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Risk, Uncertainty, and the Real Economy

by NBBooks Wed Feb 20th, 2008 at 04:16:44 AM EST

Last week, the financial news was full of stories on credit default swaps, which appear to be the next shoe ready to drop in the financial crises millipede that has engulfed the globe since the IKB Deutsche Industriebank of Germany announced on July 30, 2007 that it was marking down the value of some of its financial derivatives based on U.S. sub-prime mortgages. From the comments posted in various blog discussions,  of credit default swaps, it is very clear that most people are very, very confused. More troubling, most people are unable - or unwilling - to recognize that the world as they know it is now crashing down about their ears.

Diary rescue by Migeru

Basically, what is happening is that the financial and banking system has found that what it thought was measurable risk is instead unmeasurable uncertainty. And what the system cannot measure, it is unwilling to deal with. This uncertainty has now extended to the financial health of the very banks, hedge funds, and other financial agents themselves. Nobody knows how healthy or unhealthy anybody else is. Therefore, the banks and other agents in the financial and banking system have become unwilling to lend to one another. Goldman Sachs has estimated that these crises have contracted credit in the U.S. by $2 trillion (with a t, not a b). The U.S. economy is now about $15 trillion, as measured by gross domestic product--you can do the math for yourself, to see what a massive impact this is going to have on the real economy.

Some voices have been raised from within the financial and banking system calling for the world's governments to begin re-regulating the financial markets and actors. Foremost among these is Bill Gross, Managing Director and Chief Investment Officer of PIMCO, the world's largest bond fund, with $687 billion in assets under management. Re-regulating is only half of what needs to be done.

In October 2007, when these crises were just getting started, Marshall Auerback discussed Risk vs Uncertainty: The Cause of the Current Financial Crisis:

The champions of securitization have long argued that it carries many benefits for the financial system - most notably that it disperses risk across a much wider pool of investors. But this trend also carries at least one downside; it has added to the opacity of financial markets, leading to greater uncertainty. Here, uncertainty must be distinguished from the concept of "risk", even though the two are often used interchangeably. The distinction between the two was first drawn by the economist Frank H. Knight in his seminal work, Risk, Uncertainty and Profit (Hart , Schaffner & Marx; Houghton Mifflin Company, 1921). In an essential passage, Knight noted: "Risk is present when future events occur with measurable probability" while "Uncertainty," he elaborated, "is present when the likelihood of future events is indefinite or incalculable". This distinction helps us better understand what has transpired over the past several weeks and why the problems cannot be easily mitigated through a simple manipulation of the Fed Funds rate. Ultimately, if uncertainty, as Knight defined it, is to be resolved going forward, it will likely entail a substantial re-regulation of the financial services industry to eliminate the complex, opaque "financial weapons of mass destruction" (to paraphrase Warren Buffett) now at the heart of today's credit crisis.


If anything the history of the past twenty years illustrates that these "non-standard deviation" events do occur more often than our brilliant quant theoreticians allow for in their mathematical models: the real estate bubble and bust and S&L crisis of the late 1980s; the boom and bust of the tech stocks in 2000-2001; the 1987 stock market crash; the 1998 LTCM debacle; the variety of asset bubbles that ended up into busts from Japan (1980s) to East Asia (1997-98). So combine an opaque and unregulated global financial system where moderate levels of leverage by individual investors pile up into leverage ratios of 100 plus; and add to this toxic mix investments in the most uncertain, obscure, mis-rated, mis-priced, complex, esoteric credit derivatives (CDOs of CDOs of CDOs and the entire other alphabet of credit instruments) that no investor can properly price and you have the perfect financial storm.

Financial derivatives are supposed to reduce risk by securitizing it, allowing it to be sold to other parties. Credit default swaps, a particular type of financial derivative, were designed to reduce counter party risk. I.e., if your counter party did not pay, the writer of your credit default swap would.

But if you can longer determine the numerical probability of your counter party not paying, you are now dealing with uncertainty, not risk.

Since securitization depends on being able to use computer-based mathematical models to price risk as a numerical probability, once you can no longer come up with a  numerical probability, you can no longer assess risk. The entire system begins to crumble. Which is exactly what's happening now.

OK, so what's the solution? Re-regulate the financial system. But why is that the solution? Because regulations remove uncertainty by corralling it within certain bounds. Outside those bounds, it is assumed that the government will step in and take whatever action is required to bring things back within measurable bounds. With government regulation, incorrect estimations of risk become far less likely. This is why there is a swelling chorus of voices from banks and financial houses, such as that of Bill Gross, calling for the government to start regulating again.

