Archive for category Markets

Inequality

piketty

French economist Thomas Piketty has put growing income and wealth inequality center stage, publishing a well researched book full of data that pretty conclusively shows what many of us have been arguing for sometime: there is a growing gap between the rich and poor and this could be dangerous to democracy and modern society.

I plan to read the book and will blog more on the details/arguments.  For now, I offer only a general reflection about the subject matter and the importance of taking inequality seriously.

His book isn’t a radical appeal to the masses.  It is a lengthy academic tome with a target audience that includes economists, political scientists, and other scholars.   Among this audience his argument is neither new nor earth shattering – economists and political scientists have been pointing out how the centralization of wealth has been increasing, creating a real threat to democracy and capitalism itself.    However, perhaps because the public is waking up to this fact, his work has suddenly became a best seller and is perhaps one of the most important books of our era.

Pointing out the dangers of out of control capitalism is not an argument for socialism; quite the contrary, thoughtful supporters of market capitalism should take it seriously and ask themselves: is the growing power and influence of the very rich a result of hard work and initiative, or are they able to rig the game in their favor?   If the very wealthy are rigging the game, then they are undermining capitalism and democracy.

Libertarian thinkers sometimes have an understanding of economics that is skin deep.  They have learned the basics of how the market works, and thus have an understanding that, all things being equal, the market does better than anything else at communicating demand and using price to allocate goods and services.  Government policy simply distorts that mechanism and thus creates inefficiencies.   So, they conclude, government is the problem, less government is better.

But that’s only if reality operates as pure market theory says it should, and if you take economics beyond the first year you know that is not the case.   Markets are distorted by a myriad of factors: imperfect information, misinformation, inside deals, connections, the capacity to use wealth to influence others, and the utter lack of knowledge many have about the way the system operates.

lewis

A good example is in Michael Lewis’ new book, Flash Boys.  The rigging of the game there is rather minor – big banks can use lags in time to make trades to figure out what trade is coming and make an offer that will earn them a few extra pennies on every trade.  No big deal; no 401K investor notices the slight variations.  Yet a few pennies off of hundreds of millions of trades and it adds up!   That’s just an example of what you can do if you are on the inside.   Of course, the way the big banks took investors to the cleaners over derivative bonds during the housing bubble (and in fact caused the housing bubble) is a more dramatic example – described in Lewis’ earlier book The Big Short.

Now one might say that this is nothing new.   Throughout history the wealthy, elite class has always assumed they deserved privilege while the poor were looked down upon as being lower in character or worth.  In the 19th century the British tried to make any form of social welfare painful and difficult so as to avoid anyone wanting to stay on it.   Yet workers have defied that notion of the poor as lazy for centuries.  After all, when in Britain millions of factory workers endured horrific conditions during the industrial revolution, they still worked.   They put up with sustenance wages, filth, squalor, child labor 80 hour work weeks, and numerous work related deaths and injuries to keep earning.

Compared to then, workers have it pretty good now.   So does that mean inequality doesn’t matter?

top1%

It does matter.  Consider the two charts here.  Above, the share of wealth that the top 0.1% have is shown, and it has doubled in the last thirty years to the point that they control a over a fifth of the country’s capital.   Below, the graph shows the income of the top 10%.  Again, the share going to the very wealthy has increased dramatically over the last 30 years, to levels from the early 20th Century.

top10

This matters for a number of reasons.   First, such a distribution of wealth and income makes bubbles more likely.  In theory, the very wealthy should be investing their money to create jobs for the poor, allowing that wealth to “trickle down.”  In practice, when too much capital is centralized to the very few, bubbles become more likely as they are looking for “easy money” rather than investing in jobs.    And when they do invest, overseas investment is common.   That money does not go into improving our economy.   It would be more efficient to tax it and use it to build infrastructure and support the economy.

The key to long term growth is demand from the middle class.  Money earned by the middle class does not usually flow into bubbles; rather, it creates demand for goods and services that require domestic jobs.    When a higher proportion of the wealth flows to average folk, the economy grows.  Moreover, social mobility in the US as become very low – where you were born has become the best predictor of where you will end up.

That is contrary to the American dream – and the value that individual initiative and effort matter.  The best way to assure that people can achieve all they are capable of is to assure access to education, health care, and the things needed to overcome obstacles caused by poverty or lack of status.  That means government programs to promote equal opportunity are good for capitalism and freedom; by expanding the capacity of people to achieve all they can we avoid becoming an oligarchy.

