Atanu Dey On India's Development

On the US Financial Crisis

Richard Feynman has claimed that “it is safe to say that nobody really understands quantum mechanics.” He was serious about it because of the complexity of the subject and the counter-intuitive consequences of the theory. Sometime I think that the global financial system is also beyond comprehension. But that is not quite true. Unlike quantum mechanics, the financial system is an artifact, albeit a very complex one. Also, it is possible to understand something and yet be unable to fully control it all the time. Once in a while, it can crash. When–not if–it does crash, you figure out what broke, fix it so that it does not break again, and get on with life. It will break again later due to a different bug but it will never be entirely bug free.

As I am an economist, I am supposed to understand the financial system. Luckily, I am not that sort of economist and so I don’t feel the slightest embarrassment admitting that I don’t have much of a clue. But sometimes I think that perhaps not too many people — even those whose business it is — have a clue either. Some suspect that even the chairman of the Fed, Ben Bernanke, too is not fully clued in. Go figure.

Anyway, I wrote a piece on the meltdown of the US financial system for MailToday. Why? Because everyone and his brother is writing one. So why not I? It will be in the papers tomorrow. But you, dear reader, get to read it today!

Atanu Dey’s Musings on the Financial Crisis

On September 10th, the Large Hadron Collider at CERN, went operational. The largest physics experiment ever built, the 27km-circumference accelerator took decades of planning, over a decade to build, involved 10,000 scientists from 75 nations, and cost $10 billion. For guiding particle beams, it uses over 1600 superconducting magnets, most weighing over 27 tonnes, cooled with 96 tonnes of liquid helium. On September 19th, a “quench” occurred that affected the magnets in one of the sectors and the LHC had to be shut down for repairs.

Critical failures can be expected to happen in any sufficiently complex system, whether mechanical or institutional. Though they are engineered by people, and therefore humanly comprehensible, the complexity can surpass human ability to fully manage and control them. This appears to be true of the global financial system which is a critical component of the modern global economic engine.

September appears not to be too good for complex systems. In September 2001, the US sense of invulnerability collapsed with the Twin Towers of the World Trade Center. This month’s spectacular near-meltdown of the US financial system is another collapse.

Whatever happens in the US happens on an unprecedented scale. Like its successes, its failures have global impact because of its disproportionate influence in the world. You cannot talk of the modern world without reference to the US. Practically every bit of modern science and technology – from bombs to computers – was developed there. It innovates and naturally so because 40 percent of the world’s R&D spending happens there. Seventy percent of the world’s Nobel prize winners work there, and is home to 30 of the world’s top 40 universities.

The figures one comes across in the reporting of the US financial crisis boggle the mind. The US Federal Reserve and the Treasury Department have asked for $700 billion to buy distressed mortgage-related assets. Add to that the $200 billion to rescue the mortgage guarantee firms Freddie Mac and Fannie May. Top it off with the loan of $85 billion to keep the giant insurance company American International Group afloat. The total assistance allocated to prop up the financial system so far – and it is anyone’s guess how much more will be spent eventually – is approximately the annual GDP of India, a country of a billion people.

All this spending by the US government will raise the public debt of the US to around $11.3 trillion. That makes it the biggest borrower in the world. The creditors, among others, are the central banks of many countries such as Japan, China, the oil-rich nations, and even India. Many countries maintain foreign reserves in US dollar denominated financial instruments. The US borrows approximately $2 billion dollars from the rest of the world every day. Why does the world permit the US to get away with it?

It is perhaps for the same reason that the US government is rescuing AIG, Freddie and Fannie: they are too big to fail. To recount briefly, there was a housing bubble in the US and it burst. With asset prices falling, there was a rush to sell assets. But if everyone rushes to sell, the prices fall. This leads to a downward spiral called a ‘debt deflation’. The housing bubble was created over years of easy money thanks to Greenspan, and subprime mortgage lending. The pendulum of market sentiment swung from the one extreme of greed to the other extreme of fear, as it always eventually does.

