Kevin Drum

Bubbles and Public Facts

| Mon May 2, 2011 7:45 PM EDT

After the Great Collapse of 2008 it became common to assign part of the blame to the increasing opacity of the modern financial system. By the middle of the last decade, wholesale funding had transitioned to a shadow banking system that was unregulated and nearly impossible to measure. The mortgage industry had stopped asking borrowers for documentation of creditworthiness, which made the value of mortgage portfolios more guessing game than anything else. CDOs and other credit derivatives became so complicated and self-referential that only a computer model could begin to make sense of them. High-frequency trading swapped human analysis and intuition for automated algorithms that worked at sub-microsecond speeds. The result was a financial system so Byzantine that no one truly understood the underlying value of the securities they held. Thus, when the downturn came, it wasn't enough to try to dump only specific kinds of assets. Since worthless securities could be hiding in the fine print of nearly anything — or in nearly any institution — panicked investors had no choice but to sell everything. A housing bubble that might have been painful but still manageable became instead a rout of the entire global financial system.

Economist Hernando de Soto puts a different gloss on this in the current issue of Bloomberg Businessweek, suggesting that we've lost the system of "public facts" that was painstakingly built up at the end of the 19th century in order to move finance onto a sounder, more stable footing:

The result was the invention of the first massive "public memory systems" to record and classify—in rule-bound, certified, and publicly accessible registries, titles, balance sheets, and statements of account—all the relevant knowledge available, whether intangible (stocks, commercial paper, deeds, ledgers, contracts, patents, companies, and promissory notes), or tangible (land, buildings, boats, machines, etc.). Knowing who owned and owed, and fixing that information in public records, made it possible for investors to infer value, take risks, and track results. The final product was a revolutionary form of knowledge: "economic facts."

Over the past 20 years, Americans and Europeans have quietly gone about destroying these facts....The results are hardly surprising. In the U.S., trust has broken down between banks and subprime mortgage holders; between foreclosing agents and courts; between banks and their investors—even between banks and other banks.

....Without standardization, the values of assets and relationships are so variable that they can't be used to guarantee credit, to generate mortgages and bundle them into securities, to represent them in shares to raise capital. Nor do they fit the standard slots required to enter global markets. That's why credit crunches and massive unemployment are chronic conditions for most people forced to operate in the informal economy. These are the ones you see protesting in the streets of Arab countries or living in tents surrounding Port-au-Prince. We know only too well that facts don't speak for themselves: They have to be constructed through legal processes and kept transparent. They have to be defended, too.

When then-Treasury Secretary Henry Paulson initiated his Troubled Asset Relief Program (TARP) in September 2008, I assumed the objective was to restore trust in the market by identifying and weeding out the "troubled assets" held by the world's financial institutions. Three weeks later, when I asked American friends why Paulson had switched strategies and was injecting hundreds of billions of dollars into struggling financial institutions, I was told that there were so many idiosyncratic types of paper scattered around the world that no one had any clear idea of how many there were, where they were, how to value them, or who was holding the risk. These securities had slipped outside the recorded memory systems and were no longer easy to connect to the assets from which they had originally been derived. Oh, and their notional value was somewhere between $600 trillion and $700 trillion dollars, 10 times the annual production of the entire world.

In a sense, de Soto isn't saying anything that hasn't been said before: modern financial instruments became so opaque in the runup to the Great Collapse that sensible asset valuation was essentially impossible. But de Soto's historical perspective is an interesting lens to view this through, and it provides him with a nice organizing principle with which to recommend reforms. It's worth a read.

In the end, I don't entirely agree with de Soto that "the recession wasn't about bubbles but about the organization of knowledge." It was about bubbles too, which have plagued us since long before the first CDO was ever invented. Still, the opacity of modern finance surely helped supercharge the housing and credit bubble at the core of the Great Collapse, and the financial reforms that have been passed so far aren't nearly enough to ensure that the same thing won't happen again in the near future. As de Soto says, "Markets were never intended to be anarchic: It has always been government's role to police standards, weights and measures, and records, and not condone legalized sleight of hand in the shadows of the informal economy. To understand and repair one of mankind's greatest achievements—the creation of economic facts through public memory—is the stuff of nation-builders."

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Notes on the Economy

| Mon May 2, 2011 5:48 PM EDT

Today Karl Smith provides several reasons to be optimistic about the trajectory of future growth. There is, he says, still "a huge employment problem that should not be ignored," but even on that front he thinks the recovery of the past year doesn't look too bad. Since I tend to be pretty pessimistic about this stuff, I figure this is worth passing along.

