flyingblogspot on economics
Flist buddy extraordinaire flyingblogspot from Australia wrote a great post about the global economic woes in Plain English and I got her permission to re-post here. It's awesome. Lengthy, but take the time to read it!
For all of the people who have taken the time to ask me 'what's going on?' only to be rewarded with a frantic 'I don't know where to start!')
Trying to talk about the the global economic situation is, at best, a juggling act. This isn't a linear story of cause and effect, but a complex system of interacting parts. There are so many threads here to pick up, so I'm going to try to go through a selection of them individually, in the hope that together they'll contribute to a better understanding of the global picture.
Sub-Prime, Toxic Debt and Consumption
I've already spoken at length in the past about the sub-prime debt crisis, predatory lending practices and the unsustainability of a market that relies on consumption for consumption's sake. Rather than reiterating it all here, I'd suggest you go back and read my post on the sub-prime crisis, as it was not only an critical triggering point for what we're now experiencing, but also goes some way to explaining the structural problems underlying many major western economies, and in particular that of the United States. (In short, a culture/economy in which issuing unrepayable loans to finance consumer spending is normal practice is essentially screwed in the long term.)
This, of course, is why I want to mash my face on the keyboard when I see Australian commentators suggesting that our salvation will come from making sure that Australians maintain and even increase consumer spending.
A Credit-Driven Global Economy
If you don't already know this, to understand the current situation, you need to be aware that at all times, there's a hugely complex web of lending and credit going on behind the scenes, that is largely invisible to the individual. Banks lend to each other, banks lend to customers, banks lend to countries, countries lend to other countries, and all of this goes on constantly, and in mind-boggling amounts.
The interbank lending has arisen partly because banks are required to hold, at any given time, a sufficient amount of liquid assets (that is, cash) to meet any potential withdrawals from clients. And the lending to governments? Well, sovereign debt has a long and complex history in itself, but as I understand it, one of the main drivers is the mentality that it's better to borrow the money and use it to drive growth, production and development, than to not have the money, produce more slowly, and grow more slowly or not at all. On 30 September 2008, the United States' sovereign debt alone surpassed the US$10 trillion mark.
The more I read about this, the more it brings home to me that we exist in a culture where to have money and then to use it, is actually the exception. Not only on a personal level, but far more on a commercial, bank and governmental level, the normal practice is to use money that has been borrowed, and then to carry debt. (On an tangent, it is exceptionally interesting to contrast this culture of debt - essentially a Western cultural norm - to Islamic economics, under which this system of debt would be prohibited under Sharia.)
Then you have the current crisis, in which - for reasons that will be partially addressed under other headings - we see a freeze on lending. A failure of lines of credit in a system with a phenomenal reliance on credit. Suddenly, banks can't borrow money. Firms can't borrow money. Governments can't borrow money. And all of these banks, firms and governments exist within a system where the norm is not to have any money, but to borrow it. Also bear in mind that, in this system, the lenders don't always have any money themselves - they've simply borrowed from someone else. It doesn't take a PhD in Economics to see that turning off lending is going to make this system break in a big way.
Complex Systems and Crystal Balls
"The change is partly structural, partly political and partly cultural. The five great investment banks that dominated Wall Street and world finance are no more: two have failed, one is selling up to the Bank of America, and the others have become commercial banks."
- Ben Macintyre
Hearing contradictory reports in the media? Confused by people predicting things? Have no idea where it will end? There's a good reason.
As much as journalists like to draw parallels to the late 1980s and, more concerningly, to the Great Depression, what we're seeing here is something that has never happened before. Certainly, there are parallels in both cases, but the complexity of modern debt markets, the influence of globalisation and the associated influence of the United States on world markets, IFRS (the international standardisation of accounting regulations), 21st century communications technology and countless other factors combine to create a situation which is immense, insanely complex, fast-changing and - most importantly - fundamentally unprecedented.