If this trend is not reversed, the economy will stagnate and America’s best days will be behind us.   The good news is that it appears the anti-tax anti-government sentiment that has been the norm for the last 35 years is starting to fade.   Despite the fights over Obamacare, it was passed and implemented; public opinion is shifting.   For now it’s important that the conversation about inequality continue – the future of market capitalism depends upon avoiding or reversing today’s inertia to oligarchy.

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They Got Away With It

The new semester is underway and I’m teaching an honors course:  “Consumerism, Politics and Values.”  We start with the book  The Big Short by Michael Lewis, describing the housing bubble and derivative market mania that caused the collapse of the economy in 2008.

bigshort

The housing bubble and subsequent crisis was created by the big banks who were able to pull off the equivalent of a high stakes ponzi scheme and get away with it.  Alan Greenspan, onetime devotee of Ayn Rand, even admitted that events had proven his “markets get it right” philosophy wrong.

Markets don’t always get it right; unregulated, markets can create calamities.   We shouldn’t forget what happened.

Back in 2000 we entered a recession thanks to the puncturing of the dot.com bubble.  It had been a classic bubble and when the bubble burst the economy went into a needed recession to balance out the excesses of the late 90s.  Then on 9-11-01 al qaeda attacked the US with a devastating blow to the American economy.  The blow wasn’t a direct result of the terrorist attack, but an indirect one – the federal reserve decided to offer extremely cheap credit to help pull us out of the recession.  That turned out to be poison.  That is the one area where the government shares the blame – bad monetary policy.  But that alone could not have created this crisis.

The housing bubble was also not a sub-prime lending problem, nor one related to Fannie Mae and Freddie Mac.  They had their faults, some extreme, but nothing they did could have caused the economic collapse.   What happened can best be viewed by considering risk and incentives.

It doesn't take a genius - this is adjusted for inflation home prices since 1890 - look at the insane bubble after 2002!

It doesn’t take a genius – this is adjusted for inflation home prices since 1890 – look at the insane bubble after 2002!

Risk:  Between 2002 and 2005 virtually all risk was removed from the mortgage market – or so it seemed.  Banks and mortgage brokers knew they’d sell their mortgages to one of the big Wall Street banks.   That meant they had no risk – so every home loan was a win for them, regardless of whether the lender could pay it back.  The banks then took the mortgages and turned them into mortgage backed derivative bonds which they sold, pushing the risk to the investors.  These bonds received a AAA rating from the rating agencies, meaning they were viewed as the safest form of investments.  98% of mortgages get repaid.   Investors gobbled them up, thinking they were essentially risk free.   There was, it seemed, no risk!

Incentives:  Mortgage brokers thus had incentive to cheat – to make loans they knew couldn’t be repaid.   This started the housing market booming.   As prices went up, banks, brokers and buyers had incentive to create risky mortgage instruments.  Since value was going up so fast, it appeared that if you could buy a house at $100,000, it would be worth as much as $150,000 in two years.  So if you couldn’t afford a standard mortgage, you could buy one with artificially low payments for two years.   At that time the house would be worth more, you could refinance at a standard rate and take out a home equity loan for easy money.   Everyone wins!   Meanwhile, the banks gobble up more and more mortgages as they are making massive amounts of money – hundreds of trillions of dollars in mortgage backed derivatives!

Derivatives include futures markets and anything where the value is derived from something else.  But the huge spike in derivative trade from 2000 to 2007 was due to unregulated mortgage backed bonds

Derivatives include futures markets and anything where the value is derived from something else. But the huge spike in derivative trade from 2000 to 2007 was due to unregulated mortgage backed bonds

As with any bubble, everyone thinks all is great until it pops.   Housing prices started to drop in early 2007.  The first pain was in the worst loans, the subprime market.   No one panicked – that market wasn’t big enough to cause a crisis.   Little did people realize that the entire derivative bond market, even bonds with the best loans, were toxic.

Soon prices started to drop.  Thanks to the people at CNBC and the other business “reporting” networks, people had the belief that real estate prices might level off, but wouldn’t go down.   While some like Peter Schiff had been warning people, most of the media were predicting real estate price growth as late as 2007.  People simply didn’t believe the party was ending.

Many people were directly affected.  People who had adjustable mortgages planning to refi with a higher value ended up bankrupt.  People who bought the AAA ranked derivative bonds ended up losing their entire investments.  This included groups like fire departments and school systems which thought a AAA bond was no-risk.   People who had been doing real estate speculation thanks to the rising prices went from being nouveau riche to old fashioned poor.  Those who simply bought houses at record high prices ended up under water – they often owe tens or even hundreds of thousands of dollars more than their homes are worth.

