvinism. The drunken, friendly Boris Yeltsin has yielded to the stern Vladimir Putin. China has become so economically powerful so fast, and its military budget has increased so rapidly, that Americans wonder how long it will be before their undisputed standing as the world's only superpower will last.


China also holds more than $1-trillion in U.S. debt, which itself stands above $9-trillion. China's trade surplus with the U.S. remains huge. Jobs continue to move from the U.S. to China. It is cold comfort to hollowed-out towns and workers at empty mills that these moves might keep costs down in the U.S., make companies lean and lower inflationary pressures. Pew Center surveys of world opinion now show support for free trade lowest in the United States of all the countries surveyed.

The erosion of respect for and the popularity of the United States bothers at least some citizens in a country that is supposed to offer a "light unto the world," to be a repository of values and institutions to which all countries will aspire, now or eventually. To discover through the media or travel or personal experience that the country's standing has declined almost everywhere (India and Japan being two exceptions) is hard for alert Americans to accept.

Elections are usually fought on domestic issues, even in a country so engaged in the world. Domestically, the sense of losing control permeates many parts of the electorate.

Immigration has become a huge and emotional issue. For many Americans, whatever they think of immigration per se, a widespread sense exists that the country has lost control of its borders. There are so many illegal immigrants in the United States that a compromise immigration bill foundered in Congress, destroyed by critics who wanted massive deportations and even tighter border measures.

Immigration opponents play on the loss of jobs, which is in turn linked by opponents to the country's massive and chronic trade deficit. Americans are told that they are the world's best at everything. Yet that assertion doesn't jibe with the trade deficit. The answer to this conundrum must be, in the minds of many Americans: If we are the best and yet we run this kind of deficit, someone else must be to blame. The culprits are therefore: trade agreements that need revision, unfair trading practices and currency manipulation by others. To which the remedies on offer, from both parties, are forms of protectionism and assertive trade policies that will give Americans back control over trade.

Americans' vulnerability is deepened by how they have run their own country in the past decade. They have compiled deficits on trade, current account and the national budget. States, constitutionally impeded from running deficits, are scrambling to keep their budgets balanced. Americans have become significantly indebted to the rest of the world, a reversal to the historical pattern whereby the dominant power of an age runs a surplus with its colonies and weaker countries. If they peer down the road, Americans see enormous unfunded Social Security and public health entitlements. And they see around them, or at least some of them do, social debts: to the poor and the uninsured. They see a dollar that is losing relative value, a natural outgrowth of the trade deficit but nonetheless a symbol of a less omnipotent currency.

They are carrying very high personal indebtedness. Their financial institutions, as the subprime mortgage crisis revealed, got caught up in the "irrational exuberance" of debt. They launched a war that cost hundreds and hundreds of billions of dollars. Fighting a war, Americans also cut taxes on themselves. The chickens of such folly have come home to roost, loudly and persistently.

Being in debt at home, and in debt abroad, contributes to this sense of not being in control. So, too, does being so heavily dependent on foreign oil, especially when suppliers include such countries as Venezuela, that is anti-American, and Saudi Arabia that Americans do not trust. Looking around the world provides cold comfort for Americans about which countries control large stocks of oil: Arab states, Iran, Russia, Nigeria. At home, all presidential candidates pledge to make their country far less dependent on foreign oil, but no credible plan to do so in the lifetime of any adult American can be crafted.


None of the Republican candidates, when they were still competing, called for "more of the same," a devastating indictment of the Bush administration from the President's own party. It's one thing to put distance between yourself and an incumbent, since elections are about the future. It's another rarely to mention his name.

Barack Obama's remarkable appeal is based on the hope that he can, through the charisma of his personality, the force of his rhetoric, and the novelty of his resumé, cut through the gridlock in Washington, loosen the grip of special interests, make government "work again," and restore faith and trust.

