Re: Guest Post - The Big Short

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Lewis misses the point that it wasn't just that the rating agencies were being stupid here. He gives the impression that they had holes in their models that the banks found by experiment and exploited, like shoplifters finding the bits of the store not covered by security cameras. In fact the rating agencies were giving the banks guidance on exactly how to structure the deals to get the required ratings: basically answering the question "So, exactly how crappy can we make this and still just get a AAA rating?"


Posted by: ajay | Link to this comment | 04- 2-14 7:31 AM
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Micheal Lewis is contemptible. I wouldn't trust him to synthesize 2 and 2, much less a topic where I don't already have a good idea of the answers.

In his most recent play for attention about HFT, he fails to distinguish between large traders and small ones, so hedge fund guys whose clients are pension funds are indistinguishable from widows and orphans. Krugman, Rubin, Yves Smith, maybe Ritholtz are all IMO preferable for finance.


Posted by: lw | Link to this comment | 04- 2-14 7:41 AM
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I thought this was going to be about his new book and I was going to link to Felix Salmon's review of it. I guess I still will.


Posted by: Sifu Tweety | Link to this comment | 04- 2-14 7:42 AM
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The right-wing narrative has tended to blame the loan bubble either on the government... or on the subprime borrowers themselves for borrowing money they had no realistic prospects of repaying. The role of Wall Street, the rating agencies, and the banks in all this is curiously absent from that narrative, except as passive victims.

According to the Cult of Econ 101 the ratings agencies, banks, and Wall Street in general did not have a choice but to exploit those loopholes. There is no moral question to be addressed. There was money to be made and the market mindlessly pursued it, as is good and right and just. The fault lies entirely with those who shifted the incentives so that the loopholes existed in the first place. That the pressure to create and widen those loopholes came more often from the Makers than from the Takers is swept under the rug.


Posted by: togolosh | Link to this comment | 04- 2-14 7:45 AM
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Evidence of the rating agencies' culpability: things like this instant message exchange between two Standard & Poor's officials about a mortgage-backed security deal in May 2007:

Official #1: Btw that deal is ridiculous.

Official #2: I know right...model def does not capture half the risk.

Official #1: We should not be rating it.

Official #2: We rate every deal. It could be structured by cows and we would rate it.


Posted by: ajay | Link to this comment | 04- 2-14 7:55 AM
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3: It's big investors who get hurt by HFT: because they need more stock than is immediately available, the algobots can try to front-run their trades. But Lewis plays the "all investors are small investors" card: if a hedge fund is running money on behalf of a pension fund, and the pension fund is looking after the money of middle-class individuals, then, mutatis mutandis, the hedge fund is basically just the little guy.
I'm not sure what's wrong with the Lewis's logic. Obviously, David Einhorn isn't a "put-upon small investor", but isn't the HFT industry skimming money from his clients who are?


Posted by: Eggplant | Link to this comment | 04- 2-14 7:55 AM
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It could be structured by cows and we would rate it.

This is perilously close to my idea to have monkeys determine black-scholes thresholds.


Posted by: Sifu Tweety | Link to this comment | 04- 2-14 7:56 AM
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Monkeys would provably be better at running hedge funds than index tracker fund managers. http://www.cassknowledge.com/research/article/evaluation-alternative-equity-indices-cass-knowledge


Posted by: ajay | Link to this comment | 04- 2-14 7:58 AM
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They would! They would be free from bias. I have it all worked out. You just need to display historical price movements as a random dot display and pay them in juice. They would probably be a lot closer to optimal than any human doing the task.


Posted by: Sifu Tweety | Link to this comment | 04- 2-14 8:00 AM
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I wonder just how much of the problem was 14k migrant strawberry pickers -- not doubting the anecdote, just its salience as an example -- as opposed to simple 'houses in Las Vegas cannot fail to appreciate at 20% per year' and its cousin 'of course your income will always increase year over year' bubblethink.


Posted by: CharleyCarp | Link to this comment | 04- 2-14 8:00 AM
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Oh, one place that had interesting facts was Lessig's Republic, Lost

In 1993, the departing chairperson of the Commodity Futures Trading Association, Wendy Gramm signed an order exempting most over the counter derivatives from federal regulations, then went on to accept a position with Enron.

More summary here, It's a pretty good book, maybe 2/3 of pages are intersting, some fantastic. I'm liking it a lot.

In case derivatives seem like an obscure thing that belongs in the fine print-- removing regulation of edrivative trading (so, reporting, capital requirements for speculating with borrowed money, trade settlement) creates a huge loophole. Derivatives equivalent to owning a stock or a ton of wheat are easy to write-- it's not a new, alternative market, rather is a less regulated completely equivalent market in addition to the novel one.


Posted by: lw | Link to this comment | 04- 2-14 8:02 AM
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link failure above, sorry:
http://dmarkkey.weebly.com/lawrence-lessigs-republic-lost.html


Posted by: lw | Link to this comment | 04- 2-14 8:03 AM
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I get out of my depth quickly on finance issues but reading the bit quoted in the OP makes me wonder if the documented phenomenon of steering qualified (for prime, that is) African-American lenders into subprime loans was to pad out the pools with high FICO scores so they could stuff in a bunch of low FICO scores and still hit the magic 615. I'd also buy just plain bloody minded racist assholery, though.


Posted by: togolosh | Link to this comment | 04- 2-14 8:03 AM
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Really, the problem is with the whole narrative of "bad loans to poor people caused the crash." They didn't.


