In Larry Summers Exit Interview, the famous Harvard economist, former U.S. Treasury Secretary under Bill Clinton and senior economic advisor to Obama, gives his opinion on the financial crisis and its aftermath. There is no doubt that Larry Summers has seen it from inside and that he is both highly intelligent and very insightful in his comments. Yet, he does not admit to anything. It's too bad.
It seems like former officials don't like to take any blame for what happened and even remain blind to some indeniable realities. They've seen it from up close which implies that they know. But I believe that they believe themselves to be 100% honest. Wow! In the movie Inside Job, the inability of acquiring a different perspective on the events marking the financial crisis was shown to be a very strong personality trait on the part of many actors of the financial crisis: It was just a big accident! What me? Conflicts of interest? Impossible! I discussed the movie a few times on this blog; here, here and here.
I find the denial from many experts today as shocking as was the denial from financial pundits during the unfolding of the financial crisis in 2007-2008. How many times did we hear that the crisis was contained? That everything was under control? They believed it! They could not see their world falling apart and, to this day, they don't understand why and how it happened.
Today, Larry Summers who saw the crisis coming from afar to a certain extent (he was back at Harvard when Republicans were in power) thinks that it was managed perfectly. For one, as I tried to convince you yesterday, TARP was a big improvised scheme that left a lot to be desired. Yet, even if Larry Summers was able to reflect on the crisis objectively at Harvard, he had too much at stake as a former Treasury Secretary and Board member of big financial corporations to see the big picture through the smoke and mirrors.
I had seen him give a very good presentation in the winter of 2007-2008 in Boston and he had convinced me that the financial crisis had just started; at least he did not think it was contained. But for him, it was just the consequence of the juncture of certain very unfortunate events. No words on why this was all happening; no words on the flaws of the system. Maybe he knew something but did not want to admit to anything. Or maybe he saw the crisis as a consequence of certain decisions he had made as Treasury Secretary but refused to talk about it. It's impossible to know and you won't learn "that" in reading the following "exit interview". Yet, maybe we will be luckier one day when he does his Big Exit in a few decades.
Anyways, here is the piece:
TIE: Let’s start with China. The Chinese government is hinting that it plans to spend another $1.5 billion on new technologies. Housing and retail spending, the preoccupations in the United States, are not part of that spending. In the meantime, China’s military has been engaged in a lot of bravado. How do you size up this brave new world?
Summers: President John Kennedy died believing that Russia would be richer than the United States by 1985. Every issue of the Harvard Business Review in the early 1990s contained some joke or allusion to the effect that the Cold War has ended and Japan and Germany have won. Ezra Vogel’s 1979 book Japan As Number One was a bestseller. But none of these prophecies proved to be correct. In fact, looking at the history of growth rates in all countries, the correlation between growth rates in one decade and growth rates in the next decade is remarkably low. Extrapolative forecasting is perilous. If concern about China leads the United States to strengthen our education system, invest more heavily in research and development, and contain our borrowing, then it could be very constructive. At the same time, it is easy to exaggerate what is happening in China.
The average Chinese citizen is not nearly as rich as an average American was even two or three generations ago. The Chinese government is riding a tiger given all of the changes that are underway in that society. There is always a seductive appeal to technology and public infrastructure. In the 1950s and 1960s people talked about the Moscow subway system in the same way that they talk about Chinese high speed rail today. Whenever I hear about Chinese high-speed rail, I remember that the Shinkansen bullet train in Japan was built in the early 1960s. It may be fast, but it’s not actually twenty-first century technology. It’s very easy to overestimate our problems, and even easier to underestimate the political, environmental, financial, and societal transformational problems that China faces.
At the same time, history as far back as Athens versus Sparta cautions about rising economic powers. The United States is often cited as a benign example, but that’s probably not how people feel in the Philippines, Cuba, Colombia, and in a number of other parts of the world. Relations with China are going to require a great deal of understanding and accommodation in both directions. We in the United States tend to be better at asserting the universality of our values than at accommodating the interests of those who see the world quite differently than we do. Usually, hoping for the best while preparing for the possibility of much less is a good idea. It will require a lot of discussion and mutual trust on both sides to prevent the worst outcomes from materializing. No question, when historians look back a couple of hundred years from now, the relationship between the United States and China is more likely to be the major story than either the end of the Cold War or anything that happens with the Islamic world.
TIE: In the United States and Europe, elites have done everything they can to prop up bank balance sheet values, usually at taxpayer expense. Even in China, the situation is building to where the government may have to bail out the banking system. Did Clinton political advisor James Carville get it wrong? He said that if he believed in reincarnation, he would want to come back as the bond market. Maybe he should come back as a Wall Street banker. Looking back several decades from now, do you think elites will be seen to have put the livelihoods of middle-class workers in jeopardy by attempting to prop up asset values that were unsustainable?
Summers: Whatever’s happening in other countries, it needs to be emphasized that in the United States, the government got back all the money it put into the banks and earned for taxpayers a very good return. U.S. taxpayers are going to have to pay less in taxes than they would have if the government hadn’t made those investments in the banks and the automobile companies. Taxpayers are not financing the bailout in the United States.
TIE: Looking at it from the Federal Reserve’s standpoint, the top twenty Wall Street banks enjoyed access to the Discount Window and were able to borrow for next to nothing. The small- and medium-sized financial firms—the job producers—meanwhile were starved for capital.
Summers: But it’s crucial to separate when taxpayer money is being transferred to elites and when it isn’t. And the current perception in the United States is of much larger taxpayer transfers to elites than, in fact, took place. There really weren’t taxpayer transfers to elites. That said, concern about the middle class is increasing around the world. One crude theory of politics is that outcomes depend on the preferences of the middle class, and when the middle class thinks they have more to fear from a rich elite then they tend left, and when they think they have more to fear from their money being taken away and given to the undeserving poor they tend right. In 2008, the middle class felt they had more to fear from money going to elites and that contributed to the election outcomes. My late Harvard colleague Sam Huntington talked about the rise of the cosmopolitan elites. There’s a concern within countries that business leaders are more citizens of Davos than citizens of their particular country. To win support, global integration is going to require more credible demonstration that globalization doesn’t mean local disintegration.
The difference between efforts that cost the government money and ones that don’t is going to turn out to be a very important distinction. As you well know, the profits earned by the Federal Reserve System have never been higher. The thinking that recent economic recovery programs are a straightforward cost on taxpayers is thus misleading. Nevertheless, as the connection between governments and elites becomes closer, the question of the legitimacy of government is going to become more real.
TIE: Compare the average annual U.S. growth rate since the year 2000—about 2.6 percent—with the rate from 1945 to 2000, which was 3.4 percent. The difference is only 0.8 percent. While that sounds like a small difference, it accounts for the loss of ten million jobs. Americans therefore are witnessing an underperforming economy with big equity markets fuelled by unprecedented central bank liquidity. So if you own a big stock portfolio, everything is wonderful. If you are strictly a middle-class wage earner, you’re in trouble. Is this system politically sustainable?