We've built ourselves a system so big, so complex and so sensitive, that I suggest it may not even be possible for a single human brain to consider cause, effect and all the relevant factors and come up with a reasonable, likely prediction as to the outcome. Further, analysis and economic theory is essentially coloured by political belief - assignation of blame, suggested solutions, explanation of causes...these things don't stand in isolation from the politics of the individual analyst. And so, given the same set of facts and a system complex enough that it can't quite be unravelled, it's likely that two different commentators will give you different and even contradictory responses. (The similarity between political and religious belief strikes me here - when something is too big to fully understand, sometimes we just believe.)
Contagion and Falling Dominos
Contagion, in a financial sense, refers to what we see when a shock to one economic system affects other economic systems to a degree that - rationally - appears to be excessive. There have been many explanations put forward for this phenomenon, but I'll leave you to do your own reading on the subject if it interests you - for the purposes of this discussion, all you need to know is what contagion is, and that it happens in the real world.
Now, in theory, last year's sub-prime crisis in the US would not be expected to - for example - cause the market value of all of the companies on the Australian stock market to drop so much as has been observed. But when we talk about contagion, we're talking about an irrational fear of the unknown - not the fundamental value of firms or predictable outcomes. And as that fear spreads and has an impact upon increasingly far-removed and insulated economies, the more new fear is generated. (Look at this way - you're on the internet, so you know what a meme is. Economic fear is, at the moment, a global meme.)
Investors, and consequently markets, are not acting in their own best interest because they are scared, and so we see markets across the world in free-fall as panicking investors dump their shares in an attempt to recoup at least part of their investment before the value of those shares falls any lower. And of course, the fact that they're so scared of the unknown that they'll sell their shares at almost any price, pushes those prices lower and lower.
Game Theory, Economic Theory and Political Belief
In an oversimplified, Economics 101 sense, free market economics is based on a number of assumptions. One of these assumptions is that participants in the economy will act rationally and in their own best interest. This, of course, is not exactly true. It's one of those ideas we run with contingently, because it works reasonably well most of the time to explain what we see in the world around us. (Somewhat like Newtonian Physics - it's less that about it being right, and more about it being useful.)
The field of game theory, on the other hand, can provide ample demonstrations showing that human beings don't always act in their own best interest, and hence that this assumption of rationality that underlies free market economics is flawed. (As can studies of fear, greed and the mob mentality - held to be the three emotional drivers of markets.) Generally, this doesn't seem to matter too much - free market economics generally explains what happens in the free market in a sufficient and workable manner. However, once you look at an extreme situation (being the current one), I suspect that game theory is going to provide a more useful conceptual framework. (For example, contagion and panic selling are quite interesting to consider in terms of the Prisoners' Dilemma.)
As far as theory goes, it's all terribly interesting but at the same time rather academic. How does it actually relate in practical terms to the current situation? Let's go back for a moment to the point I made above, about economic theory being coloured by political belief. Now say, for instance, that you have a country and a system built on political beliefs wherein free market economics is not regarded a theoretical construct, but as the foundation for a passionately - dare I say religiously - held political-economic Truth. And so, successive administrations in that country build their economy on the idea that free market economics is Right and it reflects How Things Really Are.
So, hypothetically, you see an immensely influential country with a powerhouse of an economy that is regulated and built based around flawed assumptions that don't work particularly well under extreme conditions. And, moreover, a country that takes a normative economic theory (that is, one that seeks to prescribe 'how things ought to work') and treats it as if it were a positive economic theory (one that seeks to describe how things actually work). Oh, and let's say that this country owes US$10 trillion in debt.
And then, you get extreme conditions. Well, what did you think was going to happen?
Punishment and Pragmatism
"We are now in the golden age of thieves. And where I come from we put thieves in jail, we don't bail them out."
- Pete Visclosky (Indiana Democrat)
"But it is an unfortunate paradox of financial systems that while it might be right to punish individuals, punishing the guilty through the banking system means much greater pain is borne by everyone."
- The Times
It is a spectacular understatement to say that people are not happy. And when people are not happy, they tend to call for what you may call either justice or vengeance, depending on how cynical you are feeling at any given moment. Whatever you might call it, it would seem to be a popular political move to take action upon those evil, greedy banks who have brought the end of the world upon us.
I can see where the anger is coming from. And, as I mentioned in my sub-prime post, predatory lenders and so forth are hardly blameless parties. However, I personally think that it's staggeringly stupid to be talking about punishment right now, and that we should be talking about addressing the problems rather than dealing out a hearty serving of vengeance.