Posted by: Robert Halford | Link to this comment | 04- 2-14 8:07 AM
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6. I think not-- the bid-ask spread before decimalization and the common practice of market-makers to skim were pretty bad, especially for cheap or thinly traded equities.

The estimates I've seen, at least in Salmon but also elsewhere, for the effect of HFT is hundredths of a basis point per trade. Not my field, possibly I'm wrong, but I'm pretty sure that this is not a big problem, IMO a distraction.


Posted by: lw | Link to this comment | 04- 2-14 8:09 AM
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As far as I know, I'm the only Dave W. commenting here. My google searches of site:unfogged.com for "Dave W." and "Dave W" all seem to be me.


Posted by: Dave W. | Link to this comment | 04- 2-14 8:12 AM
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15: "How much are they skimming?" is a different question than "From whom are they skimming?".


Posted by: Eggplant | Link to this comment | 04- 2-14 8:15 AM
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OT but this is probably the right thread in which to note that, as of this morning, there is NMM to aggregate campaign contribution limits.


Posted by: potchkeh | Link to this comment | 04- 2-14 8:16 AM
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There's also someone with a similar name from Europe, but I don't think he signs as Dave W. Unless that's you.


Posted by: fake accent | Link to this comment | 04- 2-14 8:19 AM
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10: I don't think those are competing explanations -- I think they're explaining two separate parts of the problem. The people who were extending and securitizing loans (the ones who would have been using thin-file FICO scores) didn't have to worry at all about how the loans would be performing two or three years out, because they (or their employers) weren't going to be holding the assets. The people who were buying the resulting product (and whose employers or clients wound up holding it when the shit hit the fan) wouldn't have known about the thin-file FICO scores, but might have heard more generalized rumblings about problems -- and they might have been engaging in the kind of bubble-think you're describing to justify why they weren't thinking too hard about what was in the sausage.


Posted by: widget | Link to this comment | 04- 2-14 8:21 AM
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19 is what crossed my mind when I threw that line on the end, but I also remembered that he goes by his whole name. I'm pretty sure you, Dave W, are indeed unique, aside from your passing resemblance to all twenty other Dave Initials.


Posted by: heebie-geebie | Link to this comment | 04- 2-14 8:28 AM
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17. Sure, but
a) hedge funds skim much, much more from their clients than do HFT places that interact with their trades and
b) costs of order execution (which is basiaclly what the HFT hubbub is about) have never, ever been transparent, and I have not seen evidence to suggest that the problems with HFT are worse than the previous problems.

I'm not defending these guys exactly, but I feel that drawing attention to effectively rounding error while not mention repeatedly and emphatically just how awful the largest banks are is an error. Certainly possible for reasoned disagreement on this-- my claim that this should be ignored is a matter of style, basically. I'm pretty sure that I am right in this being a small problem.

To my main, ad-hominem point, Here is Drum reviewing Lewis. There was something pretty awful about the way ML wrote about his wife somewhere, but I can't find it now. He's ovvasionally correct about something, but so is Saletan or Friedman, and I won't read them either.


Posted by: lw | Link to this comment | 04- 2-14 8:28 AM
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20 -- Right, I'm just wondering how much actual shit, as opposed to ground up snouts and tails etc, is in the sausage.

My experience in this is limited by having worked a particular angle, and amounts to a whole lot more 'old people extracting the inflated equity in their homes to pay off credit card debt run up by (a) kids and/or (b) prescription drugs' than 14k strawberry pickers. That could just be luck of the litigation draw, of course.


Posted by: CharleyCarp | Link to this comment | 04- 2-14 8:29 AM
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Fair enough.


Posted by: Eggplant | Link to this comment | 04- 2-14 8:31 AM
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I wish that, when they were born,
I had named one of them Bodkin Van Horn
And one of them Hoos-Foos. And one of them Snimm.
And one of them Hot-Shot. And one Sunny Jim.
And one of them Shadrack. And one of them Blinkey.
And one of them Stuffy. And one of them Stinkey.
Another one Putt-Putt. Another one Moon Face.
Another one Marvin O'Gravel Balloon Face.
And one of them Ziggy. And one Soggy Muff.
One Buffalo Bill. And one Biffalo Buff.
And one of them Sneepy. And one Weepy Weed.
And one Paris Garters. And one Harris Tweed.
And one of them Sir Michael Carmichael Zutt
And one of them Oliver Boliver Butt
And one of them Zanzibar Buck-Buck McFate ...
But I didn't do it. And now it's too late.


Posted by: OPINIONATED MRS. MCCAVE | Link to this comment | 04- 2-14 8:31 AM
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I agree with 20, would add that 11 explains why nobody was keeping track of just how much of these awful things were being sold.


Posted by: lw | Link to this comment | 04- 2-14 8:32 AM
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Moneyball was awesome and really well written. The Blind Side and Liar's Poker were also really good. I enjoyed The Big Short but have no idea how accurate it was.


Posted by: dz | Link to this comment | 04- 2-14 8:32 AM
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I thought David nameW was the one posting as David The Unfogged Commenter. Have I got that confused too?

And does everyone accept how completely, absolutely right I am about pseuds?


Posted by: LizardBreath | Link to this comment | 04- 2-14 8:35 AM
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17: True, but if we really care about the "from whom" so much, we should have shouty CNBC debates about payment for order flow and maker/taker exchange pricing, not HFT.

