If we only had a financial system…

Here’s Paul Krugman:

Sooner or later, then, consumers were going to have to pull in their belts. But the timing of the new sobriety is deeply unfortunate. One is tempted to echo St. Augustine’s plea: “Grant me chastity and continence, but not yet.” For consumers are cutting back just as the U.S. economy has fallen into a liquidity trap — a situation in which the Federal Reserve has lost its grip on the economy.

…The capitulation of the American consumer, then, is coming at a particularly bad time. But it’s no use whining. What we need is a policy response.

…[W]hat the economy needs now is something to take the place of retrenching consumers. That means a major fiscal stimulus. And this time the stimulus should take the form of actual government spending rather than rebate checks that consumers probably wouldn’t spend.

Tyler Cowen responds:

Krugman… calls for fiscal stimulus… I am more inclined to think that consumers need to cut their spending now. It is widely understood that consumers have been living beyond their means. Let us say instead that consumers maintain their spending (say through fiscal stimulus, a cut in sales taxes, or sheer exhortation) but that everyone knows consumer spending will fall in three years time. In three years time, the “liquidity trap” (not exactly how I think of it) will be over, but in the meantime investment commitments will be lackluster, given that people will be waiting for the economy to digest the forthcoming change. Maybe we need to spend less now and get the adjustment over with more quickly, even though that will be painful.

I love this exchange, because it beautifully dances around the elephant that is not in the room.

Krugman’s point is that, ordinarily, a dip in consumer spending could be offset by an investment boom, courtesy of the Federal Reserve. As always, there’s model just behind Dr. Krugman’s words, summarized in this case by an accounting identity:

Y = C + I + G + NX

If C (consumer spending) contracts, and I (investment) cannot be made to grow, then Y (GDP — truth, goodness, and happiness) must fall, unless we start messing with G (government spending) and NX (net exports). Hoping for an export boom during a global recession seems daft (although NX shifting toward zero from recent negative values may help), so we are left to work with G. It’s time to ramp up government spending.

You can almost hear the words of Hayek echoing in Dr. Cowen’s rejoinder: “Mr. Keynes’ Krugman’s aggregates conceal the most fundamental mechanisms of change.” Cowen’s rather subtle point is that if we artificially support current patterns of consumption by having the government spend money into people’s pockets, we won’t know what future, sustainable patterns of consumption might look like. Without that, we won’t know what to invest in. Paradoxically, we might exacerbate the short-term problem by suppressing private investment. Longer term, we cannot run the economy off of government spending indefinitely, and if we just postpone the pain, we will find ourselves with fewer resources when we have to deal with the underlying problem.

The elephant that is not in the room is a financial system. By a financial system, I don’t mean the tottering cartel of banks and insurers loudly sucking newly printed cash into “collateral postings” and “deleveragings” and other meaningless nonactivities. That is no financial system at all. It is an ecology of intestines and tapeworms, tubes through which dollars flow and are skimmed en route to destinations about which the tripe-creatures have little interest or concern.

No, a financial system would be forward-looking. A financial system would be interested in the world, rather than fascinated by the patterns that formed behind its own mathematical eyelids. A financial system would hunger for information. It would leave no human preference overlooked and no technological possibility unconsidered. A financial system would embrace us all, would want to learn from us all. It would not be something external, something outsourced to specialists in London or Manhattan. It would want “savers” to express what they plan to do, how they hope to live, rather than offering generic claims on money along a disembodied spectrum of “risk”. It would thirst for proposals, ideas, business plans designed to meet the preferences thus expressed, or to achieve possibilities not widely considered. A financial system would be creative. No stock exchange could contain the vast and multifarious tapestry of investable ideas a financial system would educe. A financial system would offer us opportunities to invest not in distant opportunities where we are disadvantaged, but in projects that are informationally, if not physically, near to us. A financial system would be ruthless. It would allow us to have a voice in the most important decision we collectively make, but would force us each to bear the costs of our errors.

We simply do not have such a system. We don’t have anything remotely like such a system.

If we did, Dr. Krugman’s preferred remedy would have worked five years ago, when the Fed still could, and did, stimulate an investment boom. If we had a financial system, we would not have invested in luxury housing and disinvested from tradables while our current account deficit ballooned. We would not have securitized current consumption, and the called it “investment”. Extrapolation is not foresight, and Ponzi schemes do not generate wealth. We did not have a financial system on 2003. That is how we got to 2008.

If we had a financial system, we wouldn’t require the world economy to collapse, just so we could learn how it might be put back together again (with expectations sufficiently lowered). Our financial system would be considering a wide array of possible futures, and using us all to push the world toward to a future that actually makes sense. If we had a financial system, we would be saving by spending to enable future production, not by making sure our dollars are in the kind of bank accounts the government guarantees. Strained consumers would shift from C to I without depleting Y, by purchasing claims on future goods and services, which investors would sell while funding projects designed to ensure the production of those goods. The very act of cutting back current consumption would generate new information about the structure of future consumption, as nervous savers factor price into claims on the future and nervous investors compete to offer claims at prices low enough to sell but high enough that they can ensure profitable fulfillment through an uncertain future.

Of course, this is a kind of dumb utopianism. If we had a magic wand, we’d have better options too. But I suggest you look at it the other way around: the “financial system” that we actually have is an awful dystopia. Yes, it will be impossible to create the perfect massively decentralized optimizer of collective and individual human futures. Screw perfection, but we should at least go for mediocre. Right now, banks don’t even bother to sell themselves to savers on the basis of their superior acumen in choosing real investments. Investors in mortgage-backed securities never believed there was a deficiency of luxury exurban housing. People don’t invest in index funds because they have a considered belief that the projects available to listed firms are superior on average to other projects that might be pursued. We have methodically erased information about real-world activities from the financial decision-making process. We’ve created an intrafinancial mandarin class, treated as experts, entrusted with wealth, but lacking knowledge of anything other than the arcane wheels and gears of finance, as if the finance exists apart from the workaday world of producing and consuming, serving and being served.

There will never be a perfect financial system. But the system we have is so far from reasonable that it must be undone, or it will be our undoing. We should not be propping it up. We should be tearing it down, and using all these hundreds of billions of dollars to replace it with something sensible.

By the way, as a policy matter, in this world as it is, I don’t mean to criticize either Krugman or Cowen. I think they are both right. Per Krugman, for now we have little choice but to have government do a lot of spending, since we have no financial system to convert present savings into real investment. But, for the reasons that Cowen highlights, I think we should channel any stimulus towards basic consumption by those facing hardship (e.g. unemployment benefits, food stamps, etc.) and obviously necessary infrastructure investment (fixing bridges, dams, power grids, etc.). In any reasonable future, everybody will eat, so offering money to those struggling to put food on their table or a roof over their heads will create less uncertainty about future tradeoffs than subsidizing discretionary consumption by those better off. And it’s a cliche, but a true cliche, that our public infrastructure is crumbling. Pulling forward restoration projects that will be necessary unless there are radical changes in the structure of American life also introduces relatively little noise.

But the most important thing we should be doing is building a real financial system.

