Dr. Doom Collects His Prescient Thoughts About Economics and the Financial Crisis

Nouriel Roubini and Stephen Mihm has written a book about the financial crisis that could become the most influential book on the subject thanks to Roubini's brilliance and track record as the man who most clearly and definitively predicted the crisis.

The new book is called Crisis Economics - A Crash Course in the Future of Finance and is reviewed in today's New York Times. "Instead of imposing a doctrinaire theory upon the facts, Mr. Roubini employs an eclectic, common-sense approach to history, picking à la carte from the thinking of such disparate economists as John Maynard Keynes and Joseph Schumpeter," Michiko Kakutani writes in her review.

Stephen Mihm, a journalist and professor of economic history at the University of Georgia, wrote an excellent portrait of Dr. Doom in New York Times Sunday Magazine in August 2008, the month before the financial collapse. Mihm's story began like this:

On Sept. 7, 2006, Nouriel Roubini, an economics professor at New York University, stood before an audience of economists at the International Monetary Fund and announced that a crisis was brewing. In the coming months and years, he warned, the United States was likely to face a once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence and, ultimately, a deep recession. He laid out a bleak sequence of events: homeowners defaulting on mortgages, trillions of dollars of mortgage-backed securities unraveling worldwide and the global financial system shuddering to a halt. These developments, he went on, could cripple or destroy hedge funds, investment banks and other major financial institutions like Fannie Mae and Freddie Mac.

The audience seemed skeptical, even dismissive. As Roubini stepped down from the lectern after his talk, the moderator of the event quipped, “I think perhaps we will need a stiff drink after that.” People laughed — and not without reason. At the time, unemployment and inflation remained low, and the economy, while weak, was still growing, despite rising oil prices and a softening housing market. And then there was the espouser of doom himself: Roubini was known to be a perpetual pessimist, what economists call a “permabear.” When the economist Anirvan Banerji delivered his response to Roubini’s talk, he noted that Roubini’s predictions did not make use of mathematical models and dismissed his hunches as those of a career naysayer.

So much for the power of abstract mathematical models in economics! Or as Mihm puts it in his 2008 essay:

The dismal science, it seems, is an optimistic profession. Many economists, Roubini among them, argue that some of the optimism is built into the very machinery, the mathematics, of modern economic theory. Econometric models typically rely on the assumption that the near future is likely to be similar to the recent past, and thus it is rare that the models anticipate breaks in the economy. And if the models can’t foresee a relatively minor break like a recession, they have even more trouble modeling and predicting a major rupture like a full-blown financial crisis. Only a handful of 20th-century economists have even bothered to study financial panics. (The most notable example is probably the late economist Hyman Minksy, of whom Roubini is an avid reader.) “These are things most economists barely understand,” Roubini told me. “We’re in uncharted territory where standard economic theory isn’t helpful.”

In their book, Roubini and Mihm analyses the current proposal for reform of the financial markets, proposals that have the backing by both President Barack Obama and treasuru secretary Timothy Geithner. They are way too timid according to the authors, who also propose a break-up of Wall Street's financial giants:

Throughout most of 2009, Goldman Sachs chief executive Lloyd Blankfein repeatedly tried to quash calls for sweeping regulation of the financial system. In speeches and in testimony before Congress, he begged his listeners to keep financial innovation alive and “resist a response that is solely designed to protect us against the 100-year storm”.

That’s ridiculous. What we’ve experienced wasn’t some crazy once-in-a-century event. Since its founding, the United States has suffered from brutal banking crises and other financial disasters on a regular basis. Throughout the 19th and early 20th centuries, crippling panics and depressions hit the nation again and again. The crisis was less a function of sub-prime mortgages than of a sub-prime financial system. Thanks to everything from warped compensation structures to corrupt ratings agencies, the global financial system rotted from the inside out. The financial crisis merely ripped the sleek and shiny skin off what had become, over the years, a gangrenous mess.

The road to recovery will be a long one. For starters, traders and bankers must be compensated in a way that brings their interests in alignment with those of shareholders. That doesn’t necessarily mean less compensation, even if that’s desirable for other reasons; it merely means that employees of financial firms should be paid in ways that encourage them to look out for the long-term interests of the firms.

