03 April 2009

Forgetting Simon Johnson

Simon Johnson's article in "The Atlantic" is being chatted up just about everywhere; David Brooks got into it today in the "Times" and was dismissive, so when Mr. Brooks takes umbrage I have to take a look. One thing to remember about the IMF/World Bank: some have had the temerity to point out that their strictures, in the past when dealing with other Third World Countries (we'll see how they treat the USofA), are to impose hyper-Capitalist requirements on those countries. In other words, rewarding the capitalists (foreign and domestic) and oligarchs, and not the society as a whole. The words tough love and strong medicine were often used to describe what the IMF imposed. The tough and strong were always leveled at the weak in the country.

As is my wont, I am writing out notes as I go along. I will assume that you are familiar with his article. Therefore, I will reach conclusions which Mr. Johnson may or may not later in his text. You'll just have to trust me that I haven't peeked. I find this approach more useful: does a text under review display logical and thoughtful coherence? Does it motivate truth, as understood by this endeavor?

Off we go.

He says of Russia: "all other things being equal, [foreign investors] prefer to lend money to people who have the implicit backing of their national governments", but what really happens is that capitalists prefer to send the cash to societies where only capital (one leg of the three legged stool of basic production; land, labor, capital) is protected. That has been happening in this country since the shoe and textile industries left liberal New England for the "capital friendly" or dare I say, fascist, South in the 19th century. He is holding back.

So now we have: "Meanwhile, needing to squeeze someone, most emerging-market governments look first to ordinary working folk - at least until the riots grow too large." I give Mr. Johnson his due, I wasn't expecting such clarity and honesty from an IMF person. On the other hand, some have questioned why the riots haven't started here. The speculation is that the venting available in cyber-blogo-twitter spheres has kept the lid on. As someone who was adolescent in the 1960's, the passivity in the face of American oligarches now can be rather depressing. We'll see how it works out. Obama's caving to Wall Street, so far, is not a good sign.

He goes on: "the weakness in the banking system has quickly rippled out into the rest of the economy, causing a severe economic contraction and hardship for millions of people." But this misses the point. Our crisis wasn't caused by the banking system, per se. The cause is the culmination of nearly 3 decades of income and wealth transfer from the many to the few. And this is always the cause of economic collapse. The specific trigger may be often be in the banking system, but it is not the banks which cause the problem. They profit from it along the way, certainly. It needs reiterating: the figures I have seen is that 70% to 80% of 'toxic' mortgages came from mortgage companies, not banks.

Then: "financiers, in the case of the U.S. - played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse." But there is nothing new or unique in this time or this place. Historically, capitalists do only two things: socialize cost and privatize profits. This was going on here in the 19th century. It is not news, unfortunately. And, I have always argued that there was no gambling here. There was no assumption of risk; the certainty was that they knew they were too big to fail. There would be no downside, at least until after the performance and retention bonuses were paid.

He gets credit, so far as am I concerned, in going back to Reagan to spot when the changes in our economy which precipitated the mess began. He misses a couple of key points: the IRA/401(k) and ascendency of financial services were both the results of capitalists seeking their normal levels. The IRA/401(k) move was to socialize costs through the removal of defined benefit retirement plans. The general ascendency of finance is a side effect of deindustrialization. Jack Welch was the master of this at GE. Replace (real) capital intensive manufacturing with, effectively, non capital services. He was worshipped for his genius. Less so today. He also misses out the comparison to pre-1929 and pre-1907 with regard to finance as proportion of economic activity. He also has nothing to say about how and why this process shipped production to China, India, and other less than middle-class and democratic countries. He is boxing with kid gloves.

Well, the text gets better: "The great wealth that the financial sector created and concentrated gave bankers enormous political weight - weight not seen in the U.S. since the era of J.P. Morgan (the man). In that period, the banking panic of 1907 could be stopped only by coordination among private-sector bankers". Unfortunately, he continues with the right-leaning shibboleth of "wealth creation". No wealth is created by financial manipulation. Never has been, and never will be. Real wealth is created by the application of Real Capital (economists, when they pay attention, make a distinction between fiduciary capital, money, and real capital, plant and equipment). What 1907, 1929, and 2007 are all about is wealth transfer. I takey, you losey. There is a too large faction in the economics profession which clings to the notion that economic growth is always a non-zero sum game. It's about time we all grew up.

Alright, I cannot let it pass that Mr. Johnson Quayle-d Snow. A manifestation of irony, pehaps subtle, from a banker. Hoziah.

But then he quavers: "Regulators, legislators, and academics almost all assumed that the managers of these banks knew what they were doing. In retrospect, they didn't". It is quite clear that Cassano and the others understood what they were doing: reaping cash for trash. I recall reading an article in the news back in the early 2000's, unfortunately, I didn't clip it. In the report, a person involved in the sale of a house says to the broker that the buyer couldn't possibly afford the mortgage when it reset. The reply from the broker: "I don't care". The broker, and all those up the chain had gotten their profits, nothing else mattered. They all knew it was gossamer, and they didn't care. They all knew that gummint would clean it up. The real problem here is that those who can lade away the cash upfront, and never have it "clawed back", are simply criminals who go unpunished. And they knew this from the getgo.

