This bit from Barry Eichengreen (ht Mark Thoma) is getting a lot of attention. (See, for example, Dani Rodrik.) Describing the “roots” of the current financial mess, he writes…

In the United States, there were two key decisions. The first, in the 1970’s, deregulated commissions paid to stockbrokers… In response, investment banks branched into new businesses like originating and distributing complex derivative securities. They borrowed money and put it to work to sustain their profitability. This gave rise to the first causes of the crisis: the originate-and-distribute model of securitization and the extensive use of leverage.

I want to push back on this a bit. I find it hard to believe that on Wall Street, there were these lucrative side businesses just waiting to be exploited, but investment bankers would have been content to ignore them if they had retained their thick commissions on stock trades. As a historical matter, I’m sure Eichengreen is right that May Day was a spur. But it’s a huge stretch to say that derivatives and originate-to-distribute wouldn’t have been discovered, grown, and grown massively, if only there hadn’t been a competitive squeeze on stockbroker profits.

Eichengreen’s story, taken naively, might lead to the suggestion that we give financial intermediaries cushy sinecures, because, if we don’t, we will have forced the poor dears to get creative and deploy financial weapons of mass destruction that destroy the world!

Financiers will destroy the world however much money you give them (it is never enough), if they have a profitable scheme for doing so and if they are not held back by regulation.

Financiers may also improve the world, in large and important ways, when they find profitable schemes for doing so. We want the financial community to innovate, we just don’t want them to innovate crappily. That means that, yes, we want regulators to have some veto power over their innovations. But a bad response to this crisis would be to suggest that today’s big names be given monopolistic cash cows so they can make lots of money running a museum of Wall Street, circa 1970.

Today’s big names deserve to be ripped apart. They should not be granted plush monopolies. Tomorrow’s big names deserve competition just as much as the next business. More so, actually. Finance should be rife with creative destruction to keep that market discipline vibe going… the “masters of the universe” must always be kept meek and terrified.

Finally, not all “financial innovation” is created alike. Collateralized, cleared, exchange-traded derivatives were a marvelous innovation. Letting poorly collateralized, opaque, nonstandard, eclectically-offset swaps grow into a large-scale financial instrument was idiotic, and was recognizably idiotic (which is why ISDA has had to work so hard and diligently to patch all the idiocies as they showed through the cracks). We desperately need good innovation, tools for intermediation that increase investor discrimination and decrease aggregate credit and counterparty risk. Sure, that’s precisely the opposite of what this decade’s signal innovations were all about. But developing a poison and developing the antidote are both innovation.

The following expands on ideas from a previous post, but is similar in spirit to a wonderful essay by Luigi Zingales (ht Tyler Cowen, Arnold Kling). If you have not read that, please do. I think it is the most important document to have arisen from this debate this far.

Rather than a bail-out, Congress should pass an “ARISE act”. ARISE would stand for Automatic Reorganization of Insolvent Systemically-important Enterprises. It could be very simple.

The Secretary of the Treasury, in consultation with the Chairman of the Federal Reserve and subject to judicial review, would declare certain firms systemically important according to criteria specified by the act. Those firms would be subject to a streamlined form of bankruptcy rather than ordinary Chapter 11 reorganization or Chapter 7 liquidation. The Treasury would compile a list of all systemically important firms, not just those considered to be imperiled, so inclusion would not signal any sort of distress. Should a systematically important firm find itself unable to meet its obligations, it would be subject to a very simple reorganization procedure: common and preferred equityholders would be wiped out (but would be given deep out-of-the-money warrants on stock of the restructured firm), a new class of $1 par value common equity would be established, which would replace existing debt claims dollar for dollar, until the resulting firm would be no more than 4x leveraged and can be certified as conservatively solvent and liquid by independent auditors. Junior debt would be swapped for equity before senior debt, and secured debt would become unsecured. All creditors would have the option of exchanging their debt for equity in the new firm. Further, reorganized firms would have the right to pay off unsecured contingent liabilities (including, for example, liabilities under derivative contracts) in stock at par value rather than in cash.