I don't have a comprehensive understanding of the Great Depression, but it's my understanding that a similar thing took place at that time, where 'irresponsible banks' were punished rather than bailed out. I've recently read a number of articles suggesting that the lack of intervention in this case actually caused the Depression to be far, far worse and more widespread than it would otherwise have been, and effectively punished small shareholders, institutional investors, and ultimately the general populace far more than it punished the perceived wrong-doers.
In other words, it's easy to complain about government bail-outs (and I certainly have thoughts around the way these should be structured and implemented) but bear in mind that people may acting pragmatically to save your [collective] ass.
It's An Accounting Thing
Or at least, it's partly an an accounting thing. After the corporate collapses of the early 2000s (most notably, Enron) a whole lot of accounting regulations were introduced and tightened. These were, at the time, largely an excellent thing, in that they prevented unscrupulous entities from concealing insolvency.
However, in 2008, we've seen an unexpected side effect from one particular accounting standard - the one that states that assets held by an entity must be valued at the lower of cost or fair value. And fair value, in this case, is determined by the amount for which the assets could be sold in an arm's length transaction on the market. Where these assets are debts expected to be collected by a bank, the process of determining the fair value for which the debt contracts could be sold is known as 'marking-to-market'.
This relies, of course, on an assumption that (in valuation terms) the market is always right. As I've discussed in relation to contagion, and also game theory, this is certainly not an infallible assumption. And so, in this particular situation banks with little or no exposure to toxic debt are required to value the loans they've issued at the irrationally low market values (which have been driven down by the spreading panic contracted from the United States in the aftermath of the sub-prime crisis.)
Watching the UK banking crisis unfold during my time there, it was clear that perfectly viable banks with solid future cash flows were threatening to go under (and indeed going under) because they appeared to be insolvent thanks to mark-to-market accounting, because they were required to value the debt they had issued at a far lower amount than the repayments they would most likely collect. Now, while there were very good reasons for the accounting reforms seen in 2001, it's difficult to say that mark-to-market accounting has not exacerbated the crisis in this particular case.
What does it mean for me?
As I've discussed above, part of the problem is the sheer unpredictability of the situation - we simply don't have comparable previous experiences to use as a guide. For the Australians, at least, rationally our banks appear safe and our economy to be somewhat insulated, especially in Western Australia. But then, as also discussed, we can hardly afford to take those things for granted in the face of a failure of rationality.
I'd love to say 'you'll probably be okay', but I don't know. No-one knows. The media frenzy and the market frenzy continue to feed off one another, and it's hard to tell where the bottom will be. While I sincerely doubt that we'll all be living in refugee tents by this time next year (as the worse of the panic would appear to suggest), recession, downsizing of staff, redundancies, job losses and the like are all probable outcomes. The collapse of more banks is also a possibility, although I would hope that the Australian government would step in (as seen recently in other countries) to guarantee savings under those circumstances.
Anyway, as I've often commented, "If it all goes to crap, money won't be worth anything anyway; I'll go live in the hills and farm some goats." That said, I'll be surprised if I need to turn my hand to goat farming anytime soon, but it doesn't hurt to have a Plan B.
Where to from here?
Essentially, what the governments of affected countries are now trying to do is to mitigate the contagion of fear by reducing unpredictability. This can be done in many, many ways - some include the buying out of worthless toxic debt by the government to take it out of the system, the nationalisation of banks, government investment in banks to keep them afloat, the guaranteeing of personal savings and so forth. There's a critical need to break this self-perpetuating cycle of fear and uncertainty before it leads to a[n even more] widespread collapse.
In the medium-term future, I'd hope to see the tightening of regulations around financial institutions, and particularly around the requirement for them to hold a certain amount of capital, and also a certain amount of structural change, particularly relating to our use (or abuse) of debt as a society.
For now, I can only suggest that you sit tight, enjoy the wild ride and never, ever make the mistake - easily done, in the face of media doom and gloom - of presuming that money can buy you happiness. (Oh, and if you have a little money to gamble, maybe buy a few shares and sit on them for four or five years. If the world as you know it doesn't end, you'll have got one hell of a bargain!)