Mr. Obama articulates the hope that Americans can take back control of their destiny by being more respected abroad and more unified at home, to shrink social deficits, transcend the divisions of race, join the struggle against climate change, and use government again as a way of solving problems rather than consider the institution as the country's biggest problem.

The good news for America, and for those who admire much about the American spirit, is that so many people are engaged in their politics now. Without understanding perhaps the difficult tradeoffs that lie ahead, many of our neighbours are excited by their politics, deeply desirous of changing course, wiser for the errors and failures of the Bush presidency, still believing in their country and its destiny as a force for good in the world.
The financial markets are very complex and interrelated (one reason to avoid intervention in the markets); an interview with one of the people responsible for creating some of the currently available new instruments:


On Markets and Complexity
Economist Robert C. Merton talks about the current crisis, risk, and financial engineering.
By Nate Nickerson

Robert C. Merton, currently the John and Natty McArthur University Professor at Harvard Business School, shares the 1997 Nobel Prize in economics for his work on the Black-Scholes model for determining the value of a stock option--work that led to the creation of options and futures markets in the early 1970s, and thus to a revolution in financial markets around the world. Merton has also seen firsthand what a modern market crisis looks like: he was a founder of Long Term Capital Management, a hedge fund that saw enormous success followed by enormous losses in the mid-1990s, and which became a symbol of the limits of financial engineering.

Today's financial crisis is often blamed on a system so complex as to be beyond the comprehension of even its practitioners. (See "The Blow-Up.") We asked Merton what he thinks of complexity--and whether he thinks markets have too much of it.

Technology Review: Is it fair to say that the current financial system is too risky?

Robert Merton: Let me give you this analogy. If you're driving in inclement weather, you'd say that a four-wheel-drive car is safer than a two-wheel-drive car. Now suppose that we observed that over the last 15 years, the number of passenger accidents per passenger mile driven hadn't changed at all. And someone says, Now wait a minute: Has four-wheel drive made us safer? And the answer would be, Technically, no, because we're having just the same number of accidents we used to have. So, was this all a waste, or were we wrong? I think you know the answer, as I do. What really happened is that people get something that will unambiguously make you safer if you behave the same way you did before. That's the key element to understand first. The amount of risk we take personally, individually, or collectively is not a physical given constant. We choose it. What happens is, we look at some new, safer instrument and we say, Yes, we could be safer doing the same thing. Or, we could take the same amount of risk and do things that were too risky to do before. So with a four-wheel-drive car, you look out the window and see six inches of snow, and you say, That's okay: I'm going to go over and visit my family. So the question to ask is not, Are we safer? The question to ask is, Are we better off?

TR: So do we have a better financial system than we did 10 years ago?

RM: Unambiguously. For example, I believe the people at almost every central bank are far more knowledgeable about the various financial markets than they were 10 years ago. Also, in general, we know how to measure and manage risk better than we did 10 years ago. And I think there's more transparency than there was 10 years ago, in the following sense: One of the big areas with the current crisis is in credit. Bank loans are the prototypical, classic credit of the past. Bank loans were not repriced, like a mutual fund, due to market conditions. So when a crisis came, they were very opaque. There were loans sitting in these banks that had been sitting there for years, and nobody really knew what they were, and when a crisis came, all they know was that they were worth less. That's not transparency--that's opaqueness. Today, we have a credit-default swap market. On a daily basis, that market prices what sophisticated institutions were really willing to pay to guarantee the credit of probably 500 to 700 companies and virtually every sovereign country in the world. You can see that price every day. That's a very big increase in transparency. Also, we have much more global diversification of risk. And look at mortgages. If you go back to the 1980s, virtually all mortgages were originated through thrift institutions. Today, you have a national mortgage market. Even in these tough times, mortgage money is available. It's not that there aren't problems, but as a technological matter and as an operating matter, those are all the pluses.

TR: So why aren't we safer?