An intended “unanticipated consequence” of this proposal is that it would make the debt of firms that are potentially “systemically important” much more equity-like, long before any hint of financial distress or reorganization (and even before an explicit listing by the Treasury). That would raise the cost of capital for such firms, serving as a kind of a tax on scale and criticality. Leveraged firms that are “too big or interconnected to fail” create negative externalities for markets, taxpayers, and the public at large. Under the ARISE act, lenders would absorb some costs that the general public would otherwise bear, and would charge appropriately for the insurance. Firms that prefer inexpensive debt financing to the strategic options associated with scale can spin-off independently controlled entities as they grow.

Those who claim this would be a radical abrogation of contract should note that it would only be a change in the bankruptcy code, basically a new form of reorganization. Individuals have been subject to many retrospectively applicable changes in bankruptcy law over the years, and property rights have survived. This change would affect a very small fraction of firms (although a much larger fraction of debt, since it would predominantly affect very large firms).

See also: Mark Thoma, Willem Buiter

Okay. Let’s leave no room for ambiguity here. The Treasury’s draft plan for saving the world is breathtakingly awful. It would give the Secretary of the Treasury entirely unchecked discretion over up to 700B dollars. Even that “limit” has a loophole big enough that you could drive a truck through it, so the Secretary could in effect spend up to 1.8T dollars, right up to the newly raised Federal debt ceiling, without further Congressional action. This act would be such a wholesale delegation of the power of the purse that I wonder whether it is even constitutional. Of course, the act explicitly puts the Secretary’s actions beyond any judicial review, so perhaps questions of legality or constitutionality are merely academic. (Paul Campos shares these concerns.)

As Paul Krugman has pointed out, for the plan to help insolvent institutions, the Treasury would have to overpay for these assets. Yves Smith unearths an account that Secretary Paulson has acknowledged this fact in private, although he won’t cop to it on the Sunday talk shows. It is almost old-fashioned to raise questions about whether or not the former Wall Street banker will offer sweetheart deals to his industry (an industry that has harmed the American economy more deeply than most people realize). Just as big lies boldly asserted can trump plausible untruths nervously defended, overt corruption on a massive scale (but “in the public interest”) might leave a lot of naysayers dumbstruck. It becomes the way we do business. Of course, none of Dean Baker’s progressive conditions, none of Brad DeLong’s dealbreakers, not even my plea for a little transparency are incorporated into the proposal.

The oldest technique for the usurpation of power by the executive from the legislative is the manufacture of a state of emergency. That is not to say the present financial crisis is not actually an emergency. But the how the crisis is understood by legislators and the range of options by which it might be addressed have been set by Messrs Paulson and Bernanke. They have presented a single option, one more radical than seemed reasonable even at the height of the depression. (ht Brad DeLong)

It is worth noting that Paulson and Bernanke have thus far proven themselves to be capable technocrats. (Although, as Dean Baker points out, they’ve been awful prognosticators.) There’s a lot to disagree with in how the dynamic duo have handled the torrent of crises that began last August. But they have acted aggressively and creatively, and in their ad hoc interventions so far, they’ve gone to some lengths to create upside for taxpayers and to squeeze miscreants at least a bit. Until reading the text of the Treasury’s proposal and stewing on it overnight, I was inclined not to fight too hard. I saw things as I’m sure legislators see things: Something must be done, a megabailout is disagreeable and imperfect, but it’s something that we can do quickly, and it’s what our experts, whom we trust, recommend. Let’s fiddle at the margins to get it done as best we can.

But the proposed text flipped a switch in my brain. This is not, as Senator Schumer put it, “a good foundation of a plan that can stabilize markets quickly”. It is a raw arrogation of power. My trust, my willingness to extend the benefit of the doubt, has evaporated.

This is overreach. This is bad.

See also… Glenn Greenwald, John Hempton, Sebastian Mallaby, David Merkel, Robert Reich, among many, many others, I am sure.

For a contrary view, check out the always thoughtful knzn. I disagree pretty strongly, but he’s always worth reading.

FD: I am short broad stock indices, which seem to like the prospect of a bailout, so opposing the plan might seem self-interested. But I am longer precious metals and I’m short long-maturity Treasuries. My guess (and of course it is only a guess) is that those positions would do well under the plan.

I am not, on balance, a fan of the proposed megabailout of the financial system. But if it is going to happen, we should require at the very least this — that taxpayers learn immediately what assets they have purchased, from whom, and for how much.