Of course, this all lead to massive loses on Wall Street and an economic downturn that is still with us today.   People totally outside the housing market lost their jobs or their investments when the economy tanked.  The ones who suffered the most were the poor.  The wealthy can take a hit on their portfolio and still enjoy nice homes and an easy life style, after all.

Yet the ones who did this – the ones who created the derivative bonds and then worked to disguise or avoid risk, taking massive short term profits even knowing that in the long run everything could collapse – they’re doing well.  No one had to repay their bonuses or their income from the bubble years.  Most simply found new work.   Sure, Bear Stearns, Lehmann Brothers, and a number of other banks went under.  Yet the people working there found other work.   Some  probably ended up with a dramatic downsize in lifestyle, but prison time or actual penalties?  Nah, they were just doing business.

Many people are still livid about the lack of accountability, but that’s the its always been.   The wealthy have power and clout, and can usually avoid accountability, especially if they’re in the financial sector.  In this case both Democrats and Republicans accepted the free market mantra and refused even modest regulation.  Yet tighter regulation might have avoided the collapse and we’d be at 5% unemployment now.

During the Clinton Administration Brooksley Born tried to regulate the derivative industry; Greenspan, Summers, and Rubin led the attack to stop her, documented in the PBS special "The Warning."

During the Clinton Administration Brooksley Born tried to regulate the derivative industry; Greenspan, Summers, and Rubin led the attack to stop her, documented in the PBS special “The Warning.

It’s also proof – absolute proof – that the ideology that the market is always best is dead wrong.   It is just as wrong as the Communist belief that a state run economy is more fair.  Ideologies delude more than enlighten. Reality is messy, ambiguous and paradoxical.   People enslaved by simplistic ideological beliefs tend to interpret reality in a way that suits their beliefs and avoid cognitive dissonance at all costs.  We need accountability, rule of law, and transparency — especially in the market.

So now six years from the collapse we’re still reeling, trying to correct imbalances that could have been avoided.  The people who created the mess and made huge profits off the bubble got away with it.

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Why the Euro will Survive – and Thrive

American and British commentators are often surprised, annoyed or dismayed by the fact the Euro trudges on, as both the European Central Bank (ECB) and the core states of Europe do what is necessary to protect the currency and avoid contraction of the Euro zone.   Why are German taxpayers willing to pay so much to protect banks in Ireland, or government debt in Greece, Portugal and Spain?   Why do Greeks accept an austerity program that put them into depression – and in 2012 elect a new government that favors that very program?

First, what is the Euro crisis?    On the surface it’s a sovereign debt crisis – southern European states have so much debt that investors are doubting they can pay it back.  This means that to sell bonds states have to offer a higher interest rate, since the risk is higher.  However, it’s not just a debt crisis.   Consider these bond rates:

bonds

Note how Germany and the UK’s rate has been dipping, meaning it’s easier for them to sell bonds, while Spain and Italy’s cost more – though historically near the average.  Only Ireland and Greece had an extreme crisis.   Those two were caused by very different factors.  Ireland’s deregulation of the financial sector was patterned on American practices, and thus they got hit hard by the bubble bursting.

The problem for Greece is not just debt, but structural weakness in their entire economic system (that’s why it’s always a false comparison when politicians try to compare the US or even California to Greece).

debt explosiondebtgdp

 

The first is telling – there has been a debt explosion throughout the Eurozone, including Germany.   This makes clear that one of the structural aspects of this crisis is a need to reduce debt.    Debt always goes up in a recession since revenues are down and claims for aid increase – yet with the bursting of the bubble it has become crystal clear that debt to GDP ratios above 60% are unsustainable.

The second chart shows that there is wide variation of debt growth since 2008 – but Ireland, Greece, Spain and Portugal have had the greatest debt increase, and are four of the problem states.  Italy’s debt growth is less, but while Italy hasn’t had a debt explosion, they’ve had consistently high debt.

spainitalydebt

 

Italy’s actually made significant structural reforms and was not hit as hard by the recession as others in terms of new debt – yet it’s debt level is one of the highest in the Eurozone.

The problem in Europe is that there is a core set of countries with strong economies that simply have to find a way to reduce debt and a set of weaker economies that have managed to hide their structural problems with debt or financial gimmicks.  The recession laid that structural weakness bear.