And a sentence later: "AIG's Financial Products division, for instance, made $2.5 billion in pretax profits in 2005, largely by selling underpriced insurance on complex, poorly understood securities." He gets it fundamentally wrong here. He doesn't tell the reader what actually AIG did. AIG did not sell insurance. Cassano and the rest were explicitly clever about this aspect of the con. If they had sold CDS as *insurance* product, they would have been subject to capital and actuarial requirements of insurance. AIG sold nothing at all. They never had any intention, nor funds, to pay off any CDS.

Ah, to be a prophet before his time. "As mathematical finance became more and more essential to practical finance, professors increasingly took positions as consultants or partners at financial institutions. ...This migration gave the stamp of academic legitimacy (and the intimidating aura of intellectual rigor) to the burgeoning world of high finance." As I have written in earlier posts in this nascent blog, one of my long held gripes with the economics profession is its willingness to grovel for dollars. Mr. Johnson now points to the symbiotic relationship between the quants, who could have figured out the problem with the mortgage business just by tracking the ratio of median income and median house price and the bankers who needed cover. By 2003, this measure was already heading into the weeds. But that was the point. Had I a blog back then, and spoken up, I might be famous now. Oh well.

"In a financial panic, the government must respond with both speed and overwhelming force. The root problem is uncertainty -- in our case, uncertainty about whether the major banks have sufficient assets to cover their liabilities." He still gets it wrong. The problem isn't with credit or the banks, per se. The problem is that, since 1980, the real median income in this country has fallen. What kept consumption afloat during the Bush/Gingrich/Bush years was burning of unearned appreciation of housing. It was pure ideological bait and switch perpetrated on the Republican base and Reagan Democrats. They bought it hook line and s(t)inker. With that source of consumable income gone, demand for goods and services vanishes. Collapse results.

In his response to the anonymous banker he says: "But there's the rub: the economy can't recover until the banks are healthy and willing to lend." He's wrong. He too is groveling to the bankers, though he seems not to know it. As Dr. Keynes made clear: there cannot be a stable, growing industrialized economy without equivalent consumption. And you cannot have that consumption without a broad and deep middle class. The banking problem we are in is an effect, not a cause. China would be shrugging off this situation if it were a stable country with a broad and deep middle class. It is industrialized, but doesn't consume what it produces; it cannot since there is virtually no economic equity (in any sense of the word). It has vast capital. But it is not self sufficient. Neither is the US.

There is a small, and I hope growing, body of literature delving into the concept of absolute advantage. Ricardo was fundamentally wrong. Comparative advantage is grounded in the assumption of immobile assets. Land is. Labor is, to a significant extent. Capital never is. History has proven that capital flows to the most repressive regimes. Mercantilism may well be the most advanced form of economic structure. If so, then the middle class of the post World War II era was an aberration, not progress. Malthus was likely right. Since capital is nearly instantaneously mobile, recession is too.

He goes on to talk about nationalization and, in particular, recognizing true value of assets. That is now less likely, given that FASB has just caved, too. One cannot blame Mr. Johnson for not being a seer.

Finally, he says what I have been saying for some time: yes, unless we do the right thing, this will be worse than the Great Depression. Those who have been saying that this is just a really bad recession give no concrete evidence why things should stop with that. They talk of the safety net which exists now but didn't in the 1930's. The failure in that argument, as I have made in earlier entries to this endeavor, is that recovery in the 1930's was possible because physical capital remained to employ labor to make real goods for war. Where will the currently unemployed go to work? Because this situation is not just a banking problem, but a consumption problem, those who assert that there is a good end need to justify.

There is continued evidence that the job growth that had been occurring in the Bush years was disproportionately in low skill, low wage occupations. The tech sectors not just manufacturing, including financial services, have been replacing American techs with foreigners unabated. IBM just announced thousands more. A recovery of demand cannot occur without a recovery of incomes. That is not in the cards. Again, self sufficient economies will prosper in a world that, while not flat, is marked by fleet capital. The reason is simple (as China is finding out): supply side economics is fantasy. While IBM believes, as a microeconomic actor, that it can either sell more services and/or make more profits from said services by employing Indians at starvation (by US needs) wages; it is a pyrrhic victory. Microeconomics is beloved by the quants, but fails just because the whole is not merely sum of the parts. As any good mother said to the brat, "what would the world be like if everybody behaved like you?" Given the rapidity of the wired world, soon enough, IBM and its brethren will have impoverished so many citizens, that there will be none left to buy their services. Certainly not all those Indians. Ouroborus.

Prosperity in this future will be in those countries which have trade only in those resources not native to their soil, and which have broad and deep middle classes. The other countries will be autocracies. Which will be the majority? I fear the latter. I cannot see any motivation for the former to propagate. Kim Song-Il said of starvation in North Korea, it is fine if the masses live well, but they are better behaved if they don't. There are more Kim's in this world than is obvious. As Mr. Johnson implies this, while not invoking Kim; that is my insight.

This blog started because I recalled my senior thesis, whose theme was deindustrialization in Uruguay in the 1960's, and the results. Today, that process is called financialization and is the subject of research exploring the negative implications. I was nearly 40 years ahead of the rest of you in figuring out the problem. My conclusion, from memory since the paper is long since disappeared, was that Uruguay would be in trouble until it balanced income and wealth to levels consistent with economic self sufficiency.

On the whole, "The Quiet Coup" is a paper with which I can agree about 90%. It is worthwhile that one with his credentials is finally telling the truth. Stiglitz and Krugman are not alone. Nor am I, to a marginally greater extent than yesterday. That helps.

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