Summers: The challenge for this country over the next decade will be what happens to middle-class incomes and middle-class families’ sense of well-being. Statistics say that U.S. middle-class incomes have stagnated in real terms, and they’re right. But it’s worth looking beyond those statistics. In terms of durable goods like television sets or refrigerators, or in terms of clothing or even food, there has been real progress. Where middle-class incomes have fallen heavily behind are healthcare, childcare, and, until very recently, housing. This is why President Obama felt that addressing the problems around health care had to be done at the beginning of his presidency. We need job creation, and that’s why infrastructure continues to be an ongoing priority, not a countercyclical one. The group that’s having the most difficult time is men who didn’t go to college and who expect to work with their hands. By supporting infrastructure development, we can help that group.
TIE: How about the middle classes of China and Europe?
Summers: If you ask the Chinese how they were living when they were children, they will say that no society has ever made as much progress. On the one hand, people generally expect their children to live much better than they do, but on the other hand there is acute resentment toward elites who lack legitimacy. In Europe, there’s a growing uneasiness about the future of an aging society. This is coupled with both a lack of acceptance of austerity in the countries that are in the most financial trouble, and failure to understand why it should be the responsibility of ordinary Germans to deal with whatever happens in Greece, Portugal, and Ireland.
In many ways, European integration seems to be one of mankind’s more noble endeavors, but many ordinary citizens view integration as a project by the elites for the elites. Going back to the debates about the European constitution, there’s been a real public legitimacy gap in Europe. But throughout the world, the question of confidence in institutions is becoming increasingly important. The more complicated the world becomes, the more it needs institutions even though the world finds itself with less and less confidence in those institutions.
TIE: How about the monetary mechanism in the United States? The Fed has engaged in a second round of quantitative easing, the so-called QE2. A lot of people hope it will produce some kind of a wealth effect. While QE2 may be a clever idea, is the jury still out on whether the policy produces some negative unintended consequences?
Summers: Credit flows require both borrowers and lenders. In the early stages of the crisis, there was clearly a problem with lenders being unable to lend even to creditworthy borrowers. It appears now that the larger problem in lending is on the demand side rather than on the supply side. The evidence is in the extremely low level of interest rates in credit spreads, and in the failure to invest even by those sitting on large amounts of cash earning a zero percent interest rate. It’s common sense that you don’t expand your restaurant or hire new waiters if your existing waiters are sitting around with no customers to serve. At this point, the problem is less with the monetary transmission mechanism than with a lack of effective demand to borrow.
Then there are bubbles. Bubbles lead to excessive optimism, excessively high prices of assets, and excessive creation of those assets, whether they’re factories or houses or shopping centers. Bubbles then lead to excessive borrowing against those assets. When a bubble bursts, you are left on the one hand with an excess supply of assets sitting empty, and on the other with an excessively indebted set of asset holders. After a bubble, there is a very high desire to save in order to restore normal balance sheets, and no desire to invest because of the large number of assets sitting empty. The normal economic mechanism for bridging excessive saving relative to investment is a decline in interest rates.
But you can’t jump very far out of the basement, and interest rates can’t fall from zero. Thus, the mechanism doesn’t really work to restore the economy. I’ve been an advocate for fiscal discipline throughout my career. Reducing deficits in the 1990s was part of what drove the economy forward. But in the current circumstance, where the private balance had swung into massive surplus, an upwards adjustment in the government budget deficit was appropriate. Only by getting demand going in the economy—so people would to see their office building start to fill up and see that existing workers had too much to do—could you start to engage the forces of expansion.
TIE: Isn’t it true that the wealth effect on the asset side is the only hope of those pushing quantitative easing, simply because the employment challenge is so enormous that anything short of a monstrously large monetary stimulus is doomed to fail? Some analysts argue that reducing the U.S. unemployment rate from 10 percent down to 5 percent would traditionally require a 400-basis-point cut in interest rates. With short-term nominal rates in the basement, the Fed to match that level of stimulus would need to do $4–$6 trillion in bond purchases.
Summers: If the multiplier of a policy instrument is relatively low, it’s never entirely clear whether that’s an argument for not using the policy instrument, or for using it on a larger scale. It’s certainly true that Taylor Rule calculations suggest that interest rates could be—if it were possible—minus-3 percent or even minus-5 percent. And no one thinks that $600 million in quantitative easing corresponds to a reduction in interest rates of anything approaching that magnitude. I understand the view that QE2 will be relatively ineffective, or that it will be inflationary. But I don’t see how it could be both. If QE2 does not meaningfully affect the credit process, then it is hard to understand how it can be inflationary. The greater risks in the current environment are more on the side of doing too little to assure that the recovery is rapid and normal conditions return, than on the side of making the mistakes of the 1970s and running into an excessively inflationary environment.
TIE: No postwar U.S. recovery has performed well without housing leading the charge. Yet housing is still in the basement. Statistics show that if a person borrowed to buy a house within two years of the peak, because of negative equity in the house, that person can’t refinance even if rates are attractive.
Summers: The Obama Administration put in place a set of programs, though nothing as rapidly as we would have liked. The HARP program through the Federal Housing Administration was directed at exactly at that problem— financing for people who had met all their obligations but whose mortgage was currently underwater. But the challenge is deeper. We have a substantial inventory of unused homes. It’s not clear that if we somehow found a way to get more houses built before that inventory was worked off, it would be an especially good thing to do. I’m hardly Austrian in my outlook, but building more of what’s already in excess supply as a countercyclical tool does not seem like nearly as good an idea as trying to encourage energy efficiency investments in existing houses.
Traditional economic thinking puts too little weight on qualitative change as distinct from quantitative change. People always talk about excess capacity and they’re right. Despite three personal computers in our basement, I still bought an iPad because it was able to do different things. Solving the housing situation is going to be difficult. But we should look at spurring investment in areas where qualitative improvement is possible.
TIE: Banks have a lot of inventory on their balance sheets with foreclosures and so forth. Are you concerned at all about accounting forbearance? One of the reasons the inventory stays on bank balance sheets is the failure rates—the banks don’t want to write it off until they are earning profits. Wouldn’t getting inventory off the balance sheets and into the market help clear this process and make housing more affordable?
Summers: You raise an important point. We put a lot of emphasis on raising capital ratios in banks. However, a number of the institutions that failed were reporting terrific regulatory capital almost on the brink of their failure. I hope over time we will look carefully at our measurement concepts for regulatory capital as well as our levels of regulatory capital.
TIE: If the German people end up backstopping the European sovereign debt problem, presumably the Bund (ten-year government bond) will take a hit and interest rates will rise? Will there be a contagion effect with U.S. Treasury rates?
Summers: I could argue both sides on that issue. You could argue the inflationary effect, but you could also argue a flight to quality develops if there used to be two quality assets and now there’s only one.
TIE: What about the dollar?
Summers: You have to hold something. That’s the explanation I’ve been giving for years for why gold’s done so well. There is no alternative currency to buy. It’s implicit in the way you’re talking about it to judge what the impact will be, because the extent to which Europe has difficulty will tend to reduce demand relative to supply of global credit markets. This will tend to lower interest rates, which will tend to raise uncertainty premia, which will raise interest rates, which will tend to lead to a flight to quality to the United States, which will tend to reduce interest rates, and so on.