The financial system is a web of interconnected banks and financial institutions. AIG the mortgage insurer (assets of $1 trillion) cannot be insulated from the troubles of the mortgage guarantee firms Fannie and Freddie (combined assets $5 trillion.) They in turn are linked to other financial institutions globally and the contagion could spread unless action is taken urgently. Financial insolvency is contagious. By nationalizing Freddie and Fannie, and giving a bridging loan to AIG, the US government put a backstop to the slide. They were too big to be allowed to fail. But Lehman Brothers ($600 billion in assets) was allowed to go under because the collateral damage was manageable, and Merrill Lynch was sold. It was simply a matter of maintaining market confidence to arrest the domino effect of major institutions failing.

The US government rescued the US financial institutions it did because as noted before they are too big to fail. The US government is able to spend all that money it does not have simply because the US is too big to fail. The domestic financial crisis could have snowballed into an international financial crisis, the beginning of which would have been a crisis of confidence among the investors of the corporation known as the US.

It is said that if owe the bank a little money, and are unable to repay, you are in trouble; but if you owe the bank a billion dollars that you are unable to repay, the bank is in trouble. In the larger context, the US owes the rest of the world a lot of money. If it cannot pay it back, the rest of the world is in trouble. Therefore, the rest of the world has to make sure that the US never fails. That is why the US continues to get a massive line of countries credit –- often from relatively very poor countries such as China which has lent the US an estimated $2 trillion.

But it does not come without a cost to the US. Economists estimate that the financial crisis will cost it around two percentage points in GDP growth for the next couple of years because recession in the US is a given. Global economic slowdown is also guaranteed. As Niall Ferguson wrote in the Financial Times recently, it is not merely gloom but doom in terms of more shocks to the global economic system. The financial system cannot be isolated from the economic system.

Which is of course very depressing news for India because India any slowdown of the global economy will adversely impact India’s growth. India’s high technology sector income is tied to the US economy’s prospects. Global economic slowdown will have a major impact on the growth of emerging economies.

It is well to remember what Nietzsche said, “What does not kill me, only makes me stronger.” Financial crises, not unlike the problem with the collider, are not random. They are indicative of systemic problems. But in the final analysis, they are generally good because they force necessary changes. The complexity of the system had overtaken the ability of the regulatory authorities to manage the system. Now more thought would be given to regulations that work. The unreasonable success of the US is built upon a culture of innovation. The US will figure out a way out of this self-created mess and build a more robust system. The immediate effect of this financial turmoil will be short term pain but in the long run it would make the system less vulnerable.

In a few months time, both the LHC and the US financial system will be back up and running—at least till the next failure. You can bet your money on that.

  • http://the-redpill.blogspot.com vakibs

    Atanu

    You cannot wishwash the utter failure of these American institutions away.

    Lehmann brothers, AIG, Freddie-Fannie duo.. they all failed because they have criminally over-invested in unproductive sectors. Particularly, US home mortgages.

    This failure should be owned up by the guys who are writing market simulations for these companies. But these people will not pay for their criminal mismanagement. Their careers will receive bonuses and their multimillion dollar salaries are going to rise.

    What is fundamentally missing in the market system is accountability. The ancient banking system evolved during the printing era is woefully short of addressing accountability issues in the modern internet-era. We need new models for accountability.

    The current banking system is such a joke, that the French bank Societé Generale has recently realized it is 5 billion euros short of its market worth, due to the adventures of a math-geek that it employed.

    Fundamentally speaking, productive investments pay. If you are investing in producing energy or “stuff”, you will be spinning the wheels of the economic engine. The USA has mismanaged its money by not investing in new energy production and not investing in high-production-avenues such as in India, China or Brazil.

    Non-productive sectors such as real estate or home mortgages can take only a limited amount of investment.

