I had this thought while I was trying to decide whether a huge
Keynesian stimulus will be likely to trigger an unhealthy amount of
inflation (as pre-monetarist Keynesian theory actually suggests).
The major effect that is transforming finance in a fundamental way is de-leveraging. (The major effect that is transforming finance in a cyclical way, on the other hand, is the destruction of bank equity.) By "de-leveraging," I mean the end of financing models based on huge amounts of short-term borrowing, constantly rolled over, at very low interest rates.
A leveraged financial system behaves just like a leveraged physical one: small changes in inputs produce large changes in outputs. (The difference in finance, of course, is that the changes are usually nonlinear.) Leverage is a beautiful thing when you're making money, because you can make more money than would be suggested by the amount of nominal risk you take.
Leverage is an evil thing when you start losing money, because every adverse movement is magnified, and you quickly get into situations where you no longer have freedom over your actions. (Margin calls force you to sell good assets, which means that everything becomes undervalued at once. Across the whole global economy, this is exactly what produces panics, as in 1998 and 2007.)
So you could well argue that financial de-leveraging is ultimately a good thing. It will certainly (and necessarily) produce economic pain, because it means that nominal returns on capital will be lower. (Footnote: I keep talking about "nominal" returns rather than risk-adjusted ones, as a way of acknowledging that high leverage, as practiced in recent years, actually masked rather than reduced overall investment risk, a fact that didn't become evident until 2007.) But if the system is less susceptible to cascades of forced asset sales, that can only make it more stable, and more resilient. It will behave more like markets theoretically behave, discounting available information correctly, rather than exhibiting obviously erroneous undervaluations.
But I'm thinking that rather than allowing the financial world to de-leverage, the response of policy makers around the world has been to pursue desperate measures to keep markets more or less where they are, or at least not to let them fall farther. Obviously, they're responding to the political distress that happens when millions of people see their life savings suddenly sliced in half.
What if there's a law of conservation of leverage? Rather than being based on inexpensive short-term borrowings, the system is now dependent on blanket risk-guarantees by governments and monetary authorities. And the US economy will very soon be getting a great deal of its demand generated by a quite small number of people in the White House and in Congress.
And the biggest overvalued asset class of all, US housing, is stubbornly refusing to lose value because Congress, the Fed, and the FDIC won't let it.
There still is a tremendous amount of leverage in the financial system. It's just moved from one place to another. The leverage is now contained in the fact that decisions made by a very small number of very powerful people will disproportionately affect the system. Small inputs produce large outputs. The fact that these decisions will be made from political rather than economic motivations is hair-raising.
Highly-leveraged nonlinear systems exhibit wild, unpredictable and rapid swings in behavior. The economic projections that are the basis of the stimulus proposals aren't likely to come anywhere near the truth. This year might be as economically dramatic as last year. Welcome to our strange new world.
The major effect that is transforming finance in a fundamental way is de-leveraging. (The major effect that is transforming finance in a cyclical way, on the other hand, is the destruction of bank equity.) By "de-leveraging," I mean the end of financing models based on huge amounts of short-term borrowing, constantly rolled over, at very low interest rates.
A leveraged financial system behaves just like a leveraged physical one: small changes in inputs produce large changes in outputs. (The difference in finance, of course, is that the changes are usually nonlinear.) Leverage is a beautiful thing when you're making money, because you can make more money than would be suggested by the amount of nominal risk you take.
Leverage is an evil thing when you start losing money, because every adverse movement is magnified, and you quickly get into situations where you no longer have freedom over your actions. (Margin calls force you to sell good assets, which means that everything becomes undervalued at once. Across the whole global economy, this is exactly what produces panics, as in 1998 and 2007.)
So you could well argue that financial de-leveraging is ultimately a good thing. It will certainly (and necessarily) produce economic pain, because it means that nominal returns on capital will be lower. (Footnote: I keep talking about "nominal" returns rather than risk-adjusted ones, as a way of acknowledging that high leverage, as practiced in recent years, actually masked rather than reduced overall investment risk, a fact that didn't become evident until 2007.) But if the system is less susceptible to cascades of forced asset sales, that can only make it more stable, and more resilient. It will behave more like markets theoretically behave, discounting available information correctly, rather than exhibiting obviously erroneous undervaluations.
But I'm thinking that rather than allowing the financial world to de-leverage, the response of policy makers around the world has been to pursue desperate measures to keep markets more or less where they are, or at least not to let them fall farther. Obviously, they're responding to the political distress that happens when millions of people see their life savings suddenly sliced in half.
What if there's a law of conservation of leverage? Rather than being based on inexpensive short-term borrowings, the system is now dependent on blanket risk-guarantees by governments and monetary authorities. And the US economy will very soon be getting a great deal of its demand generated by a quite small number of people in the White House and in Congress.
And the biggest overvalued asset class of all, US housing, is stubbornly refusing to lose value because Congress, the Fed, and the FDIC won't let it.
There still is a tremendous amount of leverage in the financial system. It's just moved from one place to another. The leverage is now contained in the fact that decisions made by a very small number of very powerful people will disproportionately affect the system. Small inputs produce large outputs. The fact that these decisions will be made from political rather than economic motivations is hair-raising.
Highly-leveraged nonlinear systems exhibit wild, unpredictable and rapid swings in behavior. The economic projections that are the basis of the stimulus proposals aren't likely to come anywhere near the truth. This year might be as economically dramatic as last year. Welcome to our strange new world.
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