Other Criticisms of the ‘Gloomy Narrative’

Some support for our recent assertion that the U.S. press absolutely bungled the recent meeting between President Obama and President Hu of China (TOH to Brad DeLong):

• The Atlantic’s James Fallows, “Manufactured failure: press coverage of Obama in Asia”
• Fallows’ “Manufactured failure #2: the press, Obama, Asia” in which he cited the following three stories
• Howard French interview in the Columbia Journalism Review
• Tish Durkin in The Week, “Obama in China: What the media missed”
• Interview of Ambassador to China Jon Huntsman in the AP, “US envoy criticizes coverage of Obama visit” (Obama bashers should note that Huntsman is a Republican)

Additionally, a friend who’s an expert on China agreed with us that the behavior of students at the Shanghai townhall meeting was a rather worthless piece of evidence. They also pointed out that no matter what the financial relationship between China and another country, the Chinese government was not going to listen to any outside advice regarding its internal affairs (censorship, human rights, etc).  

All in all, the press really blew this one, perhaps out of a desire to perpetuate the prevailing myth of the U.S.-China power shift. Yes, there will be ongoing shifts in the two countries’ relative power. But a sudden shift is not going to happen overnight, and it’s especially not going to happen because China has accumulated vast USD reserves and U.S. Treasury holdings. In fact, on that latter point, one could argue that China has stepped on to the same tightrope that the Fed and U.S. Treasury – and U.S. Congress and Administration – have.

The press can sometimes get things wrong without meaningful consequences. But in this particular case, they’re feeding public debt (and other) anxieties of many voters, which could lead to short and/or intermediate term policy errors, and thus raise the likelihood of the dreaded “double dip” recession. 

URLs:

http://symmetrycapital.net/index.php/blog/2009/11/the-curiously-gloomy-narrative-continues-obamas-lack-of-leverage-over-china/

http://delong.typepad.com/sdj/2009/11/links-for-2009-11-22.html

http://jamesfallows.theatlantic.com/archives/2009/11/about_press_coverage_of_obama.php

http://jamesfallows.theatlantic.com/archives/2009/11/manufactured_failure_2_the_pre.php

http://www.cjr.org/campaign_desk/not_for_all_the_news_in_china.php

http://www.theweek.com/bullpen/column/103219/Obama_in_China_what_the_media_missed

 http://www.google.com/hostednews/ap/article/ALeqM5hopMZkJxkn_lh9AvGu2oQySbyl7wD9C35FNO0

http://prasad.aem.cornell.edu/doc/policy/ChinaReservesNote.July09.pdf

Fool: Open Letter to the Fed

A bittersweet piece of satire from a couple of folks who write for The Motley Fool. The (fictional) premise is that they’re starting a new financial institution called Money Unlimited, and are submitting a business proposal to the Federal Reserve:

…let us assure you that we will start from day one as a very well capitalized institution, with no need to raise outside capital. While actual cash is on the lower end of the spectrum, we both own stock portfolios that we plan to use as collateral for our banking operations…In addition, Matt owns a home in Las Vegas. Though this asset is currently considered “under water” based on market valuations, a house down the street just sold for slightly more than Zillow.com said it was worth. We extrapolated that gain into infinity and determined the housing bust is simply a figment of the media’s imagination…Without getting into the complexities, our models show our combined net worths at just over $1 billion, all of which we’ll use as capital for Money Unlimited. We hired a 22-year-old right out of college who’s pretty darn good with Excel. He assures us it’s a conservative figure.

Their plan is to avoid the nuts and bolts of deposit taking and lending, and to focus on capital markets instead:

…we’re going to leverage our borrowings from the Federal Reserve to create a massive, money-spewing trading operation. It’s quite simple, really. We’re going to borrow money from the Federal Reserve at 0%, then lend it back out to the U.S. Treasury at 3%… If we leverage our $1 billion asset base 20-to-1, we’ll pull in $600 million in year one without breaking a sweat. Because we want to do what’s right for the economy, we plan to keep operating expenses to a bare minimum and limit our bonuses to $20 million each for the first five years…We understand that hard work and tangible economic contributions need to be rewarded, so in the sixth year of operation we both plan to take $500 million bonuses and use company money to buy ourselves private jets.

