Category Archives: ECONNED

Philip Pilkington: Neoclassical Dogma – : How Economists Rationalise Their Hatred of Free Choice

By Philip Pilkington, a journalist and writer living in Dublin, Ireland

What if all the world’s inside of your head
Just creations of your own?
Your devils and your gods
All the living and the dead
And you’re really all alone?
You can live in this illusion
You can choose to believe
You keep looking but you can’t find the woods
While you’re hiding in the trees
– Nine Inch Nails, Right Where it Belongs

Modern economics purports to be scientific. It is this that lends its practitioners ears all over the world; from the media, from policymakers and from the general public. Yet, at its very heart we find concepts that, having been carried over almost directly from the Christian tradition, are inherently theological. And these concepts have, in a sense, become congealed into an unquestionable dogma.

We’ve all heard it before of course: isn’t neoclassical economics a religion of sorts? I’ve argued here in the past that neoclassical economics is indeed a sort of moral system. But what if there are theological motifs right at the heart of contemporary economic theory? What does this say about its validity and what might this mean in relation to the social status of its practitioners?

Let us turn first to one of the most unusual and oft-cited pieces of contemporary economic doctrine: rational expectations theory.

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Felix Salmon Misreads AAA Bond Demand to Say “Overcaution” Caused Crisis

Lordie, I can’t believe someone who professes to understand markets has written, at length, that caution, no, “excess of overcaution,” was a major contributor to the criss. Or has Felix Salmon been spending too much time with lobbyists from ISDA and SIFMA?

I hate seeming rude, but Felix has a habit of tearing into Gretchen Morgenson for errors much less significant than the one he made in a post today. He wrote, apropos this chart, which comes from FT Alphaville:

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The Sorrow and the Pity of Economists (Like DeLong) Not Learning from Their Mistakes

I hate to seem to be beating up on Brad DeLong. Seriously.

As I’ve said before, he is one of the few economists willing to admit error and not try later to minimize or recant his admission (unlike, say, Greenspan). And he seems genuinely perplexed and remorseful. This puts his heads and shoulders above a lot of his colleagues, at least the sort whose opinion carries weight in policy circles.

Even with DeLong making an earnest effort to figure out why he went wrong, his latest musings, via a Bloomberg op-ed, “Sorrow and Pity of Another Liquidity Trap,” show how hard it is for economist to unlearn what they think they know. And as the great philosopher Will Rogers warned us, “It’s not what you know that gets you in trouble. It’s what you know that ain’t so.”

So it’s important to regard DeLong as an unusually candid mainstream economist, and treat his exposition as reasonably representative if you could somehow get his peers to take a hard, jaundiced look at how wrong they have been of late.

DeLong’s mea culpa is about how he and his colleagues refused to take the idea that the US could fall into a liquidity trap seriously. As an aside, this is already a troubling admission, since many observers, including yours truly, though the Fed was in danger of creating precisely that sort of problem if if dropped the Fed funds rate below 2%. It would leave itself no wriggle room if the crisis continued and it had to lower rates further into the territory where further reductions would not motivate changes in behavior. That’s assuming we were in a “normal” environment. But the big abnormality is that we are in what Richard Koo calls a balance sheet recession. And as we will discuss below, Keynes (and Minsky) had a very keen appreciation of the resulting behavior changes, but those ideas were abandoned by Keynesians (it is key to remember that Keynesianism contains significant distortions and omissions from Keynes’ thinking.

But notice how he starts his piece:

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Bhidé Cites “Rampant, Extensive Criminality” As Proof That Bank Reform Has Gone Down the Wrong Path

I though readers might welcome an antidote from the nonsense that bank industry touts like the Office of the Comptroller of the Currency’s John Walsh routinely puts forth.

I’ve known Amar Bhidé, who is now a professor at Tufts, for thirty years; we both worked on the Citibank account at McKinsey (although never on the same study). He’s long had a reputation for being incredibly smart and iconoclastic.

Amar enjoys annoying people by saying completely commonsensical things that are not acceptable and watching chaos ensue.

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JP Morgan Pays $153.6 Million to Settle SEC Charges on Toxic Magnetar CDO

The SEC announced that JP Morgan has agreed to pay $153.6 million to settle charges related to a $1.1 billion heavily synthetic CDO called Squared which JP Morgan placed in early 2007 and was managed by GSC Partners, a now defunct CDO manager. The SEC has a cute but not all that helpful visual on the site, save it reflects the role of Magnetar as the moving force behind the deal.

Per the SEC’s complaint against JP Morgan, Magnetar provided $8.9 million in equity and shorted $600 million notional, or more than half the face amount of the CDO (this is consistent with our analysis, which had suggested that Magnetar, unlike Paulson, did not take down the full short side of its deals, since it like staying cash flow positive on its investments. The size of its short position was limited by the cash to be thrown off by the equity tranche). And needless to say, this was a CDO squared, meaning a CDO made heavily of junior tranches of other CDOs, so it was a colossally bad deal.