Cliff Asness (bad at politics, good at finance), saying that HFT is neutral or maybe a positive: http://online.wsj.com/news/articles/SB10001424052702303978304579475102237652362?mod=wsj_streaming_stream&mg=reno64-wsj&url=http%3A%2F%2Fonline.wsj.com%2Farticle%2FSB10001424052702303978304579475102237652362.html%3Fmod%3Dwsj_streaming_stream


Posted by: Lepto | Link to this comment | 04- 2-14 8:37 AM
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I've had trouble keeping Dave the Unfogged Commenter and Dave W/eman and DaveW straight for years. But apparently being a Dave is very important to the Daves.


Posted by: DaveHal | Link to this comment | 04- 2-14 8:44 AM
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In 1993, the departing chairperson of the Commodity Futures Trading Association, Wendy Gramm signed an order exempting most over the counter derivatives from federal regulations, then went on to accept a position with Enron.

Wendy Gramm, eh? Any relation to Phil Gramm, author of the Gramm-Leach-Bliley Act, written to retroactively legalise the illegal takeover of Travelers by Citigroup, and which contained the "Enron Loophole", exempting most energy derivative trades from regulation?
(Yes. Husband and wife.)
Well, fancy that. You mean that, at a time when Wendy Gramm was a director of Enron - and, apparently, engaged in activities which might or might not have rhymed with "blinsider braiding", as a result of which she and her fellow directors ended up paying $168 million to aggrieved Enron shareholders - you mean that at that very time her husband was writing laws that helped Enron avoid scrutiny from the very regulators which she used to lead and he was overseeing?
(Yep.)
Gosh.


Posted by: ajay | Link to this comment | 04- 2-14 8:47 AM
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23: Fair enough; we're hardly going to be able to figure out the industry-wide snouts/shit ratio in blog comments. Probably no one will ever really know, given the size and scope of the review that would be required, and the access to privately held data. Even in individual cases (as it sounds as though you're fully aware) it's a lot of work.


Posted by: widget | Link to this comment | 04- 2-14 8:49 AM
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I just don't see how, at this point, anyone can say that the crisis was not the product of a number of separate, but interrelated factors. On the finance side, you've got deregulated banks/brokerages who were looking for ways to bulk up their portfolios & commissions post-dotcom crash. Some of that was clearly mendacity, but some of it was fairly sincere wishful thinking too. You've got the rating agencies, who are basically one big implicit moral hazard, and the SROs, which had been eviscerated by that time, and weren't ever all that great at tracking down big, complicated schemes while they were going on. The media did a pretty piss-poor job of reporting on all of this, mostly focusing on the positive side of economic expansion, mixed in with a few "Gee whiz, houses are sure getting expensive!" pieces. Individual real estate agents and larger agencies had an obvious incentive to lie about loans and push houses on people who really shouldn't have bought. You also had a lot of suburbanites and old people who were either bleeding equity out of their existing properties, or got greedy for more house than they needed. Mortgage originators had all the incentives thus far described, and those were just the legitimate ones. Lots of people got into the game specifically to commit fraud, weakening the underpinnings of the market, even if it wasn't that many actual fraud cases looked at objectively*. Then too, developers and municipal authorities saw nothing wrong with building a glut of McMansions in the burbs and high-end condos in the urban core, increasing their sales volume and taxes respectively, so they had little reason to kick. I mean, the only people in the whole mess who weren't part of the problem were the relatively few families and individuals who tried to buy just as much house as they needed, and took out loans for much less than they were authorized to do. And even they were adding to the amount of churn, driving up prices somewhat, and when everything collapsed, they had to make forced sales or get foreclosed on too.

*Is there an overall national statistic on how much outright fraud there was? I have heard reports that in some impoverished neighborhoods, over half the mortgages/2nd mortgages were fraudulent, but I don't know how widely that applies.


Posted by: Natilo Paennim | Link to this comment | 04- 2-14 9:00 AM
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I think ajay gets it right on the first comment. The fact that, in effect, the ratings agencies would instruct the banks and funds on the exact parameters of their system made the whole thing pretty collaborative. (Of course, the parameters should be well-known, so the right solution is somewhat unclear.)

There is plenty of blame to go around. All the explanations and "causes" are true, and they all come down to greed fueling a bubble market. A $14K/year strawberry picker applying for a $700K loan is exhibiting greed, unless you deny such a person has agency. It's greed all the way from the top to the bottom, alas.


Posted by: DaveLMA | Link to this comment | 04- 2-14 9:01 AM
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Rating agencies could be very irritating to deal with, but not an intellectual strain. There was a habit (if not a practice, quite) of threatening to slap a non-investment-grade rating on transactions if the RA weren't paid a fee to deliver the AAA.


Posted by: Prez the Teenage President from '70s DC Comics (Look It Up) | Link to this comment | 04- 2-14 9:02 AM
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this reminds me of a post! http://fistfulofeuros.net/afoe/yes-the-banks-are-to-blame/


Posted by: Alex | Link to this comment | 04- 2-14 9:07 AM
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And does everyone accept how completely, absolutely right I am about pseuds monkey hedge funds?


Posted by: Sifu Tweety | Link to this comment | 04- 2-14 9:07 AM
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FWLIW, I've come around to the position that some crash was inevitable given low interest rates and high limits on leverage. Implicit TBTF guarantees, mismatched incentives, and deregulation changed who exactly ended up holding the bag.


