Impossible Conversations

Christmas dinner is coming, and that’s when, after you’ve all stuffed yourselves, the talk turns to politics. And it will be how Obama is ruining America – because he hates America, or at least he hates hard-working successful white folks – black folks are like that for no reason at all – and of course he’s not really an American and so forth. And there’ll be talk of how it will be a Palin-Beck ticket in 2012 – and they’ll win handily, because everyone is so fed up with the guy, which is too bad because Christine O’Donnell should be the next president, really. And there will talk of how there should be no gays in the military, and maybe there should be no one in the military who’s not a Christian, and a real Christian, not a fake one like those Mormons and Catholics – and no Hispanics, they’re all gang guys with hairnets and tattoos, and maybe no blacks, as they’re all hip-hop thugs, save for the Colin Powell fellow, the wimp who deep down didn’t think our war in Iraq was going to end well. And mixed in with that will be talk of illegal immigrants taking over everything, and the economic talk – it’s time for austerity and shutting down everything, to reduce the deficit and incur no more debt, and that means ending Medicare and Social Security and all unemployment safety nets. People need to take personal responsibility. The government has to show some tough love – no one gets anything. You do it on your own, all of it – and you’ve got your gun, or guns, to make sure no one messes with you. And no one has the right to take your stuff.

And that’s just part of it – you could add the threat of One World Government and those black helicopters full of UN troops coming to enslave us all, or add whatever you will – FDR actually caused the Great Depression or Lincoln just didn’t understand that the slaves in the Old South loved their colorful ways and had been quite happy. The list goes on and on, and everyone knows that conversation is going to happen. And, because perhaps every family in America has one token liberal on hand, once or twice a year, someone is going to be uncomfortable. But that comes with the territory. It’s best to pretend that you’re interested, if not a bit fascinated.

And it’s Christmas. Why not be generous? See Kevin Drum:

Every once in a while I feel like I’ve succumbed to partisan madness and need to back off and assume a bit more good faith and sincerity from thinkers and activists on the other side. I need to treat conservative arguments with a little more respect and a little more generosity.

But then he reads a story like this one telling him that the four Republican members of the Financial Crisis Inquiry Commission have refused to agree to a bipartisan final report and will instead issue their own minority report:

During a private commission meeting last week, all four Republicans voted in favor of banning the phrases “Wall Street” and “shadow banking” and the words “interconnection” and “deregulation” from the panel’s final report, according to a person familiar with the matter and confirmed by Brooksley E. Born, one of the six commissioners who voted against the proposal.

Drum’s first reaction is this:

I don’t even know what to say about this. I could write a hundred words about it or a thousand. But what’s the point of pretending to take this stuff seriously? They’re not, after all.

And his second reaction is this:

Let’s take those phrases one by one.

I could live without Wall Street. We can just call it the finance industry instead. That works fine and spares delicate sensibilities. I could even, at a stretch, live without deregulation. You have to talk about prudential regulation and leverage rules somehow, but maybe there’s a way to do it without actually using that word. It’s a stretch, but maybe.

But interconnection and shadow banking? It’s just literally impossible to usefully discuss the financial crisis without mentioning those things. They’re absolutely central to the whole story, and I don’t even know what kinds of words you could replace them with. It’s like writing about the New Testament without mentioning Jesus. I guess you could do it, but what’s the point?

It’s hard to be generous with such stuff, and in parallel Duncan Black adds this:

I really can’t comprehend that with 9.6% unemployment politicians keep talking about the deficit as if it’s the big problem.

And Matthew Yglesias agrees:

Of course he’s right. The deficit is a problem only in the sense that the short-term deficit is currently too small. But this is one reason I’m surprised so many liberals are being so stingy in their praise of the recent tax deal. We’d just all been spending 12 months arguing that contrary to the conventional wisdom, short-term deficits should be smaller. We also spent a lot of time observing that conservative deficit-talk is fraudulent and all they care about is tax cuts for the rich. Then the Obama administration, after a year of fruitless austerity gambits, finally called their bluff. “Fine, you can have your deficit-increasing tax cut extension, but give me some other deficit-increasing stuff that my economists say has a higher multiplier than your tax cuts for the rich.” Now the deal is done, and for all the panels and commissions and all the money Pete Peterson’s spent the parties are coming together to make the deficit bigger.