We should tolerate no more of what the Fed did when it bailed out Bear Stearns’ creditors. Maiden Lane LLC sits opaque on the Fed’s balance sheet, hiding an unknowable book of derivatives and a portfolio of assets valued at about $29B, coincidentally almost exactly what the Fed kicked in to purchase them. If we are going to spend roughly a trillion dollars on assets that self-styled masters of the universe failed to value, we ought at least have the opportunity to take a crack at pricing them ourselves, especially once we’ve bought them. It will be essential to form opinions about whether the assets Secretary Paulson will purchase from his former colleagues are fairly priced. The possibility of chummy dealing, the near impossibility of avoiding it, is obvious.

Further, the word confidence keeps coming up, we must restore confidence in the American financial system. It is not enough that we hand over our money, we must hand over our trust as well. Surely, then, if this is a new era of trust, there should be no problem with requiring sellers to disclose at precisely what value the assets for sale had been booked on their financial statements, with criminal penalties for misstatement. We should be able to evaluate, in the light of day, how forthright financial institutions have been in representing their true condition to potential investors and the public-at-large. We may find that some have played things relatively straight, while others survived by sleight-of-hand and exaggeration. The former group will have earned our confidence. The latter will have earned something else.

This is not “a modest proposal”, presented in irony. If we are going to spend hundreds of billions of dollars, absolute transparency strikes me as a minimal prudential requirement. They say sunshine is the best disinfectant. I’m afraid there is a lot of rot in our financial system. It’s time to open up the windows wide.

So the whole “banning shorts” thing was wearily predictable. The very politically-connected “good” investment banks had a little scare this week. Call it panic selling, call it a bear raid, whatever. Suddenly, it’s illegal to short financials. Go figure.

People like me are appalled. If it’s illegal to short in a “panic”, we ask, why isn’t it illegal to go long during obvious asset price bubbles? If you can tell a panic from a correction, then surely you can tell an asset bubble from a genuine boom, right Mr. Greenspan? Most people were perfectly aware of the housing and tech bubbles in real time. Only economists and idealists get confused.

Whatever. As I said, the whole dialog is tired, obvious, predictable.

But… Much as I’m an unapologetic short, I’m perfectly willing to concede that there’s such thing as irrational momentum selling, just as there is irrational momentum buying. Momentum buying is far more insidious and destructive in the long term, but both are bad. Banning short sales (or, in mirror image, restricting asset purchases to short covering) might help prevent momentum trades, but it’s a lousy way to address the problem. Decapitation is a perfectly effective cure for migraines, but that doesn’t make it good medicine.

Dean Baker frequently suggests a “Tobin tax” on securities trades, which, as reforms go, is not a terrible idea. What if we did put a small transaction tax on taking financial positions? Reduced liquidity means an increased commitment by investors to the underlying economics of their paper. That’s a good thing.

But what if we designed this tax so that, rather than being calculated as a constant fraction of transaction value, it was a function of both value and trading volume, so that it would be more expensive to trade when everyone else is also trading? Maybe it’d cost 0.02% of notional value to trade when daily transaction volume has been within 1 standard deviation of the trailing year’s mean, but the cost would increase as steeply rising function of any abnormal volume?

Such a tax would have lots of nice properties: First, it would be symmetrical, neutral between buyers and sellers. It would not harm transactors bringing new information into the market, since transaction volume would be normal while the information remains closely held. But it would bite transactors who react to widely known news or who pile on to price momentum. That is, “congestion taxing” wouldn’t much damage the information aggregation/price discovery of markets, but would tax the zero-to-negative sum rush into or out of positions once the information work is already done. “Me too” purchases would be expensive, and those that occur would be informative, because they would reflect conviction rather than copycatting. Low-conviction information cascades would be discouraged by a high cost of entry, rather than prevented outright by administrative fiat.

Is this a good idea? It’s Friday night, been a phukked up week, and I’m drinking right now (Kentucky Bourbon Ale, ya gotta try it), so maybe I’m slurring my thoughts. Just thought I’d toss this out into the world, and see where it lands.

Update: Jesse Eisinger has just published a nice column on the Tobin Tax in Portfolio.

I am sorry to go all AWOL lately. I’ll try to post something substantative over the weekend. My temporal balance sheet looks a great deal like Lehman’s financials. Plus, despite the generous antidotes provided by Yves Smith, the events of the past few weeks have me twitchy and disoriented, reading obsessively but barely capable of drooling. I think I speak for a lot of us who’ve been on the pessimistic side of the financial blogosphere these last few years in saying I wish we had been wrong. (I wish the mighty who are now falling had paid us some mind, too.)