The complaints (one against JP Morgan and the other against GSC employee Edward Steffelin) make clear that the SEC had gotten its hands on some pretty damning e-mails. The core of the allegation against JPM was that all the marketing materials represented that the assets in the CDO were selected by GSC when they were in fact to a significant degree chosen by Magnetar.

Magnetar made clear that it regarded its equity position as “basically nothing” and really wanted to “buy some protection”, meaning get short and that Magnetar was actively involved in choosing the exposures for the deal.

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Mirabile Dictu! SEC Probes Relationship Among Toxic CDO Sponsor Magnetar, Merrill, and CDO Manager

It has taken forever for the SEC to probe the workings the biggest sponsor of toxic CDOs and of course the agency is going after only one highly publicized doggy deal. Nevertheless, the SEC has finally decided to look at the less than arm’s length relationship between the hedge fund Magnetar, whose Constellation program played a central role in blowing up the subprime bubble, and its collateral manager, which in this case a Merrill affiliated firm called NIR. As we will discuss, collateral managers were critical because they effectively served as liability shields for the other participants.

Note that Magnetar does not appear to be the target; the Financial Times reports that the SEC is examining how the deal’s underwriter Merrill sold the deal and how it worked with NIR.

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Stephanie Kelton: What Happens When the Government Tightens its Belt?

Yves here. This post is certain to annoy some readers. Note that Kelton does not address under what circumstances it is desirable to have the government run a surplus versus a deficit, merely what the implications are. Bill MItchell is rather forceful on this matter:

The US press was awash with claims over the weekend that the US was “living beyond” its “means” and that “will not be viable for a whole lot longer”. One senior US central banker claimed that the way to resolve the sluggish growth was to increase interest rates to ensure people would save. Funny, the same person also wants fiscal policy to contract. Another fiscal contraction expansion zealot. Pity it only kills growth. Another commentator – chose, lazily – to be the mouthpiece for the conservative lobby and wrote a book review that focused on the scary and exploding public debt levels. Apparently, this public debt tells us that the US is living beyond its means. Well, when I look at the data I see around 16 per cent of available labour idle in the US and capacity utilisation rates that are still very low. That tells me that there is a lot of “means” available to be called into production to generate incomes and prosperity. A national government doesn’t really have any “means”. It needs to spend to get hold off the means (production resources). Given the idle labour and low capacity utilisation rates the government in the US is clearly not spending enough. The US is currently living well below its means. But the US government can always buy any “means” that are available for sale in US dollars and if there is insufficient demand for these resources emanating from the non-government sector then the US government can bring those idle “means” into productive use any time it chooses.

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UBS’s Magnus Warns of Risk of Chinese Minsky Moment

UBS strategist George Magnus helped popularize economist Hyman Minsky’s thinking in the runup to the financial crisis by warning of the likelihood of a “Minsky moment.” For those not familiar with Minsky’s work, a short overview from ECONNED:

Hyman Minsky, an economist at Washington University, observed [that] periods of stability actually produce instability. Economic growth and low defaults lead to greater confidence and, with it, lax lending.

In early stages of the economic cycle, thanks to fresh memories of tough times and defaults, lenders are stringent. Most borrowers can pay interest and repay the loan balance (principal) when it comes due. But even in those times, some debtors are what Minsky calls “speculative units” who cannot repay principal. They need to borrow again when their current loan matures, which makes
them hostage to market conditions when they need to roll their obligation. Minsky created a third category, “Ponzi units,” which can’t even cover the interest, but keep things going by selling assets and/or borrowing more and using the proceeds to pay the initial lender. Minsky’s observation:

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Magnetar Strikes Again: JP Morgan Negotiating Settlement with SEC on Toxic CDO

As longstanding readers of this blog presumably know, we broke the story of Magnetar, a Chicago-based hedge fund. Magnetar was arguably the biggest player in driving toxic subprime demand through its program of creating hybrid CDOs (largely consisting of credit default swaps, but also including cash bonds by design).

Magnetar constructed a strategy that was a trader’s wet dream, enabling it to show a thin profit even as it amassed ever larger short bets (the cost of maintaining the position was a vexing problem for all the other shorts, from John Paulson on down) and profit impressively when the market finally imploded. Both market participant estimates and repeated, conservative analyses indicate that Magnetar’s CDO program drove the demand for between 35% and 60% of toxic subprime bond demand. And this trade was lauded and copied by proprietary trading desks in 2006.

As a source who worked in the structured credit area of a firm that did Magnetar trades explained in ECONNED:

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OMG, Greenspan Claims Financial Rent Seeking Promotes Prosperity!

I was already mundo unhappy with an Alan Greenspan op-ed in the Financial Times, which takes issue with Dodd Frank for ultimately one and only one disingenuous and boneheaded reason: interfering with the rent seeking of the financial sector is a Bad Idea. It might lead those wonderful financial firms to go overseas! US companies and investors might not be able to get their debt fix as regularly or in an many convenient colors and flavors as they’ve become accustomed to! But the Maestro managed to outdo himself in the category of tarting up the destructive behaviors of our new financial overlords.