RM: You have to ask, What have we done with all of these improvements? We've gone to much greater complexity. We have many more instruments. Firms and individuals have been more willing to cut back on their equity cushions and leverage more. To go back to our car analogy, we're more willing to drive faster because of the better tools at our disposal and great transparency.

TR: So where does complexity come into all this?

RM: Sometimes the term "complex" is used as a euphemism for "less-well understood." People sometimes say, "Things have gotten more complex," but what they're really saying is, "I understand things less well."

TR: But in your time, have things gotten a lot more complex?

RM: Yes, they have. Let me give you an extreme example. For certain very specialized hedge funds that do what's called very high frequency trading, the location of the outsider's server and the exchange's server matters.

TR: It's that tight.

RM: Yes--speed of light. So in fact one of the exchanges used to delay just slightly the information going out from the East Coast to allow a little more parity for those on the West Coast. Today, they rent or auction space for people to put their servers near the exchange server, so the speed of time between exchanges is reduced by that metric. And the number of trades that get offered in this thing is vastly greater than the number of trades that actually get done. So the volume of activity is orders of magnitude greater than the number of trades you would record as the actual volume. The reason I'm taking you into all this is to say that there is no one who can sit and watch those trades directly and apply anything to them. So what do we do? We build computer programs to extend our human skill, and we try to audit what's going on, but at the end of the day, the computers do the trading. Yes, there can be a dysfunctional aspect to that, but it's not as if people are setting things on their computers and then going to the Bahamas.

TR: So do you not think that the complexity of what the quants are building is a problem?

RM: There's no question it can have dysfunctional aspects. Anything we do can have a dysfunctional side effect. That doesn't mean that, net, it's not worth doing. Of course, when you have this speed of transactions and executions going on, there can be times, because they are driven by a computer, that if something happens that is not understood, the programs are going to end up continuing to try to trade, and that can affect markets. But that's not prima facie saying it's out of control--that these people don't know what they're doing, or that it was better before. Things used to get out of control without computers.

TR: So how do you think about technology generally, as it affects the functioning of markets?

RM: Well, first of all, it's very important to it. Second--and I say this a bit tongue in cheek--the people who are in the chip business ought to be very, very happy. If anyone worries about whether, with the advance of Moore's Law, we'll get to the point where computing is so excessively fast that we don't need anything faster: any time we think we get there, at least in the financial applications, all we have to do is add one more variable in our equations we want to solve, and you move yourself to the frontier of computing. But that's just an aside. Technology is a huge thing. If you look at the costs of transferring risk around the world, it's just remarkable what technology has done. That's the good side. The bad side is that things are much more complex and much faster. Does that say it's riskier than before? No.

TR: So what do you make of the current crisis?

RM: Anything I or anyone else tells you about it has got to be speculation, because the pathology hasn't been done. We really don't have all the data, and so very good stories we come up with now may not turn out to be the accurate explanation. And certainly I don't have the access that many other people who are in this have. But I would point out a couple of things that are structural that fit this. You'll hear in this case as in the past, "Look at all this financial innovation or financial engineering--it's caused too much complexity, and now the system has run off the tracks." To that I would say, structurally, one would expect that in the case of a successful innovation, the infrastructure to support it properly will lag behind. Why is that? It's because if you have 100 innovations, maybe 2 of them will be successful. So it is not practical to build a full infrastructure--regulatory, educational, et cetera--for all 100 innovations. Innovations are going to run ahead of the infrastructure. That, we have to recognize, is structural. It's not about bad people, it's not about incompetent people, it's not about greedy people. It's not about having a market system or a nonmarket system. Whether the problems are addressed by external regulation or a combination of that along with internal regulation--whatever set of ways, we have to be prepared when innovations come in to have some degree of oversight modulation. If you do too much of that and you stifle innovation, that's not good. If you do none at all, that's not good either. So there's something in between. Sometimes we don't do enough of it, or the growth of innovation is too quick, but the point is that there is a reason why you will typically find that financial crises are often connected with what are perceived as new things, big changes--innovations.