Update: This post has attracted an extraordinary comment thread. A lot of bright people are looking past all the logos and glass-and-steel towers that try to persuade us that what we have is permanent, a fact of nature, necessary. Some are so old-fashioned as to try to build a better mousetrap and outcompete the slime creatures. (It would be peevish to point out that trillion dollar subsidies and captured regulators may leave upstarts with a not-quite-level playing field.)

Update History:
  • 10-Nov-2008, 5:50 p.m. EST: Added update re comment thread.

61 Responses to “If we only had a financial system…”

  1. Mitch writes:

    Something like Kiva for the developed world? With equity stakes instead of just debt?

    Most people working in the “real” economy understand their own field much better than someone who specializes in finance. This means that there’s a vast, (relatively) untapped reservoir of resource-allocation wisdom that could be brought to bear on the question of what projects deserve investment.

    We’ve gotten rid of so many other kinds of middlemen lately, why not financial intermediaries as well?

  2. Alessandro writes:

    Steve, I’m always surprised by your thinking way above the others, one more excellent post.

    I absolutely agree with you that what’s called the “financial system” is really just a wealth black hole, but how did it happen? What has enabled this that is an obvious Ponzi scheme, to become “The financial system”?

    My pet theory, that hope will interest you, is that what has transformed the financial system away from its true meaning is “forced savings”. In developed countries people are forced to save 20% or even 30% of their salary due to pension planning, and they cannot freely choose to consume it. This make for a huge amount of fresh credit that needs to be allocated every month even if there is not enough good investment ideas around.

    Since people can choose whether to save more, but cannot choose to save less, returns on savings will be suppressed. This created easy money (the FED just went with the stream), and we know what come from easy money.

    What’s worse is that easy money make savings less appealing and people in order to lower its saving rate has been borrowing the same money they were saving (put your 401k in ABCP, have a rolling CC balance, you are borrowing your own money giving probably 10% to the bank!). Could those people actually choose, they’d not saved and not borrowed. No free money for the bank, higher returns for those actually saving.

    China forex manipulation is “forced saving” as well, this time via yuan inflation.

    And if you say that people need to plan for their pension, I ask you: how can be the best pension plan to lend money to a stranger at 4% hoping he will care for me when I’m old and at the same time have my son borrow money from a stranger at 7% for his education and have my son care for him when he is old? Why can’t I just care for my kids and have them care for me when I’m old? Why do I need perfect strangers and a negative rate spread in the process? It has worked for thousand years.

  3. RueTheDay writes:

    Steve – Great post as always.

    Re: Fiscal stimulus – It’s difficult for me to wrap my mind around the idea of what fiscal stimulus means during a period where savings rates are zero or negative. If the marginal propensity to consume is 1, then increased deficit spending represents a pure transfer not a stimulus. MPC must be under 1 for there to be any sort of stimulus. I suppose it could be framed as a pro-active stimulus (people aren’t saving yet, but they’re going to, so let’s nip it in the bud). If that’s the case, then I agree 100% with Robert Reich – the only stimulus that needs to pass is an extension of unemployment benefits (Reich’s Blog

    Re: The financial system or lack thereof – This one troubles me, because we seem to be moving AWAY from where we ought to be moving. I have been calling for re-instatement of Glass-Steagall for quite some time. Repealing it was a huge mistake, and ignored the lessons of the Great Depression. However, it’s hard to see how we get back to a post Gramm-Leah-Bliley world now, particularly after Goldman and Morgan Stanley became “banks”. Likewise with the increasing concentration in financial services. Competition and diversity make the system more resilient. Yet the Fed and Treasury seem intent on forcing a consolidation, even funding it through TARP, and leaving us with a much more concentrated industry with fewer independent players.

  4. SW:

    Do you follow Mencius Moldbug at Unqualified Reservations? He had a post within the last three months or so on “maturity transformers”. If you haven’t read it, you should. I think you’ll get something out of it. As for our financial system, it’s just a big numbers game with very little value backing it up. Most large banks are insolvent and the Feds are busy counterfeiting currency to keep them afloat. Well said Steve.

  5. MrM writes:

    The Government is already actively stepping in to fill the consumption/investment void. And it is doing that in the most inefficient way – by increasing military expenditures! Just look at the GDP details: in Q3-2008 military expenditures rose 18% vs. Q2-2008, which contributed to 0.86 pct to Q3 GDP growth rate. Without this burst of military expenditures the GDP would have contracted by more than 1%.

  6. beezer writes:

    Nice thinking Steve and RueTheDay. Concentration of power in a few “villages” is not the way to go. Stronger regulation is absolutely mandatory. As is fiscal stimulus.

    Keep low capital gains for investment in real goods, and raise taxes on short term investment returns to discourage gambling.

    If banks won’t lend, go around them. Depositors will eventually wander away, as they should. Make direct investments with taxpayer money. And take equity stakes for the taxpayer.

    Our current topheavy, intermarried and inbred financial system has produced the equivalent of bankers and economists with mental limps. Way past time for new blood.

  7. RueTheDay writes:

    IA: I just dug up and read Moldbug’s post.

    He’s essentially advocating the plan that Henry Simons advocated during the 1930’s. Simons’ plan was intended to draw a bright line between money and credit and to eliminate all maturity mismatch. The plan was two-pronged: 1. impose a 100% reserve requirement on all demand deposits (checking accounts) and 2. eliminate the various categories of time deposits (savings accounts) and replace them with maturity-matched deposit/term-loan pairs (e.g., banks would offer CDs with a range of maturities and then make term loans with the funds in identical maturities). The idea was to eliminate the borrow short/lend long structure of modern banking.

    There were always a number of objections to Simons’ proposal. One being that there was no way to go from a fractional reserve system like we have now to the sort of narrow banking system Simons wanted, without destroying the economy in the process (you’d have to call in ALL bank loans since they were all made on fractional reserve terms and somehow simultaneously reflate the monetary base back to where it was before you did this). Moldbug’s nationalization plan would attempt to do this. The other objection concerns how you would enforce such a system. Would the CDs be negotiable (which has the implicit effect of shortening their practical maturity)? How exactly do you prevent individuals from funding long term assets with short term liabilities (in Moldbug’s example, Dwight would claim he’ll have the weed in one week); would you make rolling over loans illegal? I’m not sure that there’s a good answer to this.

  8. Farrar writes:

    Mitch wrote

    Most people working in the “real” economy understand their own field much better than someone who specializes in finance. This means that there’s a vast, (relatively) untapped reservoir of resource-allocation wisdom that could be brought to bear on the question of what projects deserve investment.

    Forty or fifty years ago, there used to be a profession called bank lending officer or credit officer, and these people served as a link beteen the “real economy” and specialists in finance. If that profession still exists, it ain’t what it used to be. Nowadays it seems that even small business loan applications are judged by some semimechanical process of credit scoring, meaning that the human interaction necessary in exercising credit judgement has largely disappeared, and that loan allocation has effectively been taken over by financial people.

    The 3 C’s of Character, Capacity, and Collateral also seem to have been forgotten.

    This has meant that the loan approval process has been simplified and expedited, but it also seems to mean that the DISapproval process (that is, the cancellation of credit lines) has also been expedited, because the financial people no longer know what they are financing.

  9. joebhed writes:

    whoa !

    This IS getting kind of interesting.

    On a Steve Waldman post, we have two knowledgeable commentors bringing in two other knowledgeable posters around the matter of Henry Simon’s 100 percent reserve, Chicago-Plan, almost-Friedman-esque type of a “financial system”, if you will.