Now we are at the actual foundation of the problem: the Milton Friedman / Margaret Thatcher / Ronald Reagan "theology" of the free market that has led us to deregulate banking and finance over the past three decades. What deregulation basically did was created more uncertainty within the economy that the players in the financial and banking system could repackage as "risk" and devise various arcane instruments to "manage" that risk, charging nice fees and commissions for all their brilliant work. But think of the underlying dynamic here: financial and banking system does better, i.e., "earns" more fees and commissions, when the uncertainty in the real economy increases.  It is really never in the system's interest to actually decrease the amount of risk and uncertainty - until it realizes that it is killing itself.. But the more important question is: where does this dynamic leave the rest of us?  

As Marshall Auerback observed in Risk vs Uncertainty: The Cause of the Current Financial Crisis:

David Viniar, CFO of Goldman Sachs, recently justified the massive - 30% plus - losses of the two Goldman Sachs hedge funds by arguing that these were unpredictable "25 standard deviation events" that should occur only once in a million years. Responding to this, John Dizard of the FT sardonically remarked: "For 20 years numerate investors have been complaining about measurements of portfolio risk that use the Gaussian distribution, or bell curve. Every four or five years, they are told, their portfolios suffer from a once-in-50-years event. Something is off here."

Steve Fraser, writing on Tom Dispatch on December 09, 2007, noted that what this underlying dynamic of securitization has done is "Enronize" the economy:

Beginning with the stock market crash of 1987, however, [crises] have become ever more common again, most notoriously - until now, that is - with the dot.com implosion of 2000 and the Enronization that followed. Enron seems like only yesterday because, in fact, it was only yesterday, which strongly suggests that the financial sector is now increasingly out of control. . .

[There has been] a proliferation of financial activities and assets so complex and arcane that even their designers don't fully understand how they operate . . . .One might call this the sorcerer's apprentice effect. In such an environment, the likelihood and frequency of financial panics grows, so much so that they become "normal accidents" - an oxymoron first applied to highly sophisticated technological systems like nuclear power plants by the sociologist Charles Perrow. Such systems are inherently subject to breakdowns  . . .

At some point the whole system was going to fail. We are now about six months past that point. What is happening now is that Ben Bernanke and Henry Pauslon are struggling desperately to save the U.S. financial system will be saved from collapse - by decimating the living standards of about 70 percent of Americans. This is what is meant by all the recent talk about increasing the savings rate in the U.S.: "an unpleasant period of low to negative growth as we lowered consumption and increased savings."

We have a choice: we can either save the country, or we can save Wall Street. So far, U.S. elites are choosing to save Wall Street. The pain will not be felt by them, but by the 70 percent of Americans sitting at the bottom of the income pyramid. What the banking and financial system itself is now doing, has been doing, and wants to keep doing, is sucking the life out of the rest of the economy. John Bogle, founder and retired CEO of The Vanguard Group of mutual funds, believes that the financial system is taking about $500 billion in value out of the rest of the economy. I believe it is two to four times that amount.

How does the banking and financial system rob value from the real economy? In August 1971, Nixon ended the Bretton Woods system of fixed exchange rates, in other words, deregulating exchange rates. Previously, companies that conducted business overseas knew what it would cost them to convert foreign currencies into dollars and vice versa. The system of fixed exchange rates managed by national governments under the terms of the 1944 Bretton Woods system removed all uncertainty concerning exchange rates -- there was not even any need to try and measure and manage risk. But once foreign exchange rates were deregulated, companies had to go to Wall Street and the futures pits in Chicago to buy "risk management," such as futures contracts on different currencies. (But it got even worse, as computer-based sophisticated mathematical models began to make it very lucrative for the banks and hedge funds to trade on their own account.)  In the United States, forex leaped from $110.8 billion in 1970, 10.7 percent of U.S. Gross Domestic Product, to $5.449 trillion in 1980, 195.3 percent of U.S. GDP. By 2001, forex trading was $60.961 trillion, sixty times larger than GDP. Who ends up paying all those fees and commissions for all that financial trading?

And here, I want to make something very, very clear: the economic advisers for both Hillary Clinton and Barack Obama believe in the Democratic version of Friedman / Thatcher / Reagan economics, known as Rubinomics. So do, apparently a large number of people that consider themselves progressive. They are NOT going to solve the problem, because they are trying to find a solution within the system, when it is the system itself that is the problem. Friedman / Thatcher / Reagan economics and its sidekick Rubinomics has to be abandoned.