Securitization must be overhauled as well. Simplistic solutions, such as asking banks to retain some of the risk, won’t be enough; far more radical reforms will be necessary. Securitization must have far greater transparency and standardization, and the products of the securitization pipeline must be heavily regulated. Most important of all, the loans going into the securitization pipeline must be subject to far greater scrutiny. The mortgages and other loans must be of high quality, or if not, they must be very clearly identified as less than prime and therefore risky.

Some people believe that securitization should be abolished. That’s short-sighted: properly reformed, securitization can be a valuable tool that reduces, rather than exacerbates, systemic risk. But in order for it to work, it must operate in a far more transparent and standardized fashion than it does now.

Absent this shift, accurately pricing these securities, much less reviving the market for securitization, is next to impossible. What we need are reforms that deliver the peace of mind that the Food and Drug Administration (FDA) did when it was created.

There is an allegory that bites!
Wall Street is a lawless jungle that has served us rotten food, hence we need a financial FDA! I'm sure Upton Sinclair smiles in his grave! (His 1906 novel about Chicago's meatpacking plants, The Jungle, led to new food inspection laws in 1906, and eventually - 1930 - the FDA.)

Hans Sandberg

Greek Drama Let the Animal Spirits Loose On Wall Street

It didn't take long for the week to turn sour with the smoking loaded car on Times Square, BP's worsening oil spill in the Mexican Gulf, and the growing nervousness about Greece, a country on the brink of default. But on Thursday things went really rough as the Dow plunged 997 points while our cable networks showed street scenes from Greece that made you think of May 1968 in Paris or Bangkok in April 2010.

The guys on Wall Street may have thought or hoped that the worst was over now that the Tea Party was starting to fizzle and the grilling of CEO's at the BBQ in Washington was starting to wind down, but then the climate changed and a sudden icy chill blew in over Wall Street. The crisis in Greece went from bad to worse, and now it looked like the country could collapse and drag the other "PIGS" (Portugal, Italy, Greece and Spain) with it, maybe even pulling down Great Britain, which is also struggling with huge debt issues and were likely to emerge politically weaker after Thursday's election. Who can blame the Masters of Universe for feeling a little paranoid? The rational expectations turned into irrational fear and panic faster than you can flip channel on your TV.

"Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits - a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities."(John M Keynes, The General Theory of Employment, Interest and Money, London 1936.)

The trouble with Wall Street and the pundits is that they are not all that smart when it comes to the real economy. The models don't tell them what to expect, and they don't know how to interpret the battles in the streets. They got scared and they sold. Add to that computer programs that send the consumer giant Proctor and Gamble down drastically, and everybody was talking about how America's recovery would be hit if the European market goes down and the dollar strengthens against the Euro. There goes the recovery....

"There was a lot of panic selling that came in and the market fell apart,” Peter Cardillo, the chief market economist of Avalon Partners, told the New York Times.

The rational for the obscenely huge bonuses Wall Street pays its executives is that they are supposed to be superstars, who carries enormous responsibility, and are really, really smart.

But on a day like this, they proved themselves to be driven by fear, greed and ignorance, like the rest of us, except that they somehow had managed to rake in millions and millions in bonuses, while we others counted our losses. For all its beauty, capitalism is a self-destructive system, which is why we need the government to rein it in, to set the rules and make sure that they are followed. This is were the stupids in the Tea Party got it all wrong. If you don't want to get screwed over again and again by the rich and powerful, you need government, and not just a little of it. Keynes knew that, FDR knew it and we should all know it by now. Government is not socialism, not even big government. It's actually the only way to save the capitalist system from blowing itself up.

Hans Sandberg

More on the nattering nabobs of negativity

First, watch Jon Stewart ripping into CNBC and their sorry bunch of pundits (with the exception of Steve Liesman who is smarter and more knowledgeable than the rest of the bunch together).
It's a gem; funny, sad, and a piece of media history.
Watch it! 

