Friday, November 21, 2008

The Fall of Citigroup means we don’t understand what’s happening …

So it now appears that the US government, at the least, will come to own Citigroup. October had the first CPI fall in … well … a long, long time. Switzerland is teetering on bankruptcy …

End of the beginning? — Crooked Timber

The failure of Citigroup, which looks increasingly likely to happen in the near future, would mark the end of the beginning of the financial crisis…

… Citi is not only too big to fail, it’s too big to rescue with any of the half-measures that have been tried so far. Only outright nationalization is feasible, and that will probably require joint action by a number of governments; Citigroup’s global operations are too big for the US to handle alone….

… The national bankruptcy of Iceland seems likely to followed by something similar for Switzerland. As Citi itself points out, UBS and Credit Suisse are bigger, relative to the Swiss economy, than Kaupthing was for Iceland. Felix Salmon (also predicting doom for Citi, has been all over this).

Given a failure and rescue, Switzerland would probably have to follow Iceland in a rush application to join the EU (which might have its hands full rescuing some of its own members). It’s a safe bet that the end of secret bank accounts, “wealth management” through tax minimisation and the like would be part of the price…

… If even part of this plays out as it seems likely to, the financial system that emerges from the crisis will be radically different from the one that went in: massively smaller, with far fewer institutions and products, and tightly regulated where it isn’t under outright public ownership.

But before we can even get to that point, we’ll have to survive a global recession which is already the worst in decades, even though it’s still in the opening phase where unsold inventories pile up on wharves. Obama’s inauguration is going to look a lot like that of FDR in 1933.

Is this a part of the unwinding of $300 trillion in derivatives that we’ve been wondering about? Who’s winning in these monstrous money flows?

In the good-old-days of five days ago, I wrote:

One theory is that the combination of the 1994 Gingrich Marketarian [3] "revolution" and consequent firewall demolition, combined with at least one major technology transition, produced accelerated returns at the cost of new instabilities. Over a long enough timeline investment returns might be somewhat lower than with a balanced regulatory environment, but "safe" investment timelines are now 20-50 rather than 10-15 years.

I think that's true, but not the entire story…

… We know humans are predictably irrational. We know people will aggressively search for cheap gas when prices are rising, but won't when prices fall -- even at the same income/price ratio. [5] Similarly we know humans will criticize balance sheets when share prices fall, but not when they rise.

This means that market volatility enables predictable predation strategies during rapid rise. Money can be diverted into senior executive compensation, into insider trading, into payments to political parties and senators, and into sophisticated financial instruments that none of us have the ability to fully understand or model.

This form of market predation (parasitism really, since a dead host is not useful) is bad enough by itself, but it's aggravated by "ratchet effects" [4]. CEO compensation doesn't fall as quickly as share prices. Senatorial contributions can't be stopped without risking undesirable electoral outcomes.

Volatile markets, like those of the past twelve years, can start to look an awful lot like Amway…

So does the combination of technology transition, firewall demolition and volatility-facilitated fraud account for what we’re seeing? How about if we throw in the rise of China and India? What role does skewed wealth concentration and the effective “disabling” of about 20-40% of the US population?

What was it Reich wrote last March

… American consumers are coming to the end of their ropes and don't have the buying power they need to absorb the goods and services the U.S. economy is capable of producing. This is likely to mean fewer jobs, which will force Americans to pull in their belts even tighter, leading to still fewer jobs – the classic recipe for recession. That recession may turn into a full-fledged Depression if fiscal and monetary policies can't make up for consumers' lack of buying power. And there's reason to worry they cannot because consumers are in a permanent bind. They're deep in debt, their homes are losing value, and their paychecks are shrinking...

...We're reaping the whirlwind of many years during which Americans have spent beyond their means and most of the benefits of an expanding economy have gone to a relatively small group at the very top. Adjusted for inflation, the median wage is below where it was in 1999. The nation's median hourly wage is barely higher than it was thirty-five years ago. The income of a man in his 30s is now 12 percent below that of a man his age three decades ago. The rich, meanwhile, can't keep the economy going on their own because they devote a smaller percentage of their earnings to buying things than the rest of us: After all, they're rich, and they already have most of what they want. Instead of buying, they're more likely to invest their earnings wherever around the world they can get the highest return...

... Go back to the years just before the Great Depression and you see the same pattern. As I've noted before, Marriner S. Eccles, who served as Franklin D. Roosevelt's Chairman of the Federal Reserve from 1934 to 1948, noted this in his memoir "Beckoning Frontiers":

"As mass production has to be accompanied by mass consumption, mass consumption, in turn, implies a distribution of wealth -- not of existing wealth, but of wealth as it is currently produced -- to provide men with buying power equal to the amount of goods and services offered by the nation's economic machinery. Instead of achieving that kind of distribution, a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. This served them as capital accumulations. But by taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants. In consequence, as in a poker game where the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped."...

So here’s my current list of the contributing factors …

  1. firewall demolition enhancing returns at the cost of instability (rise of the Marketarian religion)
  2. technology transitions – computing and communications
  3. globalization – rise of China and India
  4. wealth concentration in the hands of people who don’t need to spend to live – they can sit on their money
  5. fraud (including quality collapse) and wealth diversion enabled by firewall demolition and rapid market rise
  6. aging populations in wealth producing nations

Bush and the GOP have responsibility for #1 and #4 and partial responsibility for #5 (culture of greed, think “broken windows” for CEOs). They don’t have responsibility for the entire catastrophe, but they may own the critical mass.

Silence can speak loudly. Nobody I read is now saying Depression is impossible.

The “end of history” seems pretty funny now. Hah, hah.

Update: I'd forgotten about a earlier post that covered things from a slightly different angle. I have more to say about the complexity factor in a later post.

Update 1/12/2009: This 2003 post feels relevant. Generational wealth transfers and the Bush estate tax cut combine with declining family size to boost high end real estate purchases.

See also:

  1. Lewis and Einhorn: repairing the financial world
  2. The role of the deadbeats
  3. Complexity collapse
  4. Disintermediating Wall Street
  5. The future of the publicly traded company
  6. Marked!
  7. Mass disability and income skew
  8. The occult inflation of shrinking quality
  9. GD II: How great is global idle capacity

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