Gillian Tett: "Where is Gordon Gekko when you really need him?"???

Full disclosure: I am normally a fan of the Financial Times’ Gillian Tett, but her latest piece reveals she has been co-opted by the industry she covers.

While there are matters of substance I take issue with (we’ll get to those soon), the whopper is the positioning. How can Tett possibly depict Gordon Gekko as a model of any sort of remotely desirable behavior?

For those who never saw or have largely forgotten the movie Wall Street, Gekko is a crook. He engages in market manipulation and invests on inside information. His “Greed is good” speech is based on a lecture given by another criminal, convicted risk arb Ivan Boesky.

So Tett starts the piece by saying the markets need more marauding miscreants. Lovely.

Her point is that risk capital has dried up, and provides examples:

But some recent anecdotes are chilling. Last week, for example, a group of senior hedge fund players and chief investment officers gathered in Dublin – and collectively guessed that about 80 per cent of the risk capital that was sitting in the European system a year ago has disappeared….

What is even more dramatic – but less visible – is the disappearance of banks’ proprietary trading desks… traders in London say there is really only one bank in Europe which is even pretending to run an active prop desk now – namely Goldman Sachs. As a result, billions of dollars of risk-taking capital is believed to have quietly vanished.

That has had all manner of extraordinary consequences. Two years ago, a host of hedge funds and prop desks in London were building up their distressed debt-trading teams to take advantage of a future turn in the credit cycle. Logic might suggest such funds should be wildly busy right now, swooping in to buy distressed companies, or securities. Nothing could be further from the truth. As banks have slashed their risk-taking operations, they have also cut their distressed prop desks, and most have stopped making markets in distressed products. Hedge funds dealing with distressed assets have also folded, unable to raise funds.

As a result, there is a dire shortage of capital to organise – or fund – even “simple” restructurings of companies, distressed investment entities or anything else. Hence the gridlock on dealing with toxic assets.

But not just credit assets are being hit. As asset managers hunt for places to put their cash away from the carnage of the credit or property world, some have been tempted by the world of small-cap equities. But trading in small caps can only take place with market makers – and right now, banks are not just cutting prop desks but market making activity too. As a result, fund managers are sitting on their hands. “We would love to buy small caps but we just cannot tolerate the liquidity risk,” explains one large asset manager. “Almost any sector which needs marketmakers is half-dead.” Logic would suggest that eventually this pattern should change. After all, oodles of cash remain in the system. That cannot all stay in government bonds for ever, least of all in a world where the Fed is busy intervening in such a dramatic fashion to suppress yields.

What is wrongheaded about this is the assumption that hedge funds and proprietary trading desks are necessary and desirable sources of “risk capital”. In my view, their wild unsuitability for this role (save as arbitrageurs) is part of why we got in the mess we are in.

Until the recent, explosive growth of hedge funds, the folks who stepped in during down cycles were typically substantial individual financiers and investment-oriented families. It wasn’t hedge funds or proprietary trading desks that hoovered up the bad assets in the savings & loan crisis. Hedge funds were few and primarily global macro players; proprietary trading back then were small by today’s standards and would never have looked at taking assets that were illiquid.

Tett is failing for the same flawed thinking that bedevils many experts and commentators. They keep seeing a restoration of status quo ante (n a somewhat cleaned up and tamed form) as the best solution for our mess. Most expedient, maybe, but remedies like that have high odds of getting us quickly back in trouble.

All the players that Tett mentions have fatally flawed incentives. It’s the OPM (Other People’s Money), heads I win, tails you lose syndrome. Distressed investors in days of yore played substantially, if not entirely, with their own money (they might organize a syndicate, but they would act as lead investor, and would not take a huge promote).

In fact, hedge funds are wildly unsuited to be risk players except in the short term. Remember, they report results monthly to investors. I’ve spoken to hedgies, for instance, who have a very clear view of a market trend over the next say, nine to twelve months, and they often won’t play it (or will play it in smaller size than they would if it was their money) because they might show more than they’d like in interim losses. But waiting means they might miss the trade entirely.

Tett’s point on market making is fair but also misleading. A sudden drop in both number of market makers and the risk appetite of the ones that remain is a standard feature of markets adverse enough that many of the major firms have taken hits., such as the year after the Asian crisis (just about everyone, particularly Goldman, took big bond market losses). Spreads were elevated for a full year after the 1998 LTCM collapse, a casualty of the crisis.