TR: Okay. So when you overhear people say, "The market is more complex today," what do you most want to tell them?

RM: Yes, the markets are more complex today than they were five or ten years ago. On the whole, I believe that complexity is a reflection on improvements in the system that made possible greater complexity within an acceptable risk range. The benefits came from performing the functions of the financial system either more efficiently or [from] performing more of them. That said, complexity also raises the specter of risks that can cause a crisis in which you don't fully understand what's happening, because you're in a new environment where the structures are different from what they were ten years ago. There's a psychological reason for that. We tend to be much more comfortable doing something familiar than we are with doing something new, even if the risk is the same in both cases. I'm not saying that bad things haven't happened. But if you take a horizon of, say, ten years, on the whole, the system is structurally better, but we probably have had a mismatch between the infrastructural growth and the growth of the innovations such that we find ourselves in a situation that is very costly and expensive and unnerving.

TR: Back in 1973, when you had enhanced the Black-Scholes model for the pricing of a stock option, did you have any idea about the growth of complexity that was going to unleash?

RM: Well, I couldn't have anticipated the enormous growth. But we did recognize, even back then, that its applicability went far beyond options. Also, it was coincident with the 1970s, when the world got turned upside down. You had the breakdown of Bretton Woods [the international agreement, set up in 1944, that created rules and institutions for international trade, and which pegged currencies to gold], so you suddenly had all these currencies floating; you had interest rates in double digits in the United States, which probably hadn't been seen since the Civil War; you had inflation rates in double digits; you had the stock market between 1973 and the end of 1974 fall by 50 percent, which was a greater fall than had been seen since the Great Depression; and you had the oil shocks. All of this created a high need for the development of risk sharing. So the futures market and the options market were all created back then. It was a response to need. It wasn't about capability, it was about need. You can have all the technology in the world, you can have all the great models in the world, and if there isn't a perceived need, it doesn't get adapted.

Copyright Technology Review 2008.
The blowback from the Subprime mess expands:


The Financial Page
Iceland's Deep Freeze
by James Surowiecki April 21, 2008

By now, we're all familiar with the major victims of the subprime meltdown: greedy mortgage brokers, overleveraged hedge funds, feckless banks and brokerages, incautious homeowners, and so on. But the crisis is also wreaking havoc in places that, on the surface, might seem to have nothing to do with the price of foreclosed homes in Miami. Places, that is, like Iceland.

Insofar as Americans think about Iceland at all, it's as a land whose remoteness belies a vibrant cultural scene featuring hipster titans, like Björk and Sigur Rós, and exceptional social conditions—it's the top-rated country in the U.N.'s most recent human-development index. But in the financial world Iceland is now a hot topic of discussion for a different reason: many people suggest that it could become the "first national casualty" of the ongoing credit crunch. Until last year, Iceland's economic track record in this decade had been phenomenal—its annual growth rate averaged close to four per cent over the past decade, and its per-capita gross national income is now higher than that of the U.S. This year, though, the country's currency, the króna, has fallen twenty-two per cent against the euro; the economy has stagnated; and a global rating agency has put the nation's three major banks on a credit watch. Now analysts are wondering whether the new Nordic Tiger will end up, instead, as "the Bear Stearns of the North Atlantic."

So how did Iceland get in so much trouble? That's the odd part of the story: it isn't because its banks gambled on the worthless subprime securities that helped undo Bear Stearns and so many others. Iceland's banks prudently avoided the subprime market, even as they embarked on a lending boom at home and expanded abroad. What got Iceland in trouble was something more subtle: its banks got their money primarily from international investors, making the Icelandic miracle heavily dependent on foreign capital.