It’s pretty difficult to work out what the impact of developments in Europe will be, but one possibility is that complexity in Europe raises uncertainty which leads to a flight to quality. I was struck by the extent to which the U.S. bonds were a flight-to-quality asset even in a global financial crisis in which the United States was at the epicenter. And in a financial crisis where the United States is not the epicenter, I would expect the flight to quality and safety to happen on an even more pronounced basis. The alternative view would be that if Germany signals in some unambiguous way that the European debt situation is going to be resolved in a manner easier than expected, then some of the uncertainty premium may come out of interest rates and you may have less flight to quality.
TIE: The Chinese have just announced that Chinese overseas corporations no longer need to bring back capital, which is another way of saying the Chinese will no longer be big buyers of U.S. Treasury securities. What are the implications of this decision? Will the Fed be forced to become the big buyer in the Treasury auction the way it performed during World War II? Is there a chance of an inflationary effect? How about a crowding-out effect from such policies?
Summers: I see a very different situation in a substantially demand-constrained liquidity trap economy. Many of the traditional shibboleths about prudent policy don’t really apply in that context. That’s why John Maynard Keynes’s book, General Theory of Employment, Interest and Money, was so important. At the same time, Keynes’s book was actually a specific theory of a depressed liquidity-trap economy. As we succeed in the United States in normalizing conditions, then the normal laws of economics regarding inflation, interest rates, and confidence can come back very quickly. As MIT Professor Rudi Dornbusch used to say, things in markets and economies take longer to happen than you think they will, and then they happen faster than you thought they could. That was a good thing to remember as imbalances built up before the crisis, and I think it’s a good thing to remember now.
Bankers and government officials would have you believe that TARP was a success. Their main two arguments are 1. Without it, we would be in the abyss and 2. TARP was a profitable operation for the U.S. government and thus taxpayers.
I will first present the case in favour of the Troubled Asset Relief Program by reproducing below an article published yesterday by Robert Samuelson (no relations to Paul) who writes often for the Washington Post and others newspapers. I will then lead you to John Taylor's blog to bring you a much more unbiased assessment of the initiative. Taylor is a professor of economics at Stanford and the Taylor rule is named after him. Let me know who you believe!
"It isn't often that the government launches a major program that achieves its main goals at a tiny fraction of its estimated costs. That's the story of TARP - the Troubled Assets Relief Program. Created in October 2008 at the height of the financial crisis, it helped stabilize the economy, using only $410 billion of its authorized $700 billion. And most of that will be repaid. The Congressional Budget Office, which once projected TARP's ultimate cost at $356 billion, now says $19 billion. This could go lower.
"You would hardly know.
"Almost everyone loves to hate TARP. It's a favorite political sport of liberals, conservatives, Republicans, Democrats - and the public. A Bloomberg poll last October asked how TARP had affected the economy. Forty-three percent of respondents said it weakened the economy; 21 percent said it made no difference; only 24 percent said it helped, with 12 percent unsure one way or another. Commentators in newspapers from the Wall Street Journal to the New York Times disparage TARP.
"One lesson of the financial crisis is this: When the entire financial system succumbs to panic, only the government is powerful enough to prevent a complete collapse. Panics signify the triumph of fear. TARP was part of the process by which fear was overcome. It wasn't the only part, but it was an essential part. Without TARP, we'd be worse off today. No one can say whether unemployment would be 11 percent or 14 percent; it certainly wouldn't be 8.9 percent.
"That benefited all Americans. TARP, says Douglas Elliott of the Brookings Institution, "is the best large federal program to be despised by the public."
"The source of outrage is no secret. Bankers are blamed for the crisis and reviled. The bank bailout - TARP's first and most important purpose - was instantly unpopular. Most Americans, says Elliott, "believe that taxpayers spent $700 billion and got nothing in return."
"What this ignores - aside from being factually incorrect - is that an alternative being promoted at the time was widespread nationalization of banks. The cost would have been many times higher; the practical problems would have been enormous. As it was, TARP invested $245 billion in banks(and about $165 billion into the other programs). The extra capital helped restore trust. Meanwhile, the Federal Reserve increased its lending; the Federal Deposit Insurance Corp. guaranteed $350 billion of bank borrowings. Banks resumed dealing with each other because they regained confidence that commitments would be honored.
"Of the $245 billion invested in banks, the Treasury has already recovered about $244 billion, including interest payments, dividends and cash from sold bank stock warrants. So the bank rescue has roughly broken even. When TARP's remaining bank investments are closed, the Treasury expects an overall profit of about $20 billion.
"Almost all of TARP's activities have been distasteful. This was surely true of the rescue of General Motors and Chrysler. But the automakers' collapse would clearly have worsened already dismal unemployment. Did we really want these companies to shut down, with some plants sold to foreign automakers? Of the $80 billion committed to the auto rescue, the Treasury now expects to recoup about $65 billion. The government still owns about 33 percent of GM and 9 percent of Chrysler. By contrast, the sale of its 92 percent stake in AIG, the insurance giant, might yield a small profit.
"We need to remember that TARP was a desperate program for desperate times. It's had its failures: The Obama administration's forecast that it would provide mortgage relief to 3 million to 4 million homeowners has fallen well short (the current number is about 600,000). But the larger purpose of helping calm financial markets succeeded. Costs have been lower than predicted because aid was extended at the panic's height, when expectations of losses were greatest. As the economy has recovered, the gloomiest predictions proved exaggerated.
"Some TARP critiques reflect desirable oversight by Congress, the Government Accountability Office and a special Treasury inspector general. But some criticisms are broad generalities that, on inspection, are highly suspect. One common allegation is that TARP will encourage more reckless risk-taking because big financial firms know they'll be bailed out if their gambles backfire - a problem economists call "moral hazard." Bankers keep profits but are protected against losses, which are assumed by the public.
"This is a serious issue, but TARP's legacy is actually the opposite. During the crisis, investors in banks and financial institutions suffered huge losses. It wasn't predictable which institutions would survive and which wouldn't - or on what terms. The same would be true in the future. Indeed, TARP's extreme unpopularity compounds uncertainty, because it suggests that politicians will recoil from more bailouts. The moral hazard is more imagined than real."
Now that we read the case for TARP, have a deep look at the following blog entry, Evaluating Tarp, from Economics One, John Taylor's blog. In the text below, I also reproduced the links to the different testimonies to the Congressional Oversight Panel of the House of Representatives as I want to strongly encourage you to click on them to get various opinions from different economists on TARP.
Here is Taylor's March 17th entry about the infamous program:
"Today’s TARP hearing at Senate Banking follows a slew of recent reports. The Congressional Oversight Panel (COP) issued its final report yesterday. Economists Simon Johnson, Allan Meltzer, Joe Stiglitz, and Luigi Zingales submitted testimony to COP two weeks ago. The Special Inspector General for TARP (SIGTARP) issued a comprehensive review in January. Three members of COP published an oped in today’s Wall Street Journal.