Today’s big news is the hint of a bail-out to end all bail-outs. I often have mixed feelings about Robert Reich’s commentary, but I commend to you his piece today.

There is no question that we are going to spend a lot of public money to address the current crisis. We have already put a very extraordinary amount at risk. The question we should be asking is not whether or how much, but to whom and for what. The financial crisis we are facing is a symptom of a much larger economic and social crisis. Wall Street is not the source of the pain. On the contrary, the financial sector has been put this decade primarily in the service of hiding, literally of papering over, unsustainable trends in the current account, income distribution, human and physical capital deterioration, and the sectoral composition of the American economy. The conventional wisdom is that this is a financial crisis, and that so far “Main Street” has been largely insulated from the catastrophe. That is rubbish. The cancer is on Main Street, and the tumor has been growing there for years. Wall Street provided drugs to hide the pain and keep us going, palliative but not curative. What is happening now is those drugs are wearing off. The American economy is fundamentally unsound, and has been for some time. We would have noticed sooner, were it not for financial methamphetamine conjured by mad scientists in lower Manhattan from a whirlwind of foreign central bank money.

I think we’ll only get one shot to set things right by throwing a ton of money at the problem, so we’d better think carefully before we throw it at symptoms rather than causes. Trying to figure this out in a week before Congress goes off to reelect itself strikes me as ambitious. Broadly, my view is that if we are going to legislate, Congress should empower regulators to declare systemically important firms insolvent, write off existing common and preferred, fire incumbent management and unilaterally convert debt to equity as far up the capital structure as they need to go until the firms are unambiguously well-capitalized, with little or no public money involved. Going forward, investors should understand that firms that are too big to fail are too big to be debt-financed, and government enforcement of debt claims against such firms will be limited. If economies of scale are real, equityholders should be glad to reap them. Otherwise markets function better anyway when populated by small actors who compete rather than by behemoths who dominate. The government should not subsidize the many negative externalities of scale. Members of the Pigou Club might suggest that bigness should be taxed and diversity subsidized.

As far as the money is concerned, throw it at infrastructure. Increase worker bargaining power by offering Federally funded retraining sabbaticals for any worker over thirty who decides they want to retool. I’d rather see a new WPA than a new RTC. If it is true that during a debt deflation, the government can spend freely without fear of inflation, let’s spend in a way that balances the economy, not in a manner that tries to ratify the imbalances that brought us here in the first place.

There’s no such thing as a choice-free bailout. The government’s largesse will go to some and not to others, and we have to decide. Don’t believe self-styled technocrats who claim that science or the market tells them who deserves the tax- (or inflation-) payers’ dollar. In a bail-out, there are winners and losers, and we get to pick. I think we should focus on a simple goal: Restructuring the economy so that the vast majority of Americans can afford a middle-class lifestyle with very little leverage on household or government balance sheets. That may be a radical suggestion in 2008, but our grandparents would have considered it only common sense.

It’s a clich&eacute, of course, that the 2000s are the new Gilded Age, that inequality in America is at levels not seen since the original Gilded Age, which you may recall was ended by a terrible depression.

During this decade’s tiresome debates about inequality, the don’t-worry-be-happy side of the argument frequently, and correctly, noted that income inequality statistics overstate the lived experience of inequality, since the poor spent more than they earn and the rich spent less.

Of course, the poor spend more than they earn primarily by taking on debt. In the halcyon days of 2006, that was no problem. Credit flowed like honey, and what could always be refinanced need never be repaid. It’s a wonder we didn’t do away with the whole “money” thing entirely. If you can spend all the way down to negative infinity, it hardly matters whether your starting wealth is one dollar or a billion dollars. Why keep track?

But, alas, people did keep track. They also stopped lending to people who might not be able to repay, people who, you know, spend more than they earn. Which means, even putting aside the terrible hardship of bankruptcy, or struggling to pay down old loans, all of a sudden the lived experience of inequality must come very much to resemble those unpleasant income inequality statistics. Are we cool with that?

In a way, the credit crisis comes out of a tension between the broad-middle-class America of our collective imagination and the economically polarized nation we have in fact come to be. We borrowed to finance an illusory Mayberry. The crisis won’t be over until this tension is resolved. Either we modify the facts of our economic relations, or we come to terms with a new America more comfortable with distinct and enduring social classes.