Posted by: Eggplant | Link to this comment | 04- 2-14 9:09 AM
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as opposed to simple 'houses in Las Vegas cannot fail to appreciate at 20% per year' and its cousin 'of course your income will always increase year over year' bubblethink

Seriously. People with only like 50k in income owning multiple properties, people using that inflated equity to buy cars and boats, do ridiculous upgrades on their house, etc. It had the same feeling of the tech bubble when people would look at me like I was being an asshole for pointing out that maybe a three digit PE ratio wasn't realistic for companies that weren't profitable and didn't have realistic prospects for profitability anywhere on the horizon.


Posted by: gswift | Link to this comment | 04- 2-14 10:25 AM
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As I pointed out in the earlier thread on finance, as bad as the subprime stuff was, subprime losses alone would not have brought down the global economy. You need to add on top the repo (funding) problems, leverage, derivatives, and resecuritizations and synthetic securitizations. Arguably the worst thing the ratings agencies did was not the misrating of the initial MBSs, but playing along with the CDO game. Losses were much greater on secondary securitizations referencing the original MBS than they were on the MBS themselves. The ratings agencies actually went along with the argument that you can take a bunch of subordinated tranches from MBS, stack them up in a new CDO subordination structure, and the senior levels in the CDO will be protected because senior. Of course, when the housing market starts to go down all the junior MBS tranches tank at once, they are extremely correlated so subordination doesn't work at all.

Some fun facts...from the Financial Crisis Inquiry Commission:

From 2000 to 2007, Moody's rated nearly 45,000 mortgage-related securities as triple-A. This compares with six private-sector companies in the United States that carried this coveted rating in early 2010. In 2006 alone, Moody's put its triple-A stamp of approval on 30 mortgage -related securities every working day. The results were disastrous: 83% of the mortgage securities rated triple -A that year ultimately were downgraded.

The The Philadelphia Fed on structured finance ABS CDOs -- these crisis-era CDOs eventually lost 65 percent of their value.

And a colorful description of what it was like to work at the big ratings agencies prior to the crisis, by whistleblower William Harrington.


Posted by: PGD | Link to this comment | 04- 2-14 11:23 AM
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Of course, an implication of the stuff in 40 is that the bad lending was more driven by Wall Street demand for product to stick into the securitization blender than by demand from stupid plebians who wanted idiotic mortgages. Although once people realized that Wall Street had a powerful incentive to shovel money out there without underwriting, there was of course plenty of folks on the retail end willing to cooperate by committing mortgage fraud themselves.


Posted by: PGD | Link to this comment | 04- 2-14 11:31 AM
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Well, at least we have the comfort of knowing that the perpetrators of this fraud have all been prosecuted and sent to jail!


Posted by: Spike | Link to this comment | 04- 2-14 11:40 AM
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Or they've all lost their jobs, at least.


Posted by: Spike | Link to this comment | 04- 2-14 11:42 AM
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Well, some did retire because they made so much money during the bubble that they didn't really need to work any more.


Posted by: PGD | Link to this comment | 04- 2-14 11:47 AM
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38: Well that was the point of D^2's Big Global Bezzle piece from some months ago, wasn't it? And others have made the argument as well, but the Welshman really laid out how there was a global imbalance that had to be mediated, and that's what the financial system is there for. As long as that imbalance exists, someone has to move the money around to rebalance it. The fact that the system is set up such that "somebody" was in practice going to be a bunch of insane greed heads meant that there'd be lots of skimming and self-dealing, and shady practices, but, at least in his telling, there's no way around the rebalancing.

I have a simple question that may be based on an oversimplified story, but I wonder: the simplified story is that there was too much money chasing too few low-risk investments, and so the Moodys had a huge interest in collaborating with Wall Street to invent low-risk investments that weren't. Is that (roughly) correct? If so, what happens if, say, some quasi-governmental entity (the Fed? the World Bank?) puts the ratings agencies out of business and does it themselves using more or less honest and correct practices? In that world, nobody can create fake AAA-rated investments. Do you get investors accepting more risk (at a higher return), or does investment shut down and everyone buys Treasuries? And if the latter, then what?

I guess what I'm getting at is that there seems to have been an attempt to artificially constrain risk-taking by pretending that there was less risk out there than there really was. If demand for water outstrips supply, the price of water goes up; you don't (in the first world, mostly) satisfy that demand by bulking up the water with sewage.


Posted by: JRoth | Link to this comment | 04- 2-14 12:13 PM
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D-squared is a banker who is not trustworthy on this stuff. 'Global imbalances' meant that China had a big incentive/need to reinvest in the U.S. economy to recycle their surplus. It didn't determine how they did it.

Also, the 'who holds the bag' question in 38 is important, because uncertainty about who held the bag and how triggered a big run that appeared to massively amplify the relevant damages. It's like people who make this argument don't believe that financial industry structure affects how financial stress impacts the economy.


Posted by: PGD | Link to this comment | 04- 2-14 12:29 PM
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45: The difference between water and bonds is that the price of bonds is artificially capped. The price of a bond can't be more than its face value because then nobody would buy the bond -- they would keep the cash instead. This is the "liquidity trap" story.

Here's one interpretation of events that's occurred to me. There was a lot of concern after the NASDAQ bubble burst that we would hit deflation and enter the liquidity trap. In reaction, the Fed kept rates pretty low. Employment recovered slowly (it was the "jobless recovery"), so the Fed kept rates low for a while. Now it's fashionable to blame the low interest rates for the housing bubble. What if the housing bubble and all of the fraud simply delayed the inevitable? The effect of widespread fraud is that by creating a fake supply of bonds, it prevented us from hitting the zero lower bound sooner?