Floyd Norris put the question better:

Where is the next J. P. Morgan?

In times of market crisis, the safest course for any one market participant may be the riskiest course for the entire market. If everyone wants to sell, prices can go in only one direction.

In past financial crises, it has fallen to someone — regulators, investment banks or even a single banker — to organize collective action and avert disaster.

Such moves involved persuading people to take steps that seemed to go against their own private interests. …

In 1907, Morgan demanded that presidents of New York trust companies — then a type of second-class bank — act together to save one of their own, the Trust Company of America, from a bank run.

The presidents, wrote Robert F. Bruner and Sean D. Carr in their book, “The Panic of 1907,” were “convinced that it was their primary responsibility to conserve their assets in order to survive the financial storm that was swirling around them.” Morgan said that would simply assure that all would fail, one by one.

Morgan, then the dominant figure in American finance, called the presidents to a Saturday meeting in his library — and locked the door. Not until dawn Sunday did he let them out, after they had committed the needed cash….

Mr. Bruner and Mr. Carr hailed Morgan’s actions, as well as the Fed’s 1998 move to salvage the [LTCM hedge fund. But they warned, presciently as it turned out, that the current environment might hamper similar efforts in a new crisis.

“In a globally complex financial system, will such collective action be possible if the crisis is triggered beyond the reach of any of today’s regulators?” they asked.

Even though one can argue, correctly, that JP Morgan was far from a paragon of virtue, he is a more estimable figure than modern Masters of the Universe. Morgan and his contemporaries had a sense of noblesse oblige and recognized that they needed to consider the broader social and institutional fabric along with their own interests. Indeed, Morgan, contrary to Gekko, backed men who understood the importance of good conduct :

One of the most famous exchanges in the history of finance took place almost a century ago on Capitol Hill. An aging J.P. Morgan, the most powerful financier in the world and America’s unofficial central banker, testified before a House committee investigating the tangled web of financial interests that dominated the economy of the emerging industrial nation. Morgan’s inquisitor was Samuel Untermyer, a tough corporate lawyer.

Untermyer: “Is not commercial credit based primarily upon money or property?”
Morgan: “No sir. The first thing is character.”
Untermyer: “Before money or property?”
Morgan: “Before money or property or anything else. Money cannot buy it…because a man I do not trust could not get money from me on all the bonds in Christendom.”

So for someone as smart and savvy as Tett to be invoking Gekko types as possible saviors points to the absence of alternatives. This is a variant on George Akerlof market for lemons. It became more attractive for financial experts to operate on an OPM basis, since they could both earn more and shift risk to investors. But now that investors realize that they have been had, and that it is difficult to tell good actors from bad. According to Akelof, the equilibrium is a no-trade market, and that appears to be where we are headed.

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  1. Anonymous

    I enjoyed reading this work. But I also prefer material where the broader historical reference frame is illuminated.

  2. Anonymous

    I believe G. Tett earlier peace is
    more insightful. When there were too much entitlement and crookery, character just can't make it.

    When 9/11 finished the way it did, insightful commentators knew the day the real World trade centers (USA) collapse wouldn't be far away, but strangly Lehman, AIG … all finished in the week between Sept 11 and 18, 2008. 7 years after 9/11/01. And 7 hours after WTC1&2 collapsed, WTC7 imploded in 7 seconds.

    Insight: The financial world is stumbling blindly
    By Gillian Tett
    Published: March 5 2009 16:31 | Last updated: March 5 2009 16:31
    This month, Sergei Polonsky, one of Russia’s largest and most indebted property developers, is trying to prevent powerful western banks from calling in their loans.

    But as his company, Mirax, battles on, he admits he is in a cognitive fog. “Frankly, everything is uncertain right now,” he told a gathering of bankers, business leaders and policymakers that I attended in Moscow this week. “We don’t know whether to cut any contracts in roubles or dollars, or something else. We don’t know what prices for anything will be, what demand will be, what our market will look like.”

    It is a comment that reveals much about the way that finance is developing right now. In the past few weeks, policymakers and investors have scurried to make sense of the sharp decline in global economic activity.

