The Anglo Irish Bank (AIB) jumped to more than 796 basis points in credit default swaps prices. Ireland already pumped €22.9 billion into AIB, which was nationalized in January 2009. Standard & Poor’s last month said the bailout cost may eventually rise to €35bn, about 10% more than the projected tax revenue for this year, and Central Irish Bank Governor Patrick Honohan estimated a cost of as much as €25bn. The Irish government announced yesterday its decision to split AIB and pass its ‘toxic assets’ to a bad bank. Despite strong economic fundamentals (current balance surplus, exports of high value-added, forecasts for growth above European average), Ireland is in the last thirty days in the eyes of speculators.

Greece, despite Brussels repeated political support to the Athens cabinet, just reshuffled, and IMF and ECB interventions maintains the second place in the probability of default world ranking. Portugal reentered the ranking on August 24 and maintains a high level of cds prices and a probability of default above 25%. The yields of Portuguese OT are rising again, above 5,7 per cent, although below the peak on May 7 at 6,33 per cent. Although the yield premium on September 8 regarding the German Bunds’ yields was for the first time above the peak on May 7 and hit a post-euro record.

The Wall Street Journal, last September 8, reported that the recent European bank stress tests understate some lender’s holdings of potentially risky government debt and focused on the cost of insuring government debt against the risk of default in Spain, Portugal and Ireland, adding more alarm to the speculation.

From London, the Financial Times stated that the eurozone debt crisis is about to enter a critical phase as governments must raise €80 billion in September, more than €70b in October, €75b in November and only €40b in December. Spain must raise €27.5b, Portugal €6b and Ireland 2.5b. according to ING Financial Markets.

Are we approaching a new crisis like the last one from April 21 until May 7? A new high stress period for government bonds yields of peripheral countries may come?

Janelanaweb.com interviewed Cinzia Alcidi, Research Fellow from the Centre for European Policy Studies (CEPS), based in Brussels.

INTERVIEW by Jorge Nascimento Rodrigues
© 2010

Q: Almost four months after the Eurozone crisis of last May and more than a month after the European bank stress tests results, probabilities of sovereign default are rising again in the so-called PIIGS. What went wrong?
A: Fundamentally, the current sovereign debt crisis in Europe is a banking crisis. The only exception is probably Greece, where the real issue is about the solvency of the government. In the case of Portugal and Ireland (also Spain) the fundamental problem is in the state of health (or better unhealthy) of banks combined with the weak economic fundamentals of those countries. Banks are huge, sometime their size is comparable to the GDP of the country to which they belong, largely interconnected and leveraged. Some of them are probably insolvent. If a bank gets into trouble, government is expected to intervene. But in some case, it does not have enough resources to guarantee a solution especially if it is already largely indebted. Until now the troubles of the banking sector have been addressed as liquidity problem, by providing cash or guarantee, but now the blanket of guarantees required is too big for many countries. Some countries will need in turn guarantee.

DEFAULT: “I would say NO in the short-term”

Q: Do we risk bankruptcy or debt restructuring in those countries in a five year horizon?
A: I would say no in the short-term, neither banks nor countries, but picture may change in the longer run. The country with the highest probability of debt restructuring is Greece and at the moment the country is benefiting of a special agreement that basically excludes any form of default. After 2013, situation could be different. Markets seem to believe that Greece will not be able to honor its obligations and a debt restructuring is inevitable as soon as the special plan is over (what happened yesterday is again a sign of this belief, despite there was not real breaking news on the Greek front).

Q: Politically debt sovereign default is a word out of the official double-speak?
A: The ECB and the Commission have a clear position against default or restructuring: sovereign nation cannot default. It is also clear that the ECB is playing a crucial role in avoiding or at least postponing a default by proving unlimited financial support to banks and intervening on the government bond markets.

Q: And regarding banks?
A: For banks the situation is very tense. One of the most important lessons from the Great Depression during the 1930s in the US is that one should avoid bank default, as to confirm the lesson after Lehman Brothers was let down we had huge market disruption. Yet, this situation create huge moral hazard that was also one of the elements that contributed to the pre-conditions of the current crisis. Hence, I think that first we need in place a system for bank crisis resolution. European authorities are working actively on this front. This is necessary and urgent, it will reduce moral hazard, protect citizens/taxpayer and safeguard trust in banks that deserve it.

TRUST: “It will be extremely difficult to restore market confidence and go back to the previous situation.”