    Really, a substantial dialogue could be happening on monetary reform. PLEASE stay with it gang.


  10. merry-will-go-round writes:

    I’d like to see someone criticize Krugman’s policy stances. I wonder whether Steve’s deference to Krugman and Crowe actually stymies serious policy development that might occur with the kind of critique of the dysfunctional global financial system that Steve advances. Perhaps if at least one of the variables of the basic economic equation of Y = C + I + G + NX were expanded, wise policy development might suggest a course beyond increased government spending. For example, assuming the “G” marks both government spending and regulation, doesn’t the argument for massive increases in government spending alone aid and abet continued dysfunctionality in current financial (and political) systems? I think Steve alludes to the far more important need for regulation in his closing sentence. If he consciously inserted this factor into the “Y” equation, he may find that Krugman and many others MAY BE proposing an economic system that will eventually need revision to:

    Y = G – (C + I + NX), where “G” is predominantly government spending.

  11. JKH writes:

    The prevailing financial system featured excessive deregulation distorting real investment allocation via financial intermediation (mortgage lending practices), and excessive complexity combined with excessive incompetence destroying the financial intermediation process from within (e.g. CDO and CDS propagation; value at risk methodology). A new system requires the equivalent of comprehensive risk limits and capital requirements for all economic sectors (including households “investing” in houses). With appropriate streamlining and reasonable but broad capital/leverage constraints, there may still be hope for the power of specialization and the invisible hand of finance operating within an intelligently redesigned system.

    But in terms of treating the patient in the interim, I prefer Krugman to Cowen.

  12. Reino R writes:

    Alessandro: It’s not the “forced savings” that creates the massive flow of credit. Haven’t you noticed that no savings of any kind are actually needed for modern credit creation. The fraction in fractional reserve banking has been taken to practically zero.

  13. Massimo GIANNINI writes:

    From Europe, we think that U.S. should start to stop thinking in spending always money and start saving it to invest later on. U.S. is borrowing from abroad and from future generations in an attitude worser than a developing country. Should they need revenue to finance further public spending to keep economy alive maybe they could think in a Tobin Tax to avoid financial mess. Moreover some savings could also come from the defense budget to be invested in more productive sectors as Krugman and other suggest.

  14. Benign Brodwicz writes:

    ah, yes back to principles of macroeconomics, drilled into my mind by a seemingly infinite series of courses taught while I was still sacrificing myself on the alter of higher education….

    There are two big problems, IMHO:

    (1) the composition of output was skewed toward an unsustainable level of consumption by

    (2) phony money-grubbing “I’ll be gone, you’ll be gone” larcenous financial tricksters.

    To cut to the chase, it took willful ignorance for the people and their elected representatives and their regulators to turn a blind eye to the frauds being perpetrated in the markets, and to the obscenely greedly and self-deluded something-for-nothing, win-the-lottery, get-rich-quick mentality of American households, who played one bubble after another, never bothering to wonder if all this sudden wealth could possibly be real.

    But they had the examples of the plutocrats in New York and Hollywood and Silicon Valley to whisper in their ears that, yes, they too could be unimaginably rich….

    Prospect theory teaches that people gamble more when they’re losing. The majority of American households have been losing relative position for a generation, and they got desperate. The financial tricksters preyed opon them with pyramid schemes, sucking their wealth away, knowing that any problems they got into would be forgiven by the politicians they’d purchased over the years.

    In other words, people bought into fantasies out of desperation. Government turned a blind eye to malfeasances in the markets. Financial markets will always tend to excess because they are driven by volatile human psychology, and maybe after a long human lifetime the atrocities preceding the Great Depression are forgotten, and enforcement goes lax.

    Fiscal stimulus to consumption is a bad idea now–but most investment is derived demand, so if we don’t stimulate consumption, who do we prevent a collapse of aggregage demand? The Bushes used wars to do it. I don’t think the American people are for trashing another foreign country (IRan) and then spending billions to rebuild it with humanitarian aid.

    Government will have to divert military spending into infrastructure, health and education. The military-industrial complex that Dwight Eisenhower (a military man) warned us of fifty years ago has had its run of stupid wars with no strategic value, and maybe people are wising up to those facts. The Baby Boomers, if at last half-witted, should be starting to see a pattern, having had two length stupid wars, each longer than WWI, in their lifetimes.

    If a new social contract cannot be achieved, one that a majority of people buy into, the US of A is toast. The corporations will take their business elsewhere, and we will devolve into a quasi-feudal society.

    You won’t hear any of this from a mainstream academic economist. They are cheerleaders for the status quo.

  15. lark writes:

    “If we had a financial system, we would not have invested in luxury housing and disinvested from tradables while our current account deficit ballooned.”

    You don’t mention the yuan peg, which has disadvantaged domestic investment for exports.

    How would you deal with currency manipulation?

  16. Steve — Thought provoking and excellent post. Well done.

    Now, of course, that you have volunteered, can you please deliver a comprehensive report on how you would propose we go about creating such a true intelligent, effective capital allocation system and what it would look like? I would like it on my desk in 10 days.

    Failing that, further thoughts along the same lines but in less developed form would also be highly welcome.

  17. carpingdemon writes:

    “The elephant that is NOT in the room is a financial system.”

    Aaah. An old reprobate hears an echo of something he’s been muttering for the last 40 years, “Capitalism is not a system.” Socialism is a system. Communism is a system. They don’t work.

    They don’t work because they are systems, dependent on prognosticating future events according to sets of rules (misapprehended as “laws” subject to quantification) based on observations of past events. But the observations are incomplete memories of outcomes of human behavior, removed from their contexts. There are infinite possible histories of past events, and Lorenz has shown that the slightest differences in initial conditions result in unpredictability.

    Capitalism works, or appears to work, because societies in which it appears to work have accepted/posited that the results of human activities that seem to follow from certain principles afford them the best lives they can expect. Principles are standards of human behavior, not laws arising mathematically from natural events. Thus there is no capitalist “system,” no “set of rules (misapprehended as ‘laws’ subject to quantification) based on observations of past events”. There are only people doing whatever they can think of to try to make the best lives they can without trampling on their principles and accepting what they get without a system, because any known “system,” which usually means some sort of command economy, must eventually contravene those principles.

    If you think there’s an unseen elephant in the room, and there isn’t, your activities are going to be inappropriate to the room as it exists. Decisions you make about seeming past events, made in the mistaken belief that there’s an invisible elephant there, won’t produce the future you expect . It is the same with the so called invisible hand. It’s not there. It is no more or less than symbol for all that we do not/cannot know about the situations in which we find ourselves acting.

    Policy wise, we should accept the fact that we do not have a system, accept that we get pretty good results doing what we’re doing, and bend our efforts to ameliorating the harm to some (sometimes a great many) that inevitably arises from our attempts to prosper as individuals. Pretending that we are moved by natural, quantifiable laws (Y = C + I + G + NX) when in fact we are guided by social principles, pretending that we can improve a system that we do not have, will only diminish the returns on our efforts.

  18. Mitch writes:


    You don’t mention the yuan peg, which has disadvantaged domestic investment for exports.


    Seriously! Not just exports, but import-competing industries as well.