For all of the people who have taken the time to ask me 'what's going on?' only to be rewarded with a frantic 'I don't know where to start!')
Trying to talk about the the global economic situation is, at best, a juggling act. This isn't a linear story of cause and effect, but a complex system of interacting parts. There are so many threads here to pick up, so I'm going to try to go through a selection of them individually, in the hope that together they'll contribute to a better understanding of the global picture.
Sub-Prime, Toxic Debt and Consumption
I've already spoken at length in the past about the sub-prime debt crisis, predatory lending practices and the unsustainability of a market that relies on consumption for consumption's sake. Rather than reiterating it all here, I'd suggest you go back and read my post on the sub-prime crisis, as it was not only an critical triggering point for what we're now experiencing, but also goes some way to explaining the structural problems underlying many major western economies, and in particular that of the United States. (In short, a culture/economy in which issuing unrepayable loans to finance consumer spending is normal practice is essentially screwed in the long term.)
This, of course, is why I want to mash my face on the keyboard when I see Australian commentators suggesting that our salvation will come from making sure that Australians maintain and even increase consumer spending.
A Credit-Driven Global Economy
If you don't already know this, to understand the current situation, you need to be aware that at all times, there's a hugely complex web of lending and credit going on behind the scenes, that is largely invisible to the individual. Banks lend to each other, banks lend to customers, banks lend to countries, countries lend to other countries, and all of this goes on constantly, and in mind-boggling amounts.
The interbank lending has arisen partly because banks are required to hold, at any given time, a sufficient amount of liquid assets (that is, cash) to meet any potential withdrawals from clients. And the lending to governments? Well, sovereign debt has a long and complex history in itself, but as I understand it, one of the main drivers is the mentality that it's better to borrow the money and use it to drive growth, production and development, than to not have the money, produce more slowly, and grow more slowly or not at all. On 30 September 2008, the United States' sovereign debt alone surpassed the US$10 trillion mark.
The more I read about this, the more it brings home to me that we exist in a culture where to have money and then to use it, is actually the exception. Not only on a personal level, but far more on a commercial, bank and governmental level, the normal practice is to use money that has been borrowed, and then to carry debt. (On an tangent, it is exceptionally interesting to contrast this culture of debt - essentially a Western cultural norm - to Islamic economics, under which this system of debt would be prohibited under Sharia.)
Then you have the current crisis, in which - for reasons that will be partially addressed under other headings - we see a freeze on lending. A failure of lines of credit in a system with a phenomenal reliance on credit. Suddenly, banks can't borrow money. Firms can't borrow money. Governments can't borrow money. And all of these banks, firms and governments exist within a system where the norm is not to have any money, but to borrow it. Also bear in mind that, in this system, the lenders don't always have any money themselves - they've simply borrowed from someone else. It doesn't take a PhD in Economics to see that turning off lending is going to make this system break in a big way.
Complex Systems and Crystal Balls
"The change is partly structural, partly political and partly cultural. The five great investment banks that dominated Wall Street and world finance are no more: two have failed, one is selling up to the Bank of America, and the others have become commercial banks."
- Ben Macintyre
Hearing contradictory reports in the media? Confused by people predicting things? Have no idea where it will end? There's a good reason.
As much as journalists like to draw parallels to the late 1980s and, more concerningly, to the Great Depression, what we're seeing here is something that has never happened before. Certainly, there are parallels in both cases, but the complexity of modern debt markets, the influence of globalisation and the associated influence of the United States on world markets, IFRS (the international standardisation of accounting regulations), 21st century communications technology and countless other factors combine to create a situation which is immense, insanely complex, fast-changing and - most importantly - fundamentally unprecedented.
We've built ourselves a system so big, so complex and so sensitive, that I suggest it may not even be possible for a single human brain to consider cause, effect and all the relevant factors and come up with a reasonable, likely prediction as to the outcome. Further, analysis and economic theory is essentially coloured by political belief - assignation of blame, suggested solutions, explanation of causes...these things don't stand in isolation from the politics of the individual analyst. And so, given the same set of facts and a system complex enough that it can't quite be unravelled, it's likely that two different commentators will give you different and even contradictory responses. (The similarity between political and religious belief strikes me here - when something is too big to fully understand, sometimes we just believe.)