The Daily Show With Jon StewartM - Th 11p / 10c

CNBC Gives Financial Advice

Paul Krugman commented on the pundits/economics reporters pang for fiscal conservatism in his latest column:
 
'President Obama’s plan to stimulate the economy was “massive,” “giant,” “enormous.” So the American people were told, especially by TV news, during the run-up to the stimulus vote. Watching the news, you might have thought that the only question was whether the plan was too big, too ambitious.
Yet many economists, myself included, actually argued that the plan was too small and too cautious.'

And Frank Rich picked up on Jon Stewart's CNBC-segment in his Sunday Times column Some Things Don’t Change in Grover’s Corners.

On Monday, the New York Times had an interesting piece explaining how the CNBC network is struggling to retain its tiny, but wealthy, group of viewers by becoming more political and by lambasting president Obama.

'But in a change from previous downturns, CNBC is now a place for politics, to borrow a phrase from its sister channel MSNBC. The network’s journalists have been encouraged to speak their minds, making the line between reporter and commentator almost indistinguishable at times.

“When they are all sitting around the table it’s hard to tell a business pundit versus a reporter,” said Tom Rosenstiel, the director of the Project for Excellence in Journalism.
(...)
With economic attention focused on Washington, the network is spending less time on bullish stock picks and more time assessing the government’s actions.

In recent weeks some have perceived the network to be leading the campaign against President Obama’s economic agenda."

Now you may be ready for a little more nabob skewering from Jon Stewart's side:

The Daily Show With Jon StewartM - Th 11p / 10c

The Dow Knows All

In case you missed my previous blog about the revenge of the nattering nabobs of negativity, scroll down to read it!

Hans Sandberg

Prospect of Healthy Change Spooks Wall Street

The Dow keeps falling, reaching ever new lows, and some Wall Street analyst are blaming Barack Obama and his team for the sad state of the market. They complain that the investors are confused, and don't know the rules anymore, because the government are changing them. 

In a way, they are right, because from Wall Street's point of view, the new administration is doing exactly what it set out to do - to bring change, and change means insecurity, and makes it harder to apply the old models and rules of thumb. This is as it should be, because Wall Street has forsaken most of its credibility by pursuing short term greed so recklessly that it almost brought down the world's financial and economic system. Very few on Wall Street, and in the Republican Party complained when CEO's awarded themselves 100's of millions in bonuses for what we now know was a mostly fictitious performance. That was the order many Wall Street gurus and financiers want to return to as it made it so easy to make outrageous profits from doing no good. But that order is gone, imploded under the weight of greed and corruption. 

Barack Obama stepped into this chaos, and started to clean up the mess, but doing so he is bound to ruffle the feathers of those who profited from the Bush era corruption of the markets. It will take some time before the force of the new regime, and the new reforms will be felt and understood. Once that is done, share will start to move up again, but not driven by derivates and Bernie Maddoff style shenanigans, but but companies pursuing real opportunities, making real things and providing services we really need. It might not go as fast as it did before the latest bubble burst, but neither will it deflate as easily.

Hans Sandberg

What Would Jesus, the Pope, and John Maynard Keynes Do?

What would Jesus do about the financial collapse? Would he come down on Wall Street flipping those tables that haven’t already been flipped? Or would he, like Pope Benedict XVI, preach Buddhist sounding nihilism - 'money vanishes, it is nothing'' - something that an innocent soul - God forbid! - could take to mean that it is all right to fill this globalization pioneer's collection baskets with words rather than those vanishing bills and checks. After all, "only God's words are a solid reality" as the pontiff preached in Rome on Monday.

When the Pope declared the world's financial systems "built on sand," he should have reminded us that not even the most solid faith is enough to keep St. Peter’s Cathedral from crashing down, hence Bramante made sure that it had a firm underpinning. In Wall Street’s case, such underpinnings are called regulations, and I can’t remember having heard demands for government regulations of the financial markets from the Catholic Church.

If we take the Pope’s statement on a personal level, there is certainly an existential truth in his paraphrasing Jesus, "he who builds only on visible and tangible things like success, career and money builds the house of his life on sand''. But one does wonder if that truth also holds in the Vatican City with all its displays of conspicuous wealth? I much enjoy visiting catholic churches, but there is something to say for Lutheran frugality.