Q: Yields for 10 year Irish bonds maturities are near 6%. In the case of Portugal also near 6%. The deterioration of the credit conditions of these countries, despite the intervention of the European Central Bank and the IMF, is again uprising. How those countries can reverse this trend?
A: It will be extremely difficult to restore market confidence and go back to the previous situation. At best it can take years and markets do not seem very patient. Markets are still very nervous and my impression is that uncertainty about the real situation is still playing an important role. Yesterday spreads reached new highs because of bad news about banks. After the stress tests we should not observe these phenomena. In peripheral countries, banks rely almost completely on the ECB as source of funding. In other words, Greek, Portuguese and some Irish banks seem unable to find other banks to lend to them except the ECB. The reason is that potential lenders do not trust the ability of repayment of those banks short of liquidity. The main purpose of the stress tests was exactly to shed light on the real situation of individual financial institutions, and by reducing uncertainty restore the function of some segment of the interbank market. Some banks can be cut out of the market because they have solvency issue. When the entire banking system of a country is cut out it’s because the worst scenario is applied to the whole country without distinction between the different entities and this is the case when uncertainty is high.

Q: And the climate is even worse, after the articles published at Financial Times and The Wall Street Journal this week…
A: Yesterday the tests were discredited in the international press, as providing incomplete information, and raise a lot of questions about the true exposure of some banks and the financial market reacted simply by selling. Until volatility in the markets is so high it will be very difficult to find some normality. One has also to keep in mind that fundamentally the intervention of the ECB, IMF and the Commission or even the EFSF are meant to solve liquidity issues (the only one they can address) and buy time hoping that some problems will find a solution. Of course this can help, but in some case, either country or bank, if the real issue is solvency, simply providing money will not cure the disease, only its symptoms and for some time.

GREAT RECESSION: “A double-dip is not necessarily the most likely event.”

Q: How the “unusual uncertain” (to use the words of Mr. Bernanke) forecast for most of the OECD economies, the risk of a double-dip in part of the developed countries or a stag(de)flation, will influence the European situation?
A: Of course the risk of double-dip is concrete. News coming from the US are certainly not re-insuring, but in my view a double-dip is not necessarily the most likely event. I would certainly exclude the kind of growth rates we experience before 2008 over the years to come in all the OECD countries, but a sort of muddling-through seems more likely. In particular, in the EZ, on average, I would expect positive, low growth with large heterogeneity between core and peripheral euro zone countries lasting over some time. The EZ countries need fundamental adjustments, domestically and cross country (convergence), to absorb excesses of the last decade in some countries (mainly bubbles in consumption and housing in some countries) and undertake a convergence path in competitiveness, which can happen largely through market forces driving up wages in some countries (increasing demand and employment in Germany should increase wages) and down in others (falling demand should drive down wages in Spain, Greece and Portugal). These processes are slow and can be painful, but at this stage unavoidable.

ECB ROLE: “My view is that without the support of the ECB we would be in depression!”

Q: Neville Bennet, from Australia, said at LeMetropole Café blog, “My case is that [European Central Bank-ECB] gross over-funding transmitted a terrible shock to the world financial system in late April 2010, and that shock had the effect of compromising the recovery.” Is it fair this hard comment?
A: The ECB is the one avoiding banks and government from falling! It is a very risky approach, it is true that it may imply a cost and it won’t be easy for the ECB too exit (from exception policy measures) but at this stage if the exit strategy comes too early (extraordinary measures removed) the outcome will not be pleasant for anybody. I would also suggest that if now banks sell all the bonds they have from GIPS [Greece, Ireland, Portugal, Spain], those countries will face a substantial risk of default. In fact this is already happening, the more banks sell the higher the risk. We have to be careful what we wish for. We are not in a normal situation on which we have to avoid a crisis, we are in a situation of crisis, we need to manage it. Crisis prevention is different form crisis management. The problem of excessive credit and too loose monetary policy was before 2008. My view is that without the support of the ECB we would be in depression! Just as example in Greece, where there is already a deep recession, without the ECB banks would be completely cut of liquidity (Spain was in a similar situation before stress tests, and Portugal and Ireland are not far from it) and firms and people unable access to credit. I agree we have to exit and go back to market rules, but the situation is still extremely complex.

The old rules of sovereign defaults still apply even to the rich countries and particularly to the “graduated” economies, those who “stepped” from emergent market status to the OECD club in the last twenty years.