Contagion and Falling Dominos
Contagion, in a financial sense, refers to what we see when a shock to one economic system affects other economic systems to a degree that - rationally - appears to be excessive. There have been many explanations put forward for this phenomenon, but I'll leave you to do your own reading on the subject if it interests you - for the purposes of this discussion, all you need to know is what contagion is, and that it happens in the real world.
Now, in theory, last year's sub-prime crisis in the US would not be expected to - for example - cause the market value of all of the companies on the Australian stock market to drop so much as has been observed. But when we talk about contagion, we're talking about an irrational fear of the unknown - not the fundamental value of firms or predictable outcomes. And as that fear spreads and has an impact upon increasingly far-removed and insulated economies, the more new fear is generated. (Look at this way - you're on the internet, so you know what a meme is. Economic fear is, at the moment, a global meme.)
Investors, and consequently markets, are not acting in their own best interest because they are scared, and so we see markets across the world in free-fall as panicking investors dump their shares in an attempt to recoup at least part of their investment before the value of those shares falls any lower. And of course, the fact that they're so scared of the unknown that they'll sell their shares at almost any price, pushes those prices lower and lower.
Game Theory, Economic Theory and Political Belief
In an oversimplified, Economics 101 sense, free market economics is based on a number of assumptions. One of these assumptions is that participants in the economy will act rationally and in their own best interest. This, of course, is not exactly true. It's one of those ideas we run with contingently, because it works reasonably well most of the time to explain what we see in the world around us. (Somewhat like Newtonian Physics - it's less that about it being right, and more about it being useful.)
The field of game theory, on the other hand, can provide ample demonstrations showing that human beings don't always act in their own best interest, and hence that this assumption of rationality that underlies free market economics is flawed. (As can studies of fear, greed and the mob mentality - held to be the three emotional drivers of markets.) Generally, this doesn't seem to matter too much - free market economics generally explains what happens in the free market in a sufficient and workable manner. However, once you look at an extreme situation (being the current one), I suspect that game theory is going to provide a more useful conceptual framework. (For example, contagion and panic selling are quite interesting to consider in terms of the Prisoners' Dilemma.)
As far as theory goes, it's all terribly interesting but at the same time rather academic. How does it actually relate in practical terms to the current situation? Let's go back for a moment to the point I made above, about economic theory being coloured by political belief. Now say, for instance, that you have a country and a system built on political beliefs wherein free market economics is not regarded a theoretical construct, but as the foundation for a passionately - dare I say religiously - held political-economic Truth. And so, successive administrations in that country build their economy on the idea that free market economics is Right and it reflects How Things Really Are.
So, hypothetically, you see an immensely influential country with a powerhouse of an economy that is regulated and built based around flawed assumptions that don't work particularly well under extreme conditions. And, moreover, a country that takes a normative economic theory (that is, one that seeks to prescribe 'how things ought to work') and treats it as if it were a positive economic theory (one that seeks to describe how things actually work). Oh, and let's say that this country owes US$10 trillion in debt.
And then, you get extreme conditions. Well, what did you think was going to happen?
Punishment and Pragmatism
"We are now in the golden age of thieves. And where I come from we put thieves in jail, we don't bail them out."
- Pete Visclosky (Indiana Democrat)
"But it is an unfortunate paradox of financial systems that while it might be right to punish individuals, punishing the guilty through the banking system means much greater pain is borne by everyone."
- The Times
It is a spectacular understatement to say that people are not happy. And when people are not happy, they tend to call for what you may call either justice or vengeance, depending on how cynical you are feeling at any given moment. Whatever you might call it, it would seem to be a popular political move to take action upon those evil, greedy banks who have brought the end of the world upon us.
I can see where the anger is coming from. And, as I mentioned in my sub-prime post, predatory lenders and so forth are hardly blameless parties. However, I personally think that it's staggeringly stupid to be talking about punishment right now, and that we should be talking about addressing the problems rather than dealing out a hearty serving of vengeance.
