STAFF NEWS & ANALYSIS
Nobel Prize Winners Warn Financial System Is Still Not Out of the Woods
By Staff News & Analysis - August 25, 2008

A top caste of Nobel Prize economists has warned that the world's financial system may not start to recover for at least another year, leaving banks at mounting risk of an insolvency crisis. "There is a tremendous amount of de-leveraging still necessary in the United States and Europe," said Myron Scholes, the father of complex derivatives. "I'm not exactly sure when it's going to end. There are many financial institutions that need to add capital or sell assets, but it's getting more difficult," he said, at the annual gathering of Laureates on Lake Constance hosted by Sweden's Riksbank. … He said the European Central Bank was making a serious error trying to squeeze inflation. "There is no theoretical justification for this," he said. "They seem to have recognized that there are other risks beside inflation, so there is a glimmer of hope," he said. "A lot has changed since the wage-price spiral of the 1970s. Labour unions are weaker, and globalization acts as discipline on wage demands," he added. Mr Stiglitz said the watchdogs had failed to prevent the credit bubble because they were themselves captives of ideology. "There was a party going on and the regulator didn't want to be a party pooper. They encouraged people to take out floating-rate mortgages at 1pc." "Banks didn't just fail to manage their credit risk, they created credit risk. We have to bear the consequences," he said. He cautioned against a punishment policy that would further damage the banking system, saying it was Japan's refusal to bail out the banking system in the 1990s over fears of moral hazard that led to the protracted slump. Mr Scholes, an unrepentant free-marketeer, said governments had been a key cause of the debacle. "It is necessary to remind people of risk. I hope there is not a rush to regulation, because the costs might be higher than the benefits," he said. Moves to restrict lending by the mortgage giants Fannie Mae and Freddie Mac six years ago are a textbook case of what can go wrong. Other lenders operating outside any normal restraint muscled in on their once stodgy home loan business. Berkeley Professor Daniel McFadden said the crunch was now moving into the broader economy, threatening a number of companies with bankruptcy. He said the disastrous errors of recent years bring into question the whole assumption of "market efficiency" that lies at the core of modern economics. He proposed a body like the US Food and Drug Administration to certify new types of securities and derivatives. But at root, the failure is one of moral care. "Amid a rush to profit, what's been lost is the idea that a banker has some responsibility to protect the client's interest," he said. – UK Telegraph

Dominant Social Theme: It's very bad, but we'll come up with the answers over time.

Free-Market Analysis: What an article. There's no doubt the people quoted are brilliant mathematicians, but one wonders if they are "all that hot" as economists. Let's examine some of its points:

… He said the European Central Bank was making a serious error trying to squeeze inflation. "There is no theoretical justification for this," he said.

Scholes could – but does not mention – that subprime loans are in part tied to the European Central Bank-created interest rates. This is a most interesting point – why, in fact, are US subprime loans tied to European Libor? The European Central Bank's primary function is price stability. Unlike the American Federal Reserve it does not have to worry about employment. Thus, the bias in Europe these days is toward higher interest rates, which will likely only exacerbate the sub-prime default problem in the United States.

"They seem to have recognized that there are other risks beside inflation, so there is a glimmer of hope," he said. "A lot has changed since the wage-price spiral of the 1970s. Labour unions are weaker, and globalization acts as discipline on wage demands," he added.

This is an astounding statement. It intimates that Keynesian "wage push" is a primary factor in a "wage-price" spiral. Yet inflation, as serious modern-day economists agree, is a monetary phenomenon. To indicate that a "wage-price" spiral can aggravate an inflationary situation is like pointing to water on the floor from a leaky bucket and pretending that one has nothing to do with the other.

Mr. Stiglitz said the watchdogs had failed to prevent the credit bubble because they were themselves captives of ideology. "There was a party going on and the regulator didn't want to be a party pooper. They encouraged people to take out floating-rate mortgages at 1pc." "Banks didn't just fail to manage their credit risk, they created credit risk. We have to bear the consequences," he said. He cautioned against a punishment policy that would further damage the banking system, saying it was Japan's refusal to bail out the banking system in the 1990s over fears of moral hazard that led to the protracted slump.