Re-regulating the banking and financial system is only one thing that needs to be done. The second thing is to return to Keynesian full-employment industrial economics, which is what ruled the U.S. from the end of World War Two until the Nixon regime. As economist Thomas Palley points out in an article this past weekend, The Debt Delusion, since the shift to Friedman / Reagan / Thatcher "free market" economics (unfortunately called "neo-liberalism" by economists) the U.S. economy has become dependent on financial bubbles to maintain the appearance of normalcy. Prior to the 1980s, the U.S. economy was based on wage growth tied to productivity growth and full employment:

But there is a deeper problem that has been overlooked: the US economy relies upon asset price inflation and rising indebtedness to fuel growth.

   Therein lies a profound contradiction. On one hand, policy must fuel asset bubbles to keep the economy growing. On the other hand, such bubbles inevitably create financial crises when they eventually implode.


   America's economic contradictions are part of a new business cycle that has emerged since 1980. The business cycles of presidents Ronald Reagan, George Bush Sr, Bill Clinton, and George Bush share strong similarities and are different from pre-1980 cycles. The similarities are large trade deficits, manufacturing job loss, asset price inflation, rising debt-to-income ratios, and detachment of wages from productivity growth.

   The new cycle rests on financial booms and cheap imports. Financial booms provide collateral that supports debt-financed spending. Borrowing is also supported by an easing of credit standards and new financial products that increase leverage and widen the range of assets that can be borrowed against. Cheap imports ameliorate the effects of wage stagnation.

   This structure contrasts with the pre-1980 business cycle, which rested on wage growth tied to productivity growth and full employment. Wage growth, rather than borrowing and financial booms, fuelled demand growth. That encouraged investment spending, which in turn drove productivity gains and output growth.

So there is the plain and ugly truth. The U.S. economy has been, and is being, sacrificed to the need of the banking and financial system for ever expanding levels of debt, risk, and uncertainty. Until that reality is seriously acknowledged and squarely confronted, there will not be any permanent fix. The present crises may be somehow papered over by more finessing and manipulation in the financial markets, but there will be more, ever larger crises that follow. Not until the whole rotten system is rejected will the crises end.

This is the question society has to ask at some point (if not now, probably in the next two to five years, when the mass protests over "saving more" begin): Do we want our banking and financial system to focus on finding areas of uncertainty it can repackage as risk and sell esoteric tools to manage that risk? Or do we want our banking and financial system to focus on helping find, allocate, and distribute the capital for rebuilding our economy? Because, here's the good news: just like after World War Two, we are sitting on top of a powder keg of pent-up demand. But this time the pent-up demand is for a green economy. Just think of what needs to be built:

Every single car and truck in the United States needs to be replaced with hybrids or super fuel-efficient vehicles (see a picture of the Aptera further down-thread).

A replacement for the entire system of gasoline delivery and distribution.

Almost the entirety of the U.S. housing stock needs to be replaced or retrofitted with green technology.

Same with commercial buildings, especially skyscrapers built in the 1950s to 1990s, which is almost all the core downtowns. Tear `em down and start over again, make them user friendly and environmentally neutral.

Urban mass transit rail systems. New York City has the most dense network, and it is only half as dense as what you find in Tokyo, London. Paris, Moscow. Cities like Miami and Phoenix, which are now in the top ten urban areas in the U.S. don't have ANY mass transit rail, or have a single line with one or two dozen stations.

Passenger rail with its own rights of way. How many people know Amtrak has to run on rails owned and maintained by the freight railroads? In the northeast corridor, from Washington DC to Boston, we really should build this entirely underground. One long tunnel from DC to Boston.

The entire grid for electricity generation and distribution needs to be almost entirely replaced.

Is the "free market" going to get all this done? Of course not. The "free market" and the banking and financial system at this point have become addicted to quick profits in the range of 10% to 40%. You simply cannot get industrial projects done under those conditions. So, we can choose to try and keep the present system going. If you are a bond trader or a broker or a manager at a bank or hedge fund, that is what you are probably inclined to choose. But there is an alternative. We can instead choose to begin replacing the past, replacing the fossil fuel economy and the hot-money financial shell games, and begin building the future.  We can either choose to save Wall Street, or we can choose to save the future.

Yep, it gets 240 miles per gallon - umm, that's 102 kilometers per litre. Here's some links to learn more:

And yes, we will need and build lots and lots of wind turbines!

by NBBooks on Tue Feb 12th, 2008 at 12:17:39 AM EST
Excellent diary!