Posted by: Walt Someguy | Link to this comment | 04- 2-14 12:45 PM
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Also, if investment shuts down and everybody buys Treasuries, then government spending should take up the slack.


Posted by: Walt Someguy | Link to this comment | 04- 2-14 12:48 PM
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You're a funny man, Walt.


Posted by: Tom Scudder | Link to this comment | 04- 2-14 12:54 PM
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47.2: isn't that fairly widely held to be what happened? In order to recover from the dotcom boom the fed semi-explicitly inflated another bubble?


Posted by: Sifu Tweety | Link to this comment | 04- 2-14 12:56 PM
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47.last is, afaik, a common belief/theory. A lot of it seemingly comes back to the 2% inflation target (and, effectively, ceiling); if it were 4%, there's be a lot more room to cut rates before reaching the ZLB, plus it would change the value on no-risk treasuries vs. cash.

47.1 is true, but I'm talking pre-crash, before we were especially near the ZLB. Treasuries in, say, 2006 probably had about 5% headway between their face value and their market value, combining interest and inflation. In a world where BS CDOs don't exist, does that drop a few percent (saving the government money on interest, if nothing else) while forcing other investors to take on a little more risk and invest in actual, potentially-valuable prospects instead of bullshit, pseudo-safe CDOs?


Posted by: JRoth | Link to this comment | 04- 2-14 1:02 PM
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50: I don't think there's any evidence that the Fed did it deliberately. I know people who work at the Fed (nobody actually important), and they definitely expected monetary policy to stimulate production, rather than cause a bubble. Once it was clear that there was a bubble, the Fed steadily raised interest rates from June of 2004 until June 2006. The Fed held the Federal funds rate at 5.25% until August 2007, at which point they realized that the economy was tipping into recession. So the Fed raised rates all through the biggest bubble period.


Posted by: Walt Someguy | Link to this comment | 04- 2-14 1:13 PM
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51: But what if long-term Treasuries had a 5% interest rate because the supply of long-term "riskless" assets was artificially inflated, which pushed the prices down and yields up.


Posted by: Walt Someguy | Link to this comment | 04- 2-14 1:18 PM
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I was in a hurry earlier today, so didn't have time to make clear just how wrong and possibly pernicious I think the 'global imbalances' theory of the crisis is. The global imbalances hypothesis is problematic just on its face -- if the result of another country wanting to invest lots of free money in your country is a massive misallocation of capital, then maybe we should just nationalize the financial sector, since clearly its not very good at allocating capital. It also directly conflicts with the 'bad Fed policy' story, since the Fed deflating the currency through low interest rates is supposed to be the response to a big trade deficit.

But more than this, it's just completely mistaken about how the financial sector works and how interest rates are set. It draws on an Austrian/libertarian idea of the 'natural interest rate', and the invisible hand punishing you when you diverge from that rate. See this paper for an excellent/classic explanation of how a focus on net trade deficits misunderstands the nature of finance. See this Rortybomb post for a good informal conceptual discussion of what's wrong with both the 'global imbalances' and the 'bad monetary policy' theories of the crisis.


Posted by: PGD | Link to this comment | 04- 2-14 5:23 PM
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54 seems right on, and that Rortybomb post is great (I think you posted it before; in any event I read it before somehow).


Posted by: Robert Halford | Link to this comment | 04- 2-14 5:37 PM
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22: For a while, Lewis had a good column in the NYT and a bad column in the LAT. In the good column he wrote intelligently about Wall Street. In the bad column he wrote about the undeniable feeling of pride he felt in getting his wife former MTV VJ Tabitha Soren to give up her career in order to be the mother of his children.


Posted by: k-sky | Link to this comment | 04- 2-14 5:53 PM
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22.last: as covered in TFA.


Posted by: Josh | Link to this comment | 04- 2-14 6:08 PM
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The Austrian argument summarised here is weird:

When flows of capital from Asia to the United States (or from northern to southern Europe) pushed down interest rates in the recipient countries, they argue, it was inevitable that the projects funded as a result would be speculative and ultimately wasteful.

Why? Because they won't be profitable at a higher interest rate. But this is true of literally any project. There is some value of the interest rate for which any project would be unprofitable. Google would not be profitable at a cost of capital of 300% a month.

You can try and fix this by saying that the interest rate has diverged from some value and will eventually correct, and then you'll be sorry, but then you have to give up the notion that the market is right - you're second guessing what the "true" rate should be. If you actually believe in efficient markets, all you can say about the interest rate is that it is what it is. But if you think it can diverge from some sort of "sensible" value, then you're basically doing standard macro with a policy rate.

There's also the whole weird thing in which the rate can be artificially too low and poors get jobs, but for some reason it's never too high.


Posted by: Alex | Link to this comment | 04- 3-14 2:52 AM
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as bad as the subprime stuff was, subprime losses alone would not have brought down the global economy

This is absolutely right. It's not true that "no one saw the crisis coming". Lots and lots of people saw it coming in the sense that we were warning that subprime lending was going to go bang pretty soon and banks would take big losses as a result. What we didn't see coming was the amount of secondary damage that it would produce. In June 2007 I was reading articles and research reports starting "Since the subprime crisis earlier this year..." We thought that the worst was over, you see. Bear Stearns and Northern Rock were pretty shocking at the time.