Many Americans want to blame European social welfare programs for the crisis, but that’s’ also easily disproven.  The chart showing debt to GDP ratio growth since 2008 shows Sweden actually reducing debt, and the Scandinavian countries faring well.   Germany is running a 7% current account surplus and remains the engine of Europe.   Countries with the best social welfare systems are faring very well, even better than the US.

germany

This is evident in bond rates.   Germany’s 10 year note now has a yield of 1.3 %.  That means that despite high debt levels, investors have faith in German bonds thanks to the strength of the German economy.    The US, UK, Sweden, and France all have yields of about 1.8% – still very cheap.   Ireland’s yield is now under 4%, thanks the EU and IMF recapitalizing Irish banks.   The worst of their crisis seems over – Ireland’s was a banking crisis caused by financial deregulation and that’s easier to solve than structural debt crises.

Ever since the ECB, EU and IMF made clear they’d do whatever it takes to protect the Euro, Spanish and Italian yields have gotten down around 4.5%  – historically a common yield.    Portugal is over 6%, and Greece still over 11%, meaning that markets still aren’t confident about Greece despite the EU bailouts.  Clearly, though the sense of crisis is passing, the smart money is now on the Euro.

So why – why has the Euro proven so resilient and gotten so much support?   Simply, the Europeans realize that if the continent fractured between the wealthy core and poor fringe, it would harm everyone.  Greece, Spain and Portugal, late joiners of the then European Community  (EC), would see their progress towards modernizing their economies punctured.   The core countries would also suffer.  They’d lose markets in the fringe countries, and their currency — perhaps a contracted Euro – would appreciate so much that their exports would suffer.

If the Euro were to break up, the poor countries would do like Iceland did – allow a depreciation of the currency to effectively cut everyone’s pay by 50%.    But defaulting and inflating on the fringe would do severe damage to the core’s banking system, as they are heavily exposed to that debt.   So it’s in the core’s interest to make sure that doesn’t happen.

Some of called Merkel the "Abraham Lincoln" of Europe, keeping the EU together

Some of called Merkel the “Abraham Lincoln” of Europe, keeping the EU together

German Chancellor Angela Merkel, in demanding countries undertake austerity programs and reform their economic structures in exchange for bail outs, has been criticized as wanting to force everyone to have the German model economy.   Germany’s gaining control of Europe!   But the German model works – and it’s what Sweden and other northern European countries follow.  You base your economy on supporting production and having sound fiscal and monetary policies.

If Italy, Greece, Spain and Portugal aren’t forced to structurally adjust to the realities of 21st Century globalization, they’ll fall behind and might never recover.  If they do – as hard as the next few years will be – they could emerge with new economic structures in place to allow them to grow and have sustainable, productive economies.   That will be good for everyone.

What the skeptical commentators don’t get is that the European Union has developed a different notion of sovereignty, one that sees the destinies of the European states as linked.  That’s a different way of thinking, people aren’t just German or French, but also European.   Such a re-conception of sovereignty is incomplete and has pockets of opposition.  But as Merkel pushes the EU towards a model of fiscal union, with other states recognizing it is in their self-interest to follow, the European Union might once again defy skeptics and prove itself stronger than ever.

 

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Time for Pragmatism

newengland

Notice anything interesting about this map?   The US is in a lighter shade of blue then New England, which is off colored and unlabeled.   This map is from a Republican guide to finding one’s Senators and representatives.   To the GOP New England appears to be persona non grata.

Indeed, with a few exceptions (Senators from Maine and New Hampshire) the region has become very Democratic.  New England along with the upper Northwest were the only regions where white males supported Obama in the election.

Not only that, but New England Republicans are distrusted in their own party.  They are often pro-choice, moderate and labeled RINOs (Republican in name only) by ideological conservatives.   Maine Senators Collins and Snowe voted to acquit President Clinton after his impeachment, breaking with their party.   Senator Snowe’s retirement this year was in part a reaction to all the anger and partisanship that has overtaken the Senate.   Yes, Maine has a tea party governor, but that’s only because of a three way race in which 39% could win.

Republican Olympia Snowe personified pragmatic conservatism

Former Republican Senator Olympia Snowe personifies pragmatic conservatism, she wants to solve problems and focus on the people, not a set of rules or an ideology

This is interesting because New England does not fit the usual left-right demographic patterns.   Maine is the most white and least diverse state in the union.    New Englanders are pragmatic and rather conservative.   But there is one thing that sets the region apart: ideology is distrusted.  Here in Maine the tea party governor couldn’t get his fellow Republicans to impose a true conservative agenda when they had control of both houses.  Instead they continued the tradition of trying to build consensus, often angering Governor LePage.    I supported President Obama, but voted for many Maine Republicans – it’s not good vs. evil here!