    I’d like to hear less about G and more about NX. I’m a layman economically, but I’m sure there are a variety of policy tools we could use to deal with this.

  19. Boy. This one inspired a bit of comment…

    Mitch — Re your first comment, yeah exactly. Disintermediation is a lot of what i think the financial sector needs. Equity-like microfinance would be a good thing too.

    Alessandro — You make a couple of great points. I don’t think that “forced savings” is enough to explain the wealth destruction, because I don’t think that the last dollar of savings was well-invested, even given the fact that the glut of previous dollars had taken the most obvious opportunities. The way I would put it is that the glut of thoughtless, safety-seeking “forced savings” exposed the weakness of the existing financial system, that is that it is uncreative. Once a bunch of default investing options was exhausted and could no longer produce “adequate” returns, the system tried to recycle those same options (broad equities, mortgage investing), rather than creatively seeking new ideas. Explicitly risk-tolerant investors did pour into “alternative” investments, but it was the low-risk, delegated “forced-savings” sector that blew the system apart. Fundamentally, our financial system doesn’t offer very good choices for true savers (forced or otherwise) to purchase future consumption with imperfect but transparent protections against default. Savers are forced to become investors (forced savers most especially) with an informational disadvantage. Today’s NYT piece on state investment funds serves as a good example.

    I’m going to opt out, for the moment at least, on commenting about whether forcing savings is sometimes a good idea. I’m not sure what I think. But forcing savings when and where it cannot be productively invested or safely preserved is obviously bad, so the capacity of the financial system has to be included in any calculation about savings programs. (Imagine the nightmare if Social Security funds had been blindly placed in the stockmarket, a beautiful bubble for the savvy, a nightmare loss for naive and forced savers.)

    I love your point about forced-antiarbitrage. That’s something I never considered, deliciously ironic and policy actionable. It’s theoretically a no-brainer to suggest that 401-Ks should be permitted to lend to their owners to pay down credit-card balances, as long as third-party with no power to forgive or restructure the debt and a mandate to do usual credit reporting required you to repay the 401-K at something between what you’d earn from an investment-grade bond fund and your credit card interest rate. You’d pay your future self for your present self’s credit risk, you’d be less likely to default (you’d default on everyone else before on your own 401-K, if your credit will be shot regardless), and both your present and future selves would be better off from the deal. The credit-card companies and banks would not be. Hmmm.

  20. “Longer term, we cannot run the economy off of government spending indefinitely, and if we just postpone the pain, we will find ourselves with fewer resources when we have to deal with the underlying problem.”

    A recession (demand crunch) is not a long-term problem. You take temporary measures to end the temporary demand crunch, although there may be some measures that help in the short term and the long term, like increased government spending on high return investments of the kind the market will substantially underprovide due to well established in economics market problems like externalities, etc. A good example is alternative energy.

    Also, no one’s saying to run the economy entirely off of government spending, it’s just the optimal amount is a lot higher than what we have now both in the short and long term, especially for the abovementioned high return investments.

    The quote above, if that’s what Cowen meant, is like the infamous advice of Herbert Hoover’s Treasury Secretary Andrew Mellon, thinking which lead to the great depression:

    ‘Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people’

  21. RueTheDay writes:

    carpingdemon – Capitalism is every bit as much of a “system” as the other systems you listed. Private property rights and enforced contracts, which are at the heart of capitalism, are human devices, institutions created by people, and they did not always exist. Furthermore, they are both dependent upon a well-developed legal system, which is also a creation of human society. One should also note that even after the development of the requisite institutions (the rule of law, private property, and contracts), it was quite some time before some things (namely labor and land) were accepted as tradable commodities. Don’t fall into the trap of assuming that your preferred system (laissez-faire capitalism) is the natural order of things or some similar such nonsense. It isn’t.

  22. RTD — I’m not sure I get your reasoning. I’d think there’d be no stimulus if MPC were 0, that is if government spending/transfers were hidden in mattresses or saved in banks that don’t lend. If MPC is literally 1, doesn’t that translate to a dollar of gov’t stimulus multiplying to infinite GDP? The distinction I get between a transfer and spending as stimulus is the power of the first transaction: if spending, that directly increases GDP becauses it purchases/inspires new production. If transfer, we have only the greater or lesser multiplier that would obtain after a dollar is in private hands, high if MPC is high, low otherwise, but always less than if the gov’t had spent rather than transfered to the same individual. Menzie Chinn discusses this, but I still think I am missing your point, and your points are always good.

    I agree with you 110% that we are moving the wrong way, consolidating because it’s the easy thing to do and it offers a momentary safety (and pays off many incumbents), while architecturally it is precisely the wrong thing to be doing, and it is moves us in the direction of state corporatism, whose other name I won’t be so incendiary as to use. We are going to have a fight on our hands. Do those of us who don’t consider a patch together of the status quo ante have the will or he means to do anything about it? Or will the crises continue long enough to thoroughly discredit arrangements that need to be discredited? I’d hate to adopt the pose of a cynical revolutionary, “the worse the better” (via Ezra Levant). I’d rather think that institutionally we have the tools to rationalize finance without experiencing a fully catastrophic failure first.

  23. RTD — I was responding to your first comment… I’m going in order, but it’s a moving target…

  24. IA — I’m a big fan of Mencius Moldbug’s financial writing. I think he called a lot right about how this credit crisis would play out (he insisted early on that there would be no feasible option but to guarantee everything in sight, regardless of what he thought about that). We’ve argued a bit over what a good monetary system would look like, and I have small differences with him about what good banking would look like, but our views are much more alike than different, and I view hime as one of the most thoughtful and provocative writers about this stuff.

    (He wants maturity matching banks, I want narrow banks that are restricted to gov’t securities for the guaranteed sector and a requirement that liquidity risk be explicitly be shared with investors rather than silently borne by intermediaries for the unguaranteed sector. Fundamentally, the shared idea is to end the practice of banks making implicit promises beyond their capacity to keep even when no risk that depositors have knowingly assumed goes bad.)

    All — My comment-o-rama’s interrupted, I gotta go meet my wife. Hopefully I’ll be back late tonight…

  25. RueTheDay writes:

    Steve – Re: The MPC, stimulus, and a 0% savings rate, I was getting ahead of myself a little there. You’re right in that the multiplier is 1/(1-MPC). However, the whole idea of a Keynesian fiscal stimulus is the notion that savings represent a leakage from the system if they aren’t invested, and are brought back into equilibrium with investment by a decrease in income. My point was that in an environment where there are no net savings (I should not have said MPC, as it wasn’t really relevant), it’s hard to make the case that a stimulus is needed (assuming that the economy is operating at or near the PPF).

  26. carpingdemon writes:

    RTD: Wow. That’s the first time THAT’s ever happened. How you get laissez-faire capitalism out of that beats me. Look. We have an opportunity here, Lord knows for how long, to move this society, (US, Western, whatever) away from the idea that the strong take what they want and the rest die, if necessary. That’s the bedrock of laissez-faire capitalism, contracts, private property, commodification, etc., etc. notwithstanding. We’ll lose that opportunity if we spend our efforts trying to add a little capitalization here, a little regulation there, a little deleveraging over there, as though there existed a system we could tweak. We have to (and that means we have to get our “leaders” and “representatives” to) start to consider what people’s lives should be like, everybody’s, and what the existing state of the world requires/offers to bring that about. The economics of the last fifty years has failed to “spread the wealth” because it wasn’t designed to spread wealth. It wasn’t designed at all. Here’s a chance to try.

