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LQD: "How to stop the next bubble?"

by Melanchthon Thu Jul 10th, 2008 at 10:26:31 AM EST

In the Prospect Magazine July 2008 issue,there is an interesting debate abou how to stop the next bubble. It involves Mark Hannam, who has worked for the Bank of England, Citibank and Barclays, Jonathan Ford (chair), deputy editor of Prospect, John Gieve, deputy governor for financial stability of the Bank of England, Martin Wolf, chief economics commentator at the Financial Times, Anatole Kaletsky, economic commentator and associate editor of the Times and George Soros, chairman of Soros Fund Management. Here are some excerpts:


GEORGE SOROS: There is now a widespread belief that the crisis is over. I think, on the contrary, that the effect on the real economy is yet to be felt. The measures taken by the authorities will not bring recovery. There are four reasons for this. First, the fall in house prices in the US is only halfway over and in Britain it has hardly begun. Second, consumers have been slow to adjust their spending habits, but this is about to happen. Third, the financial system is severely wounded, and even though banks have been remarkably successful at raising more equity, they will cut back on lending and this will feed through to capital spending and business activity. Finally, and most important, there is a threat of inflation at the same time as a slowdown. The rise in energy and food prices will turn the slowdown into a recession.

(...)

MARTIN WOLF: The whole risk adjustment process has still not worked its way through. Credit spreads in the inter-bank markets, commercial paper markets and so forth remain wide, and so banks remain reluctant to lend to one another. I am closer to George than I am to Anatole on the US housing market. And looking at the world as a whole, the US shock is combined with two others: inflation and energy prices, particularly for Europe and emerging Asia. It is hard to imagine that this won't have a significant negative effect. The appreciation of the euro is shifting the US current account deficit to Europe. That is creating large stresses within the eurozone in terms of divergences of competitiveness between Germany and southern Europe. Meanwhile, because of inflation fears, the European Central Bank (ECB) will do nothing to help Europe in a difficult world situation. That will lead to a bigger slowdown than we now expect. China and India are suffering from weaker US demand, and will not be able to respond easily because inflation has become a big problem there too. Energy prices also act as a big tax on these economies. If you add these things together, we are heading for a significant global slowdown--if not a global recession--which will last some time.

(...)

SOROS: We are coming closer to the crux. As I explain in my new book The New Paradigm for Financial Markets, the regulators and the market participants were acting on a false interpretation of how financial markets operate. They worked on the assumption that markets tend towards equilibrium and deviations are random. That false perception about financial markets led to the construction of the structured products, and it made this crisis much bigger than it would have been if it was merely a US housing bubble. Some people didn't understand this. Ben Bernanke [the Fed chairman], for instance, said that it was a specific problem of the sub-prime loans, which is wrong. Others, like Paul Volcker [a former Fed chairman], did understand it. Asset bubbles are endemic. There are self-reinforcing processes that operate where investors' initial misconceptions then reinforce a trend, and that leads to a bubble.

Regulators have to accept responsibility for preventing asset bubbles from getting out of hand. To do that, it isn't enough to regulate the money supply; you also have to regulate the availability of credit. Markets are given to extremes of euphoria and panic, and therefore you need to use margin requirements and minimal reserve requirements more actively and vary them according to market conditions. That is the main lesson.

(...)

SOROS: [the financial sector] should shrink. It has really got overblown. The size of the financial industry is out of proportion to the rest of the economy. It has been growing excessively over a long period, ending in this super-bubble of the last 25 years. I think this is the end of that era.

KALETSKY: (...) There is, though, still a possibility that the financial system will survive the test. If it does, the appropriate analogy would be not 1929 or even 1973 but what happened in the late 1990s with Long Term Capital Management, whose collapse was followed by an even bigger bubble. I think eventually there will be a bubble that totally blows up the financial system, but we may not be there yet. I don't see many hedge fund managers driving taxis. And George, you made a lot of money in 2007.

SOROS: Yes, I did. And if we do pass through this without a hitch you will find that the private equity funds will replace the investment banks as the dominant force in the economy, because they are the ones who are now buying the assets.

(...)

WOLF: We have really had only one big backlash against finance in the last 100 years, and that followed the great depression. Things have to become very serious before people connect it to finance. I hope there is enough of a backlash to impose more sensible regulation. Too little response will be a disaster, because then we may have to deal with Anatole's even bigger bubble--which could bring down the system.


Poll
Do you think the current crisis will be deep enough to bring about radical change in the system?
. Yes, it will be the beginning of a new era where the finance isn't the dominant power anymore 28%
. No, some cosmetic changes will be made, but the system will remain unchanged 52%
. I don't care, we're all doomed! 0%
. Jesus savings will solve the problem (yes, Jesus saves!) 19%

Votes: 21
Results | Other Polls
Display:
The "voices of the elites," Wolf and Kaletsky regretfully inform us that we need a bigger bubble before finance can be tamed...
by Metatone (metatone [a|t] gmail (dot) com) on Thu Jul 10th, 2008 at 11:23:44 AM EST
There is a chance that this bubble is it, though Kaletsky and Wolf downplay that possibility.

But re-regulation will be useless unless we get a crop of reformists in charge of economic policy who actually believe in economic policy rather than "the market will provide".