You can't be me, I'm taken
by Sven Triloqvist on Tue Feb 12th, 2008 at 03:09:46 AM EST
... like I told my students, back when I had students, you diversify to protect against stochastic risk, and build institutions to protect against true uncertainty.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.
by BruceMcF (agila61 at netscape dot net) on Tue Feb 12th, 2008 at 08:56:58 PM EST
This is utterly brilliant.  You have doing a bunch of deep thinking this winter, my good man!  Congratulations.

"Remember the I35W bridge--who needs terrorists when there are Republicans"
by techno (reply@elegant-technology.com) on Wed Feb 13th, 2008 at 12:13:13 AM EST
... tonight's Midnight Oil, and heavily featured in the Midnight Thought.

Heck, I even picked the musical clip to suit:

Used and Abused
I was talking to the man he said we're gonna make a deal
I was fooled into thinking the paper in my pocket was real
I said
No no You've been taken again
No no You're losing all your friends
No no It's just a matter of sense
It's just a matter of sense

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Wed Feb 13th, 2008 at 12:38:54 AM EST
The system that is failing is not called "neoliberalism."   It's called "capitalism," and any attempt to re-establish the populist Keynesianism of the 1960s is going to run up against the second contradiction of capitalism; business, sheer business, is simply destroying the ecosystemic integrity of the planet, and no amount of prating about "resource efficiency" will be sufficient to rescue business from its predatory role.  The solution, as usual, is called ecosocialism.    Support it if you want to survive.  At all.

"Imagine all the people/ Sharing all the world" -- John Lennon
by Cassiodorus on Thu Feb 14th, 2008 at 07:01:21 AM EST
Thank you for another illuminating diary and summary of what needs to be done. Unfortunately; I haven't seen specific proposals for re regulation and which commissions or government organizations would make the regulations and I also have not seen specific programs with projected results from 'Keynesian' types of investing by the government and how it would work. I have seen lots of generalizations but until we see the details and what ways they could be implemented; its just polemics.

Just like the addicts always refusing rehab until they hit bottom; the collective 'we' are not ready to seriously reform our government and our own lifestyles until we realize we have no choice. Right now we have the same people in government and our financial institutions who are part of the problem and no impetus for real reform and introspection as to how we all can change.

Its still the philosophy of 'growth'(greed) for the top 5% who think the platitudes they speak of like social justice can be in parallel to their greed.

Our leaders will only respond when they realize their political survival is threatened by the vast majority of the people and being beholden to the special interests is no longer viable.

Unfortunately we are a long way from the amount of pain necessary to bring real permanent change.

by An American in London on Thu Feb 14th, 2008 at 11:23:58 AM EST
It seems that the best thing the governments could do would be to change the recipients of their subsidies from the rich to the poor (the not-rich). We've lived too long under aristocratic rule, and it just hasn't worked out.
by bil on Wed Feb 20th, 2008 at 10:09:16 AM EST
<calvinist>But you can't subsidize the poor: that promotes laziness!</calvinist>

We have met the enemy, and he is us — Pogo
by Carrie (migeru at eurotrib dot com) on Wed Feb 20th, 2008 at 10:12:31 AM EST
[ Parent ]
<socialist worker> and by  subsidising the rich they all do nothing but work? </socialist worker>

Any idiot can face a crisis - it's day to day living that wears you out.
by ceebs (ceebs (at) eurotrib (dot) com) on Wed Feb 20th, 2008 at 10:21:08 AM EST
[ Parent ]
Not that I don't agree with you, but is there any way short of a major guillotine party to get out of this mess?
by tjbuff (timhess@adelphia.net) on Wed Feb 20th, 2008 at 11:19:56 AM EST
Hmmm, a world war?

We have met the enemy, and he is us — Pogo
by Carrie (migeru at eurotrib dot com) on Mon Feb 25th, 2008 at 07:45:26 PM EST
[ Parent ]
<crawls out from under radioactive rubble...>

i just couldn't handle that being the last comment in this fine diary and thread...

hate to admit you might be right, lol. rapture-ready, everyone?

another brand new day of being just another squawking pawn in the meatheads' game of 'risk'....

lalala, i'm not depressed...toughen up...it's just a dream, you'll wake up soon...

see ya in the next world....don't be late, don't be late

'The history of public debt is full of irony. It rarely follows our ideas of order and justice.' Thomas Piketty

by melo (melometa4(at)gmail.com) on Mon Feb 25th, 2008 at 11:45:39 PM EST
[ Parent ]

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