Soros, you're always such a breath of fresh air.
Noland makes wonderful analogies between our financial situation and the N.O. levees
The Greenspan Levee:
In light of Katrina’s devastation, I have been encouraged to update my “Town by the River – A Derivative Story.” I will patiently await changes in the financial landscape before penning the next “chapter.” Although I will note that, to this point, the hastily constructed Levees up the river continue to hold the potential cataclysmic flood at bay. What’s more, the altered flow of water has induced booms to sprout up all along a world of new lake waterfronts and tributaries provided by the enormous expanding upstream pool of liquid. Risk-taking has been emboldened and, importantly, it has broadened.
Few (in the Town by the River) recognize that the issue of flood management has become immensely more complex, now involving scores of additional thriving communities, markets and policymakers – not to mention the unfathomable amounts of accumulating water! And while authorities in The Town huff and puff about their increased concern for the aged housing boom along the river, the enterprising players in the Bubbling insurance and asset markets have understandably unwavering confidence that timid local politicos will no longer risk more than tinkering with the fragile Levee system. The consequences of a Levee failure and resulting complete system breakdown have become too catastrophic to even contemplate.
I do often contemplate the real world weakness of the flood insurance analogy – that while booming activities in the insurance and building sectors do significantly heighten systemic risk, they at least don’t influence weather patterns (make it rain more!). In financial insurance markets, however, rapid growth in derivatives does directly increase the probabilities of a financial crash. If one believes that Credit, leveraged speculation and liquidity excesses pose inevitable serious risks to system pricing and trading mechanisms, and that booming derivatives markets by their very nature spur an expansion of Credit, speculation, leverage and liquidity -- are financial insurance markets not the contemporary bane of system stability?
Are there pertinent financial lessons to be gleaned today from Katrina’s devastation? Well, I am again reminded of the notion that “a culture of optimism is a culture of denial.” Many argue that this disaster was a very low-probability, unpredictable event. In reality, however, a storm with sufficient force to breach New Orleans’ aged Levee system was a near certainty – only a matter of “when and not if.” It was also clear that a period of relative tranquility masked the reality that underlying conditions were ripening for a mega-storm.
But as a society, we are simply incapable these days of objectively analyzing potentially devastating scenarios. “Negativism” is un-American. We certainly won’t tolerate it from our leaders, and they don’t want it from us. Don’t worry… Why weren’t we better prepared to respond to Katrina’s devastation? Because it is virtually impossible to openly contemplate, discuss, plan and mobilize significant resources in preparation for such a catastrophe. Lip service, perhaps, but nothing more. We and our policymakers are conditioned to emphasize potential positive returns, to downplay risks and virtually disregard the potential for disaster. After all, with our nation’s vast resources and legendary resourcefulness, why not assuredly exploit all opportunities, ignore perceived low-probability negative outcomes and enthusiastically employ a “mop-up strategy” if things somehow ever run amok?
To acknowledge the possibility of a catastrophic outcome is unacceptable, as it would demand a change in behavior and sacrifice that we, as a society, are simply unwilling to make prior to its occurrence. And, let’s face it, the more financially stretched one becomes, the more inclined one is to totally disregard the worst-case scenario.
We see such a mindset phenomenon at work with the manner in which households manage their finances; with government and business management of spiraling healthcare costs and underfunded pensions; with the execution of the war in Iraq; and with the federal deficit and the Current Account. If there is no easy solution, then better to not even address the dilemma. We are conditioned to scoff at warnings of global warming, much to the chagrin of the rest of the world. And evidence of future energy shortfalls is not sufficient to have us question our god-given right to SUVs and our huge new homes a long drive out to the suburbs of suburbia. And while “risk-management” is all the rage throughout the expansive business of finance and monetary/economic management, the financial sector just drifts farther and farther away from having any capacity to effectively manage a catastrophic development.
It has become, these days, increasingly interesting to watch key policymakers (Mr. Greenspan, in particular) and our more attuned pundits jockeying to buttress their reputations in preparation for the inescapable financial storm. The always-ingenious Mr. Greenspan has focused the debate on narrow “risk premiums” and unsustainable liquidity, in the process setting the stage for policymaker finger pointing at overzealous market participants when boom inevitably turns bust. Powerful Market Pundits, on the other hand, would like to fashion the debate around the “Greenspan Put,” attempting to walk a very fine line as stalwart supporters of Wall Street finance and general supporters of Federal Reserve inflationary policies. Things have been so good – the Greenspan Fed so successful in fostering “price stability” – that the upshot of low yields across the risk spectrum has been an ironic expansion of risk-taking behavior. Minksy’s astute “stability is destabilizing” hypothesis is, today, an all too alluring expedient. It is, nonetheless, decidedly unsuitable analysis.