Implicit TBTF guarantees, mismatched incentives, and deregulation changed who exactly ended up holding the bag.

Not just government guarantees either. A lot of these SPVs were specifically structured so that banks would not be on the hook if they failed - that was the whole point, the banks could shift the assets in them off their balance sheets - but when the crisis happened the banks realised that, whatever the terms said, they would still have to back them up because the market still expected them to do so.


Posted by: ajay | Link to this comment | 04- 3-14 3:23 AM
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Yeah, it wasn't until Rhineland and Rhinebridge blew up, and the rest of the ABCP market froze as a result, that it looked like more than a fairly run of the mill, if severe, housing market crash.


Posted by: Ginger Yellow | Link to this comment | 04- 3-14 4:35 AM
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54: It seems like you're in such a hurry to hitch balance of payments explanations to an easily (if rightly) demonized political wagon that nuances get lost.

In the JW Mason post you link to, the last third of the article allows that a BoP account is fine as long as you follow through on some consequences that, I take it, many conservatives and Austrians won't.

Mason's last point, that maybe there should be multiple different interest rates for different types of agents, is arguably already taking shape as the Fed started paying IOER in 2008 and now ramps up the reverse repo program.

if the result of another country wanting to invest lots of free money in your country is a massive misallocation of capital, then maybe we should just nationalize the financial sector, since clearly its not very good at allocating capital

I mean, there are persuasive arguments for nationalizing finance, but poor policymaking by the Chinese sovereign is not one.


Posted by: Lepto | Link to this comment | 04- 3-14 8:24 PM
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If you really want to understand why the BOP explanation just doesn't work, go to the first article I linked in 54, the Borio and Disyatat paper (direct link: http://www.bis.org/publ/work346.pdf ). Net national account balances simply do not track how the modern financial system works or the way money is created and destroyed in the economy. Of course a net account deficit does reflect something in the world that has effects, but it's very far removed from the mechanics of how a financial crisis happens and is neither necessary nor sufficient for such a crisis. Mason is more about ideological inconsistencies in the 'excess savings' and does not take on the technical ways it simply doesn't track the facts, but I wouldn't say he thinks that explanation is 'fine'.

I mean, there are persuasive arguments for nationalizing finance, but poor policymaking by the Chinese sovereign is not one.

the Chinese mostly bought Treasuries and GSE debt, which they (correctly) surmised would be backed by the U.S. government if problems occurred. So their policy making doesn't seem poor to me. It's what the U.S. financial system did with the extra liquidity provided by those purchases that's the problem.


Posted by: PGD | Link to this comment | 04- 4-14 6:07 AM
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I thought this was going to be about his new book and I was going to link to Felix Salmon's review of it. I guess I still will.

I haven't read the book yet, but I thought that review was an embarassment. He's saying retail investors have nothing to fear from HFT, but the CEO of Charles Schwab is calling HFT a 'growing cancer' ? Sure, HFT profits are down some, but that's because of increased competition in the space -- more people doing it -- not because of any structural changes.


Posted by: PGD | Link to this comment | 04- 4-14 6:13 AM
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62: will read that paper when I get the chance

The reason China had an appetite for UST is that they were recycling funds from export and investment-based growth. They leaned on that model for too long and let elites come up from those SOEs such that now it's become politically very difficult to shift towards domestic consumption. That's the policy issue.

The U.S. could have 1) raised rates in the mid-2000s in order not to incentivize too much risk-taking and 2) offset regressive effects through fiscal policy. "Nationalize the banks because they should have known better than to act on central bank signals" doesn't make sense.


Posted by: Lepto | Link to this comment | 04- 4-14 7:46 AM
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Read up on payment for order flow and maker taker pricing, and then Schwab's hypocrisy should be clearer .

HFT is a problem for large institutions sending large orders and for older/slower market makers pining for days of wider spreads. I remember the days of huge brokerage commissions and wide spreads, and I much prefer penny bids that dance around a bit from HFT to the regime that came before. Some better comments: 1, 2


Posted by: Lepto | Link to this comment | 04- 4-14 7:57 AM
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64: so now you're back to arguing that loose monetary policy and Chinese investments in the U.S. caused the financial crisis. I give up (again, as I did on the other thread). You just have an ideological barrier to seeing any problems with the structure of the U.S. financial system.

I'm fully aware of the reasons why China accumulated U.S. dollars, although I'm not sure why it qualifies as 'poor policymaking' since their strategy led to the highest sustained economic growth rates ever recorded in the modern era.


Posted by: PGD | Link to this comment | 04- 4-14 9:16 AM
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I'm enjoying this conversation between you two, especially since I'm trying to learn macroeconomics through internet spats.


Posted by: Eggplant | Link to this comment | 04- 4-14 9:29 AM
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67: Unfogged, the world's most inefficient MOOC. #slatepitch


Posted by: dalriata | Link to this comment | 04- 4-14 9:37 AM
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66: GMAFB. I flagged plenty of problems with the U.S. financial system in the other thread. I'm a bigger fan of capital requirements and leverage limits than most anybody. Sorry if I don't think moralistic hectoring has high explanatory value. Banksters!, amirite?

You think high Chinese growth rates justify running up inequality gaps, choking pollution, and enough corruption to prevent later policy flexibility? Got it. I guess you decided not to read the part where I said that they "leaned on that model for too long."


Posted by: Lepto | Link to this comment | 04- 4-14 9:52 AM
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67: On the internet, no one knows you're wearing spats.