In normal times, this might not have mattered, given the country's solid economic fundamentals. But these aren't normal times. The subprime crisis, in which investors realized that they had greatly underestimated the risks of lending to people with bad credit, has spawned a wider credit crunch: investors now suspect disaster behind every door, and even seemingly solid borrowers find credit much harder to come by. The subprime crisis was an earthquake that caused a tsunami: the quake has done plenty of damage on its own, but the tsunami looks set to do even more.

Iceland has been swamped by that tsunami because it trusted in the availability of global credit in time for that credit to evaporate. And the fact that Iceland has been so dependent on foreign investors makes those investors even more skittish about investing there: in markets, weakness often begets weakness. Further, the country's troubles have made it a potential target for speculators seeking to drive down the value of its currency and perhaps cause a run on the banks. In 1998, hedge funds purportedly worked together to attack Hong Kong's currency and its stock market, an attack that was foiled only when the government bought up a sizable chunk of the stock market. It's not clear that a similar cabal is gunning for Iceland—the governor of its central bank insists that one is—but the notion is certainly plausible: with a population the size of Pittsburgh and a central bank whose total reserves are less than five billion dollars, the country makes an easy target for hedge funds flush with cash.

Iceland's current woes teach a useful lesson about the interconnectedness of global markets: trouble can come from anywhere. Homeowners default on mortgages in San Diego, and suddenly people in Reykjavík are paying more for gasoline and wondering if their bank deposits are safe. That doesn't mean that Iceland is an innocent victim. The country went overboard with spending and borrowing—between 2000 and 2007, domestic credit in the Icelandic banking system more than quadrupled as a share of G.D.P. And relying on foreign money to fuel that kind of frenzy is foolish, since it puts you at the mercy of fickle foreign investors. But Icelanders can be forgiven for wondering if they've really been any more reckless than many other countries—most obviously the U.S., which relies heavily on foreign capital to fund home buying and profligate consumption, and whose banking system is rife with reckless lending.

And that's the second lesson of Iceland's plight: even in a flat world, there are different rules for different players. In order to prop up the króna, and keep foreign capital from fleeing, Iceland's central bank has had to raise interest rates to an astounding fifteen per cent, a move that will slow the economy to a crawl. By contrast, the dollar, while weak, has evaded the króna's precipitous fall; the Federal Reserve, far from raising interest rates, has slashed them; and Congress is borrowing a hundred and fifty-two billion dollars to hand out tax rebates. Iceland's government has been forced to inflict pain; the U.S. is doing everything possible to avoid it. If Iceland were to attempt to emulate America's approach, its currency would be demolished, and foreign investors would almost certainly head for the exits. The U.S., by contrast, remains the beneficiary of the world's generosity—no matter how bad our financial situation looks, countries like China and Japan keep pouring hundreds of billions of dollars into U.S. securities. They're doing this not out of kindness, of course, but because the U.S. is a colossal market and they need us to keep buying stuff. The world can't afford to have the U.S. fail, and so we are able to get away with behavior that would wreck smaller countries. Great for us, but when we look at Iceland's predicament we should say that there but for the grace of China go we. ♦
Congress mandated that mortgage lenders should loosen their borrower standards to allow folks with D credit to buy a house. They did and surprise D borrowers lived up to their credit histories.Naturally Congress refuses to shoulder the blame.
Someone needs to take a stand, even if it means falling on their sword:


From the Los Angeles Times
It's got to hurt before it gets better
There are solutions to high oil prices, the housing crisis and outsourcing, but they require some sacrifice.
By Lester C. Thurow

April 11, 2008

The financial crisis in the United States is not a crisis if you do not want to sell your home, do not have a house with a sub-prime mortgage and have a good job that you are not about to lose.

Very few Americans have to sell their homes right now. Those who bought a house on speculation get what they get. After all, they "speculated" and lost. Very few Americans have a sub-prime mortgage. Those with bad credit have bad credit. Most have a job they are not about to lose.

So what is all the fuss about? The meltdown of the financial markets.

Shouldn't we just let the big guys lose? After all, they are big guys. The answer is no. The credit markets, like those before the 1929 crash and during the Depression, affect us all.