It’s a part of the pragmatism – a sense that the difficult problems we face can’t be addressed by looking to fancy theories and ideologies, but by compromising with a goal of solving problems.   In that New Englanders are more conservative than many Republicans who have a radical ideological world view – to implement ‘true capitalism’ or some other ideologically motivated “solution” to our problems.

Ideologies are seductive.  The present truths in simple terms and make seem like all you have to do to solve our problems is follow the ideological precepts.   People who want to be right, who don’t want to deal with complexity and uncertainty, often find ideologies very comforting.  They are a kind of secular religion, you can interpret the world through an ideology and avoid cognitive dissonance.    As Communism demonstrated, people can cling to ideologies even when it’s absolutely crystal clear that the evidence proves them wrong.

An example of that taken to the extreme can be seen in this over the top interview of Alex Jones by Piers Morgan:

Ideologues can ignore reality because its so complex that you can always find some other reason to explain what went wrong.   Communist ideologues blamed the West or others for making the ‘path to socialism’ more difficult.    Capitalist ideologues embrace the market, and find reasons to dismiss evidence that shows markets can be inhumane and corrupted when not regulated.

I don’t think Republicans or Democrats outside New England are all ideologues.  Rather, media plays a role to socialize people to embrace ideological thinking by creating a narrative that makes it seem natural.  Powerful corporate actors like the “Club for Growth” use money to manipulate the process and create an ideological political climate.

The classic example of media narrative is the last election.   On the right there was a widespread belief that Romney would easily beat Obama this year, a belief held by even people high up in the Romney campaign.   The narrative seemed logical: the polls over sample Democrats, Obama’s supporters aren’t as enthused, Republicans are angry and want Obama gone, the 2010 spirit still exists, the media is overstating Obama’s chances because they like him, etc.

If you looked at the evidence it was pretty clear that those arguments were weak – that the expectation had to be that Obama would win.  However, FOX news, talk radio, conservative blogs, and media outlets on the right stated that case over and over like it was a fact, and then added that the mainstream media was untrustworthy, in the pocket of Obama and even trying to demoralize the right.   In other words, rather than rationally analyze the narrative, they found excuses on why not to take the counter arguments seriously.

This happens on many issues – climate change, taxes, the economy,  guns, terrorism, the debt ceiling.   There is an ideology-driven understanding of reality that is spread by talk radio, FOX, and a host of blogs and pundits that is designed not to analyze a perspective but to promote and defend it because it is deemed true – the ideology is unquestioned.

This penchant for ideology-based understandings of reality is destroying the Republican party.    I do not believe John Boehner or Mitch McConnell are ideologues, but they are held captive by the fringes of their party.   Moreover, there are signs many on the left want to emulate the ideologues on the right by embracing partisan war.   That has to stop.  It is time for pragmatism,  pragmatism is the enemy of ideology.

Ideologues claim they are embracing principle, but that’s an illusion.  They are embracing simple rules.  Reality is complex and simple principles don’t work.   Context matters, it changes the meaning of every act.   Ideologues left and right will use terms like freedom, social justice, equality and even peace to give their causes the air of moral authority.  But beware any theory-driven understanding of a complex reality, and beware of those who interpret everything through their ideological lens rather than comparing and contrasting different perspectives.

Pragmatism is messy, but it’s the only way forward in difficult times.

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Dysfunctional Democracy

As I reflect on the last four years of economic crisis and the current stalemate in Washington over the payroll tax, a couple points stand out about democracy and markets.

First,  markets are important, but ideological free market capitalism is deeply flawed.   The core reason is simple: assumptions.

There’s an old joke – a physicist, chemist, and economist are trapped on an island with a crate of canned goods but no can opener.  “I think I can get these cans open,” says the physicist, arguing that coconuts dropped from the top of a tree would be powerful enough to rip the can open.   “That’s too risky, the food could splatter all over,” says the chemist, noting that a few choice chemicals available might help weaken the metal and make it easier to open.   “You guys are making this far too difficult,” laughed the economist.

“OK,” the other two said, “what’s your solution.”

“Easy,” said the economist, “first, assume a can opener….”