Does Torture Work?

| Mon May 2, 2011 1:08 PM EDT

Tyler Cowen on the news that the intelligence that eventually led to the raid on Osama bin Laden's hideout may have been the result of torturing detainees at Guantanamo:

I have never been pro-Guantánamo, or for that matter pro-torture [], but I am willing to report results which may run counter to my views. The moral and the practical do not always coincide, and perhaps we should be celebrating just a bit less. It is possible this is not a totally “clean” victory on our part.

This is one of the reasons that I think it's important not to put too much emphasis on practical arguments against torture. After all, if the reason you oppose torture is because torture doesn't work, then you'd better be prepared to change your mind if it turns out that torture does work. I'm not willing to do that.

The obvious counterfactual here is that although torture might have produced actionable information that eventually helped locate bin Laden, perhaps we could have gotten the same information another way. And maybe so. But I doubt that this kind of abstract argument has much impact on most people. The fact is that torture probably does work in some cases, and if you oppose it, you need to oppose it even so.

Hard Keynesianism is Hard

| Mon May 2, 2011 12:36 PM EDT

Paul Krugman:

If you’re a serious Keynesian, you’re for maintaining and even increasing spending when the economy is depressed, even though revenue has plunged; but you’re for fiscal restraint when the economy is booming, even though revenue has increased.

In other words, you want to (roughly) balance the budget over the course of an economic cycle, running a surplus during the expansionary phase and a deficit during the recessionary phase.

Obviously there are technical disputes about whether this is the right way to manage the macroeconomy. But in a way, it hardly matters. In the same way that real Christianity is simply too hard for mere mortals to practice (thus the need for a merciful God), so is hard Keynesianism. In the real world, you're just never going to be able to persuade people to demonstrate the fiscal restraint that Keynesianism requires during boom times. And if, in the real world, Keynesianism is too difficult for human beings to practice during the 80% of the economic cycle taken up by expansion, then it's not much good. Economics, after all, doesn't feature a notably merciful God.

I don't know if anyone has ever proposed a feasible way to overcome this problem.

Election Speculation

| Mon May 2, 2011 12:05 PM EDT

So does the killing of Osama bin Laden help Barack Obama's reelection chances? I doubt it. I'm not an economic fundamentalist when it comes to presidential elections — too many people read those economic models and forget the part where the authors explain that their model only explains about two-thirds of the variance — but it's still the case that economic conditions account for most of a president's chances of reelection. What's more, the election is still 18 months away. Even if bin Laden's death could play a role, there's no way it would continue to have much impact a year and a half from now.

But there are at least two ways in which bin Laden's death could still make a difference. First, the quality of opposition matters, and GOP contenders are making their campaign decisions now, not 18 months from now. It's possible that yesterday's news will tip a few high-quality candidates against running in 2012, and this would obviously make Obama's job easier.

The other way it could matter is a bit more subtle: bin Laden's death could, conceivably, lead to changes in U.S. foreign policy that make Obama's reelection more likely. Perhaps we'll now feel free to take a harder line with Pakistan. Perhaps Obama will be more aggressive about drawing down troops in Afghanistan. Perhaps al-Qaeda really will disintegrate somewhat after bin Laden's death and this will lead to further U.S. victories closer to the election.

Obviously this is all very speculative. But I guess that's what blogs are for. So feel free to speculate away in comments.

"Pakistan is the AIG of Nation States."

| Mon May 2, 2011 11:48 AM EDT

Steve Coll on Pakistan's role in keeping Osama bin Laden safe in a suburban mansion for half a decade:

It stretches credulity to think that a mansion of that scale could have been built and occupied by bin Laden for six years without it coming to the attention of anyone in Pakistan’s Army.

The initial circumstantial evidence suggests the opposite is more likely—that bin Laden was effectively being housed under Pakistani state control. Pakistan will deny this, it seems safe to predict, and perhaps no convincing evidence will ever surface to prove the case. If I were a prosecutor at the United States Department of Justice, however, I would be tempted to call a grand jury. 

....Outside of the Justice Department, other sections of the United States government will probably underplay any evidence about culpability by the Pakistani state or sections of the state, such as its intelligence service, I.S.I., in sheltering bin Laden. As ever, there are many other fish to fry in Islamabad and at the Army headquarters in nearby Rawalpindi: An exit strategy from Afghanistan, which requires the greatest possible degree of cooperation from Pakistan that can be attained at a reasonable price; nuclear stability, and so on.