What "party" is Stiglitz speaking of? The one in which banks created credit risk? Actually American commercial banks, at any rate, are creatures of the Federal Reserve. If they print too much money it is only because the Fed is allowing it to happen. Indeed, it is evident that Western central banks generally set rates too low and caused the boom which has been followed by this bust. Why doesn't Stiglitz spend some time analyzing the efficacy of central banking itself instead of speaking about "parties" and how "watchdogs" were "captives of ideology."

Mr. Scholes, an unrepentant free-marketeer, said governments had been a key cause of the debacle. "It is necessary to remind people of risk. I hope there is not a rush to regulation, because the costs might be higher than the benefits," he said. Moves to restrict lending by the mortgage giants Fannie Mae and Freddie Mac six years ago are a textbook case of what can go wrong. Other lenders operating outside any normal restraint muscled in on their once stodgy home loan business.

OK, governments have been a key cause of the debacle. Is this a euphemism for central banking? It is necessary, he says, to remind people of risk. But how can you remind them of it when the "watchdog" – the central bank for the most part – is "priming the pump" on a daily basis and has been for years and years. Who exactly is going to do this reminding? The system that produced the lax credit in the first place? And furthermore, entities such as governments and central banks do not decide or do anything – but people who benefit and are in positions or ultimate control do. But that's another issue altogether.

Berkeley Professor Daniel McFadden said the crunch was now moving into the broader economy, threatening a number of companies with bankruptcy. He said the disastrous errors of recent years bring into question the whole assumption of "market efficiency" that lies at the core of modern economics.

Here we have moved from what is evidently avoidance of the issue (Scholes and Stiglitz) into some sort of "Through the Looking Glass" fantasy. The market most certainly is efficient and responded appropriately to the gusher of credit produced by Western central banks throughout the 2000s by going up and up and up with each gout of easy money. As for the unwinding of that great bull market, it also has an explanation in that lax credit stimulates waste and the wasteful products must pile up and move through the system before the mis-allocation of resources causes a crash.

This is one of the cleverest elements of doublespeak offered by central bank proponents, that money "vanishes" in a bust. It does not. The technology blow off at the turn of the 2000s was caused by tens of billions of dollars invested in misdirected man-hours as well as software and hardware that was eventually junked because it was mostly hype and hot air. The mortgage blow-off of the late 2000s will be seen in large (by those who care to look) as generated by a build up of houses and developed and undeveloped properties that no one wants nor needs. Hundreds of thousands of properties in Britain and America, and probably throughout Europe, sit vacant and rotting right now. They are too far away from business centers, too big and perhaps too badly thought-out for habitation.

Yes, this is where the money goes. Once the build-up of mal-invested resources is recognized, the market crashes. It happens over time – first the run up and then the crash, or serial crashes, once it is evident that the resources have been committed badly and with no hope of recovery.

He proposed a body like the US Food and Drug Administration to certify new types of securities and derivatives. But at root, the failure is one of moral care.

Does this professor really believe that a Food and Drug Administration-like entity could "certify" new types of derivatives? The current US Food and Drug Administration couldn't figure out the cause of a recent American salmonella outbreak for months. First it blamed the outbreak on tomatoes and cost American tomato growers hundreds of millions of dollars. Then the evidence pointed to Mexican produce – but Food and Drug Administration officials apparently dragged their collective heels at pointing the finger that way for political reasons. This is the model that is supposed to certify new securities?

"Amid a rush to profit, what's been lost is the idea that a banker has some responsibility to protect the client's interest," he said.

Does this professor really believe it was a "rush to profit" that caused the current crisis. Business is, in fact, all about a "rush to profit." That's the ideal state! What created the crisis was not a "rush to profit" but a real-estate buying mania based on easy credit.

After Thoughts

It really is lamentable that the West's most esteemed economists will not explain publicly what they no doubt talk about endlessly in private – namely that the mechanism at the heart of the West's endless fiascos, the central bank, is to blame for what is taking place. What is the aversion to this discussion? Why can't it be made? If it is not made, then there will only be another crisis, and another and another. That's pretty much been the pattern since the world began moving away from the gold standard early last century.

The only honest and real money is gold and silver, and everyone at the "top of the heap" likely knows it. But apparently they won't talk about it anymore than they will talk about the real problem of central banking, namely that it is price-fixing and price-fixing never works because humans can't anticipate the market, or how much money it needs on a regular basis. It would be nice to have a real debate on this issue.

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