    In part, this can be blamed on a contraction in credit as banks get tough with their creditors. But the sheer speed of this slump and the fact it is occurring with surprising global synchronicity suggest that psychology is also to blame. It is not simply the fact that people are feeling gloomy; the really pernicious issue is extreme uncertainty – on almost every front.

    The type of cognitive fog besetting Polonsky is quietly shared to a greater or lesser degree by millions of other enterprises round the world. And while the Russians are apt to joke that “we have had plenty of practice in our history with uncertainty” the sense of disorientation is a bitter psychological blow to western bankers and businessmen. After all, most of the west has spent the past decade cocooned in a climate so calm it was dubbed the “Great Moderation”.

    In the financial sector, this cognitive fog is manifesting itself in two specific ways. First, the collapse of Lehman Brothers has created an extreme terror about counterparty risk. As fresh writeoffs keep mounting, financiers of almost any stripe are nervous about committing to long-term transactions.

    Second – and equally crucially – financiers are finding it increasingly hard to engage in the market “hedging” strategies they used to employ to mitigate risk. Most notably, in the wake of the Lehman collapse, the pattern of deleveraging and forced sales has been so intense that traditional price relationships have completely broken down, sending trading models haywire. “You just cannot devise any trading strategy now on a concept of a reversion to the mean, and you cannot really hedge,” confesses the head of one large investment bank.

    As the banking sector pulls in its horns, businesses are being tipped into a gruelling hand-to-mouth existence. In truth, plenty of banks are still extending loans and plenty of businesses are still placing orders with each other. But time horizons have collapsed. “Nobody wants to make decisions on anything,” one Swedish businessman told me this week.

    Western governments appear to be fuelling, not removing, this sense of uncertainty. The Lehman collapse has sown a sense of terror about creditors losing money on any bank bonds they hold. The only way truly to remove that terror would be for the government to persuade investors that banks are so healthy they cannot collapse – or promise to protect creditors if they do.

    But while the latter route was employed – to great success – by the Swedish government 17 years ago, it has not been endorsed by Washington yet. Instead, the US (and many European countries) are rolling out piecemeal solutions. Meanwhile, efforts to persuade voters that banks are healthy are failing to convince – mainly because there is still so much uncertainty about asset values.

    So that leaves Mr Polonsky holding his breath. He says a few weeks ago Credit Suisse agreed to restructure part of his company’s debt, and that gets him off the hook. But the ratings agencies remain unsure and two have since downgraded Mirax. What happens next remains anybody’s guess, for Mirax, for Russia – and for the world more widely. No wonder markets are in such turmoil – right now that seems the only rational response to a once-in-a-generation cognitive fog.

  3. Steve Diamond

    The problem that Tett does not want to face is that the reason the money is sitting in Treasuries is because that is the last refuge. The music has stopped in every other sector as a thirty year speculative binge by global capital comes to an end. If you check the US CDS spread it’s clear the music will stop there too soon. The problem is too much money chasing too few good projects. This will take a decade to resolve and that assumes that populist outrage does not gel into something altogether more dangerous.

  4. Anonymous

    Because of the lack of CHARACTER (ie humanistic morals) of the rich and their banking class the rest of the world has stopped participating in the morally corrupt economy. There can’t be price discovery until people believe that rule of law applys to all more or less equitably which it certainly doesn’t currently.

    As I have said before here and elsewhere, the re-regulation of the financial industry needs to occur first to establish a “new” set of rules that all will be held to and then the mess can be cleaned up. I believe that the thinking by many is that if there is no consistent rule of law applied to financial transcations and/or I am not sure that I will come out on top or be treated equitably then I don’t want to participate.

    Unfortunately some of these folks have been down the greedy and corrupt rabbit hole for so long they don’t know how to or otherwise can’t concieve of how to act differently….sad indeed.

    If we can’t admit that deruglation of investment banking has been a disaster and take the steps necessary to abolish it then we will continue to live in world where CHARACTER is only what comes out of the end of a gun.

    I am already against the next war…….


  5. Anonymous

    JP Morgan was one of the original ‘Robber Barons’ during the last vestiges of the age of rule by Kings…it took WW1 to wipe that slate clean. Anybody who thinks that man did anything good for Americans must be mad…just look at the value of the dollar after he and his cartel founded the Federal Reserve….