But enough of this, because it’s not really what Jesus would do or say that interests us. The real question is what John Maynard Keynes would think if he had been around to watch capitalism performing what looks like a global hara-kiri. Contrary to the classical economists, and our neo-conservative believers, Keynes looked at the real economy, and what he saw after the Great Crash of 1929 was that markets alone would not be able to bring about an equilibrium where all resources are optimally used. Mere humans run the markets, and humans are typically shortsighted. It takes not a village, but a government to pull a country out of a severe recession, or a depression. There is always work that needs to be done. Leaving everything up to the markets carries a political risk that no responsible government can take. Hence it intervenes, projecting its power into the future. The private sector typically does not respond well to needs that are long-term, and where the rewards are indirect and often lies years in the future. What FDR did - inspired by Keynes - was to lead the country and the economy to start working again, whether it was to build roads, dams or water systems. The government can do this and it can - and if it does it well, and for peaceful purposes - give the entire economy the jolt it needs to restart the economic engines.

When capitalism freezes up, it doesn’t mean that our private and social needs have seized to exist, but that there is a general loss of confidence among the actors in the market. There is simply too much fear and uncertainty, which means that the ball de facto has passed from the economic system to the political system.

The world, and the United States in particular, is facing a tremendous need for investments in education, health care, repairing and expanding its collapsing infrastructure, and in converting its energy system from one that exacerbates global warming to one that relies on alternative and sustainable energy and limits its dependence on foreign energy sources. The private sector cannot lead here, but if the government sets out the course, and starts the process, the private sector will soon catch up and take over. That was how the computer industry grew from serving the Department of Defense and NASA to serving the entire society, and the entire world.

The world is now shell-shocked much like after 9/11. Hopefully, the answer will not be ignorance, economic follies, chauvinism and new wars (the McCain Path), but realism, economic and ecological restructuring, fairness and global responsibility (the Obama Path).

Hans Sandberg

Not Every Speculator Deserves A Bailout...

Here is a qoute from the Center for American Progress' article Selective Bailouts: Help for Wall Street, Not Your Street:
...
In the run up to the Federal Reserve Board’s decision Sunday to essentially finance the takeover of collapsing investment bank Bear Stearns Cos. by J.P. Morgan Chase & Co., the president, Secretary Paulson, and other top Bush administration officials adamantly told us that aid to neighborhoods devastated by foreclosures would be an unacceptable bailout of lenders and would remove necessary market discipline from punishing the sins of “speculative” homeowners.

In fact, their comments suggested that the current free fall in home prices resulted mainly from excessive individual risk taking and bad bets by individuals—and that these speculators should suffer the consequences of their decisions. In Paulson's March 3 statement to the National Association of Business Economists, for example, he spoke dismissively of government intervention.

"We know that speculation increased in recent years; a resulting increase in foreclosures is to be expected and does not warrant any relief,” he said. “People who speculated and bought investment properties in hot markets should take their losses just like day traders who speculated and bought soaring tech stocks in 2000.”
...
Read the rest of David M. Abromowitz' sharp analysis of the Bush administration's double standard here.

Sorry, But There Are Only So Many Lifeboats On this Ship, Says Captain Bush

"As we take decisive action, we will keep this in mind: When you are steering a car in a rough patch, one of the worst things you can do is overcorrect," the president said in his weekly radio address (March 14, 2008) according to an AP report.

"That often results in losing control and can end up with the car in a ditch," Bush said. "Steering through a rough patch requires a steady hand on the wheel and your eyes up on the horizon. And that's exactly what we're going to do."

He also put a positive spin on the housing crisis and the falling house:

"Many young couples trying to buy their first home have been priced out of the market because of inflated prices," the president said. "The market now is in the process of correcting itself, and delaying that correction would only prolong the problem."

Wouldn't it be nice to see such an optimism in dealing with the financial markets? What if Bush instead of a multibillion dollar bailout of his wealthy Wall Street friends had stod by his principles and delivered the following message in his radio address?

"Many young investors trying to build a fortune have been priced out of the market because of inflated prices. The market now is in the process of correcting itself, and delaying that correction would only prolong the problem."

But of course, that would have been totally unrealistic. There are after all only a limited number of lifeboats on this ship. 

Hans Sandberg