Which is as it should be.

And Larry Summers explained that in his farewell talk:

Even with all the fiscal measures of the last several years, total borrowing in the American economy has failed to grow for the last two years. That is the first two-year period since the Second World War when total borrowing in the U.S. economy has not increased.

Let me be clear: Even with our deficits, the amount of extra debt is less than the amount of reduced borrowing in the private sector. Increased federal borrowing has offset, but only partially, deleveraging in the private sector.

Let’s see. The private sector is sitting on billions is cash – scared there is no demand – and thus will do nothing, and spend nothing and lend nothing and borrow nothing, and things stop. We added debt to grease the wheels, and restore demand, but not very much debt at all. What’s the problem? Do you want the economy to collapse?

No, don’t answer that. At Thanksgiving dinner that came up – and the answer was yes. Economic collapse would purge the system of the riff-raff and we could start again with only the worthy left standing. And that would be the rich. It’s a bit Darwinian – survival of the fittest. One might call them the master race, were it not someone else used those words long ago and ruined them for the Tea Party crowd. Oh well.

But that raises the other issue that is sure to come up around the table as Christmas dinner winds down – income inequality. You’ll be told that massive income inequality is no big deal – the rich earned it all and they should get to it all. Fair is fair.

But Tyler Cowen has a major piece about income inequality in The American Interest that looks at that in a lot more detail:

Does growing wealth and income inequality in the United States presage the downfall of the American republic? Will we evolve into a new Gilded Age plutocracy, irrevocably split between the competing interests of rich and poor? Or is growing inequality a mere bump in the road, a statistical blip along the path to greater wealth for virtually every American? Or is income inequality partially desirable, reflecting the greater productivity of society’s stars?

There is plenty of speculation on these possibilities, but a lot of it has been aimed at elevating one political agenda over another rather than elevating our understanding. As a result, there’s more confusion about this issue than just about any other in contemporary American political discourse. The reality is that most of the worries about income inequality are bogus, but some are probably better grounded and even more serious than even many of their heralds realize.

And then he gets down in the weeds and offers this:

The inequality of personal well-being is sharply down over the past hundred years and perhaps over the past twenty years as well. Bill Gates is much, much richer than I am, yet it is not obvious that he is much happier if, indeed, he is happier at all. I have access to penicillin, air travel, good cheap food, the Internet and virtually all of the technical innovations that Gates does. Like the vast majority of Americans, I have access to some important new pharmaceuticals, such as statins to protect against heart disease. To be sure, Gates receives the very best care from the world’s top doctors, but our health outcomes are in the same ballpark. I don’t have a private jet or take luxury vacations, and – I think it is fair to say – my house is much smaller than his. I can’t meet with the world’s elite on demand. Still, by broad historical standards, what I share with Bill Gates is far more significant than what I don’t share with him.

And James Joyner joins in:

While there’s simply no doubt that being wealthy – or even in the comfortable professional upper middle class – allows parents to confer untold advantages to their children, the differences between the well off and the fabulously rich are relatively modest. Going from making $30,000 to $60,000 in annual salary makes a profound difference. Doubling it again to $120,000 makes less difference in day-to-day lifestyle but does make nice vacations, private school for the kids, and other luxuries more easily affordable. Doubling it again to $240,000 may mean a second home and a fancier lifestyle.

But at some point it’s meaningless. Is Bill Gates living more lavishly than Tiger Woods?

But Ross Douthat at the New York Times argues that this misses the point:

Tyler Cowen’s essay in the latest American Interest is nominally about income inequality, but really it’s about the pernicious role that big finance plays in modern political economy. Cowen isn’t worried about inequality per se, but he is worried about the forces that give rise to it, and specifically the boom-bust cycle of Wall Street investment – and more specifically still, the way the “bust” part of the cycle tends to make taxpayers suffer more than the Wall Street investors themselves, thus incentivizing further recklessness and still worse crack-ups down the road.