  6. Yves Smith

    Anon of 1:59 AM,

    With all due respect, I think you are missing the point. There is no question JP Morgan was a controversial figure (look, he was the prime object of Teddy Roosevelt’s trust busting), yet even he put his capital at risk and knocked heads to reverse a crisis. He was more community minded than the banksters of today.

    I also suggest you do more reading on the gold standard. First, most countries on it, save the UK, cheated on the rules. Second, it is well documented that the gold standard forced countries like the US now, that run current account deficits, to resort to deflation (this BTW was the source of William Jennings Bryan’s “cross of gold” speech. It was well understood that the gold standard exacted a high toll on borrowers like small businesses, particularly farmers). Deflation driven recessions are also more severe and often of longer duration than the kind we have in the modern era.

    The cost of a sound currency, meaning no inflation (again, this is well documented) is lower growth.

    Now one can argue that the lack of a disciplining mechanism has led governments to push for levels of growth that are not sustainable, and that has contributed to the crisis. But you didn’t make that argument, and merely saying “mild inflation is bad” doesn’t wash with the pre-modern era evidence.

  7. Swedish Lex

    Yves’ JP Morgan quote reveals the most basic component of a working economy; trust. With trust gone and so little good-will capital left in Washington, if any, one begins to wonder where it all will end.

    The extreme expectations put on one single person (Obama) to (somehow) “fix” the economy (and a dozen other pending disasters) is to me another sign how low U.S. society has come on having a working political and institutional framwork suitable to address these issues in a coherent and just way.

    Both the character Gekko, and (the icon) JP Morgan for that part, would be normal features of the economy of any immature banana republic. But they can not be our role models any more.

  8. Anonymous

    Here is something that I’ve look for an answer by looking around and can’t find them.

    How do they calculate intra-corporation risk? Everybody talk about packaging a risk and clever in house formula that can reduce risk. But ultimately all those products are bought and sold to other companies. Certainly the risk doesn’t go away from the system as the current global crash shows. Accumulating in one company even. (eg. how could they not calculate the probability of AIG’s ability to pay all those swaps and hedges?)

    I mean, shouldn’t they calculate entire system ability to handle risk, if not being able to calculate each individual corporation ability to absorb risk.

    I love to know how those guys in AIG confidently issuing that many contracts, the basic calculation.

  9. M.G.

    I am glad to read the conclusion about the market for lemons. The existance of this kind of market and its effects for credit and banking had been ironically highlighted in my blog. Recently I also go beyond the theory of asymmetric information thinking that actually there was no information at all circulating and both parties in the trades were not actually knowing what they were doing because they were gambling not investing like Gekko.

  10. Anonymous

    this is amazing.

    In early March, after the latest bailout of AIG, Treasury Secretary Timothy Geithner took what seemed to be a thinly veiled shot at the OTS, calling AIG a “huge, complex global insurance company attached to a very complicated investment bank/hedge fund that was allowed to build up without any adult supervision.” But even without that “adult supervision,” AIG might have been OK had it not been for a complete lack of internal controls. For six months before its meltdown, according to insiders, the company had been searching for a full-time chief financial officer and a chief risk-assessment officer, but never got around to hiring either. That meant that the 18th-largest company in the world had no one checking to make sure its balance sheet was safe and no one keeping track of how much cash and assets the firm had on hand. The situation was so bad that when outside consultants were called in a few weeks before the bailout, senior executives were unable to answer even the most basic questions about their company — like, for instance, how much exposure the firm had to the residential-mortgage market.


    no adult supervision whatsoever.

  11. jmk

    thanks Yves and other commentators that have taken the time to highlight the destruction of the trust element – and the urgent need to rebuild this in order for free-market doctrine to get the global economy functioning again

    I have enormous respect G Tett, but I find it offensive that an insider trader that would asset strip companies for a quick turn (admittedly an imaginary character) at the expense of long-term value creation is promoted as a possible saviour.

    too many market participants have focussed to the extreme on the short-term profit motive at the expense of others (ie the rest of society) and have destroyed the trust mechanism requisite for a working financial system

    the OPM perspective plays a huge role here, and I commend Yves’ blog for such insight

  12. jmk

    in reference to the to Anonymous and relating to the costs of a sound currency

    be wary of what how you define a ‘sound’ currency

    in theory, this could apply to a freely convertible currency belonging to an open economy, with anti-inflationary monetary policy and a requisite counter-cyclical fiscal policy – if you do the maths, then of course this could only be a low growth state