The bond markets overreacted last week of April and first week of May to debt risk regarding the so called PIIGS,  particularly Greece and Portugal who attained historical peaks in probability of default, cost of credit default swaps and  bond yields.

In last Sunday, May 9, EU turned to ‘Nuclear Option’ to halt Euro and CDS market speculation with a massive 750  billion euro loan package from the EU (governments pledged a €440bn in credits and guarantees and €60bn from the  EU’s balance of payments facilities)  and the IMF (with a contribution of  €250 bn) in an attempt to stave off a severe  lack of market confidence in the European common currency and neutralize the risk of a serial default crisis in the more  vulnerable eurozone members. A huge package of $900 bn, more than the $700 bn TARP in 2008 against the financial panic.

Bold action saved the euro from a trip heading towards extinction. But debts didn’t disappear. No magic, despite politics. This package is on top of the €110bn rescue package for Greece. Also the ECB stands ready to buy government bonds in sterilized interventions on secondary markets and reactivates extra US dollar liquidity facilities and unlimited fixed rate offerings on three months loans. German chancellor Angela Merkel, meanwhile, lost biggest state elections in North Rhine-Westphalia and with it the majority in the Bundesrat (the Upper House in Germany). Probably Merkel’s tactics about Greece was a factor for CDU’s election defeat this Sunday.

Suddenly, a severe near-default crisis in a small economy like Greece and a surge in risks of default in other small economies like Portugal and Ireland generated an additional potential “cost” of  €860 bn on top of the Great Recession skyrocketing costs already done. In a bold move Monday Portugal sorted out from the TOP 10 ranking of highest default probabilities of CMA Datavision and Greece step down from the first place.

In the middle of this political and financial turmoil, EXPRESSO and janelanaweb.com blog interviewed professor Carmen Reinhart, from University of Maryland, and co-author with Kenneth Rogoff of the most important research analysis about debt cycles and default patterns in history. “This time is different” (Princeton University Press; September 2009), their last book on financial history, is a reference today. Recently several academic papers and conferences from Reinhart and Rogoff developed the methodology and the findings of the bestseller.

Crisis reality “show” just confirmed the pattern, from the first episode in Iceland to the turmoil in Dubai, the symptoms in Ireland, and most recently the near default in Greece and the high risks in Portugal.

As Rogoff wrote May 5 in the Financial Times: “Professor Reinhart and I found that international banking crisis are almost invariably followed by sovereign debt crises.”

At the heart of the present risk of serial default crises is a surge – as professor Reinhart referred in this interview – in external debt from governments and particularly businessmen and bankers that thought the “great moderation” was forever. In their business strategies and minds crises were unpleasant “things” of the past. “This time” growth and financial leverage was forever. Until 2007, when subprime gray swan appeared in the lake. Abruptly. As always.

Edited in San Francisco, May 10

PROFILE

Carmen Reinhart is the most widely read woman in economics, when measured by citation counts, says David Warsh, from the Economicprincipals.com, an independent weekly. She was born in Cuba and left the country with her father and mother in 1966 for the United States. In the 1980s she was chief economist at Bear Stearns, the global investment bank that collapsed in the financial panic of 2008. She worked also in high positions at the Federal Reserve Board. From 1996 she teaches at University of Maryland. Her collaboration with Rogoff dates from 2001, when he began a two-year term as chief economist at the IMF. He hired Reinhart to be his deputy.

FAST SUMMARY by Carmen and Vincent Reinhart
5 Realities against 5 Myths about the European debt crisis

1- This debt crisis is not new
2- Small economies in default can launch major financial turmoil
3- Fiscal austerity usually doesn’t pay off quickly
4- The borrowing bender is not specific of the eurozone
5- It’s a mistake to think that a default crisis can’t happen “here” (in a rich country or even in a great power)

Source: The Washington Post, Sunday, May 9, 2010

INTERVIEW by Jorge Nascimento Rodrigues (c) May 2010

QUESTION: Professor you refer that historically that’s not possible to detect a well-established sequence of “phases” in global crises. Regarding the ongoing Great Recession can we expect a sovereign default “phase” in this apparent final period?

ANSWER: Yes. Yes. Absolutely.