"A common theme is the high cost of the TARP. I‘m not talking about whether the government lost or made money, which is not a good measure of effectiveness, but rather the costs to the economy (stability, growth, employment, etc). Since November 2008 I have been writing about the costs of the chaotic rollout of the TARP which in my view worsened the crisis and exacerbated the panic. (Here is my written testimony for today’s hearing.) In his recent book former FDIC chairman Bill Isaac concluded that “any objective analysis would conclude that the TARP legislation did nothing to stabilize the financial system that could not have been done without it. Moreover, the negative aspects of the TARP legislation far outweighed any possible benefit.” In his recent testimony Joe Stiglitz said that “TARP has not only been a dismal failure…but the way the program was managed has, I believe, contributed to the economy’s problems.”
"Of course others are more positive about the stabilizing effect of TARP. Timothy Massad, current acting assistant secretary of Treasury, argues that the TARP prevented a more severe panic, citing as empirical evidence a paper by Alan Blinder and Mark Zandi. However, Blinder and Zandi explain that they don’t do a separate evaluation of the TARP: “We make no attempt to decompose the financial-policy effects into portions attributable to TARP, to the Fed’s quantitative easing policies, etc,” they say, so this is not really empirical evidence. COP is also positive about the short run impact though less positive than the Treasury
"Though some disagree about the net costs of TARP in the short run, few disagree that the longer-run costs are substantial. In January the SIGTARP listed these costs:
“damage to Government credibility that has plagued the program,”
“failure of programs designed to help Main Street rather than Wall Street,”
“moral hazard and potentially disastrous consequences associated with the continued existence of financial institutions that are ‘too big to fail’”
The COP final report listed these costs:
“continuing distortions in the market”
“public anger toward policymakers,”
“a lack of full transparency and accountability.”
"At the COP hearing, Stiglitz, Meltzer, Johnson, and Zingales (who rarely all agree) were unanimous in their view that the TARP actions have created an incentive for financial institutions and their creditors to take high risks due to the expectation of being bailed out, favoring big players and leaving the economy vulnerable to financial crisis. They also agreed that the Dodd-Frank legislation did not solve “too big to fail.”
"To these costs I would add that the TARP established an unfortunate precedent of heavy-handed government intervention in the operations of businesses. The government forced some financial institutions to take TARP funds, even those that said they did not want them, by threatening actions from regulators. The government used the TARP for purposes other than originally stated in Congressional hearings, including the bailing out of automobile companies.
"TARP is not popular with most Americans. Economic evaluations now rolling in support their view, but rather than pointing fingers, it is time to absorb the lessons and take actions to remove the legacy costs and try to end government bailouts as we know them."
In All You Need to Know About Why Things Fell Apart (Bloomberg February 15th), Michael Lewis gives his humorous perspectives on the reasons behind the financial crisis. The author of the Big Short gives up. After the Financial Crisis Inquiry Commission basically blamed no one and everyone for what happened, there is only one way to deal with the outcome: Irony and Sarcasms!
What else can we do at this point? Nothing in the game has changed, neither the rules, nor the players. We are just waiting for things to get back to normal and for banks to slowly get back into the game. With sufficient time, they will wash away their toxic waste (which half life is shorter than a nuclear reactor's radioactive material), rebuild their capital and get back into the speculating business. With enough taxpayers money, that should be relatively soon.
However, I expect that their return to "business as usual" will differ in one aspect. Having learned that they can get burned too, banks will design new ways to further shelter themselves from risks and thus will rely more than ever on fees to generate returns. These new business segments will require less capital and be much less risky. Yet, in order to compensate for the loss of the carry-trade business segment, banks will be forced to come up with some more fee-based business ideas. However, these will just be refinement on a business model that emerged twenty years ago and which was perfected ever since (well, almost perfected!).
Securitisation was a nice trick: take any risks, package them and to sell them to others for a fee. This might still work provided that banks find better ways to manage their inventories of outstanding loans waiting to be securitised. Last time around, banks got stuck with a very large batch of very stinky loans which they were about to unload on us, just before the scheme collapsed.
Ponzi schemes do not always pay off. That is unless you are too big to fail and the government bails you out. Now that I am thinking about it, banks did find a way to unload that last stink batch of loans on us ...
Here is the piece:
A surprising number of my fellow citizens appear to be unaware of my service these past 18 months as a member of the Financial Crisis Inquiry Commission.
Thus it may come as news that I have declined to sign the report issued by the majority, or the dissent by the three- member minority, or even the dissent from their dissent, written by the now-immortal Peter J. Wallison. I hereby dissent from the dissent from the dissent. My dissent is different from all those other dissents, which is why I am dissenting.
I do this, of course, not to call attention to myself. Still less do I seek to enhance the status of my application for employment with JPMorgan Chase. I seek merely to inform the general public of the true causes of our so-called financial crisis.
The task is not a simple one. In limiting me to a mere two pages at the end of their 633-page book, the majority and the other dissenters have suppressed not only several apt metaphors, but deep truths.
Here, in a far-too-brief executive summary, they are:
Financial Crisis Cause No. 1: Wall Street’s shifting demographics.
In the commission’s report Federal Reserve Chairman Ben Bernanke describes recent events as “the worst financial crisis in global history, including the Great Depression.” The event, in other words, was unprecedented. To understand an event that has never before occurred, we must logically begin with those factors that have never before been present. On Wall Street, the most obvious such factor is women.
Of course, the women who flooded into Wall Street firms before the crisis weren’t typically permitted to take big financial risks. As a rule they remained in the background, as “helpmates.” But their presence clearly distorted the judgment of male bond traders --- though the mechanics of their influence remains unexplored by the commission (on which several women sat).
They may have compelled the male risk takers to “show off for the ladies,” for instance, or perhaps they merely asked annoying questions and undermined the risk takers’ confidence.
At any rate, one sure sign of the importance of women in the financial crisis is the market’s subsequent response: to purge women from senior Wall Street roles. Wall Street’s gender problem is, for the moment, of merely academic interest. Less academic is...
Financial Crisis Cause No. 2: The moral collapse of the American working class.
AIG head Robert Benmosche has recently pointed out that the reason his firm has enjoyed such great success is precisely because it has avoided selling insurance to the large number of Americans who believe, as Benmosche put it, “that the government is responsible for what happens to me.” (As we know, the government is responsible only for what happens to AIG).
The CEO of JPMorgan, Jamie Dimon, has often called our attention to the outrageous amount of banker bashing by Americans outside the financial sector, who seek to blame their troubles on others.
Wall Street leaders now understand that they made a mistake, one born of their innocent and trusting nature. They trusted ordinary Americans to behave more responsibly than they themselves ever would, and these ordinary Americans betrayed their trust.
Amazingly, these ordinary Americans don’t even appear to feel guilty for their actions. Like wild animals that have lost their fear of humans, they continue to wander down from the hills to rummage through our garbage cans for sustenance.