  13. dearieme

    “The problem is too much money chasing too few good projects.” Why? Why a shortage of good projects? Two explanations occur to me.
    (1) See the discussion above about physics being “stuck” for decades. Generalise that to the slow pace of innovation in the second half of the 20th century versus the second half of the 19th century versus. Put all the self-regarding bullshit aside and accept that actually we’ve not been all that successful at scientific and technological advances recently. (I even wonder whether that’s to do with the lesser creativity of the US and Japan in the late 20th century versus Germany and the UK in the late 19th? Who knows?)
    (2) The End of Empires – particularly the British one – meant that a huge part of the world is no longer subject to the rule of law and therefore has become a hell of a risky place to invest. This matters particularly when rule-of-law countries like the US are no longer a good spot for investments in the Primary Industries – extractive industries, for instance, all deplete in the end. Perhaps you could add to that point some generalisations about the decline of rule-of-law even in rule-of-law countries. The antics of your corrupt US Congress, or the similarly corrupt EU government, or the Indian government before the recent liberalisation – would be cases in point.

  14. Bob_in_MA

    I get the feeling Norris didn’t read the book. He left out a rather important step in the process. First, Morgan put his best bean counters to the task of ascertaining if Trust Company of America was solvent, and not in the sense of Citi being “solvent”, but truly solvent.

    The answer was yes. The run that had begun was merely based on rumor and the only thing endangering the bank was the run itself. So a public display of faith by the banking community that would cease the run would save the bank. Several less solvent banks had been allowed to fail by that point.

    The bankers at the table did not bail out Trust Company of America a la LTCM, or the TARP program, by buying assets at inflated prices.

  15. Dan Duncan

    That was a good post.

    I think combining Yves’ last paragraph with Steve Diamond’s post at 1:33 am really gets to the heart of the matter.

    Yves writes:

    So for someone as smart and savvy as Tett to be invoking Gekko types as possible saviors points to the absence of alternatives. This is a variant on George Akerlof market for lemons. It became more attractive for financial experts to operate on an OPM basis, since they could both earn more and shift risk to investors. But now that investors realize that they have been had, and that it is difficult to tell good actors from bad. According to Akelof, the equilibrium is a no-trade market, and that appears to be where we are headed.

    And Steve Diamond….

    The problem that Tett does not want to face is that the reason the money is sitting in Treasuries is because that is the last refuge. The music has stopped in every other sector as a thirty year speculative binge by global capital comes to an end. If you check the US CDS spread it’s clear the music will stop there too soon. The problem is too much money chasing too few good projects. This will take a decade to resolve and that assumes that populist outrage does not gel into something altogether more dangerous.

    Sorry to clutter up the comment board with commentary that was easily accessible by simply scrolling up…but that is some good stuff right there. Thank you.

    I would only add that where Yves writes “equilibrium is a no-trade market” …that this statement should segue into Steve’s point, so that it reads— “equilibrium is a ‘Treasuries Only’ Market”.

    If people like Ms. Tett thought the The Great Unwind of speculative carry trades was painful….just wait until they get hit with The Great Safe Haven Treasury Trade Unwind.

  16. Anonymous

    Gekko character was also based on Michael Milken – the junk bond king of 70/80s. The other person you mention was a crook, Milken wasn’t. There was a bit of slight-of-hand performed by Holywood there; Milken actually provided loans to small/mid sized businesses and this did not go well with the establishment. 70/90s era witnessed major changes in capital flows that reflected the changes in economic production (switching from industrial to service/knowledge economy) and both of these effect the power structure in a country. Sometimes the bad guys and good guys get mixed up in this extremely fast evolving. fluid order of events. I recommend Alvin Toffler’s Powershift book. Excellent read, has excerpts on Milken, as well as JP Morgan.