Posted by: Thorn | Link to this comment | 04- 4-14 10:39 AM
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Capital requirements and leverage limits are not magic buzzwords that let you get out of the broader discussion about the complexity of the financial system. All of the other issues we were and are discussing are deeply, intimately related to efforts to disguise leverage at dealer banks. Leverage is an accounting concept, and a pretty abstract one. Anything that lets you inflate the value of assets or disguise the extent of liabilities will artificially increase your measured capital ratios. Derivatives and securitization worked extremely well for this purpose. Arbitraging required capital ratios was a major incentive for the growth of originate-to-distribute securitization and credit derivatives. Nor does capital get you out of the issue of 'moralistic hectoring', because it is simply impossible to rely on capital ratios for large global universal banks unless you trust the people inside the firm to report accurately. So under our current system, where banks are permitted all kinds of complex and non-transparent activities, the question of trustworthiness is essential to capital regulation as well as every other form of regulation.

Speaking of moralistic hectoring, you know who recently has lectured us all about an "important problem evident within some large financial institutions--the apparent lack of respect for law, regulation and the public trust."? And talked about "evidence of deep-seated cultural and ethical failures at many large financial institutions"? Bill Dudley, formerly of Goldman Sachs and currently head of the NY Fed, the lead supervisor of the biggest Wall Street banks. Do you want to explain to us why you sneer at this issue but he seems to think it's important?

Also, a final note on capital and leverage -- it is not emphasized enough that capital is a secondary issue when it comes to financial failure. As I said above, capital is an abstract accounting concept attempting to measure the long-term value of assets vs. liabilities. Actual bank failure occurs because of liquidity problems. The two are interrelated but not the same thing. A bank with capital but no liquidity is like a person who is broke and unemployed but has equity in their house -- if they want to pay their mortgage they better find a lender who agrees with them on the value of their house and is willing to extend them a home equity loan. When funding markets seize up during a crisis your claims about capital may not help you. This issue becomes especially salient with matched book dealers (securities/repo/derivatives), who under current methods of measuring capital have almost no liabilities that incur capital charges but have potentially huge liquidity exposures.


Posted by: PGD | Link to this comment | 04- 4-14 10:56 AM
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The U.S. could have 1) raised rates in the mid-2000s in order not to incentivize too much risk-taking

The Fed started to raise rates in mid-2004 and kept doing so continuously for the next two years. Are you saying that if they'd started in mid-2003 the biggest global downturn since the Great Depression could have been averted?

69.2 -- also I was unclear that we were debating the Chinese economy, I thought we were discussing the U.S. financial system and Chinese policy only insofar as it may have fed the financial crisis.


Posted by: PGD | Link to this comment | 04- 4-14 11:05 AM
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67: surely one of the most enjoyable ways to learn macroeconomics (if only relative to the dismal alternatives). But if you want a better way to do it -- it's hard to get much of a spat going here because I don't really understand what Lepto is arguing -- look to the Daniel Davies/Brad Delong dispute, which is the same argument conducted at a much higher level. Here's Delong to get you started.


Posted by: PGD | Link to this comment | 04- 4-14 11:10 AM
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DeLong is as committed to defending pre-crisis macroeconomic management as dsquared is the financial system.


Posted by: Eggplant | Link to this comment | 04- 4-14 11:37 AM
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Isn't his argument in that post that lending hadn't yet returned to the peak bubble glory days, so bankers must be too risk averse?


Posted by: Eggplant | Link to this comment | 04- 4-14 11:50 AM
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I read his argument as being that the (roughly) natural rebalancing of the economy that had begun starting at the deflation of the housing bubble was halted by a seizure in the financial system, a seizure that happened because the financial system was a sham, or possibly shambolic.

IOW, the economy wasn't crashed by the housing bust, it was crashed by the Wall Street bust, and Wall Street busted because of bullshit financial instruments/practices created around housing.


Posted by: JRoth | Link to this comment | 04- 4-14 12:10 PM
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JRoth's interpretation is how I read him too. He's basically standing up for the principle that, yes, the financial sector affects the real economy so when you have a disorderly collapse of the financial machinery then it has big effects on real economy production. Something that D-squared and people in that vein tend to kind of ignore (amazingly IMO). Certain kinds of conventional economics encourage you to ignore it because the financial system is just a veil.

Robert Hall at Stanford has a paper making a similar kind of argument through a modeling exercise -- he basically finds that household deleveraging cannot account for the depth of the recession but 'financial frictions' (basically credit rationing impacting investment) can. (I am somewhat skeptical of these kinds of modeling exercises but whatever, I think it's showing something). The credit rationing is not just due to some abstract risk aversion but due to bank undercapitalization created by the massive tanking of all their asset values, which is quite related to the fraud and so forth we were discussing.


Posted by: PGD | Link to this comment | 04- 4-14 12:31 PM
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Another interesting Delong piece


Posted by: PGD | Link to this comment | 04- 4-14 12:39 PM
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Lepto's position is pretty incomprehensible. As was mentioned above, the Fed raised rates exactly in the middle of the 2000s, and started raising rates 3 years before the recession. China's macroeconomic policy is the most successful the world has ever seen. For the Fed to know that somehow they had to raise rates even sooner, or for the Chinese government to know the exact moment when their model would stop working is to require people to possess the gift of prophecy.