Q: Politicians, even economists and academic researchers, argue that that will not happen this time. Circumstances are different today, they say. Sovereign defaults would be extreme events, black swans, from the past. “That’s ridiculous!” they argue.  So, why to talk today about the distant 1500s or the 1800s when external debt crises were frequent in  advanced economies including the world powers of the time?

A: Well, Greece’s last default episode only ended in 1964. “Only” 46 years ago. We had defaults in developed economies as well after the WWII. The same occurred with great recessions. We have not seen crises at global level in the last 70 years in advanced economies. Therefore I’m not surprised that we forgotten such severe financial crises. Also the possibility of an extreme event like a default or a partial default. As we refer in our research serial defaults on external debt is a surprisingly universal phenomenon, including among now advanced economies in an earlier era.

We had a real shift

Q: So, it’s always the same problem. People think this time – their time – is different…

A: Regarding this global crisis I have told in 2005 that we are waiting a financial meltdown in the US and UK. About defaults there’s not a rule that it cannot happen in Europe or elsewhere as well. We referred that it is important to study very long time horizons to understand crises and recidivism. Declaring a premature victory over vulnerability to default crises – or other crises – is a recurring error. We saw how the “great moderation” period was decidedly short.

Q: Can we say the risk of sovereign defaults shifted in the last decades from the so-called Third World to the rich countries of OECD club?

A: Yes. We saw a growth in time of the level of external debt in advanced economies. We saw recently in the period 2003 to 2009 that the debt leverage in advanced economies just took off. The same in emerging economies of Europe.  We had a real shift. On the contrary the emerging markets on the all turned less vulnerable.

Q: Can we say that in the eurozone we have a co-movement of 4 or 5 countries with a certain synchronicity to a risk of default?

A: The common fact in Portugal, Spain, Ireland and Greece – and less in the case of Italy – is a surge in external debt. I mean a real SURGE! It’s why I pinpoint the performance of that period 2003-2009. It was a period of external expansion in debt, also in high income economies. The most extreme case was Iceland which I and Rogoff emphasized in our work. But the reason why you see a co-movement of these European countries is the total external debt. This is important even for Ireland and Spain that followed particularly conservative fiscal policies.

I’m not surprised with the market reactions

Q: In the case of Ireland the total external debt to GDP ratio is so extreme, above 1000% at the end of 2009. How it happened?

A: In the Chartbook of “This Time is Different” I mentioned that private debt become public debts. That’s why I am not surprised with this reaction from the markets. When you combine external public debt with the private one you just got this situation. The external private debt is huge in these countries. Italy is less affected. Its private sector didn’t go in a spiral bench.

Q: In the case of Portugal the private external debt is above 160% of GDP. Particularly the banking system went through a surge of debt. The overall external debt to GDP ratio for Portugal is 230 per cent. Anyway below the Irish level or the British one. Now shifting from the so-called PIIGS to the UK. In the middle of this turmoil in London due to the hung  parliament that emerged from last week general elections, analysts began to refer a critical situation in the UK with an  external total debt to GDP ratio of more than 400%, larger than the majority of the PIIGS. Also a public deficit to GDP ratio of “greek” style. London is near a red alert?

A: Well regarding UK it’s more complicated. UK is a financial world center. But we have a problem indeed in the  eurozone and in the UK and US. The surge in borrowing and borrowing, and particularly in the private sector, developed a big problem. They didn’t take in account the “externalities” of this extreme leverage process. Like the pollution problem.  People didn’t take in account externalities. All this process was unchecked. So the risk debt of following into a trap was huge.

Even after IMF programs we had defaults

Q: Reading your book it stroked me that Portugal was one of the economies with a huge potential for graduation from emerging market status, even the country from 1979 till 2008 with the highest change in institutional investors ratings - 32.8%. Second to none. How it happened that Portugal risks now de-graduation?

A: The risk following into the trap I mentioned is the answer. The plain obliviousness to the all issue about the debt cycles put at risk the graduation. Graduation from serial default is a prolonged process and has been characterized by setbacks even after several decades. We pinpoint that twenty years is a minimum length of time to speak of graduation from any kind of crisis. A weak threshold – as the current financial crisis in numerous advanced economies attests. Recidivism occurs often even after many decade gaps. Just remember that the last IMF program in a “peripheral” advanced economy of the eurozone was in 1984 for Portugal.

Q: But IMF programs – and this is the last question -, like those we saw today in Hungary, Latvia, or just beginning in Greece, are not a wall to recidivism?