The most powerful assumptions in crude ‘ideological’ economic theory involve the distribution of information and the inability of people with resources to game the system, rigging it in their favor.  In any capitalist system those assumptions fall apart.  Some people know more, have access to better information and analysis, and can use their resources to reinforce their position.   This means that class divisions are inevitable and aren’t based primarily on who works harder or shows more initiative.   Ironically the more truly “free” the market is, the more such abuses can become standard, yielding a starkly bifurcated society lacking a true middle class.

Second,  democracy has real flaws.

What keeps democracy viable is the activity of the elites.   Elites have to be able to work behind the scenes to forge compromises based on their understanding of very complex issues, often issues far beyond the understanding of the average voter.  If elites become trapped in ideological combat and lose the capacity to see that their main task is to work together to deal with real problems, democracy can fail.   If the elite focus focus so much on politics over pragmatic problem solving, democracy can fail.

Our system gives the Brits a laugh

One reason Americans tend to overstate the value of democracy is that they are in denial of its need for elite guidance.   Without elite cooperation and problem solving, poor decision making can harm a polity.   Conversely, a non-democratic state can be run very well if the elite are focused on the good of society.

Perhaps the most dangerous  problem a democracy can face is if its elites not only cannot compromise but if the economic elites trump the political elites.   Remember, capitalism produces an elite economic class which can use its clout to reinforce its own position.   When those elites are countered by a political elite who have a sense of what’s best for the state as a whole, the capacity of this economic elite to truly control things is limited.   That’s good, because they operate out of self-interest and distrust even the notion of collective interest.

But when the economic elites eclipse the political elites, democracy becomes a handmaiden for what some have called “crony capitalism” or “government of the corporations, by the corporations and for the corporations.”   In the US where elections have become exceedingly costly, the ability of the economic elite to manipulate and even control the political elite has become profound.    Add to this ideological gridlock, and a downward spiral of dysfunctional government could threaten both prosperity and democratic stability.

That’s at the root of our current dilemmas, and while we may emotionally invest in Presidential and Congressional contests, when the system  is sick, no one person can fix things.   The President is doomed to become a part of the machine.   Add to that the power-mania of Washington — what Lloyd Etheredge called “hard ball politics” — and the US is facing a political crisis of our own making.

Etheredge’s solution to ‘hard ball politics’ was a stronger press to report the truth of what’s happening, and a better informed and educated public.   Back in the 1980s when his book Can Governments Learn (focusing on US foreign policy towards Latin America) appeared, that seemed a pipe dream.   You can reform institutions, but you can’t make people smarter or the press more motivated.

It seems to me, though, he was on the right track.   The information revolution gives us the internet and the capacity to get information from a variety of sources, thereby making a stronger “press” feasible.   The public is using it to organize and learn more — it may not be obvious yet, but in talking to students I realize that on so many levels even “average” students are generally more informed about a variety of issues than was common even among very good students when I was in college.

Ultimately, unless our laws our changed limiting corporate influence on politics, or our political parties forego politics as marketing and start finding ways to both solve problems and focus on the general welfare and not corporate welfare, the only solution to our crisis comes from the people.    We have relied on the elites to make democracy work for two centuries; now we have to actually start relying on the people — we have to save our democracy.

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Global Economic Collapse Imminent?

Alarming words from the head of the IMF: a global economic collapse could occur within weeks if something isn’t done head off the ongoing crisis in Europe.   The warning may seem overblown, but the danger is real.

Here’s the problem: unless investors are convinced that bonds issued by Greece, Spain, Portugal, Italy and Ireland are safe, they’ll start selling them off in the bond market.   That will drive down the price (supply increases, demand will be low).   When the price of a bond falls, that increases its interest rate.    An Italian bond set to pay off 1000 Euros in three years might normally cost 940 Euro, meaning you’d earn 60 Euro (about 2% per year) on your investment.  But if people start thinking the Italian economy is going to tank then the price may drop dramatically — the 1000 Euro bond might cost only 850 Euro, meaning a 5% yield, or go even lower. Right now the Italian 10 year bond has a 5.5% yield rate.

By comparison, US Treasuries have about 2% yield on the ten year bond, as does Germany’s.  This means that if the US and Germany sell bonds to finance government debt, the cost is relatively low — 2% a year.  If Italy wants to run deficits, they pay a much higher interest rates.    Now, guess what Greece’s 10 year bond yield rate is.   23%.   That is simply unsustainable even in the short term.  It shows that people are expecting a Greek default and thus dumping bonds to those who want to take a big risk to potentially pocket a 23% investment gain.