Predicting some of the objections to such a plan, the proposal points out how benefits are sure to accrue to financial markets and the economy at large (although at only 20-to-1 leverage, we’re not sure how they’ll compete effectively!):

Money Unlimited will offer other significant benefits to the economy as well. We’ll compete against [other large] banking organizations…who are no doubt engaging in similar practices. Plus, we’ll allow other banks to buy credit defaults swaps against us. As any financial professional worth his salt can tell you, this “increases liquidity” and helps small businesses. We can’t tell you exactly how that works, but salesmen who wear shiny cuff links and talk really fast tell us it’s true.

…Before long, the founders of Money Unlimited expect our trading operations will become so large that we will be considered “too big to fail.” While some may consider this a concern, we disagree. There should be more competition among “too big to fail” institutions so that the risk of a Chernobyl-type catastrophe in our financial system is spread more broadly.

Great stuff. Unfortunately, what they describe is still happening, as governments continue dithering with regulatory reform, and Wall Street desks resume trading as if they’ve forgotten one of investing’s best known adages.

URLs:

http://www.fool.com/investing/general/2009/11/20/an-open-letter-to-the-federal-reserve.aspx

http://www.thestreet.com/static/rules1.html

Recent Articles on Federal Debt and Budget Deficits

Some reading material on the issue of federal debt and budget deficits, which we’ve been working over pretty heavily in recent weeks (apparently we’ve staked out a decidedly contrarian position). Brief commentaries included (some articles may require subscription and/or registration):

Randall Forsyth of Barron’s, “A Foolish View of America’s Debt”, 11/18/2009 – Forsyth points to recent Treasury data showing that foreign purchases of Treasuries continue apace, and to research that questions how sustainable this buying is. We would argue that when the private sector is diligently saving, the public sector should be busy “dissaving”, i.e., fostering productive investment and engaging in sound counter cyclical expenditures. In a global financial economy, the ability of domestic savers to fund overseas investments poses some risk to Treasury’s cost of capital. But to the extent that foreign savers are willing to finance our public deficits, we should take advantage (though one worry is that some or much of the buying might have to do with exchange rate management by foreign authorities, which is likely to have inflationary consequences globally, and could be a more volatile source of funding than ‘real’ savings).

A mostly spot on critique of the fiscal stimulus debate from the FT, 11/12/2009 – The author calls both Dems and the GOP to task, and points out that progressive Dems need to admit that policy uncertainty undermines productive private sector activity. Unfortunately, the author falls prey to the questionable orthodoxy that we somehow know the upper limit of public debt, and thus will require “fiscal consolidation” in the mid term. These assertions need better theory and (especially) better data. As we pointed out in our recent Idle Speculator piece, an honest empirical economist will admit that the data set on modern, developed financial economies is rather limited.

The FT’s Samuel Brittan, “Simple truths about the economy”, 11/13/2009 – An important counter point to the prevailing orthodoxynoted above, Brittan argues that ”The hole in the world economy can only be filled by deficit spending by the stronger western governments.”

“Are the US and UK heading towards debt crises?”, FinanceAsia.com, 10/15/2009 – A short paper that lends some current and historical empirical support to Samuel Brittan’s assertion that western governments should be running sufficiently large budget deficits. The argument that debt-to-GDP should not exceed some magical threshold is based on a lot of conjecture (IMF, are you listening?). 

President Obama will be holding a “jobs forum” in December - The federal government has done well with counter cyclical stabilizers, and an OK job trying to clean up the mortgage mess; but it’s come up far too short on stimulating productive investment, both in public projects and in private sector initiatives. The President and his party are in a tough spot.