Tanta and Calculated Risk have popularized the notion that “We are all subprime now.” But that simply isn’t true. The vast majority may be subprime now, but not all of us. To use an old expression, as the easy money falls away, we are being left to “find our own level”. For many, it may be quite a bit lower than we had imagined.

I’m sure this is a bit polemic, but I don’t think it is much overstated. Credit was the means by which we reconciled the social ideals of America with an economic reality that increasingly resembles a “banana republic“. We are making a choice, in how we respond to this crisis, and so far I’d say we are making the wrong choice. We are bailing out creditors and going all personal-responsibility on debtors. We are coddling large institutions of prestige and power, despite their having made allocative errors that would put a Soviet 5-year plan to shame. We applaud the fact that “wage pressures are contained”, protecting the macroeconomy of the wealthy from the microeconomy of the middle class.

The credit crisis will end, and life in America will go on. What we have to decide now is, when the floodwaters clear, what kind of country will be revealed. Peering down through the murk, I don’t like what I am seeing.

Addendum: Tyler Cowen was prophetic on this point. He wrote in January, 2007 on income vs. consumption inequality:

People may be borrowing and accumulating large debts. Note that in this case, however, the comeuppance, however bad it may be, has yet to come. It could instead be argued that “inequality will (someday, when the debts come due) be a serious problem.”

Welcome to someday, Labor Day, 2008.

FD: I’m still very stagflation-oriented in my personal portfolio (precious metals, short long bonds and stocks), so the wage-price spiral demagoguing might be interpreted as self-interested. That said, no apologies. It astonishes me that even very liberal economists take comfort in the evisceration of wage-earners’ bargaining power. Yes, it means that Ben doesn’t need to hike, regardless of what commodities do. But what kind of economy are we building when we take the price of past mistakes out of future wage-earners’ pay packets, while protecting the accumulated wealth of those who profited by erring?

In the more eschatological corners of the financial blogosphere, a debate has raged for centuries: Inflation or deflation?

I recommend Michael Shedlock as a thoughtful and passionate proponent of the deflationary view. (See e.g. here and here, but he’s been making the case for years and it’s worth searching the archives.) Also, Karl Denninger recently offered a nice deflationary tract.

I’m more certain of monetary and price volatility than I am of inflation or deflation. But on balance, even as commodities crash and the dollar rallies, my best guess is inflation.

Do read today’s excellent post by the always excellent Brad Setser, The changing balance of global financial power. Take a look at his graphs, showing the external official claims of “democracies” vs “autocracies”. You’ll notice that the autocracies are owed a great deal more money than the democracies are. Mostly, money is owed by the democracies to the autocracies in the form of debt denominated in the democracies’ currencies.

[Note: For the purpose of this piece, it matters only that policy in the “democracies” be sensitive to public pressure. The internals of the “autocracies”, and whether they are justly characterized as such, is not relevant to the argument, and not anything I want to get into here.]

Inflation helps debtors at the expense of creditors. In democracies where those who can vote are, on balance, debtors, one would expect collective indebtedness to favor inflation. Not all citizens are debtors, there would be domestic winners and losers. But on balance, voters gain by printing currency. If that’s a good argument for free trade, why should it not be an argument for weak money?

There are, of course, institutional constraints, “independent” central banks and all. It is one thing for a nation’s central bank to stand above the fray with respect to competing domestic interests, but quite another for the bank to put foreign interests or economic ideals above a collective national interest. That’s especially true if the alternative to devaluation is deflation. Under a deflation, American workers (those who remain employed!) would have to work more to pay off their fixed dollar debts. Individuals can declare bankruptcy and default, but collectively we cannot default on official debt (pace Felix Salmon, whose heretical idea I adore). One way or another, as reckless debtors or noble taxpayers, Americans would have to work harder under a deflation than they had signed on for when they took on the debt. Americans are having a hard time coming to grips with their nominal debt burden, public and private. I think it implausible that they would accept a large increase in the real interest rate they must pay. Officially it is the policy of the American central bank to maintain price stability and full employment regardless of the external value of the dollar. If the Fed faces a choice between deflation and high unemployment, or tolerating a significant inflation (with or without high unemployment), I’m pretty certain it would choose the latter as the less-bad option.