Spain is also at about 5%, but Portugal’s bond yield is 11%, and Ireland’s at near 8%.  Those are getting into very high risk territory.   Now, at this point all these yields are kept somewhat low (relative to what they could be) by the hope/expectation of an EU bailout.   The EU has intervened in Greece, Greece has undertaken a very unpopular austerity program (after all you can’t keep running up debt borrowing at 23%!), and the panic has been minimal.

But what if the EU can’t save Greece?   Then the Greeks will likely default, they simply can’t make payments on their bonds.  The bond holders — banks throughout Europe (including Germany) will then be under stress, as some of their assetts become worthless.  Still, if it stopped there, that wouldn’t be that big of a crisis.  The danger is Contagion.   Holders of Portugese, Italian, Spanish and Irish bonds would realize that the world has changed: default is possible.    Yields on all those bonds would likely rise dramatically creating default threats across southern Europe.   At that point bank assets would be so stressed that credit markets would dry up and the European economy would be hit by a crisis larger than what hit the US in 2008.

US and British banks are relatively unexposed, but the economic impact would be to sink the world deeper in recession.   But it doesn’t end there.

Banks, including those in the US and UK, have been issuing credit default swaps on these bonds.   These swaps can be seen as akin to a life insurance policy.   Let’s say your neighbor confides with you that he has cancer, even though he’s young and fit.  You then go to an insurance agent and buy a life insurance policy on him for $1 million.    You pay a policy of $300 a year, but if the cancer kills him you could get $ 1 million.

Insurance companies sell these policies because statistically they don’t expect to make large payments.  Most of us go through life paying for insurance “just in case.”   But in the world of finance it’s more like a casino.    The credit default swaps are cheap, but have a potentially very large payoff.   It’s like placing a bet on a long shot horse — you’ll probably lose, but if you win the earnings are big.   So if you decide to bet against the EU and Italy, you can buy credit default swaps on Italian bonds.    If the bonds mature and Italy pays their value, you get nothing and lose the “premium” you paid to buy the swap.   But if Italy defaults, you get the value of the bond — potentially a huge pay off.   That happened back in the US when owners of credit default swaps on mortgage backed bonds made a killing when the real estate bubble burst.

The thing is, we don’t know how exposed banks are in terms of credit default swaps.  If they’ve felt confident that the crisis would be contained, they may be very exposed.   So even banks that don’t directly hold bonds might be on the hook if defaults spread.   That would add to the depth of the crisis and could spark a breakdown in the entire financial system of the kind that the bail outs of 2008 managed to avoid.    In such a case credit would be very difficult to come by, even for “safe” auto loans, perhaps even credit cards would be hit.

If the EU doesn’t manage to convince investors that Greece will not default the whole thing could spread quickly — within weeks.   If the EU came up with a very comprehensive package they could allay fears and Greek yields would come back down to earth and overcome the crisis.   It would be a couple years before deleveraging would get them out of the woods, but investor confidence would return and the system would survive.

However, although this may look like a no brainer in those terms, in political terms it’s a tough sell.   Any kind of package that saves the system would appear to be a bail out of countries who had been irresponsible in their borrowing and spending, and protection of banks who made irresponsible loans.    That would be very unpopular in countries like Germany, which would pay a lion’s share of the cost.   But it would also be unpopular in Greece, whose people protest cuts in spending and increases in taxes.   In their eyes they’re being made to suffer for mistakes of bureaucrats and banks, and a mix of spending cuts and tax increases assures a deeper recession and more pain.   They’d rather default than suffer austerity.   So the moves needed to save the global political economy are by nature very unpopular and arose anger.

Most people don’t know how bonds work, wouldn’t know a credit default swap from collaterized debt obligation, and have no sense of just how interconnected the financial industry is world wide.  The argument supporting such “bailouts” is only persuasive if you really work through the intricacies of how the financial system functions.  Most voters don’t do that, so any politician who tries to save the system will probably lose their job.

With so much on the line I think they’ll find a way to avert catastrophe.   The stakes are just too high, and the insiders know what the stakes are, and how inaction could mean utter catastrophe.    Still, the danger is real.   That’s why stories about European bond yields and bailout plans may be the most important news to follow in coming weeks.   Global economic collapse is still unlikely, but quite possible.

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Wealth and Society

Fundamental disagreements about taxation and government spending rest on different assumptions about the nature of wealth and of society.  Where one stands on these issues determines ones’ perspective, and while some people may believe they have the most moral or rational point of view, such claims defy objective proof.   People can only look at the arguments and go with what they believe correct.