President Obama states in an interview that ”it’s important to recognize that if the nation keeps adding to deficit spending through tax cuts or more stimulus spending, at some point people could lose confidence in the U.S. economy and that could ‘lead to a double-dip recession.’” Err, Mr. President, judging by (the admittedly limited) historical data, the surest recipe for a double dip recession is premature fiscal and/or monetary tightening (see the U.S. 1936-37 and Japan over the past two decades). In other words, if the President and his party fall prey to budget hawkishness, both a double dip and a loss of political power are likely to result. Obama did say that he is weighing tax breaks that would incentivize private sector hiring, but judging by their policy actions to date on that front, and the current makeup of Congress, the resulting policies and their economic impact are likely to be piecemeal. And, of course, temporary, like a “sunset”.

“Tax Amnesty Reaps Billions for Treasury”, FT, 11/17/2009 – Sometimes risk taking in the domain of taxes can produce positive results, as we’ve remarked before. In today’s economic climate, the deficit hawks and redistributionists should reconsider their approaches. A less distorting tax code, and a lower marginal tax burden, might not blow up the Treasury’s credit rating if coupled with productive public investments and a sound and reasonably certain regulatory outlook. Such measures are likely to be subsumed to continuing legislative efforts on health care and financial reform, which is unfortunate. Putting the economic horse ahead of those carts might have meant an earlier downturn in  unemployment, and more political capital for getting them done. Instead, we won’t see unemployment turn down until mid-2010 at the earliest; and that could prove a bigger risk for Democrats in midterm elections than budget deficits.

“Geithner: Recovery not enough without reforms,” Reuters, 11/19/2009 – Geithner testified to Congress that “the regulatory regime that failed so terribly leading up to the financial crisis is precisely the regulatory regime we have today.” Congress and the Administration’s legislative onslaught isn’t helping matters. There’s a lot on policymakers’ plate. In the meantime, the prevailing dynamic in the global financial system is the same one that has made financial crises such frequent visitors since the 1970s and 80s.

URLs:

http://online.barrons.com/article/SB125846371623352037.html

http://www.ft.com/cms/s/0/0c521d8c-cfbb-11de-a36d-00144feabdc0.html

http://symmetrycapital.net/idlespeculation/20091109.pdf

http://www.ft.com/cms/s/0/66e41076-cfc4-11de-a36d-00144feabdc0.html

http://www.ft.com/cms/s/0/0570e674-cf98-11de-b876-00144feabdc0,s01=1.html

http://www.financeasia.com/print.aspx?CIID=158204

http://news.yahoo.com/s/ap/20091118/ap_on_re_as/as_obama_economy

http://en.wikipedia.org/wiki/Sunset_provision

http://www.ft.com/cms/s/0/12465b26-d390-11de-9607-00144feabdc0.html

http://www.reuters.com/article/ousivMolt/idUSTRE5AI2Z820091119

The Curiously Gloomy Narrative Continues: Obama’s ‘Lack of Leverage’ over China

The Philadelphia Inquirer has an interesting front page article on the various issues negotiated between China’s President Hu and our President Obama during the latter’s recent visit to China. The article’s title proclaimed that “Obama finds he holds little leverage in China”, noting:

President Obama today wraps up a three-day visit to China that has left him keenly aware of the limits of his administration’s leverage over this economic powerhouse on issues from currency-exchange rates to human rights.

That characterization sounds a bit too pessimistic to us, and it’s yet another example of the curiously gloomy narrative that has developed in the U.S. media around our relationship with China. We can assess the article’s assertion by comparing the issues that each President  brought to the table.

China would like the U.S. to: 

• Tighten Federal Reserve policy in order to support the value of China’s U.S. dollar and debt holdings, and lower inflation risks in China;
• Avoid raising barriers to trade between the two countries;
• And avoid seeking stringent curbs on CO2 emissions from developing economies at the upcoming Copenhagen summit.