Japan’s experience in the 1990s and the US’ in the 1930s are often cited to suggest the inevitability of deflation, despite monetary policy heroics. But in both cases, the deflating country had a large, positive international asset position. To the degree money was owed by foreigners in domestic or pegged currency, the “national interest”, looking past winners and losers, was to tolerate deflation.

All of this ignores the secondary consequences of a partial default through inflation and devaluation. A wise polity would weigh the immediate collective benefit of reduced debt load against costs including higher future interest rates (foreign creditors get spooked), more expensive tradables, and a nationalistic backlash by creditor states. Of course, it would also have to consider the secondary effects of tolerating deflation, such as a spike in bankruptcies combined with a large tax spike to avoid a sovereign default. It seems to me that the adverse consequences of deflation would be sharp and domestic, while high prices and interest rates can be billed as “facts of nature” in a market economy, and other people’s hostile nationalism often helps domestic politicians, who can provoke some hostile nationalism of their own.

It is not impossible that the Fed will square the circle, maintaining something close to price stability while the US gears up its tradables economy and foreign creditors silently ease our debt burden via real appreciation. Obviously, that’s the best outcome (at least for the United States). But if deflationary winds do blow, if the Fed is faced with the choice of tolerating a spiraling credit contraction, falling prices, and bankruptcies or overshooting with “quantitive easing” into inflation, well, as Ben Bernanke famously put it…

[T]he U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

FD: My investment portfolio includes inflation hedges such as precious metals and short positions on long bonds. My portfolio return over the past several weeks has been large and negative, and if you take anything here as investment advice please expect a similar outcome.

One of the more depressing bits of emerging conventional wisdom is the notion that the financial system took on “too much risk” in recent years. I think it is equally accurate to suggest that the financial system took on too little risk.

Consider the risks that were not taken during the recent credit and “investment” boom. While hundreds of billions of dollars were poured into new suburbs, very little capital was devoted to the alternative energy sector that is suddenly all the rage. Despite a “global savings glut” and record-breaking levels of “investment” in the United States between 2005 and 2007, capital was withdrawn from a variety of industries deemed “uncompetitive” in large part due to obviously unsustainable capital flows. Very few brave capitalists took the risk of mothballing rather than dismantling factories and maintaining critical human capital through the temporary downspike. Under the two to five year time horizon of our most far-sighted managers, whatever is temporarily unprofitable must be permanently destroyed. To gamble on recovery is far too great a risk.

I don’t pretend to know where all that capital, that incredible swell of human energy and physical resources, ought to have gone. But it doesn’t take an Einstein to know that it probably should not have gone into building Foxboro Court. Sure, hindsight is 20/20. But lack of foresight really wasn’t the problem here. In 2005, how many macroeconomists or big-picture thinkers were arguing that the US economy lacked suburban housing stock of sufficient size and luxury? We gave the building boom the benefit of the doubt because it was a “market outcome”. But the shape of that outcome was more matter of institutional idiosyncrasies than textbook theories of optimal choice. It resulted as much from people shirking risk as it did from people taking big bets.

The big central banks, whose investment largely drove the credit boom, were (and still are) seeking safety, not risk. The banks and SIVs that bought up “super-senior AAA” tranches of CDOs were looking for safe assets, not risky assets. We had a housing boom, rather than a Pez dispenser bubble, because housing collateral is (well, was) the preferred raw material for fabricating safe paper. Investors were never enthusiastic about cul-de-sacs and McMansions. They wanted safe assets, never mind what backed ’em, and mortgages are what Wall Street knew how to lipstick into safe assets. The housing boom was born less from inordinate risk-taking than from the unwillingness of investors to take and bear considered risks. Agencies, asset-backed securities, it was all just AAA paper. It was “safe”, so who cared what it was funding?

Finance is not a closed system, a zoology of exotic contracts and rocket scientist equations. The job of a financial system is to make real-world decisions, “What should we do?” A good investment is a simple answer to that question, with clear consequences for getting it right or wrong. Mom and Pop can have FDIC insured bank accounts, and imagine that there is such thing as a “risk-free return”. But that’s a lie, a sugarcoated subsidy. Foregone consumption does not automatically convert itself into future abundance. People have to make smart decisions about what to do with today’s capital. If they don’t, no amount of regulation or insurance will prevent all those savings accounts from going worthless. When huge institutions treat the financial system like a bank, depositing trillions in generic “safe” instruments and expecting wealth to somehow appear, they are delegating the economic substance of aggregate investment to middlemen in it for the fees, and politicians in it for whatever politicians are in it for. And we are surprised when that doesn’t work out?