  • Amit

    Seems like some experts had been warning about this crisis for a while now – Bill Fleckenstein and Roubini, among others. Here’s a(n) NYT article (may require registration) on Roubini:
    http://www.nytimes.com/2008/08/17/magazine/17pessimist-t.html

  • http://ko.offroadpakistan.com KO

    Atanu, while on the whole the US finanacial system perhaps gave in more to “irrational exuburance”, as vakibs said above, there was a whole lot of fraud and gaming of the regulatory system – as well as investment in financial instruments not tied to anything productive.

    I think your post makes the whole thing sound a lot cleaner/clearer than it actually is – and given that there was so much “gaming” in the system, the after affects could be worse than just a recession…

  • http://kalabaaz.com navneet

    Atanu, there is something strange in comparing a Physics experiment with an economic model. While the underlying assumptions of a physics experiment are based on known immutable laws of nature, the underlying assumptions of an economic model are based on dynamic and unpredictable sociological factors which I’m afraid most economists are unable to account for when conducting experiments of society.

  • http://kalabaaz.com navneet

    Also, in terms of this specific U.S bailout. What is really happenning here? The U.S Government is buying the mortgage-related paper from the banks at far above the market price. If the banks were willing to accept what the market is willing to pay for it there would be no need for a bailout. To me, this gives credence to the saying that “Capitalism is socialism for the rich”. And the tune of the bailout is expected to be $700 billion to one trillion dollars. The U.S is about a $14 trillion economy. Can you justify an economy giving away 6-7% of its share to the top 5 companies in the name of fixing the system? If this money was demanded by say education or health care, it would be termed impractical and socialist.

  • http://www.deeshaa.org Atanu Dey

    Vakibs wrote, “You cannot wishwash the utter failure of these American institutions away.”

    I am not capable of whitewashing the American financial system as I don’t understand it. My position is that it is a complex system and therefore cannot be immune from occasional failures. Of course, there have been malicious and/or ignorant players in the system. Nothing man made is perfect. But when things fail, there is generally a tendency to learn from the failures and move on.

    The thing that I do is that the financial system has an effect on the economy. Most of the time it helps the economy but when it fails, it does drag down the economy. A complex modern economy cannot function without a sophisticated financial system. The success of a modern capitalist system requires a complex financial system. There are no shortcuts. It’s like a good operating system is necessary for the hardware to be of some use.

    I would recommend the posts by Becker and Posner as a good commentary on what happened and why.

  • http://www.deeshaa.org Atanu Dey

    Amit, thanks for the link in comment #2.

    Today’s NYT has a very good article by Gretchen Morgenson if one is interested in the gory background details.

  • http://www.deeshaa.org Atanu Dey

    KO, I was just taking a bird’s eye view of the current situation. The worst possible outcome of a financial crisis is a deep recession. As of now, most people who are in the know believe that that outcome has been averted.

    It is human nature to game systems for their own private profits. It is the job of others to prevent that gaming. Creating perfect systems is not humanly possible.

    Is it a failure of capitalism? Of course it is. So should one discard capitalism? Sure, if a better system were available.

    The important point I see is that failures of subsystem (the financial system is a subsystem) does not justify the scrapping of the whole system.

    When the fuel transfer pump of your car fails, you don’t abandon the car — much less decide that the entire transportation system has to be scuttled.

  • http://www.deeshaa.org Atanu Dey

    Navneet, I was not comparing the LHC with the global financial system in terms of their underlying assumptions and so on. What I wanted to do was show that all complex systems — whether mechanical or conceptual — fail. It is their complexity that I was drawing attention to, not what they are designed for.

    More in my next post on the matter.

  • http://kalabaaz.com navneet

    Thanks Atanu. That Becker Posner blog is a fantastically lucid resource.