The Fed’s ultra-aggressive 2002-2004 accommodation was an example of policy errors begetting bigger ones, in the process compounding liquidity-induced Monetary Disorder. I simply cannot stomach the “stability is destabilizing” analysis for a period where California home values, energy prices, and our Current Account Deficit spiraled completely out of control. The fact of the matter is that acute asset inflation and speculation are, as always, telltale indications of some degree of underlying Monetary Disorder. Inflationary Disorder was conspicuous throughout the technology sector, including tech stocks, telecom debt and Silicon Valley home prices, in the late-nineties. Later, with Fed prodding and gung-ho Wall Street enthusiasm, Monetary Disorder expanded, broadened, and solidified to the point of encompassing financial asset and real estate markets the world over.
If it were merely a case of years of system stability breeding a bout of risk-taking behavior, the core of underlying system fundamentals would today be sound. They are patently unsound. If a stable financial and economic backdrop were the locus fueling destabilizing behavior, the Fed would not have allowed itself to be hogtied into (ineffective) baby-step rate increases. Indeed, the key dynamic today is financial and economic systemic fragility, and this reality resonates kindly throughout the bond market. The Conundrum is a manifestation of the Powerful Bubble Interplay of Acute System Fragility and Ongoing Rampant Asset-based Lending/Liquidity Excesses ("Mega-Monetary Disorder).
I’ve never been a big fan of the notion of the “Greenspan Put.” I am, however, warming to the notion of a Greenspan Levee. The Greenspan Put conveys that there is a market instrument/mechanism always available to right the markets’ wrongs – an exercise of “mopping things up.” A Levee, on the other hand, works splendidly until it fails. If the water level is sufficiently high, a breach guarantees a catastrophic outcome (only afterwards will the toxic mop-up commence). The Greenspan Levee brooks the massive and unrelenting inflation of Wall Street finance. Worse yet, we have passed the point where our policymakers will dare scrutinize precarious system dynamics or attendant acute systemic risk.
And, quite definitely, there is a moral hazard component to ongoing excesses. But the prominent aspect of today’s Credit Bubble and Associated Global Liquidity Bubble is the structural nature of asset-based lending, securitization and securities trading, and derivative risk-transferring Credit systems now prominent on a global basis. The so-called “Greenspan put” is not some pardonable policy error that nurtured extra risk- taking (to be “mopped-up” whenever deemed necessary) that Wall Street would like us to believe. It cannot be defended as a necessary response to systemic risks, “deflation” or otherwise. Rather, the Greenspan Levee became a fundamental aspect of the evolving financial system - a critical facet of The World of Wall Street Finance, with Trillions of dollars of MBS, ABS, CDOs, CLOs, CMOs, and myriad “structured” products; unfathomable amounts of interest-rate, Credit, currency and other financial insurance; explicit and implicit debt guarantees (including the GSEs); and the widespread use of dynamic hedging trading strategies for “risk management.”
For Wall Street Finance to remain viable, Greenspan had to guarantee liquid and “continuous” (no panics!) markets. For this, he has to ensure an ever-expanding financial sector. For this, he had to peg financing costs, manipulate financial returns and do so transparently. Because of this, he essentially invited massive leveraged speculation that then had to be accommodated. Because of this, he and Dr. Bernanke had to erect an edifice of marketplace assurances that the Fed would never tolerate system deleveraging and/or Credit contraction – all in the name of fighting the scourge of deflation. These assurances – the “Greenspan Levee” – have worked to this point swimmingly. But the dilemma for the Greenspan Levee is that it has emboldened the Wall Street Inflationary Liquidity machine, along with inflationary Credit systems around the globe, that cannot today be reined in. A breech and a “flood” are anything but low probability events.
Watching the markets’ response to Katrina – higher stock and bond prices at home and abroad – I will err on the side of expecting continued economic “resiliency.” There will surely be wide-ranging financial ramifications and some economic dislocation. But, for the economy as a whole, I expect activity to continue to be dictated by interest-rates, mortgage rates in particular. And while some point to economic weakness prior to the storm, I will stick with the analysis of a U.S. and global economy demonstrating inflationary boom characteristics. If the inflationary bias is as prevalent as I suspect it is, then expect the major impact of Katrina to be higher prices for things ranging from gasoline and other fuels, to chicken, shrimp and oysters, to lumber and other building supplies. If some of these reside in “core CPI,” then we can simply adjust the core, again. To be sure, this catastrophe will ensure that an unsound and unbalanced economy becomes more so. |