Of course we should regulate and manage the risks that were the proximate cause of the credit crisis. Anything too big to fail should be no more leveraged than a teddy bear, and fragile, poorly designed markets should be fixed. But that won’t be enough. We’ve trained a generation of professionals to forget that investing is precisely the art of taking economic risks, then delivering the goods or eating the losses. The exotica of modern finance is fascinating, and I’ve nothing against any acronym that you care to name. But until owners of capital stop hiding behind cleverness and diversification and take responsibility for the resources they steward, finance will remain a shell game, a tournament in evading responsibility for poor outcomes.

Investors’ childlike demand for safety has made the financial world terribly risky. As we rebuild our broken financial system, we must not pretend that risk can be regulated or innovated away. We must demand that investors choose risks and bear consequences. We need more, and more creative, risk-taking, not false promises of safety that taxpayers will inevitably be called upon to keep.

Over the weekend, Paul McCulley offered a thought-provoking piece (ht Justin Fox, Brad DeLong), which starts with a discussion of the “paradox of thrift”:

For those of you who might not recall, the paradox of thrift posits that if we all individually cut our spending in an attempt to increase individual savings, then our collective savings will paradoxically fall because one person’s spending is another’s income – the fountain from which savings flow.

There’s a hidden assumption in the “paradox of thrift” that really ought to get teased out more often. It is true that one person’s spending is another person’s income. But it does not follow that an increase in saving translates to a decrease in aggregate income. There are two kinds of spending, consumption and investment. Laying a subway line adds to somebody’s income as surely as buying a Ferrari does. Ordinarily, nearly all savings are actually spent on investment goods, and there is no “paradox of thrift”. What is “saved” is really spent on current production of future capacity, and there are plenty of paychecks to go around. There is no “fallacy of composition“: individually and in aggregate, today’s thrift lays the groundwork for tomorrow’s abundant consumption.

However, for this to work out, two things must be true: Today’s savings must be invested in projects that will actually generate future wealth, and savers must believe they will retain a stake in the increased wealth commensurate with the size and wisdom of their investments. We have a financial system in order to make these facts true. If the investment industry is capable of finding or initiating projects likely to satisfy future wants, and if financial claims are predictable and stable stores of value, we need not trouble ourselves over the paradox of thrift. The issue only arises when the financial system breaks down. When investors lose faith in the quality of available investments or their ability to collect the proceeds (in real terms), they pull out savers’ Plan B: precautionary storage. They buy gold, or oil, or art, or whatever, and they keep it, generating scarcity rents for those who can offer perceived value stores, but very little in the way of general income and employment. Precautionary storage, not thrift itself, is the villain of the tale.

The vulgar Keynesian prescription is to encourage consumption, when a dynamic of precautionary storage takes hold. And in extremis that might be a good idea, because if all everyone does is hoard, it’s hard to figure what to invest in, except maybe storage tanks. But it’s much better to develop a financial system that actually performs, that identifies fruitful projects and allocates claims fairly. Storage eats wealth, while productive enterprise creates it. People know this. No one “invests” in gold or oil when a financial system is working. They do so when it is broken. Like now.

Encouraging people to go shopping in order to help the economy is not “second best” policy. It’s a desperate last resort. We’re not at a point where there’s so little economic activity that we can’t foresee future wants. We’re at a point where people are beginning to shift from investment to storage because of a well-deserved loss of confidence in the financial system. Encouraging consumption now is nihilistic. It feeds into a vibe (I feel it personally, do you?) that saving is so uncertain and money so volatile that one might as well spend, ‘cuz who knows what tomorrow might bring. The right way to sustain aggregate demand and maintain current income is to figure out what we should be investing in — not stocks, bonds, or CDOs, but factories, windmills, or schools — and then to put current resources to work. Our financial system is failing spectacularly because it erred grievously. It built homes and roads and sewers that oughtn’t have been built, it “invested” in vacations and plasma televisions, and it paid itself handsomely for doing so. That’s not a problem we can spend our way out of. To fix the financial system we have to change it, not rally to its support. We will know we’ve put things right when thrift is something we can celebrate, when we save because we are excited about what we are creating rather than frightened by what we might lose.