    I also think the reasons for pumping this kind of money by the Bush Administration is more political. No one in this administration wants to use the word recession or admit that the slump is downwards from now on, for at least some time to come. The present administration is just hoping that it can leave office and let the next administration deal with the consequences of full-blown recession.

    I appreciate your position of looking at the LHC and the world economy as two complex systems but this is just a suggestion. Because of the highly volatile social and political consequences of Economic decisions on human life, this introduction seems to give the impression to the reader that you’re looking at the present U.S Crisis as a minor aberration in the otherwise well understood system. My point was that even though the LHC may be experiencing hiccups, we know what they are and how to fix them because we understand the founding laws of nature that govern this experiment. That cannot be said of the complex and mostly misunderstood presumptions of economic models.

  • anuj
  • anuj

    Btw, The physicist/Quant [Emanuel Derman] I mentioned above was the head of Quantitative Risk Strategies group at Goldman Sachs. He is also responsible for several Derivative strategies, which are in use at Goldman to this day.
    And some of those strategies were even used by the Credit desk. :)

  • pankaj

    Atanu Is america going the Indian way,the effects felt around the world are a proof that usa is still number one and will remain so for some time to come, of course a declining one .

  • praveshb

    Its very modest of you to say that you have insufficient idea why system broke down. Indeed complex systems are difficult to completely comprehend, and hence are vulnerable to human error in getting absolute hold on them. It is humanly impossible to say that we understand all the effect and repercussion of the model and we err when we are too sure about anything.

    Having said that, I think the current model also shows the vulnerabilities a capitalistic, free market system presents itself. Whether the flaw in the given “free-market” system is inherent in the basic idea of it, or whether human greed makes it less useful is something I need to fully understand. However, to me its sure that socialistic and more “common” people friendly policies are not as bad as we are generally made to think.

    Atanu, the current meltdown has kind of reinforced my view of governmental need to control the basic needs and policies of the country, which it should not let any “capitalist” free market based individual to exploit in the name of innovation.

    I would love to hear more from you in the form of a similar refreshing article that you presented to your readers today.

    Perhaps, you can then say that whether free market and entrepreneaurship is the really the solution of human misery and poverty

  • http://the-redpill.blogspot.com vakibs

    Atanu

    Calling this financial crisis a death-knell of capitalism is disingenuous. Capitalism is here to stay with us.

    What needs to change is the banking system. What needs to change are the models of accountability.

    This change is needed not because of some fundamental problems with capitalism, but because of the new challenges presented by internet, e-commerce and the online trading of stocks.

    I am sorry I used harsh language such as “you cannot whitewash.. “. But I was put off by you comparing this crisis with the Large Hadron Collider (LHC). We know exactly why the LHC failed. It is because of a liquid Helium leak. We know what we have to do to fix it – adjust the connections between all the magnets. Such level of diagnosis is not present with the financial crisis.

    Actually, nobody is even keen to diagnose. Nobody is keen on looking for the problem, the Helium leaks so to speak of. The Becker article you linked says the solution would be to privatize the two freddies. I mean, come on ! These guys are trying to fix everything with the same old set of tools. There is a permanent fear that Marx will rise up from his grave. These people are diagnosing the past, not the present. t will not work, because the problem we have now is completely new. There was no internet until the 1980s. People were not swapping stocks like they are doing now.

  • http://www.deeshaa.org Atanu Dey

    Vakibs wrote, “Calling this financial crisis a death-knell of capitalism is disingenuous.”

    Sorry I missed that point. Who suggested that this financial crisis is a “death-knell of capitalism”?

  • Amit

    Given how the Dow Jones Index reacted to the talks of handbail-out and voting on the recent bill, it seems that the Wall St. approves of socialism (for the rich). :D

  • http://kalabaaz.com navneet

    Amit, if you have a decent bandwidth I would recommend that you watch this:
    “The Trap : What happened to our dream of freedom”

  • pankaj

    USA slogan is ‘Tension leneka nahi dene ka’