A: The role of IMF programs has become important in recent years in helping graduation from emerging market status.  But, as you know, there are numerous examples of default even after the implementation of IMF programs. Indeed there are many cases where even an IMF program is not enough to solve the problem. Examples in middle income economies in recent decades included Argentina (2000-2001) or Turkey (1980-1982).

GLOBAL FIGURES

- Peak of share of advanced economies in sovereign defaults (including of serial variety): more than 40% in the 1810s; more than 30% in the 1850s and the 1940s;

- Duration of “tranquil time” between two crises of external default for countries with high income status: for more than 65% of the frequency distribution the “tranquil time” was less than 20 years;

- High income countries median number of years since the last external default: 104 (more or less a century);

- Worst cases since the last external default crisis ended: Hungary (40 years); Greece (46 y); Germany, Austria and Japan (less than 60 y);

- Best cases since the last external default crisis ended: Denmark, UK, US, France, Sweden, Netherlands;

- Top advanced countries with a decrease in institutional investors ratings change from 1979-2008: Japan, US, UK;

- Top middle and low income countries with the highest decrease in institutional investors ratings change from 1979-2008:   Venezuela, Nigeria and Argentina;

- Top 10 high income countries with the highest increase from institutional investors ratings change from 1979-2008:  Portugal, Spain, Denmark, Finland, Greece, Korea, Singapore, Sweden, Hungary and Italy;

- Top 5 middle income economies with the highest increase from institutional investors ratings change from 1979-2008:  Poland, Turkey, Chile, Morocco, and Romania.

Source: “On Graduation from Default, Inflation and Banking Crises: Elusive or Illusion?”, Rong Qian, Carmen M. Reinhart  and Kenneth Rogoff, NBER Macro Annual Conference, April 9, 2010

FACTS FROM HISTORY

(External defaults since 1800s in high and middle income European countries)

Austria: 7 episodes (1802-1815, 1816, 1868-1870, 1914-1915, 1932-1933, 1938, 1940-1952); France: 1 episode (1812); Germany (Prussia, Hessen, Schleswig-Holstein, Westphalia): 4 episodes (1807, 1812-1814, 1850, 1932-1953); Greece: 5 episodes (1826-1840, 1843-1859, 1860-1878, 1894-1897, 1932-1964); Italy: 1 episode (1940-1946); Netherlands: 1 episode (1802-1814); Poland: 3 episodes (1936-1937, 1940-1952, 1981-1994); Portugal: 4 episodes (1828, 1837-1841, 1850-1856, 1892-1901); Imperial Russia: 2 episodes (1839, 1885); Russia after implosion of Soviet Union: 2 episodes (1991-1997, 1998-2000); Spain: 5 episodes (1809, 1820, 1831-1834, 1837-1867, 1877-1882); Sweden: 1 episode (1811-1812).

Source: This time is different Chartbook: Country Histories on debt, default and financial crises. March 2010.

Facing extreme events and the “tail” surprises in a transition phase, the best advice is to ride them out, to thrive through, to have agility do adapt. You can also profit from five advices that Michael Mauboussin, an investment strategist specialist and author of Think Twice (Harvard Business School Press, 2009), gave us in this interview.

Also take note that not all extreme events that take us by surprise and disrupt our lives are “black swans”, as popularized by the title of the essayist and financial expert Nassim Taleb’s book, with a second edition coming in May (Random House Paperbacks, 2010).

Analysts and journalists simply label every extreme event as a “black swan” – an unexpected great recession after 80 years of “moderation” in business cycles, a severe earthquake with catastrophic physical, economic and social disruptions, a surprising volcanic ash cloud blocking the euro airspace for a week. “This is simply not the case”, say Mauboussin. A majority of them are “gray” – “gray swans” are something that Benoit Mandelbrot or the same Taleb in the same book ask us to pay attention.

Invaded by “gray swan” events we have to understand the systems that feed them. Mauboussin give us some important clues.

A SHORT TALE: Black & Gray Swans

Taleb popularized the “black swan” metaphor used since Aristotle. Some extreme events are unpredictable and improbable because they are out of our knowledge, experience or memory. They are the unknown unknowns, by definition.

The black swan was a mythical water bird, only pure white swans are supposed to exist in the lakes, until in the wetlands of Western Australia they were first seen by Europeans in 1697, when Willem de Vlamingh’s expedition explored the Swan River. Later the naturalist John Latham described them scientifically. They turn the official state logo of Western Australia.