    I’ll go back to the garage now.

  27. MrM — Agreed… military expenditures seem like a particularly problematic kind of “stimulus”, a lot of leakages and all of that, putting aside, um, “moral hazard” issues that are deeper than what economists mean by the term… hopefully the spike you point to was a blip, and not a preview of The Plan.

    RTD — I don’t think evolving to narrow banking would be as hard as you think. First, you can just put banks into run-off mode: that is they can hold existing risky investments, or sell them off, but they can’t put new investments on the books that don’t conform to the new narrow regime. The Fed would gradually expand the money supply to make up for the fractional lending that is no longer occurring.

    The issue that maturity-matching becomes fragile if depositors can alter the time structure of their deposits by, for example, breaking CDs is real, but not insurmountable. The core idea is that promises and risks should not be fudged. If banks enter into fixed maturity investments, the same might be required of depositors, that is they might have to fully commit. Alternatively, contracts might be written to ensure that the cost of premature liquidation is borne by the liquidator, i.e. depositors breaking CDs would take a haircut proportionate to the cost of the transactions required to maintain a matched portfolio.

    The complexity of all this would be dramatically reduced if the asset side of bank balance sheets was restricted to securities of the government whose currency is deposited with the bank, which is really the variation I favor. I don’t think strict maturity matching would be required in this case: banks could continue to borrow short and lend long if they like. The “lender of last resort” role would be replaced by a state guarantee to exchange its own securities long for short at a cost that would be bearable if occasional but prohibitive if frequent.

    Alternatively, narrow banks could be restricted to very short-term government securities (e.g. T-bills), with a promise from the state to repurchase those securities at the purchase price plus interest accrued at the implied yield. Perhaps more simply, narrow banks could be restricted to overnight securities with the central bank — that is, client deposits could just be passed through to interest-bearing deposits at the Fed. In this case, “time deposits” would earn little or no interest. That’s a feature not a bug, as far as I’m concerned. Narrow banks would be for transactional money — they would hold convenience balances and effect transfers — while return seeking investors would participate in a distinct, unguaranteed risk sector.

    As far as “shadow banks” borrowing short and lending long (per Moldbug’s folksy example), that should simply be considered fraud, unless the contractual arrangement between the investment fund and its investors explicitly permits the onlending and fund managers meet a fiduciary obligation to ensure the maintenance of aggregate value (i.e. via redemption restrictions) as well as even-handed treatment of all investors (i.e. they’d face jeopardy if they allowed some investors to redeem when inadequate liquidity is forseeable).

  28. Farrar — Interesting point… live by the FICO, die by the FICO… Another issue re bank lending officers is consolidation and “economies of scale”. It’s hard to imagine that large banks would keep a numerous and diverse group of salaried pseudoinvestors on hand to simulate the crowds of a capital market. In good times, these officers seem redundant, and profits can be improved by cutting costs. In bad times, no one wants to invest anyway. The case that is usually made for banks — knowledgeable local investors in firms that otherwise would lack access to capital markets — is really a case for numerous, small banks. It doesn’t map well to the current world of nation-scale financial supermarkets. There’s an inherent tension between real economies of scale in the deposit and transfer business (I want a no-fee ATM everywhere I travel), and the diseconomies of scale associated with information aggregation for the investment decision.

    joebhed — Let’s all keep it up… we really need to escape this excuse for a financial system we’re currently living under, which first and foremost probably means foundational changes to the banking system.

  29. merry-will-go-round — Interesting, but I don’t quite get it. In the traditional formulation, G is basically a dollar value, government spending. Regulation wouldn’t affect it. But it sounds like you’ve got something in mind. I also don’t understand the transformation to Y = G – (C + I + NX) [although I do understand how a cynic might suggest a dystopian future where Y = G]. Anyway, I’m intrugued but also confused.

    JKH — One nice thing about how you’ve framed things is that it allows for optimism without radicalism, that is by regulating away some of the excesses of the existing system, we might create room for the functions that have been missing from the financial system to “naturally” come to be without requiring some massive experiment or great leap forward. I think that’s right, and finding the incremental changes that will get us from where we are to something reasonable without imposing some sudden hubris is the real challenge of our times. Re K vs C, can’t we all just get along? I like ’em both.

    Reino R — It’s true that reserve requirements have largely been loopholed away, but I think the “savings glut” has very much encouraged financial institutions to overuse this foolish freedom. Intermediaries don’t turn down savings they can manage, but the more they hold, the more they have to earn to cover the financing cost. In a world where there were really no constraints on credit creation, you’d think banks would just eschew deposits, as they’d be able lend just as much and as profitably by conjuring credit from thin air, and they would not have to share the proceeds with depositors. But the mechanics by which banks create credit depends upon the lubricant of taking and lending deposits, and the scale of credit creation possible for an individual bank depends upon its ability to attract deposits, so banks try to do just that, and in doing so they create liabilities they must fund, even if that means reaching.

  30. Massimo — I think a lot of Americans agree with you, but note that your prescription doesn’t really disagree with, for example, Krugman’s, as long as the stimulus takes the form of investment rather than enabling consumption. That is, following your recommendations does not require that Americans cut spending, it simply requires that Americans spend differently, on, for example, tradables investment rather than current consumption.

    Benign — I agree with much of what you have to say. I’m especially glad you used the term “quasi-feudal”. I’ve been trying to write about this for a long time, but it never comes out well. Fundamentally, I think all the sturm-und-drung about “capitalism vs socialism” is kind of a side-show, a dispute among family. The real dispute is between either or both of those and feudalism. Capitalism emphasizes meritocracy and socialism emphasizes egalitarianism, and despite tensions, there are all kinds of places in between. But both idealize equality of opportunity, such that whatever unequal outcomes occur are due to work, skill, or luck rather than birth, caste, or connection. It seems to me that we are moving to a society that pretends to equality of opportunity, but that primarily allocates outcomes based on membership in a self-reproducing class. There will always be social mobility poster children, but I think the currents most worth fighting are the ones pulling us towards a sugar-coated, democracy-themed feudalism.

  31. lark — The Yuan peg and currency manipulation are subjects that much preoccupy me… In a nutshell, I think a nation’s current account should be a policy variable, and for diverse and mature economies should almost always be held near zero. I think we need to develop some means or combination of means to enforce a balance-of-payments constraint. Those could include things like Warren Buffett’s “import certificate” proposal, “automatic stabilizers” on the capital account side of equation (some form of self-adjustong capital controls), or central banks leaning hard against one anothers’ currency manipulations until they reach some kind of detente.

    TED — No promises to put anything on your desk. but I’ll try to put suggestions on my blog… As I said in the piece, we can’t achieve perfection, but maybe we can move towards some tolerable mediocrity. You are certainly right to gently hint that there is little point in carping about problems if no reasonable solutions can be mooted. I don’t think it is that hard to come up with better financial arrangements, even ones that could be implemented incrementally. The hard part is the actual implementation, in a world where incumbents and regulators have sold the contours of an awful status quo as facts of nature that reasonable people do not question. It is easy to see what should change, but equally easy to see why a lot of not inconsiderable people might prefer that little does change.