Frankly, the commission’s report does nothing to improve public morals. In discussing the role of the 1977 Community Reinvestment Act, for instance, the report notes that the loans made by big banks to meet the act’s requirements -- that is, loans to poor people in crap neighborhoods -- outperformed, dramatically, the general run of subprime loans.
Such nitpicking merely obscures the critical point. For at least two centuries the U.S. government has encouraged people who didn’t work on Wall Street to think of themselves as “equal.” Government policies have emboldened ordinary Americans to borrow money they never intended to repay, just like rich people do, and cowed the financial elite into lending it to them. You can’t forget to bear-proof the garbage cans, and expect the bears won’t notice.
Along these same lines I cannot help but point out...
Financial Crisis Cause No. 3: The Chinese.
The willingness of this remote and curious people to sell us goods at ridiculously low prices is disruptive. It encourages our poor to believe they can afford many items which they should not be able to, for instance. And the vast number of dollars these same Chinese people willingly lend to us at absurdly low rates of interest places an unfair burden on our financiers, who must find someplace to put them.
This is a far more difficult job than is commonly understood; it often leaves Wall Street people feeling overworked and underappreciated. If we want our financiers to perform even better than they do, we must cease to expect more from them than they can give.
Which brings me to...
Financial Crisis Cause No. 4: Upon our trusting, hard- working and underappreciated financiers we thrust the impossible task of overcoming impersonal historical forces.
The most distressing aspect of the commission’s report is its attempt to blame actual human beings for the financial crisis: fraudulent CDO managers, greedy ratings companies, Wall Street bond traders and, especially, Wall Street CEOs. Think about this: If everyone on Wall Street is guilty, how can anyone be? If no one on Wall Street saw it coming, how can anyone be expected to have seen it?
Details for Dummies
Anyway, as several Wall Street CEOs tried patiently to explain to the commission, the details were never their responsibility. Martin Sullivan, the CEO of AIG in the three years leading up to its near collapse, even went so far as to prove that he had no idea how much he’d been paid ($107 million).
The commission proved incapable of grasping the point: the rare man capable of running a big Wall Street firm remains focused on the big picture. And in the big picture, from the point of view of their firms and their earnings potential, the so-called financial crisis was a blip. They’ve already forgotten about it.
In The Anemic Recovery Continues, published in The Wall Street Journal last week, Mortimer Zuckerman asks "Who can blame consumers for holding back when 50 million Americans depend on taxpayer-supported programs?" Zuckerman makes a strong case for why the American economy is not about to witness a strong recovery. He builts his case on three pillars: weak consumer spending, a terrible housing market and lingering unemployment.
The chairman and editor in chief of U.S. News & World Report argues that the situation is less visible than it might otherwise be as our social safety net is partially masking the real situation: "The modern-day soup line is a check in the mail".
Here is the piece:
"There's an acidic remark by Dorothy Parker, the New Yorker wit of the 1920s, that just about sums up our present economic predicament. She was asked if she'd heard the news that President Calvin Coolidge was dead and responded: "How can they tell?"
"How can we tell that our long-awaited recovery is alive? Once the pulse began to beat a little more strongly last year it was assumed that we were on course to something like full health. Recently attention has been mostly focused on the various deficits, the debt ceiling, and the budget battles. They're all matters of concern but all of them will be more menacing if the nascent recovery is stalled or even reversed. Is that happening? Or are we on an ascent at last with 192,000 new jobs added to nonfarm rolls last month?
"Three elements offer clues: consumer spending, housing and unemployment.
"Importantly, the bubble of exuberant consumerism that powered the U.S. economy for the last 10 years of the 20th century and for most of the first years of the 21st century has burst. In reaction to economic hard times, American consumers are planning for the worst rather than hoping for the best, and they continue to pay down household debt instead of spending cash.
"Who could blame people for holding back when we see roughly 50 million Americans on one or more taxpayer-supported programs, be it food stamps or unemployment benefits? This downturn may not have the 1930s feel of despair, but in large part that is because, as the economist David Rosenberg of the wealth-management firm Gluskin Sheff put it, "The modern day soup line is a check in the mail."
"An unprecedented number of Americans are borrowing against their 401(k)s, canceling their life insurance policies, and forgoing physicals. And that isn't all. The American consumer today is fearful of the impact of higher food prices, higher gasoline prices, higher insurance costs, higher everything. The inflation of food and fuel alone has absorbed the December tax cuts agreed to by Congress and the administration.
"So where has the recent modest growth in the economy come from? It is primarily due to massive amounts of federal government stimulus and a huge inventory swing, both of which will peter out this year. Only the wealthiest 10% of the population, whose stock portfolios have come roaring back, are doing well, but their spending is not enough to spur the economy or create much additional hiring.
"Why are all the vital signs discouraging? Quite simply, it is because households are still carrying far too much debt on their balance sheets. Relative to income, debt today is approximately twice as high for families as it was in the 1980s. Total borrowing in relation to disposable, personal after-tax income leaped to approximately 136% in the first quarter of 2008 from 60% in the early 1980s before it began to recede. It has now declined to 117% of income compared to the pre- bubble norm of 70%. To return to that level, debt would have to be reduced by another $6 trillion. Similarly, the debt-to-asset ratio in relation to household assets is currently 20%, but the pre-bubble norm was 12.5%. The deleveraging process still has a long ways to go.
"As more U.S. households pay down their debt, the slowdown in consumer spending will continue. The savings rate, which had averaged 8.6% during the 1980s and 5.5% in the 1990s, dropped to an alarming 2.8% in the 2000s. No longer are households engaging in mortgage equity cash-outs to the tune of over $80 billion per quarter, as they did in 2006. Cash-out refinancing today has dropped by 90%, contracting the available funds that helped power the pre-2007 spending binge.
"Not surprisingly, middle-class Americans are growing increasingly leery of debt. This trend will continue as more families realize their retirement nest egg is going to be a whole lot smaller than they expected. Credit cards provide a marker. In a survey taken towards the end of last year by Javelin Strategy & Research, only 45% of households used credit cards in 2010, compared to 56% in 2009, and 87% in 2007.
"Virtually every index of consumer sentiment supports this sense of consumer restraint. In a recent poll taken by the Pew Research Center, 71% of American consumers say they are buying less expensive brands, 57% say they have trimmed or eliminated vacations, 11% have postponed marriage or children, and 9% have moved in with their families, reducing spending on alcoholic beverages, clothing and restaurants. In other words, roughly 25 million unemployed or partially unemployed Americans are focusing on basic necessities. They make up a part of the 42 million Americans on food stamps.
"Quite simply, American households are seeking to become net savers, not net borrowers. This is hardly surprising when real median household incomes are down over 4% from the 2000-2009 decade, according to recent research conducted by Mr. Rosenberg at Gluskin Sheff. Net worth has declined by more than $100,000 for the average household compared to just three years ago, and total household net worth is $12 trillion lower today than at the pre-recession peak—an unprecedented decline of 18.5% over three years. The bulk of this loss comes from diminished home equity, and with more than six million homes in inventory or in foreclosure, prices have been declining again for the past six months.