Taleb mentioned the WW1 or the emergence of Hitler as a “black swan” geopolitical event, or the 9/11 terrorist attack in NYC. The power projection of the Portuguese in the 1400s and 1500s were regarded as “black swans” by the incumbent geopolitical powers in the Mediterranean and the Indic. Taleb differentiates also from positive (random discoveries like penicillin or Viagra) and negative”black swans”.

But the author wrote also about another type of swan – the gray one, for a different metaphor: extreme surprising events that are “modelable” in some way. They are extreme events that emerge abruptly but are probable. It is not possible to completely figure out their properties and produce precise calculations and consequences. Benoit Mandelbrot, the father of fractals, wrote about this type of swan event. He pointed out that not all extreme and rare events are “black swans” – we can “gray” some of them, we can somewhat take in account. The late management guru Peter Drucker talked about trends that are running below our feet, but that most people do not see or sense. They are systemic trends that caught most people by surprise.

We can collect a few events that are “confusing”: maybe they are “black” or “gray”. For instance, the scenario of implosion of the Soviet Union was not “visioned” by Paul Kennedy in his major book The Rise and Fall of the Great Powers (1st edition published in 1988). The coup d’état against the Maoist gang of four in 1976, a mere month after Mao Zedong’s death, brought years later the surprising Deng Xiao Ping and his reform program that changed China and the world (as we see today).

Anyway, now, many economists consider the current Great Recession as a “gray swan” event and not a black one, despite the majority of economists ever thought of the possibility of a major global crisis in the last 30 years. The majority was addicted to a state of mind enveloped by a dominant complex system of myths, like the general equilibrium in macroeconomics, the abuse of Gaussian distributions where they are not appropriate, and the “great moderation” of volatility, and also due to contemporary statistics showing a diminishing average in months of recession periods after WW2. Many specialists in extreme financial events consider that the stock market crashes are “gray swans”, despite “this time is different” illusion of the financial mob.

Many researchers of this field blamed some features of human psychology, like group thinking, confirmation biases, addiction to narrative explanations, epistemic arrogance and tunneling, stress to make out patterns, inappropriate causation in history, induction method and faulty extrapolation from past results. Mauboussin considered overconfidence the biggest factor in poor decisions. As an antidote, Karl Popper used the principle of falsifiability – as Mauboussin explains in his article at The Futurist magazine (March-April, 2010): “Popper’s point is that to understand a phenomenon we’re better off focusing on falsification than on verification.”

Mauboussin gives a key to these complex problems: you have to understand how those systems behave even if you have no reliable way to predict any specific event or context where it will emerge by surprise.

PROFILE

Michael J. Mauboussin is Chief Investment Strategist at Legg Mason Capital Management. He is also the author of three books, including More Than You Know: Finding Financial Wisdom in Unconventional Places, named in the The 100 Best Business Books of All Time by 800-CEO-Read. Michael has been an adjunct professor of finance at Columbia Business School since 1993, and received the Dean’s Award for Teaching Excellence in 2009. His latest book, Think Twice: Harnessing the Power of Counterintuitionwas published by Harvard Business Press in the Fall of 2009. He has been an adjunct professor of finance at Columbia Business School since 1993 and received the Dean’s Award for Teaching Excellence in 2009.

INTERVIEW by Jorge Nascimento Rodrigues © 2010

Q: Extrapolation from past is a risky business. Faulty extrapolation is one common mistake as you mention. But can we learn from recurrent or cyclical patterns of history? In what sense is useful to learn from the past, to understand how geopolitical systems or the financial ecosystem behaves?

A: At the core of this excellent question is what philosophers call “the problem of induction.” At issue is the natural tendency to generalize about the properties of a class-—say, stock price changes—-based on a limited number of observations. When we only look at the favorable part of a distribution of outcomes, we get lulled into a false sense of confidence. This is why Karl Popper, a philosopher, insisted that falsifying ideas is more important than affirming them. Past patterns can be helpful if you consider a large enough sample of outcomes. However, we tend to anticipate only good things after a favorable time in markets and only bad things following a challenging period.  One clear example of where the past can help you in the future is with asset bubbles. If you see large increases in an asset price, lots of public excitement, theories of why higher prices are justified, and lots of debt, you can be reasonably sure that the future returns from that asset class will be unsatisfactory.