Posted by: Walt Someguy | Link to this comment | 04- 4-14 12:47 PM
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But we are still under "potential GDP" years later, and the banks are well capitalized. Isn't a poor consumer demand and a lack of credit worthy borrowers a simpler explanation for the lack of lending? That is, to maintain DeLong's explanation over the years, as I believe he's done, you have to posit some "abstract risk aversion" (which I think he's explicitly mentioned on occasion).
His timeline in that post is also a little strange. Business investment flatlined when the bubble burst and exports, the natural rebalancing JRoth mentions, continued on their trend rather than showing evidence of compensation.


Posted by: Eggplant | Link to this comment | 04- 4-14 1:05 PM
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As was mentioned above, the Fed raised rates exactly in the middle of the 2000s, and started raising rates 3 years before the recession.
They presumably could've raised rates further. There weren't signs of inflation real economy, but there were in the financial sector.


Posted by: Eggplant | Link to this comment | 04- 4-14 1:17 PM
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They couldn't have raised rates any further, the dysfunctions in the financial sector had them boxed in. They stopped raising rates in the very month (summer 2006) that housing values peaked and started to turn down. Adding fuel to that process would not have done any good. By 2006 so much of the everyday functioning of the financial sector was premised on constantly rising housing prices that they weren't really free any more to push against it.

As another little note, discussing monetary policy as though it is somehow separable from financial regulation is wrong. Monetary policy is a way to regulate to macroeconomic growth that *depends on* the financial sector functioning a particular way, acting to transmit signals to the real economy in a particular way. Post-WWII 'bills only' monetary policy depends at least as much, probably more, on the financial sector functioning in a conventional way as the financial sector depends on monetary policy. Just a few months after stopping raising rates, the Fed had to start switching over to unconventional monetary policy.

80: the assumption would be that the period of credit constraint and bank recapitalization started a self-reinforcing downward spiral. So even once banks are recapitalized the economy is in a different equilibrium. So it doesn't have to just be a loss of animal spirits, it can be income drop due to lost jobs during the crisis.


Posted by: PGD | Link to this comment | 04- 4-14 1:28 PM
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82.1: Okay, they shouldn't have raised rates further, but they certainly could have raised them earlier. It had been obvious that we were in bubble-led growth for quite some time.
82.3: But why would we expect a recovery to the peak-bubble economy at all? From the piece linked in 78, DeLong writes, in the voice of Khremistokles,

I am sorry, in a $15 trillion/year production economy-in an economy with $50 trillion of wealth-in a global economy of more than $80 trillion of financial assets, $750 billion of bad debt losses that have to be recognized does not seem to me to be a very large disturbing factor...

This seems to be worded so as to minimize the stimulus the banks were pumping into the real economy by comparing it to large unrelated numbers and ignoring distributional effects. In reality, once that stimulus disappeared, consumer demand dropped and businesses stopped investing.


Posted by: Eggplant | Link to this comment | 04- 4-14 1:57 PM
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Anyway, thanks for indulging my questions. I realize I'm out of my depth on this stuff.


Posted by: Eggplant | Link to this comment | 04- 4-14 1:58 PM
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83: I think you're reading history backwards. GDP growth in 2001 was 1%, in 2002 was 1.8%, and in 2003 was 2.5%. The first year of normal growth after the stock market crash was 2003, and by 2004 they were already raising rates. As soon as they raised rates, growth slowed down. If they had raised rates sooner, we would have gone into recession sooner.


Posted by: Walt Someguy | Link to this comment | 04- 4-14 2:16 PM
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You take that back, Walt; I don't even read history. I think the baseline for our economy has been recession for a long time, kept afloat by the wealthy lending increasing amounts to the rest of us, so I'm not sure I'd describe 2003 as normal growth.


Posted by: Eggplant | Link to this comment | 04- 4-14 6:34 PM
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Well, yes, but the rot spread through the whole system, that's what made it a bubble. Retail bank employees knew they were doing something dumb, as did structurers, as did people at rating agencies, etc, as in this article that starts with my favourite quote

http://www.nytimes.com/2008/12/28/business/28wamu.html?pagewanted=all&_r=0

"We hope to do to this industry what Wal-Mart did to theirs, Starbucks did to theirs, Costco did to theirs and Lowe's-Home Depot did to their industry. And I think if we've done our job, five years from now you're not going to call us a bank."

And government not only underintervened with deregulation, but kept pumping money into the bubble with badly undermanaged state institutions like Fannie Mae and Freddie Mac. Oh yeah and the insurers - AIG really tied the whole cluster together. The great thing about a systemic crisis is once its over its obvious the stupidity was everywhere.


Posted by: conflated | Link to this comment | 04- 5-14 8:11 AM
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Thinking about it overnight, is it possible that low interest rates could speed offshoring and the shift to automation, helping depress wages and thus inflation? Sort of an inverted Phillips curve? If the normal effect of monetary policy during a recession is to increase the velocity of money and more quickly erase past mistakes like over leveraging, perhaps the current mistake being fixed is the tragic overpayment of labor in the US and Europe.


Posted by: Eggplant | Link to this comment | 04- 5-14 10:59 AM
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Putting it another way, monetary policy usually speeds are way back to equilibrium. What's the biggest disequilibrium today?


Posted by: Eggplant | Link to this comment | 04- 5-14 11:05 AM
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87: Here's a better version of that link (first one hung for me while waiting for the page to load, but I found the article by searching on the quote). And yeah, it's a prime example of the kind of bank behavior that Lewis was talking about Wall Street incentivizing.


Posted by: Dave W. | Link to this comment | 04- 5-14 2:51 PM
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