I don't have a comprehensive understanding of the Great Depression, but it's my understanding that a similar thing took place at that time, where 'irresponsible banks' were punished rather than bailed out. I've recently read a number of articles suggesting that the lack of intervention in this case actually caused the Depression to be far, far worse and more widespread than it would otherwise have been, and effectively punished small shareholders, institutional investors, and ultimately the general populace far more than it punished the perceived wrong-doers.
In other words, it's easy to complain about government bail-outs (and I certainly have thoughts around the way these should be structured and implemented) but bear in mind that people may acting pragmatically to save your [collective] ass.
It's An Accounting Thing
Or at least, it's partly an an accounting thing. After the corporate collapses of the early 2000s (most notably, Enron) a whole lot of accounting regulations were introduced and tightened. These were, at the time, largely an excellent thing, in that they prevented unscrupulous entities from concealing insolvency.
However, in 2008, we've seen an unexpected side effect from one particular accounting standard - the one that states that assets held by an entity must be valued at the lower of cost or fair value. And fair value, in this case, is determined by the amount for which the assets could be sold in an arm's length transaction on the market. Where these assets are debts expected to be collected by a bank, the process of determining the fair value for which the debt contracts could be sold is known as 'marking-to-market'.
This relies, of course, on an assumption that (in valuation terms) the market is always right. As I've discussed in relation to contagion, and also game theory, this is certainly not an infallible assumption. And so, in this particular situation banks with little or no exposure to toxic debt are required to value the loans they've issued at the irrationally low market values (which have been driven down by the spreading panic contracted from the United States in the aftermath of the sub-prime crisis.)
Watching the UK banking crisis unfold during my time there, it was clear that perfectly viable banks with solid future cash flows were threatening to go under (and indeed going under) because they appeared to be insolvent thanks to mark-to-market accounting, because they were required to value the debt they had issued at a far lower amount than the repayments they would most likely collect. Now, while there were very good reasons for the accounting reforms seen in 2001, it's difficult to say that mark-to-market accounting has not exacerbated the crisis in this particular case.
What does it mean for me?
As I've discussed above, part of the problem is the sheer unpredictability of the situation - we simply don't have comparable previous experiences to use as a guide. For the Australians, at least, rationally our banks appear safe and our economy to be somewhat insulated, especially in Western Australia. But then, as also discussed, we can hardly afford to take those things for granted in the face of a failure of rationality.
I'd love to say 'you'll probably be okay', but I don't know. No-one knows. The media frenzy and the market frenzy continue to feed off one another, and it's hard to tell where the bottom will be. While I sincerely doubt that we'll all be living in refugee tents by this time next year (as the worse of the panic would appear to suggest), recession, downsizing of staff, redundancies, job losses and the like are all probable outcomes. The collapse of more banks is also a possibility, although I would hope that the Australian government would step in (as seen recently in other countries) to guarantee savings under those circumstances.
Anyway, as I've often commented, "If it all goes to crap, money won't be worth anything anyway; I'll go live in the hills and farm some goats." That said, I'll be surprised if I need to turn my hand to goat farming anytime soon, but it doesn't hurt to have a Plan B.
Where to from here?
Essentially, what the governments of affected countries are now trying to do is to mitigate the contagion of fear by reducing unpredictability. This can be done in many, many ways - some include the buying out of worthless toxic debt by the government to take it out of the system, the nationalisation of banks, government investment in banks to keep them afloat, the guaranteeing of personal savings and so forth. There's a critical need to break this self-perpetuating cycle of fear and uncertainty before it leads to a[n even more] widespread collapse.
In the medium-term future, I'd hope to see the tightening of regulations around financial institutions, and particularly around the requirement for them to hold a certain amount of capital, and also a certain amount of structural change, particularly relating to our use (or abuse) of debt as a society.
For now, I can only suggest that you sit tight, enjoy the wild ride and never, ever make the mistake - easily done, in the face of media doom and gloom - of presuming that money can buy you happiness. (Oh, and if you have a little money to gamble, maybe buy a few shares and sit on them for four or five years. If the world as you know it doesn't end, you'll have got one hell of a bargain!)