Q: To have an overview of the past is it important for thriving in critical moments, in complex situations, in a stressed environment? To have historical knowledge is important for a long term thinking to avoid immediacy, for a counterintuitive way of thinking?

A: There’s a fascinating line of research studying the effects of stress on people. Take animals to start. Their stress response comes frequently from a physical threat—-for example, a lion chasing a zebra. The zebra elevates its heart rate, pumps blood, and turns off its long-term systems including digestion, reproduction, and immune system. Given the life-or-death threat, the zebra becomes focused on the present. Most stressors for humans are not physical, but rather psychological: deadlines at work, concerns about finances, issues regarding relationships. But the psychological stresses trigger the same physiological response—our bodies think that there’s an emergency. And here’s where the issue comes back to your question: when we are stressed, we have very difficult time thinking about the long term. There may be decisions that appear very sensible for the long term, but the stressed person does not select that way.

Reduce stress as a first step

Q: How we can deal with those circumstances?

A: The first step is to take action to reduce stress. Here, the advice is common but not always heeded: eat well, get sufficient sleep, exercise, and spend time with family and friends. Another step is to consider what’s going on in a broader context. What can history teach you about difficult situations? In many cases, the lesson is that “this too shall pass.”

Q: Surprise is always typical of transition phases, even if we have certain knowledge of ongoing trends. How management and company leaders, or politicians, can deal with surprise? In a severe stressed situation it is not easy to think twice…

A: Phase transitions occur when a small scale perturbation leads to a large scale change in the system. The classic example, of course, is the phase transition from water to ice. At 1 degree Celsius you have a liquid. One degree cooler and you have a solid. Dealing with these transitions is very hard, precisely because they are unexpected. But there are some things you can do. First is to learn a great deal about the system you are dealing with. Often if comprises many interacting parts, it will be susceptible to a phase transition. Second is to constantly think about the downside. Lots of “what if” thinking can help businesspeople and politicians prepare for scenarios that they wouldn’t consider naturally.

Q: You refer gray swans, picking the other “image-concept” from Nassim Taleb (usually only referred for the black “unmodelable” swans). Gray swans are “modelable”, so to speak. How do we develop that capability to “modelable” certain extreme, “gray”, events?

A: This strikes me as an empirical question. There are many systems—some with very extreme outcomes—that can be modeled. Earthquakes are an example. While it’s difficult to predict with any certainty where the next big earthquake will strike, it is not too difficult to characterize the distribution of earthquakes over time. Social systems are inherently more challenging, and in many cases we don’t really know what the exponent of the power law is. But I mentioned gray swans in my book because I was concerned that people were labeling every extreme event a “black swan.” That is simply not the case.

Transitory challenges

Q: The ongoing Great Recession was a surprise for most of the economists and politicians. And it seems it has more surprises – like the debt crisis and the default risks in “rich” countries. It seems the “tail” of this gray swan has more extreme events than the expected. How we deal with this strange “tail”?

Q: I’m afraid this important question has no simple answer. But I have some thoughts. First, a very healthy mindset for an investor is to recognize that when things go well for some time, they are less likely to go well in the future, and vice versa. Bubbles burst from high levels of asset prices, not depressed prices. And bull markets begin following a period of difficulty. As Hyman Minsky suggested, stability breeds instability. Second, it is very important to consider the role of incentives. On a very basic level, the makings of the Great Recession can be traced back to poor incentives. If people are well-paid to ignore to what could go wrong, you can be sure they will ignore it. The use of debt, or leverage, exacerbates the problem. So as a society we need to give some thought to if, or how, we can reorient incentives. Finally, I would mention the role of time. Events like market crashes, wars, or recessions are certainly very trying for the people who live through them. But considered over the span of time, these events appear much less consequential. So one way to deal with adverse tail events is to simply ride them out. Know in advance bad things can and will happen, and be prepared to sit through the inevitable, but also transitory, challenges.

LAST SHOT

5 short advices from Mauboussin

1- Avoid extrapolating in a pessimistic or optimistic mood

2- Avoid immediacy stressed decisions; think twice

3- Do not be prisoner of the “inside view”, and of the group thinking; opt out for the outside view and the counterintuitive approach

4- You have to learn how to deal with contingency; simply ride then out when black swans suddenly emerge in the lake

5- You can understand “modelable” gray swans; keep in mind not all extreme events are black swans

HIGHLIGHTS

“In the early stages of monetary development debt works to add to productivity, but is less effective the more debt there is.  Once the point of debt saturation is reached, adding more debt leads to negative output and to higher unemployment.”