Meanwhile, Jon Huntsman, the U.S. Ambassador to China, was quoted as saying that the U.S. was focused on “key global issues”. President Obama requested that China:

• Allow its currency, the renminbi (RMB), to strengthen against the USD, and moving closer to a floating exchange rate regime;
• Expand human rights protections and limit state censorship;
• Commit to shouldering its share of the burden in combatting climate change;
• And help “contain the nuclear ambitions of North Korea and Iran.”

Look at those two lists and ask yourself which country’s well-being was most on the line. Hu’s requests were aimed at preventing major economic burdens from being imposed on China by entities outside of China.  But other than the impacts that a stronger RMB could have on U.S. exporters, Obama’s requests were aimed at the distinctly non-U.S. issues of climate change, nuclear proliferation, and China’s dealings with its own population!

For several years now, the media’s prevailing U.S.-China narrative has hung on the fact that China is a major holder of U.S. debt, and that this is somehow “unsustainable”. While the last decade’s rate of accumulation may be unsustainable, the current situation is more benign than many assume. And even if the situation were dangerous, China’s position is just as precarious as ours. That’s especially true when you compare productivity and per capita income levels in the two countries (military strength is also a factor), as well as secular and political shifts in the U.S. economy.

The story also tried to make something out of the fact that neither President Hu nor students attending Obama’s Shanghai townhall meeting showed much emotion. If that were a cultural anomaly in China, we might make something of it. It’s not, so we don’t.

All in all, there seems to be little basis for the claim that President Hu had the stronger hand.

URLs:

http://www.philly.com/inquirer/home_top_stories/20091118_Obama_finds_he_holds_little_leverage_in_China.html

http://news.yahoo.com/s/ap/20091118/ap_on_bi_ge/climate

http://symmetrycapital.net/index.php/blog/2008/12/

Budget Jawboning, Right on Cue

In our most recent Idle Speculator, we argued that there’s a risk that the federal government begins to tighten the screws on the real economy too soon, which could cut short a nascent recovery, much as it did in 1936-37, and much as the Japanese government did at different times during Japan’s two decade recession. Right on cue, the Obama administration has announced that it wants to freeze or cut most domestic spending:

The Obama administration, mindful of public anxiety over the government’s mushrooming debt, is shifting emphasis from big-spending policies to deficit reduction. Domestic agencies have been told to brace for a spending freeze or cuts of up to 5 percent as part of a midterm election-year push to rein in record budget shortfalls…

[The President] is expected to make post-recession spending restraint a key theme of his State of the Union address in January and an important element of the budget he submits to Congress a few weeks later. He is under increasing pressure, including from moderate and conservative members of his own party, to show he is serious about tackling a deficit that has become both an economic and political liability.

What direction this will take is still up in the air. As the AP article points out, the move is in response to political pressures rather than economic conditions, which do not argue for a more hawkish budget. Thus, the effort might have more symbolism than substance. However it’s pursued, the primary objective appears to be the Dems’ chances in the 2010 Congressional elections, which smacks of politics-as-usual, short run consequences to citizens — whether it’s economic harm or just being lied to — be damned. Is that somehow a better recipe for electoral success than speaking honestly with your constituents about the appropriate times, places, and levels of public expenditures?

We understand the thinking that sees common sense in a balanced federal budget, and under certain economic conditions, tightening at the federal level is absolutely appropriate. But to demand a balanced budget under current economic conditions is probably not in our best interests,  especially if it includes sacrificing public investments with significant multiplier effects and/or taking tax reforms off the table. Furthermore, it would take away any room that the Federal Reserve has to tighten monetary policy, which will only exacerbate the USD carry trade that seems likely to fuel another round of commodity and emerging market speculation; that would mean yet another bout of global financial upheaval at some point. Economist Nouriel Roubini recently argued that current financial and monetary conditions could lead to the “biggest co-ordinated asset bust ever…if factors lead the dollar to reverse and suddenly appreciate.” A vigorous tightening of the federal budget could certainly catalyze such a reaction. Putting it all together, it appears that instead of helping the Federal Reserve alight from its tightrope, Congress and the Administration are choosing to step onto a tightrope of their own.

