I have a long standing theory that no one really understands how the economy works, not the government grandees in New York and Washington D.C., not the well dressed predators of lower Manhattan, not the economics professors, not the citizen day-traders, not even the money bunnies on cable television. I don’t mean to cast aspersions on their individual professions; it’s just that the economy of this country, and of the broader world, is incomprehensibly vast, even if prompt and accurate data were available – which it isn’t. Serious economists can do amazing analysis after the fact, but even the most reliable indicators and astute computer models can only guess at what’s just happened, much less take a stab at what’s going on right now, and as for three months from now, best of luck pal. But somehow, some way, it all keeps chugging along, people work jobs to earn income, store shelves have goods available for purchase, and life goes on.
We just don’t know how it works; or, more precisely, we don’t know the specifics of how, just the broad outlines. The system is too complex to be reliably predictable, but that doesn’t change the fact that there’s money to be made in predicting it. So when something big happens some people look like geniuses for having expected it and some people look like fools for having said that Big Thing X will never happen. But the people who were smart and correct the last go round won’t necessarily be smart and correct the next time, and vice versa. That’s why all those goofy investment ads have to have that marvelous disclaimer: Past performance is not a guarantee of future results.
(This will never end either. Last year it was real estate, this year it’s oil prices. Does the current high price (by historical standards) of a barrel of oil reflect a new level of supply and demand, or is it being driven up by speculators? To take a nice, internet safe example, Paul Krugman thinks the former, Jon Taplin thinks the latter. One of them is closer to correct than the other, but they’re both smart, honest guys and we don’t know which one of them is missing something vital.)
The last year and a half have seen a great credit crisis brought on by a bust in American real estate. Collateralized Debt Obligations (CDOs) have come in for a lot of blame because they have somehow allowed mortgage defaults in the United States to cause a global financial panic that threatens to melt down huge banking institutions. My understanding of CDOs is admittedly very limited, but this article in a recent issue of The London Review of Books contains some eye popping information. It does an excellent job of explaining an extremely complicated subject and I heartily recommend the whole thing, though you should know going in that it is a slog.
No summary here could do it justice, but I did learn some extremely interesting things that support my theory that no one really understands how the economy works. First, and most surprisingly, CDOs are a very recent invention. The first of them were only put together in 1996. I had long assumed that CDOs were one of those financial instruments that had been around forever but hadn’t really exploded in popularity until recently. Not so, they’re only twelve years old; so if there is ever serious political fallout from this you can take it to the bank that making CDOs illegal will be one of the first things proposed.
The second really interesting thing I learned is that CDOs and the indices created to value them are so complicated in their structure and in their holdings that the markets that sprung up to trade them operate almost completely in the blind. In order to properly value debt you need to be able to asses the odds of default. But assessing the risk of default on such diverse holdings is almost impossible; the only way to do it is with extremely complicated computer models and a faith-based amount of guessing.
The resulting programs require so much computing power that it actually strains municipal power systems and has forced hardware manufacturers to begin thinking about “performance per watt”. That right there should be an indication that you’re in over your head; trading, which is mostly done by guys who are not Ph.D.s in Mathematics, should not require enough computers to simulate nuclear explosions. The calculations are based in part on guesses and the rest is Greek to everyone without a doctorate in math, which means that the numbers the computers spit out each morning are impossible to verify, which in turn means that no one really trusts them, which at long last means that when something goes wrong (e.g. higher than expected mortgage defaults) the models stop working and no one can trade anything because there’s no way to evaluate relative worth.
That is, as best I can tell, what’s going on, though I still recommend the LRB article in full if for no other reason than you’ll learn about “end-of-the-world insurance”.
In real terms what it all boils down to is that if the financial systems we all depend upon can be nearly toppled by something as innocuous as a few over-extended Americans missing mortgage payments then there are serious problems that need to be addressed by serious people. The key word in that last sentence is “nearly”. The system didn’t collapse and while we’ll probably never know just how close it came the important thing is that it didn’t. It’s a mystery how it keeps working, but it does. Prudence nevertheless requires that some kind of reform be undertaken.
After all, if you’re pleasantly driving a car down the highway with one hand lightly on the wheel and then, without warning, the car begins to swerve violently and requires ten white knuckles just to maintain control you don’t go back to a feather touch when the swerving stops and simply trust your reflexes to save you if it happens again. You pull over and get the car examined and, if necessary, fixed.
Nobody knows what’s going to happen economically in the future, but we can examine the past and, at the very least, not repeat our mistakes. The bailouts of Bear Sterns and Northern Rock are generally seen as necessary, if distasteful, interventions of last resort; in other words, as white knuckle driving. But market systems are supposed to work by punishing failure and rewarding success. If we cannot allow one bank to fail out of fear of what that will do to the other banks, we might want to get the system checked out. The economy will continue to work somehow, but that doesn’t mean there’s nothing we can do to help it along.