"In short, the triple whammy of weak consumer sales, a weak housing market, and a deeply anemic job market is still very much with us. There are no quick fixes to the post-bubble credit collapse. The painful process of deleveraging is far from over. Current debt loads are not sustainable either by incomes or asset values, which are falling.
"That's why our economic pulse is so weak. Real GDP growth is less than half of what one would ordinarily expect to see coming out of such a deep downturn. And there has been virtually no recovery at all with respect to housing, income levels and employment.
"The government's February jobs report reaped a slew of cheerful headlines. But much of the bounce came in construction, where workers were kept idle by January's snowfalls. Job gains for the past three months averaged just 135,000—we need 150,000 a month just to keep pace with population. And government figures don't take into account the two million plus discouraged workers who've dropped out of the labor force over the past year and a half and are still unemployed. If counted, the jobless rate would have been 11.5% in February.
"Government programs may have provided an early, if minor, lift to the economy, but clearly they have not sustained it. One possible engine of recovery may be the improving profitability of corporate America, if the cash finds its way into increased capital spending and employment. But with companies uncertain about the future, that's not happening.
"Like it or not, our increasingly anemic recovery may yet require the jolt of a substantial new stimulus. For any such defibrillation shock to be effective—or politically feasible—it must not spook the bond market. That means the patient must be assured of longer-term reductions in the major expenditure programs of the national government. Until we have a credible and convincing plan, it seems we'll have an economy that is neither certifiably dead nor robustly alive."
Recently, I claimed that increasing risks to our global economy are caused by the increasing interdependence between our economies and global systems of production. I also talked about the need to improve our risk management capabilities in order to solidify our global economic system and to avoid deep crises. A few days later, in a Flock of Black Swans, I posted an article by Doug Kass warning us about the increasing frequency of Black Swan events. The author also identified globalisation and interdependence as the breathing ground for Black Swans.
Both of these blog entries claimed that the channel of risk transmission that contributes the most to increasing both the frequency and magnitude of Black Swans is an increasingly efficient but fragile global value chain.
Although recent events in Japan and in the Middle East intuitively make us understand and fear that large natural catastrophes and significant social unrest can jeopardise the weak and nascent recovery, it still remains difficult for many of us to imagine how can this concretely happen. Some would identify the rising price of energy as a damper on world growth. It is a significant element in my view but not one that is sufficient, at least by itself, to cause a Black Swan event that could reignite events similar to those that occured in 2008 and 2009.
More important, in my opinion, is the danger of a severe breakdown in the global production process. However, at that point in my posts, I offered readers no concrete examples to illustrate how this phenomenon would play out. However, in Crisis Tests Supply Chain's Weak Links, published in the Wall Street Journal a couple of days ago, James Hookway and Aries Poon supply such evidence. The article shows that the global supply chain is under some significant strains following the Japanese earthquakes and tsunami and that, as a consequence, the interdependent world we live in is indeed very risky as it rests on a very fragile construct.
Here is the piece:
“Companies around the world are scrambling to retool their supply chains as they cope with the Japan earthquake—and many are finding they might not be as well-prepared as they thought.
“Logistics experts said the quake's aftermath has exposed critical weak points for a slew of global businesses, such as electronics and automobiles.
“General Motors Co. on Thursday became the first U.S. auto maker to close a factory because of the crisis in Japan. GM said it plans next week to idle a Shreveport, La., plant that builds small pickup trucks. The company cited short supplies for a Japan-made part it didn't identify and didn't say when it expected to restart production.
“World-wide, companies slowed production or searched for new suppliers to avoid running out of components for which Japan dominates the market. Japan accounts for roughly one-fifth of the world's supply of silicon wafers used to make semiconductors, according to VLSI Research, and is home to a large number of manufacturers for a key material in liquid-crystal-display panels.
“The country also supplies about 90% of the world's supply of bismaleimide triazine, a chemical used in making circuit boards for telephone handsets.
“Meanwhile, Boeing Co. officials said Thursday that they are determining how to deal with possible airplane-parts shortages from suppliers in Japan.
“Nearly one-third of the company's coming 787 Dreamliner, and parts for all of Boeing's other in-production commercial airplanes, come from dozens of Japanese suppliers.
“A Boeing spokesman said the company had "identified points of risk within the supply chain and [is] developing mitigation plans." He said the company will be able to largely manage those risks with "minimal" supply-chain disruption as long as the power supply and transportation infrastructure doesn't worsen in the coming days or weeks.
“"What good companies do is look at a supply chain as a movie, rather than as a photo," said Yogesh Malik, a partner at consulting firm McKinsey & Co. Instead of judging a supply chain by what suppliers can deliver at one moment, a well-prepared company accounts for rising oil prices, environmental activism and regulatory risks to determine whether the chain will hold for the next five years. "It's not a matter of if, but when, something goes wrong," Mr. Malik said.
“An added wrinkle is that companies often buy parts from a producer that relies on raw materials or smaller components that come from yet another location, like Japan. Many companies were scrambling to figure out how much exposure they have to such hidden bottlenecks.
“Honda Motor Co.'s Thailand operation said it was seeking information about the availability of Japanese-made electronics systems. The company's top executive in Bangkok, Atsushi Fujimoto, said the auto maker has enough parts to keep production going in Thailand until mid-April and is considering using alternative suppliers if its Japan-based plants remain closed.
“Also in Thailand, Mazda Motor Corp. Managing Executive Officer Yuji Nakamine said the auto maker is waiting for information from Japan about component supplies and is slowing production near Bangkok. "All Japanese manufacturers are affected but we need more time to get clearer details from our suppliers," he said.
“In Taiwan, Nan Ya Printed Circuit Board Corp. was looking for new suppliers of bismaleimide triazine. Its main supplier, Mitsubishi Gas Chemical Co., suspended production in Japan on Wednesday. Nan Ya "is speeding up the testing of the substitute," a person familiar with the situation said. "Normally it would take three to four months, but this time it should probably take one month."
“Advanced Semiconductor Engineering Inc., a major Taiwan chip-packaging company, said it was attempting to get new supplies of the plastic molding compounds, which are used to house semiconductors, from China and South Korea.
“Even companies that said they were unaffected by Japan's crisis qualified their statements with "so far" and "yet." South Korean memory-chip maker Hynix Semiconductor Inc. said it has enough inventory of silicon wafers to continue operating normally in the short term. "But if the situation lasts longer, it may impact not only Hynix but the whole chip-making industry," a spokeswoman said.
“By building inventories and diversifying their range of suppliers, companies can spare themselves much of the anxiety rippling across Asia and beyond, analysts said, even if it might cost more to store contingency supplies.
“Some logistics specialists have warned that just-in-time delivery systems—pioneered in Japan and often used in the technology and car industries to deliver components and raw materials only when they are needed—are vulnerable to supply shocks.
“Many global producers also have moved in recent years to pare their roster of suppliers to get reduced rates from the suppliers they do use. That creates risks if that smaller base is unable to deliver goods.