Cowen does say this:

If we are looking for objectionable problems in the top one percent of income earners, much of it boils down to finance and activities related to financial markets … The first factor driving high returns is sometimes called by practitioners “going short on volatility.” Sometimes it is called “negative skewness.” In plain English, this means that some investors opt for a strategy of betting against big, unexpected moves in market prices. Most of the time investors will do well by this strategy, since big, unexpected moves are outliers by definition. Traders will earn above-average returns in good times. In bad times they won’t suffer fully when catastrophic returns come in, as sooner or later is bound to happen, because the downside of these bets is partly socialized onto the Treasury, the Federal Reserve and, of course, the taxpayers and the unemployed.

But Cowen says it is hard to see how anything can be done about this:

There are more ways for banks to take risks than even knowledgeable regulators can possibly control; it just isn’t that easy to oversee a balance sheet with hundreds of billions of dollars on it, especially when short-term positions are wound down before quarterly inspections. It’s also not clear how well regulators can identify risky assets. Some of the worst excesses of the financial crisis were grounded in mortgage-backed assets – a very traditional function of banks – not exotic derivatives trading strategies. Virtually any asset position can be used to bet long odds, one way or another. It is naive to think that underpaid, undertrained regulators can keep up with financial traders, especially when the latter stand to earn billions by circumventing the intent of regulations while remaining within the letter of the law.

So here we are:

For the time being, we need to accept the possibility that the financial sector has learned how to game the American (and UK-based) system of state capitalism. It’s no longer obvious that the system is stable at a macro level, and extreme income inequality at the top has been one result of that imbalance. Income inequality is a symptom, however, rather than a cause of the real problem. The root cause of income inequality, viewed in the most general terms, is extreme human ingenuity, albeit of a perverse kind. That is why it is so hard to control.

And Douthat adds this – “I’m a pessimistic sort, so this seems all-too-plausible.”

But Kevin Drum raises a question that is rather central here. Why do financial professionals make so damn much money?

The answer, of course, is that they work in an industry that’s become ungodly profitable. But how? Tyler attributes it to the practice of “going short on volatility.” That is, modern finance professionals mostly gamble that what happened in the past will keep happening in the future, and disasters will never happen. In most years this makes them a lot of money (because, in fact, disasters rarely happen).

But this is mysterious. After all, not everyone is going short on volatility. In fact, by definition, only half of the punters on Wall Street are doing it. The other half is taking the other side of the bet. Tyler explains this with an analogy to a bet that the Washington Wizards, one of the worst teams in basketball, won’t win the NBA championship. If you make that bet year after year, you’ll keep making money year after year.

This is a useful analogy precisely because it wouldn’t work. After all, to make that bet, you have to find someone willing to take the other side and bet that disaster will strike and the Wizards will win. But they know just how unlikely that is, so they’re going to require very long odds. On a hundred dollar bet, they’ll want $100 if they win but will only be willing to pay off one dollar if you win. That won’t make you rich.

So the real question is how you can make money doing this, but that’s not so mysterious:

Answer: find someone who doesn’t know much about basketball and pays off two dollars on this bet instead of one. Additionally, you need to borrow money so you can make lots of bets. So instead of placing a $100 bet and making a dollar, you borrow a million dollars, make lots of bets on lots of teams, and make $20,000. It’s the road to riches.

The questions this raises should be obvious. First, why would anyone be dumb enough to offer you such mistaken odds? Second, shouldn’t the interest on the loan wipe out the profit from such a tiny betting margin? Third, why would anyone loan you this money in the first place, knowing that you have no chance of paying it back if disaster strikes, one of your teams wins, and you lose your entire stake?

As near as I can tell, the answer to #1 is that Wall Street traders are bad at pricing tail risk. The answer to #2 is that Wall Street hedge funds, using techniques pioneered in the mid-90s by Long Term Capital Management, have figured out ways to borrow large sums of money at virtually no cost. And the answer to #3 is that Wall Street lenders are also bad at pricing tail risk.