Before expressing their will in 2010, voters should keep in mind that day-to-day common sense would have called for letting large financial institutions fail in 2008, which would have short circuited the global payments system (imagine having to barter or transact in personal IOUs from September 2008, and what effects that would have had on the economy). It is important to signal to foreign Treasury debt holders that their interests will not be ignored (we’re speculating that this could have been a concession to China and Asia). And there will come a time when federal budget tightening is appropriate. But by our reckoning, that moment is not upon us yet.

URLs:

http://symmetrycapital.net/idlespeculation/20091109.pdf

http://finance.yahoo.com/news/Obama-wants-domestic-spending-apf-691348121.html?x=0

http://www.rgemonitor.com/roubini-monitor/257912/mother_of_all_carry_trades_faces_an_inevitable_bust

Idle Speculator: Is the Federal Government Too Tight?

In our latest Idle Speculator piece, we ask whether — despite large recent and expected budget deficits — the federal government risks being too tight. We argue that:

(1) At certain times and under certain economic conditions, deficit financed improvements in the tax code and public expenditures and investments make sense.

(2) The U.S. may be in one of those periods now, while Japan may be exiting one. In both cases (as well as the Great Depression), demographic trends might be playing a larger role than conventional theories assume.

(3) Pro-growth fiscal policies would give the Federal Reserve a lot more room to raise rates and defend the USD.

(4) Given: the enormous nominal dollar figures attached to discussions of U.S. budget deficits and national debt; widespread misconceptions about public finance and its economic effects; and ideological rancor among voters and politicians; there will be increasing pressure to tighten up the federal budget in coming years. Such actions could be premature and threaten a nascent economic recovery.

http://symmetrycapital.net/idlespeculation/20091109.pdf

Great Quote

From a posting by David Merkel of The Aleph Blog, in a review of the book Nerds on Wall Street:

On Wall Street, if you are really, really smart, they will hand over to you exceptionally advanced tools that you can use to destroy yourself in a unique and memorable way.

URLs:

http://alephblog.com/2009/10/31/book-review-nerds-on-wall-street/

http://www.amazon.com/gp/product/0471369462?ie=UTF8&tag=symmetrycapit-20&linkCode=as2&camp=1789&creative=390957&creativeASIN=0471369462

DISCLOSURES: Symmetry Capital Management, LLC earns a commission on book sales purchased via Amazon Associates links on our website. Symmetry Capital, its clients, and its principals do not own shares of any companies mentioned.

An “Outraged” John Mauldin

Industry scribe John Mauldin let loose on current proposals for financial regulatory reform in a recent email bulletin:

…I am outraged at the paltry proposed financial “reforms.” Rahm Emanuel said that no crisis should be allowed to go to waste. The Obama administration is wasting this one. How can we allow banks to be too big to fail? Where is the reinstatement of Glass-Steagall? If we are going to allow large banks to exist, then their leverage must be reduced to the point where their failure would not risk the system and require taxpayer dollars. I don’t care if that makes them less profitable. They are making those large profits because they have taxpayers implicitly behind them, and I get no dividend payments from them, the last time I checked. Where is Fannie and Freddie reform (and their breakup)? No mention of an exchange for credit default swaps? (And yes, I know that such an exchange would reduce the number of swaps and the profitability of them. That is the point. They are dangerous if allowed to become too big a market.) This bill reads as if bank lobbyists wrote it. Where is the populist outrage? We have let the fox set up the rules for running the hen house. Shame on us all if we allow this to happen.

Git ‘em, John.

Update on Fiscal Multipliers

There’s a new paper on estimates of fiscal multipliers, which can be roughly thought of as how much bang an economy gets for each buck of additional government spending. This is a critically important and timely topic, as electorates around the world are debating the efficacy and timeliness of government spending (hat tip to Greg Mankiw). In what Mankiw calls a victory for Mundell-Fleming, the authors find that the effectiveness of fiscal stimulus is highly dependent upon fixed versus floating exchange rates (being a high income and relatively closed economy also makes a significant difference).