Arguments that say taxation should be minimal, even on the wealthy, have an assumption that market outcomes are proper, and that markets work in practice as they are supposed to in theory.  I believe these two assumptions to be flawed.

Unpacking the first assumption, one has to ask what determines a “proper” outcome?    To say that any market outcome is proper one requires a materialist and economistic view of reality.    Everything else — concern about human suffering, poverty, exploitation and equal opportunity — gets dismissed as secondary, or at best left up to the individual.   Society in such a view is not a unit connected by shared cultural values, norms, and interdependent relationships, rather it is simply the outcome of a bunch of purely individual choices.    Individuals are seen as rational and self-interested, simply interacting with others.

While all of those assumptions are possible to hold, they are by no means self-evidently true or even persuasive.  Human history has primarily been that of people connected by tradition and custom in social organizations that value spiritual and community bonds higher than material goods or individual self-interest.   Individual identity, purpose and interests came from tradition, culture and social norms.   Moreover, no individual chooses his or her interests, goals and ideals purely on their own.   Humans are in part cultural products; if the same person were born in Cairo instead of Boston he or she would be a different person, with different beliefs, tastes, values and interests.   Finally, no individual is fully responsible for his or her outcomes, including wealth.   Depending on how society is structured, wealth accrues to people in different ways, based on different actions.    Simply, wealth is a by product of social structures as much as it is of individual choices.

Since Freud we’ve known that humans are not guided primarily by reason and rational thought, but other impulses and drives below the surface in our subconscious.   Personality goes a long way to explain different political opinions and points of view, just as it explains ones’ philosophical perspective.   Personality is both innate (we’re born a certain way) and shaped by personal experience in both families and the larger culture.

Thus I reject the first assumption.  I do not think market outcomes are driven by purely individual choices and interactions, but have a cultural component that plays a huge role in whether or not one becomes wealthy.   Moreover, the import of culture also trumps a focus merely on the material and economic.    Values matter, as does social stability. Therefore, market outcomes are not inherently just or proper, nor do they accurately reflect the quality of an individual’s choices.    There is nothing inherently moral about a market outcome.

I also reject the other assumption, namely that markets work well on their own.   Left to their own devices markets break down, and are replaced by pseudo-markets which appear to be capitalist, but instead reflect the interests of the powerful and wealthy — those able to stack the deck in their favor.   The stacking is not a malevolent effort by the moneyed elite to control the country, but rather the result of numerous small rational choices that protect profits.

These small choices can hinder the market because of power differentials.   People who benefit from one market outcome are in a position to have greater opportunities the next time the game is played.  Over time this creates structural benefits to many, and constructs structural barriers to others.   Markets thus do not lead to the optimal outcomes implied in theory, but class divisions where a small group is able to get rich and stay rich across generations.  This inherently limits the opportunities of those who are not well off.   Some can overcome those constraints, most cannot.

Because those core assumptions are flawed, so is the argument that progressive taxation is wrong, or that taxing the wealthy harms the economy.   In reality taxing the wealthy: a) recognizes the role of society in creating that wealth — it is not merely the result of individual choices; b) allows resources to be used to help remove constraints by others to succeed, enhancing true opportunity and fixing market anomalies; and c) allows people to focus on other values a society has, rather than seeing materialist processes as the ethical core of a society.

Moreover, the flaws of those core assumptions also explain why regulation is needed.   Power differentials create incentives for “winners” to avoid the limits a true market would create.   Regulation is needed for the market to operate effectively, create transparency to limit the benefits insiders get thanks to the information and resources at their disposal, and protect market mechanisms.

Note that this argument is supportive of market capitalism.   It is not an argument for socialism or against markets, it is merely a claim that markets are not magic.   The goal of government is in part to compensate for ways in which the nature of society and the distribution of power disrupts how a market would operate “in theory.”   Yes, there are also other values a society might have that trump market processes.   These can be conservative (e.g., protect religious institutions, support cultural values such as marriage, etc.) or liberal (assure everyone has quality education and health care).   But since there is no “answer key” telling the right values to use to govern, such questions of value are inherently political and contestable — and so far democratic institutions are the best way to deal with such issues.

This still doesn’t answer what the proper tax level should be, what kind of government programs are best, or anything like that.   Those questions cannot be answered in the abstract as they are questions reflecting different opinions — there is no right or wrong answer.    That’s why democracy is best when it functions correctly — we can debate, persuade, learn from different perspectives, and over time test policies and change what doesn’t work and embrace what does.

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