What about those regulators? Never never can they keep up with those clever bankers. Greenspan airbrushes out the fact that he is the single person most responsible for the need for massive catch-up. Not only due was he actively hostile to supervision (and if you breed for incompetence, you are certain to get it), but he also gave banks a green light to go hog wild in derivatives land. And on top of that, he allowed banks to develop their own risk models and metrics, which also insured the regulators would not be able to oversee effectively (there would be a completely different attitude and level of understanding if the regulators had adopted the posture that they weren’t going to approve new products unless they understood them and could also model the exposures).

And the most important omission is that the we just had a global economic near-death experience thanks to the recklessness of the financial best and brightest.

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The Stigmatization of the Unemployed

One thing I have never understood in America is the way that people who lose their jobs become pariahs in the job market. We’ve now had a spate of commentary on the fact that official unemployment figures are looking a tad less dreadful by dint of the fact that increasing numbers of the long term unemployed have dropped out of the job market entirely. Even the conservative Washington Post woke up last week, Rip Van Winkle like, to take note of the growing number of long-term unemployed. Bizarrely, or perhaps as a fit illustration of the spirit of the day, the article was titled: “Hidden workforce challenges domestic economic recovery.” In other words, they are Bad People because if the economy ever picks up, they might come out of the woodwork and start looking for jobs!

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Shades of 2007: Synthetic Junk Bonds

Aha, the level of financial innovation spurred by super low interest rates is starting to have that “I love the smell of napalm in the morning” feel to it.

The Financial Times reports that there is a frenzy to create synthetic junk bonds, ostensibly to satisfy the desire of yield-hungry investors. Any time you see a lot of long money flowing into synthetic assets rather than real economy uses, it’s a sign that Keynes’ casino is open for business (“When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”)

The author compare this development to that of the asset backed securities CDO market, one of our betes noirs which blew up spectacularly in the crisis. There are some similarities and differences.

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A Straightforward Criminal Case Against Wall Street CEOs and Senior Executives

Various people who ought to know better, such as the New York Times’ Joe Nocera, haven taken to playing up the party line of the banking industry and I am told, the SEC, that we should resign ourselves to letting senior financial services industry members get away with having looted their firms and leaving the rest of us with a very large bill.

It is one thing to point out a sorry reality, that the rich and powerful often get away with abuses while ordinary citizens seldom do. It’s quite another to present it as inevitable. It would be far more productive to isolate what are the key failings in our legal, prosecutorial, and regulatory regime are and demand changes.

The fact that financial fraud cases are often difficult does not mean they are unwinnable. And a prosecutor does not need to prevail in all, or even most, to serve as an effective cop on the beat.

Contrary to prevailing propaganda, there is a fairly straightforward case that could be launched against the CEOs and CFOs of pretty much every US bank with major trading operations.

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Michael Lewis: Will Defamation Charges by His “Big Short” Villain Stick?

One of the dangers of framing stories as Manichean tales is the purported bad guys can take offense and try to get even. And if you do it in a book, the threshold for liability is low enough that they might indeed be able to inflict some real pain.

Michael Lewis, author of the bestseller The Big Short, along with his publisher, W.W. Norton and his source Steve Eisman, were sued today in Federal court for defamation by one Wing Chau. In case you are one of the five people in America who is interested in finance but has managed not to read The Big Short, there is a scene in the book in which FrontPoint’s Eisman, who is Lewis’ main subprime short hero, has asked to meet someone who is on the other side of his trade. That “someone” is a CDO which in practical terms means a CDO manager. Eisman and two of his employees have dinner with Wing Chau, who is the head of the CDO manager Harding. Needless to say, Lewis’ account makes it clear that he regards Chau as very much part of the problem.

Now we’ve written a LOT about CDOs; in fact, our book ECONNED broke the story of Magnetar and demonstrated how its CDO program, which it used to establish a risk-free short position, drove the demand for a large portion of the subprime market in the toxic phase. And we have taken issue with Lewis’ characterization of the shorts as heros.; Knowingly or not, the strategy that reaped them billions also distorted normal market pricing signals on a massive scale, not only allowing the subprime mania to continue well beyond its sell-by date but also by actively promoting the creation of the “spreadiest” or very worst mortgages.

Our reading of Lewis’ plight is that Chau’s claims seem to be a stretch, given that the facts are less on his side than a reading of his suit might suggest. But as we will discuss later on, litigation on books is so plaintiff friendly that even a weak claim can succeed in court.

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Another Reminder That Crime Pays: No Charges Filed Against Countrywide’s Mozilo

The New York Times’ Gretchen Morgenson dutifully tells us, based on a Los Angeles Times sighting, that federal prosecutors will not be filing charges against the Tanned One, Angelo Mozilo of Countrywide. This follows the failure of investigations to lead to a criminal prosecution of another major perp in the financial crisis, one Joseph Cassano, the head of AIG’s Financial Products unit.

There has been far too little discussion of why no legal action has been taken.

Readers can no doubt come up with additional reasons, but I see at least two.

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