When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. — John M. Keynes

by Migeru (migeru at eurotrib dot com) on Thu Jul 10th, 2008 at 11:34:57 AM EST
[ Parent ]
I agree with Soros: asset bubbles are endemic and tweaking interest rates doesn't affect the availability of speculative credit: you have to raise marging requirements (which the SEC has been empowered to do since it was created in the aftermath of the Crash of '29).

When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. — John M. Keynes
by Migeru (migeru at eurotrib dot com) on Thu Jul 10th, 2008 at 11:30:59 AM EST
But this is exactly the problem that Stiglitz was talking about (someone posted his column recently, but I don't have time to look for it now.)

i.e. Neoliberalism is at heart the belief, the faith that markets are always automatically self-correcting, stable and tend to equilibrium.

It's just not true, but until we beat the knowledge that it's not true into the average economist and the average politician we're not going to get very far in reforming the system.

by Metatone (metatone [a|t] gmail (dot) com) on Thu Jul 10th, 2008 at 12:16:45 PM EST
[ Parent ]
The problem is that when they understand it's not true, they conclude that lack of market freedom is the cause.

When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. — John M. Keynes
by Migeru (migeru at eurotrib dot com) on Thu Jul 10th, 2008 at 12:20:42 PM EST
[ Parent ]
That is why attempts to change the opinions of existing political and economic elites is futile.  They will always make the minimum concessions and move on.  If those concessions are accepted as the solution, the problem is only deferred, perhaps for a few decades, as after the Great Depression, likely for a much shorter time this time around, given resource problems.

The only real solution is to replace these policy makers with ones with a different agenda.  That requires public support.  That requires a public willing to consider alternatives.  Should the next year prove as interesting as the last those conditions may obtain.  The question is who will prevail?

"It is not necessary to have hope in order to persevere."

by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Thu Jul 10th, 2008 at 12:39:21 PM EST
[ Parent ]
But bogus market thinking and the ideology of the management class have infected everything including education - so it's haaard.

When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. — John M. Keynes
by Migeru (migeru at eurotrib dot com) on Fri Jul 11th, 2008 at 06:03:05 AM EST
[ Parent ]
Like the Freedmanites, we must await the opportunity.  In the USA, the presidential election may be enabling, but will not be determinative.  However, more financial meltdowns combined with still higher energy and food prices along with possibly unforeseen developments could set the stage.  It would only be an opportunity, and unless skillfully exploited, would be lost. Under such conditions small forces can have large effects. Why should Freedmanites be the only ones who can benefit from shocks and disasters?

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Fri Jul 11th, 2008 at 12:12:22 PM EST
[ Parent ]
Who's waiting in the wings, like the Friedmanites used to?

When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. — John M. Keynes
by Migeru (migeru at eurotrib dot com) on Fri Jul 11th, 2008 at 12:40:11 PM EST
[ Parent ]
Well, the Freedmanites didn't disappear when Freedman died.  The question is if anyone else is waiting and if there will be any contest for the "solution" to a crisis.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Fri Jul 11th, 2008 at 01:02:26 PM EST
[ Parent ]
I guess the answer is 'no', huh?

When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. — John M. Keynes
by Migeru (migeru at eurotrib dot com) on Fri Jul 11th, 2008 at 05:58:26 PM EST
[ Parent ]
European Tribune - LQD: "How to stop the next bubble?"
To do that, it isn't enough to regulate the money supply; you also have to regulate the availability of credit.

Hmmm...even Soros is not aware that money is bank credit then...

There won't be another bubble because the pyramid of credit we have just seen, and which is now slowly deflating, was supported only partly by Bank capital.

For the most part the pyramid was supported by Investors' capital through:

(a) securitisation;

(b) credit derivatives;

(c) credit insurance by Monolines eg Ambac.

This "outsourcing" to Investors has to all intents and purposes ceased.

It follows that the availability of credit does not remotely come close to that necessary to support asset prices anywhere near current levels, never mind to support investment in new productive assets and the working capital needed for the economy to flourish.

The Anglo Disease has had another interesting side effect and that is that as income for the many has declined, so has the capability of retail investors to make deposits (aka savings).  

The top 10% of investors (who were the gainers in all this as wealth concentrated in their hands) typically do not make retail deposits, I suggest, but put their money in hedge funds, private equity and the like.

We have therefore seen a secular decline in the ratio of retail vs wholesale deposits, and if the wholesale market dries up, the Central Bank is the only means of making up the difference. Northern Rock was only the beginning, IMHO.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Thu Jul 10th, 2008 at 12:57:37 PM EST
To do that, it isn't enough to regulate the money supply; you also have to regulate the availability of credit.
Hmmm...even Soros is not aware that money is bank credit then...
Well, he then talks about tightening margin requirements and raising reserve requirements so I think he's talking about speculative credit, i.e., money created just to inflate asset bubbles as opposed to investing in creating new (productive) assets.

When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. — John M. Keynes
by Migeru (migeru at eurotrib dot com) on Fri Jul 11th, 2008 at 06:05:31 AM EST
[ Parent ]
But Nietzsche scores on the rebound!

Sorry, just couldn't resist.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Sat Jul 12th, 2008 at 03:04:48 PM EST


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