  32. carpingdemon — From your first comment, it was hard to make sense of what you were after, you seemed to be saying that the world is radically uncertain, our attempts to affect and control it are based on theories that are usually wrong, and are futile and perverse. But that leaves us with little guidance about what to do, where to go, except that I sensed a (very sensible) conservatism, that things that mostly work shouldn’t be boldly undone based on yet another misguided theory. Still, in your second comment, you seemed eager (like me in the headline piece and many in the comments) to use the opportunity of a clear crisis to put something better into place, even by fairly radical means. The combination did leave me a bit puzzled. (But puzzled is good… life is too dull without puzzlement.) Anyway, am I misreading either comment? How do you reconcile these impulses?

  33. Richard — I think you’re mischaracterizing my characterization of Cowen, a bit. I don’t think Cowen was making a Mellon-y liquidationist point at all. He’s a very pragmatic guy, he’d be glad to spur us through a temporary demand shock if that’s what he thought this was. But both he and Krugman started from the point that this was not just an “air pocket” in aggregate demand, that in fact demand from US consumption actually has to fall and should fall, because we are “living beyond our means”.

    I myself don’t like that characterization, but both Krugman nor Cowen seemed to agree on that. If that’s true, if C must find a permanently lower level, then the question becomes why is it better for C to find that lower level later than now? For a while transfers and multiplier effects can at least partially sustain C while G increases to cover the still diminishing C and I. But what’s the endgame?

    Your view is more optimistic — this is really an ordinary recession, an air pocket. If we can sustain aggregate demand while we find a new wave of productive investment, we will find we were not living beyond our means after all, and we will quickly find current levels of C (in absolute terms, if not as a fraction of GDP) to be supportable after all. That might be true, and an advantage of Krugman’s approach is that if it is true, we would suffer less pain. So you might frame the issue as a Pascal’s Wager — if we support demand with fiscal stimulus, and C is sustainable, we will have avoided a painful dislocation. If C is not in fact sustainable, well, then the pain was gonna come anyway, and it doesn’t make much difference whether it comes sooner or later.

    But that last conjecture is arguable — perhaps it is welfare maximizing to make necessary adjustments quickly, perhaps the pain of a delayed adjustment would be worse than the pain of a prompt one. None of that would imply “liquidationism”, any hint that there is virtue in the pain. It strikes me as a fairly practical question about which people with similar basic views but different forecasts might disagree.

  34. As for the the developed world Kiva, there are a few around in various markets now. (I used to work for, still own a tiny bit of one of them.)

    They’re having some progress and some issues (mostly regulation).

    NYT article

    I suspect that it will take off in a big way around capital-raising for local businesses and B2B financing. But at the moment, the model seems to be facebook + consumer loans = $$$ , and consumer lending is not looking like a good bet these days.

    If anyone has $400k or so lying around I’ll send you a business plan :-)

  35. Massimo GIANNINI writes:

    Steve: My recommendation implicitly requires to cut private consumption and increase private saving so that an eventual public spending is funded domestically and is not crowding out private investments. We should not forget the twin deficits, including U.S. external debt. Krugman’s government spending needs resources, including reallocation among budget chapters (for instance invest in energy sector instead of defense). I still contend that U.S. should, with other countries, revamp a kind of Tobin Tax not only on currencies but on some financial transactions, derivatives, etc. This kind of tax will help efficient allocation of resources, thus stabilizing the financial sector and increasing government revenues to be used for public spending.

  36. Karl writes:

    Insane. We have a bubble due to massive malinvestment – and the recommendation is to provide further malinvestment?

    The bogey man that the finance system will stop is really a scare tactic. If some banks can’t/won’t lend money – others will at market rate – a rate that is higher than people want – but the market sets the rate.

    So instead we have massive money pouring in to ‘keep things liquid’ – which means that the malinvestment continues and the people get poorer as our markets can’t be rational if large hunks of bad business are not allowed to fail.

    There are things much worse than a sharp painful recession – a prolonged stagflation will do more harm in the long run. Triggering a global hyper-inflation event would be historic.

  37. carpingdemon writes:

    You nailed both comments. We don’t have much guidance on what to do or where to go. I don’t think there is much guidance to be had from looking at the economy as an existing system and poking it here and there to try to move it in a direction more to our liking. We have to start acting on the world around us instead of reacting to the economy we think is around us. For instance, if we want children and old folks to have comfortable stomachs, we have to take direct steps to feed them. We have to say, outright, “Children and old folks have to eat. No matter how many there are or where they are.” If taxes have to go up to do it, then taxes just have to go up. There is no natural reason that taxes shouldn’t go up. There’s no “system” out there that works better if people don’t have to pay taxes. At best, theories of market equalization, rational choice, pareto efficiencies, marginal propensities to do this or that, are tools to describe that little bit of human behavior we can get our minds around at the moment. They are not real things that can be manipulated. They don’t, in any combination, lead to children and old folks eating. Food. Where is it? Where do we need it? How do we get it there? How much do we need? The fact that J6P bought a bunch of stuff on credit that he couldn’t afford, and thus can be said to be in a morally weak position if we like, has literally nothing to do with whether or not his kids should eat. That is not a moral question. We must say that it is not. This isn’t a bleedin game. It’s too late to figure out what should be done. We have to say what we should do, and then actually try to do it.

    To tell you the truth, I read the first part of your opening post and wrote my first post, and the second was in answer to RTD because I was surprised. I haven’t read all of the posts yet, and do not mean to be argumentative with anything anyone has posted above. I am going to read the rest before I anything else.

  38. RueTheDay writes:

    Steve – I agree with virtually all of your comments regarding narrow banking (though I still think the transition would be a bit more difficult than you allow). I also think a system of maturity matching would work very well for many types of financing, particularly with regard to short/medium term commercial/industrial finance (where long term capital assets would be financed through the sale of bonds rather than bank loans). Where I see an issue, however, is in residential mortgage finance. I’m just not sure that there is a market for 30 year deposits with a fair amount of default risk (despite being collateralized) at any sort of interest rate approaching one that would still be affordable to the typical home purchaser after allowing even a small spread for the financial intermediary. In other words, I’m not sure how a significant residential mortgage market could exist under a maturity-matched regime.

    Recall that prior to the 1930’s, most mortgage loans in the US were made by insurance companies rather than banks and were structured as 5-7 year balloon loans that had to be continuously rolled over. The Great Depression largely put an end to that system, and Fannie Mae was chartered in 1938 to basically create a new mortgage market from scratch. While mortgage backed securities and secondary mortgage markets for whole mortgages served to open up vast capital markets to fund mortgages, it now seems that much of that revolved around the (formerly implicit) government guarantee. Even now, with the guarantee made explicit, there seems to be little demand on the part of investors for mortgages and MBS. So again one wonders if it’s possible for maturity matching to coexist with residential mortgage finance in the absence of government guarantees (and/or in the absence of enormous underpricing of risk). I don’t have any answers for that one unfortunately.

  39. Mitch writes:

    If anyone has $400k or so lying around I’ll send you a business plan :-)

    Hmmm, how about if 100 of us have $4000 lying around?