  17. Anonymous

    The 30 year credit bubble eliminated any real “risk capital.” People who say they are “risk capital” haven’t been in the mindset of taking actual risk for a long, long time. I was in a meeting about 18 months ago with the head of a real estate fund. He said (and I swear to God, he said it with a straight face), “We’re looking for returns in the 16%-18% range and we’re willing to look at deals with a little ‘hair’ on them to get there. But there’s a limit. We really don’t want to be in a deal where the ‘hair’ might push the returns below 8%.” This happened!!! This lunatic thought that he was taking risk by doing a deal that would only return 8%. Of course, the end to this story is that every deal this fund did in the last three years is a 50% to 100% writeoff and the fund has no more liquidity and no more hope of making a dollar in any one of its recent investments, but the point was that each of these guys feels entitled to making huge fortunes without taking an ounce of risk. Each thinks that he is a genius, that he is entitled to $100 million and that he should not have to take any real risk to get that $100 million. It’s a pathology.

  18. Yves Smith

    Anon of 11:40 AM,

    Milken WAS a crook, he went to Federal prision. I heard of many securities law violations from various people in the industry at the time (which I cannot confirm now, but the reports were so extensive and specific I have to believe they were true). Someone I know who joined Drexel for a handsome package quit after his first full day based on what he saw going on.

    Let me give you one incident that WAS documented (and ironically not included in the Federal indictment) to illustrate:

    Milken required any entity that sold junk bonds through Drexel to overfund and sell roughly 15% more than they needed. Lincoln Savings was one of his satellites.

    Lincoln would receive a fax at the of every day from Drexel telling Lincoln what it owned. This is a COMPLETE violation of banking regulations. Only management of the regulated S&L can make those decisions, not non employees. Lincoln was effectively a controlled entity of Drexel (also a violation of Glass Steagall).

    It gets better. Lincoln realized that the regulators were coming, that it needed to have documentation that it had done some sort of review for these investments (and there were a lot, apparently).

    It asked its accountant, Arthur Andersen, to make up the phony records.

    Another story: a friend was an in-house lawyer working for one of the Drexel funded raiders who was exercising a bit too much independence. One day, on the way to work, the #2 guy (well known also, BTW) had his Lincoln Town Car boxed in by three cars on Park Avenue. Shots were fired at the car. The car was damaged but no one was hurt.

    No one would steal a Lincoln town car, particularly on Park in broad daylight with so many vehicles involved. And the #2 guy had no known enemies. Everyone in the office understood this was orchestrated by Drexel. My friend quit soon thereafter.

  19. Yves Smith

    Inflation was more variable under the gold standard and average unemployment higher. Labor slack means an economy is operating below capacity:

    When the Fed was established, inflation was not the problem it became later in the middle of the 20th century. The United States was on the gold standard, and the purchasing power of money in 1914 was about what it had been 30 years before — or for that matter, 100 years before. The gold standard sharply restricted inflation by requiring that money created by the U.S. Treasury be backed by gold.

    Although the U.S. economy grew rapidly throughout the gold standard years, the period was marked by a number of recessions associated with deflation and interest rate spikes. Sudden sustained short-term interest rate spikes of over 10 percentage points occurred on eight occasions between the Civil War and the founding of the Fed. Five of these episodes were accompanied by bank runs characterized by a demand to convert bank deposits into currency that could not be satisfied by the fractional gold reserves held by private banks. Major banking panics occurred in 1873, 1884, 1890, 1893, and 1907.

    The gold era was thus hardly a panacea or a poster child of stability.

    As mentioned, the great virtue of the gold standard was that it assured long-term price stability. Compare the aforementioned average annual inflation rate of 0.1 percent between 1880 and 1914 with the average of 4.1 percent between 1946 and 2003. (The reason for excluding the period from 1914 to 1946 is that it was neither a period of the classical gold standard nor a period during which governments understood how to manage monetary policy.)

    But because economies under the gold standard were so vulnerable to real and monetary shocks, prices were highly unstable in the short run. A measure of short-term price instability is the coefficient of variation—the ratio of the standard deviation of annual percentage changes in the price level to the average annual percentage change. The higher the coefficient of variation, the greater the short-term instability. For the United States between 1879 and 1913, the coefficient was 17.0, which is quite high. Between 1946 and 1990 it was only 0.88. In the most volatile decade of the gold standard, 1894-1904, the mean inflation rate was 0.36 and the standard deviation was 2.1, which gives a coefficient of variation of 5.8; in the most volatile decade of the more recent period, 1946-1956, the mean inflation rate was 4.0, the standard deviation was 5.7, and the coefficient of variation was 1.42.