But they may not be:

Tyler argues that, in fact, both sides are betting that as long as everyone is doing this, the occasional disasters will be so epically disastrous that central banks will bail them out. They have no choice, after all, if the alternative is the destruction of the global economic system. So the tail risk is smaller than you think. Borrowers will make money in good years and default in bad years. Lenders, meanwhile, will also make money in good years, secure in the knowledge that on the rare occasions when everything goes pear-shaped and borrowers can’t pay back their loans, the government will make them whole. As Tyler reminds us, “Neither the Treasury nor the Fed allowed creditors to take any losses from the collapse of the major banks during the financial crisis.”

But Drum doesn’t find that persuasive as a behavioral explanation:

The problem is that there’s simply no evidence I’m aware of that Wall Street executives ever thought about this or priced it into their models. Sure, they may have been reckless or stupid. However, they weren’t setting prices for financial instruments based on the idea that, yes, they were taking a genuine risk of going bust, but they could price that away because they’d get bailed out by Uncle Sugar when it happened. Rather, they really, truly, believed that they weren’t exposed to very much risk. As near as I can tell, this was true on both the buy side and the sell side.

Tyler’s story of private gains and socialized losses is surely true as an explanation for how the finance industry stayed highly profitable even while undergoing an epic meltdown. But I’m not sure it adequately explains why the industry became so stratospherically profitable before the meltdown. Because the problem in the pre-meltdown era wasn’t that banks were taking on more and more risk, the problem was increased leverage and mispriced risk.

But Drum says this has always been one of the central mysteries of modern finance:

Why is it so damn profitable? We’re talking about an industry that’s global, largely commoditized, and highly competitive. Profits should have been under extreme pressure for the past few decades. And yet, somehow, just the opposite was true. Against all theory, banks were able to consistently charge excessive prices; consistently take the better side of financial bets; and consistently persuade every other actor in the business that mispriced risk was, in fact, correctly priced. The result has been wild profitability and huge bonuses.

And in the end all this financial engineering was based on skimming money away from everyone else. And THAT is mysterious:

The incomes of the vast middle class have lagged productivity growth by a small amount each year, and that small amount has accumulated into a gigantic pool of cash that gets funneled to a tiny number of the super rich, many of them in the finance industry.

But how? There’s still a mystery here that no one has ever adequately explained. But it’s important. As I’ve mentioned before, the primary metric for determining if financial reform is effective is the profitability of the financial industry. If it goes down a lot – by about half, I’d say – then it will have been successful. If not, then not. So far, the signs don’t look good.

Yes, he just said the way to tell if we’re on the right track is when we see the profitability of the financial industry drop by half. One smells class warfare in the air.

Well, that’s something to talk about over coffee after Christmas dinner. Forget gays in the military and Mexicans hanging around in front of Home Depot. What about these guys who make absurd sums by making nutty bets, and lying about what they’re peddling, and then when the bets go sour, turn to us to bail them out, because we have no choice, after all, if the alternative is the destruction of the global economic system. It’s a neat trick.

Ah, that will be deflected. The discussion will be about the latest episode of Sarah Palin’s Alaska, and which new species she killed with her bare hands this week. It’s best to pretend that you’re interested, if not a bit fascinated – and then just fade out. Let it be. There may be no answer to any of this.


About Alan

The editor is a former systems manager for a large California-based HMO, and a former senior systems manager for Northrop, Hughes-Raytheon, Computer Sciences Corporation, Perot Systems and other such organizations. One position was managing the financial and payroll systems for a large hospital chain. And somewhere in there was a two-year stint in Canada running the systems shop at a General Motors locomotive factory - in London, Ontario. That explains Canadian matters scattered through these pages. Otherwise, think large-scale HR, payroll, financial and manufacturing systems. A résumé is available if you wish. The editor has a graduate degree in Eighteenth-Century British Literature from Duke University where he was a National Woodrow Wilson Fellow, and taught English and music in upstate New York in the seventies, and then in the early eighties moved to California and left teaching. The editor currently resides in Hollywood California, a block north of the Sunset Strip.
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