“The political turmoil in the Mideast and North Africa, Iceland's volcanic eruption last year and China's move in September to restrict exports of rare-earth materials should have put companies on notice. "Heightened risks and outright disruptions are coming at us at a furious pace and it is absolutely critical that firms be prepared with detailed contingency plans," Jeff Karrenbauer, president of Insight Inc., a Virginia-based consulting firm specializing in supply chains, wrote recently.
“To some degree, the disaster in Japan is unusual. The country has carved out a niche as a high-end producer of many advanced components and materials, and Japanese companies often dominate their sectors. Japan supplies 78% of the global supply for the electrode materials in lithium-ion batteries, nearly all of the protective polarized film for liquid crystal displays and large quantities of other high-tech materials, according to Credit Suisse AG.
“Nonetheless, the deepening worries over supplies of such goods is underscoring how disasters can trigger global supply shocks.
“Sweden's Volvo Cars, a unit of China's Zhejiang Geely Holding Group Co., said that it has only about a week's supply of Japanese components and that unless the company can acquire more parts soon, production will be hit significantly.
“Volvo Chief Executive Stefan Jacoby and the rest of the executive board are meeting every morning to monitor supplies and assess contingency plans. One possibility is to partially manufacture some models and fit them later with the missing components, though that could work for only a short time. Another possibility is to shuffle some production to focus on models that aren't as affected by the supply shortage.”
I am absolutely confident that we made the right decision. And not only that, I'm absolutely confident that the actions we took in Iraq are influencing reformers and freedom lovers in the greater Middle East. And I believe that you're going to see the rise of democracy in many countries in the broader Middle East, which will lay the foundation for peace.
Jun. 29, 2005 George W. Bush
Today I authorized the Armed Forces of the United States to begin a limited military action in Libya in support of an international effort to protect Libyan civilians. That action has now begun…We are answering the calls of a threatened people. And we are acting in the interests of the United States and the world.
March 19, 2011 Barak Obama
Once More Unto the Breach
So, here we go again, the US is stepping in to protect the oppressed from the Tyrant. What, pray tell is the difference – morally, geopolitically and militarily – between Libya and Iraq, and why, among all Tyrannies, is the US taking up the fight against one who has become an ally?
The most perplexing question of all is; why is a President who opposed the Iraq war using exactly the same rationale as his predecessor to launch a military action against another Arab regime? In short, what am I missing here?
Libya: The Moral Case
President Obama recently justified intervention in Libya as necessary to stop a humanitarian crisis. While the goal is laudable, and leaving aside consideration of the likely efficacy of the policy, why has he chosen to act in this humanitarian crisis? What about the rape of democracy in Lebanon (if we keep focus solely on the Middle East) or why not act to support the protesters in Iran who have been as brutally repressed by their government as anything Qaddafi has meted out? Shhh, don’t dare mention Saudi Arabia.
There is just no moral case to selectively intervene in Libya, except that perhaps it is better to do something, somewhere than to do nothing anywhere.
President Obama remarked that the current uprisings in the Middle East are spontaneous and home grown, pointing out that the US is backing a popular uprising; not instigating it. I suspect he is attempting to differentiate his intervention from that of President Bush in Iraq, possibly believing the Arab masses will be grateful towards the US this time round: If so, the distinction is fallacious, as there was an active Shia and Kurd resistance to Saddam Hussein (which, incidentally, the US undermined in 1992).
Libya: The Geopolitical Case
For two decades Muammar Qaddafi had been an important financier of Islamic and Palestinian terrorism and a trafficker in nuclear arms. In 2003 he agreed to a rapprochement with the West as a part of which he renounced his nuclear ambitions and removed his support for terrorism. Insofar as the greatest perceived geopolitical threat faced by the US after 9/11 was terrorism and nuclear proliferation, the deal with Qaddafi – which, by all accounts, he has honored – counted as a major success in the War on Terror. Why would America now side with his opponents? We don’t know very much about them. Are they democrats? Are they Islamists? Do they hate the US? Will they support terrorism? We simply do not know.
Furthermore, the US made a deal with Qaddafi. Now it is telling him “that was then and this is now”. Maybe everything will be Ok if he is deposed. But even if that occurs, what signal does it send to other current and would be allies? Is the US unreliable? Can the US be trusted? That consideration is being given short shrift amidst the current frenzied calls for Qaddafi’s departure.
Many proponents of intervention believe the “Arab Spring” has given the US an opportunity to demonstrate its support for the masses, finally shedding its historic alliance with the Tyrants, who’s days appear numbered in any event. It is an historic opportunity for the US to get on the ‘right’ side of history in the Middle East and diffuse the enmity it has cultivated in the past. But for the US to gain credibility with the supposed Pan Arab uprising – it is truly breathtaking to read pundits pontificate on “the” cause and the inevitability of a movement they scarcely knew existed two months ago – it surely needs to be consistent in its support of the Street. That means it should take sides against the Monarchies in Jordan, Bahrain and Saudi Arabia –but it is unlikely to do so. Most puzzlingly, the US appears to be doing nothing to aid freedom fighters in Iran, with whom it has a high stakes confrontation. That is, where faced by an out and out enemy who also happens to be brutally repressive, the US is looking the other way.
Libya: The Military Case
This one, it seems to me, is obvious. Libya is of no military consequence to the US except if it traffics in nuclear weapons and finances terrorists, as it has done in the past. But the US made a deal with Qaddafi that put a stop to it. From the US perspective, a Libya that is pumping oil and staying neutral cannot be improved upon, and that is what it has been in recent times under the rule of Col. Qaddafi.
What to Do?
The Neoconservatives in the Bush Administration were surely correct in pointing to the vulnerability of America’s continued dependence on its alliances with the repressive regimes in the Middle East in the face of increasingly restless populations. They advocated introducing democracy and capitalism – and using Iraq as the launch pad – into the Middle East in the hope that freedom and economic opportunity would prove more popular with the Arab masses – particularly the youth - that the dark and hate filled imperatives of radical Islam. The jury is still out on its ultimate impact, but Iraq does not look like a success today. The US has opened a door into Iraq that Iran was unable to accomplish in ten years of war and a million casualties, and its intervention appears to have lowered, not raised, its appeal to the Arab masses.
The Middle East remains a quandary for the US. It is in keeping with its history and its institutions – and a blessing for the world – that the American people incline to support those seeking freedom from tyranny. But given the brute fact of its dependence of Arab oil, the US has restricted room for maneuver. It cannot throw all of its weight behind anti-government forces when it must deal with governments – like Saudi Arabia- to keep its economy afloat, and I do not here propose any solution to the dilemma.
But Muammar Qaddafi, homicidal maniac though he may be, posed no threat to US interests- before the US turned on him - and the intervention into Libya risks diverting the limited financial, political and military resources of the US from its real enemies, like Iran, whom it will, sooner or later have to deal with. Put bluntly, Iraq was a diversion and so is Libya. They are both indulgences the US can ill afford to have taken.
In A Contagion of Black Swans, Doug Kass who writes daily for RealMoney Silver (his post below originally appeared onRealMoney Silveron March 14) argues that we are in a new world where Black Swans are the New Normal.