Pakistan’s military and intelligence service takes risks that others would not dare take because Pakistan’s generals believe their nuclear deterrent keeps them safe from regime change of the sort underway in Libya, and because they have discovered over the years that the rest of the world sees them as too big to fail. Unfortunately, they probably are correct in their analysis; some countries, like some investment banks, do pose systemic risks so great that they are too big to fail, and Pakistan is currently the A.I.G. of nation-states. But that should not stop American prosecutors from following the law here as they would whenever any mass killer’s hideout is discovered.

More at the link.

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Pakistan and bin Laden

| Sun May 1, 2011 11:51 PM EDT

So the operation against bin Laden was apparently carried out solely by U.S. forces. Obama called President Zardari after the operation was over. And the best joint statement they could agree on afterward was that this was a "good and historic" day. Is it just me, or does it sound like maybe Pakistan wasn't exactly as thrilled about all this as one might hope?

UPDATE: Steve Clemons provides a different picture that suggests Pakistan was deeply involved in the operation. We'll see.

UPDATE 2: CNN emphasizing that operation was carried out "with the cooperation" of Pakistani government.

FEMA's Ups and Downs

| Sat Apr. 30, 2011 3:28 PM EDT

The New York Times on FEMA's response to the tornadoes that ripped through the South last week:

It has been the deadliest natural disaster on American soil since Hurricane Katrina. But the government response to the tornadoes that devastated the South last week has, at least in the first few days, drawn little of the searing criticism aimed at federal agencies back in 2005.

....FEMA officials contacted the White House about the need for a federal emergency declaration even before Alabama had submitted a formal request that evening, said Art Faulkner, the state’s emergency management director. It was quickly granted....In Alabama, as in other affected states, the Democratic White House was winning early praise from state, local and Congressional leaders of both parties.

Shall we roll the tape? Under Bush Sr., FEMA sucked. Under Clinton, FEMA was rehabilitated and turned into a superstar agency. Under Bush Jr., FEMA sucked again. Under Obama, FEMA's doing great and responding quickly.

I know, I know, we're not supposed to politicize natural disasters. Not when that politicization makes Republicans look bad, anyway. So I'll just let you draw your own conclusions from these four data points. I report, you decide.

The Zero Profit World

| Sat Apr. 30, 2011 11:49 AM EDT

Matt Yglesias:

In a fully competitive market, products should be sold for the marginal cost of producing a unit. And in the software world, the marginal cost of producing a unit is zero. Therefore, in the long run software should be free and nobody should make a profit.

This is an odd use of the word "should," I think. And rather than being an argument for free software1, it's really more of an argument that either (a) economic "efficiency" is overrated or (b) fully competitive markets are overrated. If nobody ever got to make a profit, after all, the world would be a pretty dreary and backward place.

But then, I suppose I'm biased. The marginal cost of producing blog posts is indistinguishable from zero, and I'd just as soon make more than zero dollars producing them. So I'm not really a fan of long run profits trending to zero, even in the nonprofit world.

1For reasons that escape me, this argument is almost always employed as a criticism of industries like software and music that have very low marginal costs. I suspect ulterior motives.

Wedding Day Cat Blogging - 29 April 2011

| Fri Apr. 29, 2011 2:09 PM EDT

So you think the royal wedding has been overexposed? Don't be silly. The overexposure has only barely begun! And today, the cats and I do our part to keep the royal media extravaganza going, with a tsotchke assist from my sister.

On the left, Inkblot is celebrating the great day — and demonstrating his serene confidence in his own masculinity — by wearing a lovely royal tiara. Majestic looking, isn't he? And aside from being made out of plastic, it's just like Kate's! Except for all the parts that aren't. On the right, Domino is royalty percatified, surrounded by my sister's treasures. Unlike Inkblot, who's generally willing to plonk down wherever you put him (for a while, anyway), Domino doesn't really like being told what to do. This meant that her picture took a little while longer to set up. Basically, I had to wait for her to go to sleep somewhere and then start piling stuff up around her. That only worked for a few minutes, but a few minutes was all I needed.

So anyway, happy royal wedding day! It's a bank holiday in Britain, and I declare the rest of the day a cat holiday in America. Go pet a cat!