The authors attempt to shed light on the disparity between the low multiplier estimates put forth by Robert Barro and the higher ones put forth by Obama advisor Christina Romer:

For the US, we find the impact multiplier is 0.64 and the long-run cumulative multiplier is 1.19. While these estimates are certainly closer to Romer’s than to Barro’s, they mask some important structural changes over the sample period. When estimating the multipliers for the pre-1980 period, we get considerably larger numbers than the post-1980 multipliers. The post-1980 multipliers are just 0.32 on impact and 0.4 in the long-run. This is certainly a far cry from the impact multiplier (1.05) and long-run multiplier (1.55) used in the Romer report.

The authors seem to imply that the falling multiplier due to unknown structural changes is likely to persist. Here’s an interesting thought though: what if demographics have been an important component in those underlying changes? For example, the M/Y ratio of Geanakoplos et al (middle aged cohort to young cohort) would predict a lower rate of economic growth and/or asset appreciation in low M/Y periods. The 1960s and 1970s were such a period, while the 1980s and 1990s were the inverse. In the 2000s, the U.S. began trending back towards a low M/Y era, as Gen Xers moved into the numerator, baby boomers moved out of the picture, and their kids started moving into the denominator. Is it possible that the fiscal multiplier is higher in periods like the present one? Put another way, is it possible that in low M/Y periods there’s more room for the public sector to step in and sop up ’demand slack’, while in high M/Y periods it’s more likely to ‘crowd out’ private investment?

URLs:

http://www.voxeu.org/index.php?q=node/4036

http://gregmankiw.blogspot.com/search?q=mundell+fleming

s+b: Better Way to Regulate Bankers’ Pay

Another take on the political fight over regulating compensation in the financial industry, this time from Shumeet Banerji at Booz+Hamilton:

…plans to limit compensation will not work, because they do not address the core problem: the disconnect among bank capital, risks (borne by both banks and society), and compensation structures (particularly the way traders are paid).

…the system is ripe for change. The solution lies not in aggregate, rules-based regulation, but in a microeconomic reassessment, within each bank, of how…to interweave the ways risk is taken, capital is allocated, and people are paid. There are probably several self-regulating and self-correcting mechanisms that banks and regulators could put in place right now. Two simplified examples…illustrate the point.

The first is “paying on the trade.” Instead of paying commissions based on a “mark-to-market” estimate of the value of a position, as most banks do now, base them on the actual profit made when a deal is consummated and the position is liquidated. There would be no need to further reserve against the downside because the risk of the deal would be fully internalized. The second is to require each institution to reserve enough capital to account for the downside risk of the asset that has been purchased, including the value of the share of the putative profit that has been paid out in bonuses.

Either of these solutions would tie compensation and capital directly to the risk and leverage in each contract, rather than setting up crude aggregate standards that don’t take into account the characteristics of a particular trade. Instead of shifting the burden of judgment to regulators, this approach would better harmonize individual and institutional incentives. And when bankers have reason to pay attention to the true economics of their deals, rather than to the impact on their bonuses alone, they might find themselves making better deals — and thus reclaiming the reputation they have lost.

Sounds nice — adjust the institutional frameworks by setting up a “granular”, trade-level approach to regulation that will make banks better stewards of shareholder, depositor, and taxpayer capital. But if the last two decades are any indication, it’s a pipe dream. Here’s the scariest part of Banerjee’s proposition (emphasis added):

…one proposal would set in place a maximum leverage ratio: borrowed funds should not exceed some value, such as 25 times equity. In principle, limiting leverage seems like a good idea, but no aggregate rule can possibly apply to the wide variety of banks, trades, and risk profiles. Such a rule would trump good judgment by skilled risk takers. And a billion dollars worth of investment capital, operating within a regulatory leverage cap, could still be deployed and lost in a million lousy trades.