    Moreover, because the gold standard gives government very little discretion to use monetary policy, economies on the gold standard are less able to avoid or offset either monetary or real shocks. Real output, therefore, is more variable under the gold standard. The coefficient of variation for real output was 3.5 between 1879 and 1913, and only 0.4 between 1946 and 2003. Not coincidentally, since the government could not have discretion over monetary policy, unemployment was higher during the gold standard years. It averaged 6.8 percent in the United States between 1879 and 1913, and 5.9 percent between 1946 and 2003.

    Finally, any consideration of the pros and cons of the gold standard must include a large negative: the resource cost of producing gold. Milton Friedman estimated the cost of maintaining a full gold coin standard for the United States in 1960 to be more than 2.5 percent of GNP. In 2005, this cost would have been about $300 billion.

    Gold has the well documented and discussed problem that the amount outstanding does not growth as economies grow, when even a neutral policy would require money supply growth to match underlying economic growth.

    The big problem with the modern regime has resulted in part from the US decision to have the dollar as reserve currency. Very long winded story, but the US given the boundary conditions it had set (geopolitical and domestic) was bound to break the gold backing, which made the 1970s inflation global (Israel gave the Gulf States a convenient excuse for jacking up the price of oil in response to the partial default on US commitments via the Nixon shock. It’s a move they would have liked to take regardless. The abandoning of gold backing, which led to a sharp fall in the dollar, also delivered a deflationary shock to US trade partners, who responded via stimulus of various sorts).

    Jim Hamilton points out another defect of the gold standard: countries cheat, and go on and off it. It can’t be and isn’t maintained over time. The domestic costs (deflation) are politically unacceptable, and price instability is also a real cost (t makes it very difficult to plan).

    The current regime has lots of problems, I’ll grant you that, but holding up the gold standard as a great solution is misguided.

  20. Anonymous

    Yves, excellent points about gold.

    In Wiemar Germany, what finally stabilized the currency after hyperinflation was not gold, but real estate.

    Given the recent real estate boom/bust, I don’t see real estate as backstopping the currency in the event of a hyperinflation, nor gold for that matter. Maybe something like baskets of needed commodities.

  21. Anonymous

    Milken threatened status quo therefore, was punished by the system. His activities were no more illegal than JP Morgan’s back in the day.

    Some of the capital Milken supplied was used in takeovers, yes, but there is nothing wrong with that. People who followed Milken created an orgy of speculation causing a bubble, but, again, not Milken. I think you are confusing this guy with Ivan Boesky.

  22. Yves Smith

    Anon of 8:30 PM,

    I was in the industry at the time, and very well aware of who Milken was, and I am most decidely NOT confusing him with Boesky. In fact, at one point, Boesky tried recruiting me.

    Milken was a crook. I stand by that comment. The Lincoln example ALONE that I cited above is criminal. He was indicted on 98 counts of securities law violations and agreed to plea guilty on six.

    The man could afford the best attorneys on the planet. Would he have agreed to go to Federal prison and be barred from the securities industry for life if he could disprove the charges?

    I think your real issue is you do not take securities laws seriously. Sorry, they are every bit as much part of our legal system as laws against rape and murder. Criminal violations are criminal violations. Securities firms have compliance departments that at most well run shops actually have teeth. But Milken had a deal with Drexel where he effectively had a firm within a firm.

  23. Andrew Bissell

    The cost of a sound currency, meaning no inflation (again, this is well documented) is lower growth.

    I’m sorry, what? Wasn’t U.S. real GNP growth higher in the nineteenth century with its gradual deflation, than in the twentieth with its constant, simmering inflation? As you point out, the growth was more variable and subject to greater near-term shocks, but it *was* faster growth. And besides that, it certainly appears that attempts to suppress this near-term volatility (by implementing the “too big to fail” doctrine, for instance) are fraught with perils of their own.

    The gold standard (or, more generally, free market money) is not the panacea many of its most enthusiastic advocates make it out to be. But it certainly appears to be unique in providing a natural constraint on the desires of central banks and governments to surreptitiously confiscate wealth from the middle classes through inflation.

    Roman emperors used to have to deceive the populace into accepting debased currency by mixing base and precious metals in the coinage. They would certainly envy modern-day central bankers, who possess a series of sophisticated arguments that inflating away their savings is actually in their best interests!

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