  40. vlade writes:

    Whatever system we come up with, it will be undone. In fact, the more successfull (by avoiding the crisi) the system, the more likely it will be undone, as the humans will tend to interpret the lack of problems as a lack of reason for the solution (it’s harder to show you avoided a problem than to show you solved a problem).

    Thus, in any world but one permanently ruled by a tyrranical alien or computer (i.e. something humans cannot influence would be responsible for enforcing and maintaining the rules), any of our solutions will be temoporary, and reversed sooner or later. The only solutions that will last are the self-correcting ones, but for that you probably need to build a meta-system first (so that the people will come with the “system” on their own as the “best possible” one). There are examples of such systems, like the general avoidance of private (i.e. non-state sponsored) murder in all societies, but they tend to take quite a while to be “in-built”.

    On MT-free:

    I don’t think MT-free would work, for the simple reason that world is not MT-free anymore (if it ever was). The world was (probably) close to MT-free when there was relatively small amount of borrowers and lenders, and the majority of the population could not save more than a few weeks worth of living, and thus the options to borrow or lend were severely restricted.

    We can get close to MT-free with something like Zopa, but even there you may need to wait before you can either lend or borrow, by which time the conditions/requirements may well change (not to mention the money has to sit somewhere in meantime). Moreover, if you want to limit your credit risk, splitting the investments into tens or hundreds of small variously maturing investments is quite inconvenient (and I don’t mean by tracking it, tracking it is easy. Reinvesting and planning around that is harder). We’re not talking a millionaire who wants to split his deposits into say 10k chunks, but somone with $1000 in savings – would it really be prudent for the MT-free bank to invest all of that into a single loan, which is the only way to ensure it all matures at the same time?

    Also, the MT-free doesn’t remove liquidity risk. What it does, is to turn it into singularity where the liquidity risk automatically becomes credit risk. In other words, when the borrower cannot repay the MT-free loan, it will automatically trigger a chain of defaults (borrower cannot, by definition, refinance. If you allow refinancing, you’re not MT-free) – the depositor will not get his money, which he might have needed to pay some bills which would be paid late, which in turn may trigger more defaults etc.. The first repayment may well fail because of liquidity problems, such as late payment – all unavoidable real world situations. There’s no liquidity slack in a true MT-free system.

    Lastly, MT-free is not self-correcting – you can generate extra profit, and therefore people will try do MT (which will translate into lobbying politicians etc…).

  41. vlade writes:

    One more comment on the self-correcting system: the necessary (but not sufficient) condition for any self-correcting system is to get the majortity of the stakeholders involved in an informed way. Given the general dis-interest in politics, any current system will be skewed in one way or another.

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  43. Steve:

    Hooray! I got back to this post and saw your 11/2 9:10 PM comment on marginal propensity to consume (MPC). I remember my first economics class. I asked the professor, as the MPC goes to 1 in the limit, if I throw a penny in the system do we all become infinitely rich? He tells me MPC only works within “the relevant range”. I respond with, “Professor, you have no theory, only ad hocery”. Another stinker is the balanced budget multiplier. Remember it? How does a dollar “know” if it’s a tax increase dollar or a spending increase dollar? 42 comments. This has spurred a lot of discussion. As for the end of MT banks, we don’t need them. The mutual fund industry will offer more “bond holding” products. The world can exist with MT banks.

  44. @Mitch – Ah, but then I’d have 100 shareholders and life would get very confusing for a poor techie.

    Debt’s preferable for “microfinance” because it doesn’t create a shifting microcosm of controlling interests. Some senior Zopa exec’s were involved in attempts to create “pre-IPO” markets that failed for this reason. Convertable Notes are an interesting compromise though.

    (The public probably considers the average manufacturer of urinal cakes in Swindon a lesser risk than Goldmans right now. But the small/medium business sector isn’t being exploited by p2p lenders at the moment.)

    I don’t think a MT-less system in unobtainable, there’s nothing stopping a bond holding system for retail investors that locks a certain amount of money at a 90-80 day duration, with the option of selling out earlier. Or lets you drop a certain amount of money in that matures a week before xmas. (I suspect rates for that would drip for that week though. The same way consumer borrowing peaks in Jan….)

  45. Mitch writes:

    Thomas Barker wrote:

    Ah, but then I’d have 100 shareholders and life would get very confusing for a poor techie.

    Debt’s preferable for “microfinance” because it doesn’t create a shifting microcosm of controlling interests. Some senior Zopa exec’s were involved in attempts to create “pre-IPO” markets that failed for this reason. Convertable Notes are an interesting compromise though.

    I don’t entirely follow this. How is having 100 shareholders worse than having a million shareholders? One doesn’t have to put every business decision up for a shareholder vote.

    Were the Zopa equity experiments written up anywhere?

  46. vlade writes:

    If anyone would be seriously looking at doing a distributed mini-finance for small/medium business (debt or equity), I’d be most interested, and (depending on the business plan), even willing to stump some capital (not 400k though :)).

  47. Steve Roth writes:

    Steve, it strikes me that one fundamental problem pointed to in your (excellent!) post is a shortage of productive investments. Too much cash, not enough plants, equipment, labor, and ideas to invest it in.

    You seem to suggest that the problem is simply that the finance system doesn’t allow the money to find the good investments. But what if they simply aren’t there to be found? (Natural selection can only work on available mutations, of which there are a limited number.) No change to the finance system would solve that.

    One obvious answer, for me, is to tax the wealth that is not being invested productively, and put it into things–infrastructure, research, education–that are proven to create prosperity.

    There’s no evidence to support an a priori belief that this kind of government investment (on a reasonable scale–we’re not talking the USSR) is less productive than private investment–especially when a great deal of that private investment is tail-chasing gimmickry that at best improves pricing information by a small margin. There’s quite a lot of evidence to say that in the long run, smart government investment is more, or at least equally, productive.

    Europe, for instance, has been taxing 40% of GDP for decades, compared to 28% in the US. But US and EU15 GDP-per-capita growth has been the same.

    This doesn’t answer the other question, though: are there policies we could implement that would increase the number of available productive private investment opportunities? Yes, making government smaller would increase their proportion–but what about absolute quantity?

    BTW, Tyler has recently suggested similarly that the problem is lack of credit demand, not credit supply.

  48. Steve,

    It is not hard to get praise for criticism of the financial system at present, but I do not agree with the post. I do not think that there has been much wrong with the financial system per se. In fact, your description “A financial system would be interested in the world, rather than fascinated by the patterns that formed behind its own mathematical eyelids. A financial system would hunger for information. It would leave no human preference overlooked and no technological possibility unconsidered.” brings to mind what hedge funds are supposed to do. In my opinion, the key problem has been the lack of rigour of too many users of the financial system – the mortgage borrowers who make the biggest transaction of their lives without reading the small print or making allowance for contingencies, the fund managers who bought investments that they did not understand, etc. Andrew Mellon’s advice is often derided, and I am not saying that it alone is the best solution now given the scale of the present mess, but I suspect that we would not be where we are now if it had been followed in 1998 or 2000.