We’ll make very clear where we stand on this issue:

• Leverage caps are the best and only way to manage systemic financial risk. It was the “competitive” lifting of caps by regulators in Europe and the U.S. that helped get the world into this mess.
• Any given trade has a winning and losing side. A precious few might have enough skill to win persistently, but trading involves a great deal of luck and provides limited social benefits (talk about crowding out…). Luck should not be leveraged!
• There is absolutely no reason, however skilled an individual trader might think themselves, to allow them to leverage their capital many times over.
• The performance of 99% of professional risk takers in 2007-2008 sucked, primarily because traders and risk management departments look myopically at their own books; they are not equipped to monitor systemic leverage and fragility, and the risks that their burgeoning trade books pose to the underlying payments system itself. Sucking and institutional blind spots should not be leveraged!
• A 25x cap on leverage still looks generous, and it’s absolutely fair game for the public to have a debate over what the caps on financial leverage should be. 

The fact that we’re talking about proposals as timid as 25x — a level which has still managed to get the global financial system into plenty of trouble in recent decades — is damning evidence of regulatory capture. As William Buiter put it:

The Fed, unlike the ECB and the Bank of England, is also a banking sector regulator and supervisor. This gives it an informational advantage. The downside to the Fed’s position is the risk of regulatory capture. I believe that what I call ‘cognitive regulatory capture’ of the Fed by Wall Street has occurred during the past two decades. The net result is that both as regards macroeconomic stability and as regards future financial stability, the Fed has performed worse during this crisis than the ECB and the Bank of England.

Future regulation will have to be base on size and leverage of institutions. It will have to be universal (applying to all leveraged institutions above a certain size), uniform, countercyclical and global.

Financial crises will always be with us.

Given the timidity of a 25x cap on leverage, we’ll revisit the mathematics of leverage once more. At 25x, a financial entity can acquire (create) $25 of assets for every $1 of equity (which according to balance sheet mechanics, means it takes on liabilities of $24). Because liabilities are senior to equity (liabilities have to be serviced from either operating cash flows or equity), a $1 loss on those assets — i.e., a decline of only 4% — wipes out all equity (or “capital”, in banking lingo). At a leverage ratio of 10:1, the loss on assets would have to be at least 10% to wipe out an entity’s capital. We know from history that financial assets in the aggregate can lose 4%, or even 10%, often in short order. The risks posed to the financial system’s solvency by high leverage should be painfully obvious (and as John Geanakoplos and others have pointed out, leverage tends to be increased and decreased by the banking sector in a very procyclical fashion).

We applaud Banerjee for trying to integrate compensation issues with systemic ones, but it’s extremely speculative to think that the deep seated human behaviors associated with outsized risk taking are going to change due to a shift in compensation practices. Leverage, commitments, and systemic fragility must be the center piece of any new financial regulations, otherwise it will be back to the future - probably within five years, almost certainly within ten.

In fact, if you want to see over-leveraged “skilled risk takers” in action, take a look at gold, which seems ready to go parabolic as traders jump alongside central bank buyers — who historically happen to be the ultimate contrary indicators in gold markets. When the fever breaks — and admittedly, there could still be plenty of ‘parabola’ to ‘trace’ before that happens – it won’t be pretty. Momentum lemmings should not be leveraged!!! Unfortunately, they still are…

URLs:

http://www.strategy-business.com/article/00007?pg=all

http://www.nber.org/~wbuiter/NAcrisis.pdf

http://www.arts.cornell.edu/econ/CAE/conferences/John%20Geanakoplos.pap.pdf

DISCLAIMER and IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy. At the time of writing, the firm, its principals, and its clients did not own any securities mentioned, or any securities issued by corporations mentioned. Symmetry Capital Management, LLC is an Amazon.com associate, and may earn a percentage of any sales generated by clicking through to the Amazon.com website from links on our website.