What should be done?

The answer starts with the heart of the problem: the sub-prime mortgages. These mortgages have to be written down to less than the current value of the house so that if the borrower walks away, he or she has something to lose. The government (taxpayer) is going to have to pay to write down these mortgages. This is the subsidy -- and the only subsidy -- that should be given to the lenders.

If the borrowers don't walk away from their sub-prime mortgages, there is no crisis in the financial markets.

In the future, we can regulate the markets to prevent sub-prime mortgages. But that is the future. Let's get to the real crisis: the rising cost of oil and the outsourcing of American jobs.

There is a solution to the rising cost of oil, but it is a painful one. Let's say there is a lot of $20-a-barrel oil in the world -- deep-sea oil, Canadian tar sands. But who would look for $20-a-barrel oil if someone else (Saudi Arabia) has lots of $5-a-barrel oil? The answer is: no one.

Basically, American taxpayers have to guarantee potential producers that the price in the future will not fall below $20 a barrel and that they will not lose their investments.

This is easy to do. The U.S. needs to guarantee that it will buy all of its oil at $20 a barrel before buying anything from OPEC. This forces the price of oil down to $20 a barrel, but it eliminates the possibility that it will ever go back to $5 a barrel.


Outsourcing has an equally simple solution. Let us encourage the dollar to fall. At some value of the dollar, it will pay producers to bring jobs back to the United States.

Suppose the dollar has to fall a lot -- let us assume 50%. Who cares? Only those Americans who plan to take foreign trips or buy something abroad. It costs them more. For those who want to go to the tropics, there are the U.S. Virgin Islands. If the solutions are so simple, why don't we do them? Because all of them are painful.

Write-downs for sub-prime mortgages cost money. Oil at $20 a barrel guarantees there will be no $5-a-barrel oil. A lower dollar guarantees foreign trips and purchases will cost more.

We have Herbert Hoover when we need Franklin Roosevelt. Luckily, we will have a new president and a new Congress come January, but January is a long time away.

Basically, we require changes from President Bush now. He needs to propose a write-down in the sub-prime mortgages, propose a guarantee in the price of oil and let the dollar fall. Unfortunately, the first two are not likely. Only the third will happen with or without his approval. As long as we have a large current account deficit, the dollar will fall. It has to for some very simple reasons.

To get foreign currencies to pay for the deficit, we must borrow from abroad. Eventually, foreigners get tired of lending because they will lose money on their holdings of dollars if the dollar falls further.

At the same time, the big American guys move money into foreign currencies to take advantage of the falling dollar. When they move money back into dollars, they have more dollars. Essentially, they have an infinite amount of money to move.

As they move money, the current account deficit gets bigger and bigger, and the pressure on the dollar to fall only grows.

We need to do something! Take painful actions! Gridlock is the worst of all worlds.

Lester C. Thurow is a professor of management and economics and dean emeritus at the MIT Sloan School of Management. His latest book is "Fortune Favors the Bold: What We Must Do to Build a New and Lasting Global Prosperity."
The markets always have an ebb and flow. I remember in the 80's the housing markets on both coasts tanked due to overpricing. There was a correction and the markets took off again until the market slowed down last year. Congress mandated that mortgage lenders should lend to risky customers and now look what we have.

The bigger problem is our poor energy policy.We rushed into ethanol without considering the effect it would have on food prices. Congress wont allow more domestic drilling and the building of new refineries and even if they agreed today we wouldnt see an improvement for 10 years. Congress needs to realize that alternative fuels/technologies isnt a substitute for oil - unless we look at oil shale and coal liquification. We have more of both than any country in the world.
Actually, plenty of people observed that chasing a small fraction of net energy at the cost of other agricultural production was a bad idea before it kicked off.  The effect was considered, but it was ignored.
Mormons keep a year's supply of canned goods on hand for an emergency.