    As for how to deal with currency manipulation, I reluctantly offer my own solution at: http://reservedplace.blogspot.com/2008/10/just-say-no.html

  49. kristiina writes:

    Incredibly thought-provoking post. Woke up this morning thinking there’s two things: the pensions (forced savings) sloshing around. And no incentives to real saving. A strange reverse of the prodence of old. It is useless to put money aside. Borrowing has been the new saving.

  50. Mises writes:

    regarding the last comment in your post,

    there isnt only not a financial system to convert savings to investment, there is no savings. This is the problem in drawing down on balances we dont have while planning to make sacrifices seem like something unnecessary in a managed world.

  51. jw writes:

    Together, automation and disintermediation will save the economy from the predations of the financial industry. Finance is one of the easiest businesses to automate. But nothing significant will change in the near future because the financial industry for practical purposes is the government. There was an analogous problem in Europe a century ago, where the landed aristocracy was similarly predatory on the economy. European governments propped up the landed aristocracy and it took the massive changes after the Great War to end that problem.

  52. groucho writes:

    “If we only had a financial system… ”

    Steve, Hayek must be turning in his grave, seeing the road to serfdom sequel that is now unfolding in the west.

    There are 2 things in this universe information and energy, a financial system need only concern it’s self with the first.

    The current structure of western hi-fi is the evolution of European development into empire and finally the US becoming the empire of last resort.

    In the US, govt captured the Fed &wall st during the depression creating The PEG during WW2 .(govt debt interest fixing at below natural market rates)

    With The Accord wall st got it’s mojo back and a dual system has been running since then. Now with wall st on the ropes govt is moving in to grab a bigger slice of the pie.

    Nowhere in any of these developments were citizens allowed their INFORMATIONAL input that should be the basis for a democratic financial/monetary system.

    During the cold war, a case could be made for self defense with citizens taking back seat to the state. But after the collapse of the USSR?

    What’s now needed is a “Citizen’s Accord” with the govt and Hi-Fi.

    First on the list, legal tender laws…..got to go.

    Monopolies are the breeding ground for fraud and corruption.

    Currency is no exception.

    Depreciation of the domestic MONOPOLIZED exchange unit is the number one cause, in the US, Anglo countries and China’s extraordinary rise in inequality.

    The connection between one’s productivity and reward has been severed and replaced with, being in the “right place”….govt, finance, top corp management, private monopoly/cartel.

    ONLY, those who can offset the depreciation(COLA labor) or use it for advantage govt, finance become winners in the current system. Globalization exacerbates the gulf for those in private non-COLA enterprise.

    The depreciation has been the key driver in this whole process.

    How was it possible that after WW2 one worker could provide for an increasing standard of living for an increasing household size AND have a deal with society that they would be credited with time served for guaranteed lifetime cashflow? Today only govt workers through a forced tax structure and monopoly private workers can claim even part of that compact.

    Bottom line…….Where’s the money….the information that tells us what has done by whom for what to whomever? It’s been stolen by the few…………………..

  53. Cassandra writes:

    RE: focusing the triage on basic consumption of those most in hardship

    Note that Stiglitz said the same (amongst other things) in a BBC interview yesterday.

  54. Dave at DYDD writes:

    Great post and thread everyone.

    Some comments: I do not see the lack of aggregate demand as the problem. Yes, a contraction is occurring. Contractions are normal, that one hasn’t occurred for so long is problematic, in that there are more imbalances that have accrued and that need to be cleansed.

    The consumer was spending far beyond his/her income for far too long. The consumer then stretched too far in attempting to leverage into a fixed asset that was inappropriately perceived to be an appreciating asset, to make up for the inadequacy of past savings. In a parallel track, existing (home) asset holders withdrew perceived (albeit nominal but not real) equity to similarly support an unsustainable life style.

    An issue not addressed, is the extent to which “leveraged speculators” have been gaming the financial system, distorting asset prices and otherwise obscuring market pricing information due to inadequate risk management and flawed modeling. Not only commercial and investment banks but also hedge funds and others that sought a positive carry without a commitment to investment, market players.

    Further, to the base point Steve had made with regard to reserve requirements, the Debt = Credit = Money system is inherently flawed as the total amount of money in the system is never adequate to repay the current debt plus accruing interest. Hence total debt/money must be constantly expanding to repay prior debt.

    While wise investments in productivity enhancing means to increase output and income more rapidly than the marginal cost of debt has beneficial offsets to the interest cost, to the extent that malinvestments are directed toward other uses, luxury homes for example or surplus production capacity, these can and will produce serious leakages that can only result in increasing defaults and bad debts which must be charged back to the originators and lenders. The extermination of these debt is currently what is choking the system.

    Sadly, this is the condition in which we now find ourselves.

    It is an opportunity to fix a gravely flawed system at many levels. And its most basic one, is the flawed monetary system from which debt, and the ability to currently consume from future income, or from which speculative carry arises that doesn’t create new or productive output.

  55. muthu writes:

    Now a days US economy will developing step by step. great president Mr.Obama surely develop our economy and financial also. don’t worry about falling.



  56. @Mitch – For startup, having 100 equity investors (or a million) creates problems with minority interests. For a startup, the aim is a trade sale or IPO. The reporting requirement that come with not being a closely held company are also a big hassle. As I said, Convertible Notes and options might be a way to solve this…

    Zopa never tied equity, an old CXO was involved in some efforts pre-Zopa. I think JP Morgan etc’s experiments have been written up in a few place.

    @vlade – Drop me an email (address is on my site). I was thinking of starting something in a couple of years, and I know some people around London who are working on related things.

  57. @Mitch – For startup, having 100 equity investors (or a million) creates problems with minority interests. For a startup, the aim is a trade sale or IPO. The reporting requirement that come with not being a closely held company are also a big hassle. As I said, Convertible Notes and options might be a way to solve this…

    Zopa never tried equity, an old CXO was involved in some efforts pre-Zopa. I think JP Morgan etc’s experiments have been written up in a few place.

    @vlade – Drop me an email (address is on my site). I was thinking of starting something in a couple of years, and I know some people around London who are working on related things.

  58. Adam writes:

    In related to your 2nd to last paragraph. I think you are completely right about your comments in regards to index funds. It also applies to the massive amounts of packaged debt products. I think this needs to be made a larger issue in the financial world. Instead there is nothing but more encouragement for index investing. Furthermore the huge growth of index investing has encourage and helped the development of firms that are “Too-Big-To-Fail” since the most widely used are based on company size.

  59. I’d disagree with the criticisms of index investing. Sure, utterly blind investment in anything is bad for society (not to mention the investor’s wallet). But indexes are selected according to some criteria, even if it’s something as basic as market cap. An aggregate holding of shares has a dividend return, etc. All the individual shares are know, and judgements can be made about them.

    IMHO index investors (like me) were more sensible and informed than most.

    I would blame the belief that capital appreciation could increase indefinitely [Dow 40000], rather than index vehicles. It’s the poor valuing and opaqueness of the stocks themselves. I don’t think people would stop buying GE if there were no index funds.

    I think the best argument against indexes is that they don’t properly represent a suitable portfolio for specific investors. E.g. an IT person shouldn’t hold IBM because their work already overexposes them to the sector. A startup or two tried to do “mass-manufactured” tailored portfolios in the DotCom era, didn’t go anywhere though.

    None of that alters the general uselessness of the public markets for funding Swindon-based urinal cake factories.

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