Globalization creates interlocking fragility, while reducing volatility and giving the appearance of stability. In other words, it creates devastating Black Swans. We have never lived before under the threat of a global collapse. Financial institutions have been merging into a smaller number of very large banks. Almost all banks are interrelated. So the financial ecology is swelling into gigantic, incestuous, bureaucratic banks -- when one fails, they all fall. The increased concentration among banks seems to have the effect of making financial crises less likely, but when they happen, they are more global in scale and hit us very hard. We have moved from a diversified ecology of small banks, with varied lending policies, to a more homogeneous framework of firms that all resemble one another. True, we now have fewer failures, but when they occur ... I shiver at the thought.
Banks hire dull people and train them to be even more dull. If they look conservative, it's only because their loans go bust on rare, very rare occasions. But ... bankers are not conservative at all. They are just phenomenally skilled at self-deception by burying the possibility of a large, devastating loss under the rug ... But not to worry: their large staff of scientists deemed these events "unlikely."
Once again, recall the story of banks hiding explosive risks in their portfolios. It is not a good idea to trust corporations with matters such as rare events because the performance of these executives is not observable on a short-term basis, and they will game the system by showing good performance so they can get their yearly bonus. The Achilles' heel of capitalism is that if you make corporations compete, it is sometimes the one that is most exposed to the negative Black Swan that will appear to be the most ﬁt for survival.
Please, don't drive a school bus blindfolded.
Owing to ... a misunderstanding of the causal chains between policy and actions, we can easily trigger Black Swans, thanks to aggressive ignorance -- like a child playing with a chemistry kit.
-- Nassim Taleb, The Black Swan: The Impact of the Highly Improbable
Black Swans are occurring with greater frequency.
Last week's historic earthquake in Japan contradicts the notion and appearance of stability and is yet another Black Swan in a series that has (time and time again) threatened the order over the last decade.
The new normal is abnormal and is bound to haunt investors for some time to come.
I am not referring to Pimco's Mohamed El-Erian's notion that world economic growth will be lower; I am referring to the new normal of disproportionate, high-impact, hard-to-predict and rare events beyond the realm of "normal expectations in business, history, science and technology" that are occurring with startling frequency. (As Dr. Benoit Mandelbrot emphasized in his work, the distributions of systemic outcomes aren't normal/Gaussian, but rather fat-tailed.)
"I'm astounded by people who want to 'know' the universe when it's hard enough to find your way around Chinatown."
-- Woody Allen
Risks of more and repeated Black Swans, previously perceived to be small by corporations, investors, politicians and regulators, should now be reassessed, owing to (among other issues) globalization, tighter correlations, advancements in technology, the growing/excessive complexities of interlocking supply chains and derivatives, the acceptance of greater/extreme risk-taking (Minsky's moment: "the longer people make money by taking risk, the more imprudent they become"), the greater connectivity of increasingly more complex systems (see Paul Ormerod and Rich Colbaugh's "Cascades of Failure and Extinction in Evolving Complex Systems") and so forth. I see a greater and more dynamic instability is the new normal. Witness the increased regularity of economically, politically and socially altering Black Swan events over the past decade (Note: three of the eight deadliest natural disasters in the last century have occurred since 2004):
the Sept. 11, 2001, attacks on the World Trade Center and Pentagon;
a 75% decline in the Nasdaq;
the 2003 European heat wave (40,000 deaths);
the 2004 Tsunami in Sumatra, Indonesia (230,000 deaths);
the 2005 Kashmir, Pakistan, earthquake (80,000 deaths)
the 2008 Myanmar cyclone (140,000 deaths);
the 2008 Sichuan, China, earthquake ( 68,000 deaths);
financial derivatives roil the world's banking system and financial markets;
the failure of Lehman Brothers and the sale/liquidation of Bear Stearns;
a 30% drop in U.S. home prices;
the 2010 Port-Au-Prince, Haiti, earthquake (315,000 deaths);
the 2010 Russian heat wave (56,000 deaths);
BP's (BP_) Gulf of Mexico oil spill;
the 2010 market flash crash (a 1,000-point drop in the DJIA);
the broadening scale of unrest in the Middle East; and
Thursday's earthquake and tsunami in Japan.
It is for this and other reasons that I produce an annual surprise list to introduce my own set of mini Black Swans. These are investment and business events that are outliers -- what I call "probable improbables."
"It is often said that 'is wise he who can see things coming.' Perhaps the wise one is the one who knows that he cannot see things far away."
We can no longer turn the clock back to a simpler time. We must play the hand we are dealt. And our time is interconnected, interlinked and increasingly complex. And our hand has, at its core, a rising number of outlier or Black Swan events.
I should emphasize that my observations on Black Swans in today's opening missive should be put into perspective. We shouldn't be overly paranoid nor should potential outlier events blind us to investment opportunity.
But we must be mindful!
Throughout history, there have been times when it has even been more profitable for investors "to bind together in the wrong direction than to be alone in the right one." The long-term direction of equities will likely always be "higher," and the crowd of optimists will invariably outperform the remnants of pessimists.
Nevertheless, for years, investors seem to have been blinded to the uncertainty of the "rare" Black Swan event. We now know that these Black Swans are occurring with greater regularity and with greater overall impact -- and, as such, we must recognize that the occurrences may not only hold the potential for reducing aggregate growth but that the uncertainty of these outlier events could conceivably cast a pall over stock valuations.
After all, the inability to predict Black Swan events implies a greater inability to predict the course of economic and market history -- whether it is a natural disaster, a surprising geopolitical event or an unexpected economic or credit outcome.
It is only obvious after the fact, as investors, in particular, seem to harbor a crippling dislike for the abstract (like Black Swans). Perhaps the problem with experts is that they do not know what they do not know.
For some time, investors have been, as Taleb writes "picking up pennies in front of a steamroller," exposing themselves to the high impact, rare event yet sleeping like babies, unaware of it.
But recent events might bring on some nightmares.
Of a more immediate practical consequence to this writer is that our domestic economy faces numerous structural issues (the most important of which are the extreme fiscal imbalances at the federal, state and local levels), with governments (here and abroad) not necessarily up to the task of dealing with the complexities.
Given the "newness" of these and other nontraditional and secular challenges as well as the greater frequency of Black Swan events, P/E multiples might be pressured and could even contract as a comparison between today's valuations to those of history can be expected to lose some of its significance and relevance.
"If you hear a 'prominent' economist using the word 'equilibrium' or 'normal distribution,' do not argue with him; just ignore him, or try to put a rat down his shirt."
-- Nassim Taleb
In summary, I marvel at the confidence of strategists in a smooth and self-sustaining economic recovery in such an uncertain world.
Strategists routinely make valuation comparisons based on it rhyming with historical experience. Similar to the belief in bell curves, these compares should be viewed with caution, because, in all likelihood, another Black Swan could appear on our investment doorstep -- maybe sooner rather than later!
It truly is different this time.
In this setting, a more conservative asset mix and higher cash position than normal seems to be a prudent strategy.
After all, as Nassim Taleb wrote, we might all be Black Swans.