“The private sector became completely debt saturated and the debt began to collapse so the government stepped in to compensate.  By doing so they transferred the private risk into sovereign risk.  The governments of the world are now also debt saturated.”

“Today there is far more debt than “money,” something I don’t think any economic theory is equipped to deal with.”

“The function of the multiplier is not linear, it is exponential.  The equations used to model our economy do not account for these phenomena.  Their models appear to work relatively well when debt levels are low in an economy, but as you move closer to debt saturation they begin to break down.”

“The only real solutions will be found by changing WHO controls the money and by nations producing their own sovereign money that is produced as an asset, not a liability.”

“All debts get repaid in one way or the other.  There are only two ways to discharge it; pay it back or default.  There is no such thing as “inflating away debt,” that is a myth.”

“The system has forced us into a corner of the box were we are darned if we do and darned if we don’t.  There is a clear escape route that can only be found by jumping outside the walls of the debt money box.”

“There will be no escaping the failure of our current monetary system until we escape from the paradigm of the debt backed money box in which we have all been placed.”

FOREWORD TO THE INTERVIEW

Financialization & Debt addiction: a systemic problem?

With the current financialization wave, “born” in the 1970s and 1980s, debt mutate in the economic aggregate most important in the world economy. German economist Moritz Schularick, from the John-F. Kennedy Institute, Free University of Berlin, showed in a working paper published by the National Bureau of Economic Research (“Credit booms gone bust”, WP 15512, Nov. 2009) co-authored with Alan Taylor, that credit and money are no more two faces of the same coin. We assisted to a decoupling of money and credit aggregates in the last 30 years, particularly in the OECD countries. This was a structural shift. The stable relationship between money and credit broke down. The credit system delinked from monetary aggregates. A new “systemic” problem just comes from the “shadows” of macroeconomics surprising the academy, regulators and the politicians.

That’s why economist Gary Dymski wrote recently (at the Cambridge Journal of Economics, 2010, 34, pp.239-255) that this Great Recession from 2007 was different from past crises, including the big one, the Great Depression of the 1930s. Today three countries (US, UK and Germany) have the lion’s part of the world debt. Only 7 European countries have 50% of the global debt. In the 1980s, the award went for the small un-famous gallery of the “gang of four” from Latin America: Argentina, Brazil, Mexico and Venezuela.

Nathan Martin, editor of Nathan’s Economic Edge blog, adds a new dimension to this problem of OECD economies addicted to debt – debt saturation due to a diminishing marginal productivity of debt, total debt, private and public. Something he showed for the US economy, studying the ratio from GDP growth to debt growth in the last 40 years. But we can extrapolate the pattern for the other OECD countries. The chart of debt saturation, based on data from financial expert Chris Rupe, can be followed through this link. (See at the end of the interview comments about the chart).

PROFILE

Nathan A. Martin is the author of the book Flight to Financial Freedom – Fasten Your Finances. The principal author of Freedom’s Vision, he writes daily on the Economic Edge, founded the American Party PAC and www.SwarmUSA.com.  An advocate for monetary reform his articles on the economy and monetary system have been published globally.  A life-long entrepreneur and current business owner, his message is clear: “become financially literate or become a victim of the external forces that are impacting everyone.”

INTERVIEW by Jorge Nascimento Rodrigues, © 2010

Q: We were used with Richard Kahn’s «Keynesian» multiplier to evaluate investment, particularly public investment related with the fiscal policies. The «Keynesian» multiplier does not function anymore in the developed economies?

A: During the time of Kahn’s education in Keynesian economics (1927-28), most economic theories were based upon linear economic concepts applied to non debt saturated constructs.  The problem is that the real world is not linear because our money systems are now based entirely upon debt – interest produces exponential growth over long periods of time, a non linear function.  Later, Kahn’s work on multipliers still did not consider the cumulative effects of adding debt to the bottom of economic cycles and failing to ever repay it at the top of economic cycles.  Today there is far more debt than “money,” something I don’t think any economic theory is equipped to deal with.

Q: That’s something most economists and governments do not understand quite well…

A: Yes, they still don’t understand how the growth mandate is created by the process of covering deficits with borrowing from the bond market.  This method of producing national debt is not a natural economic process, it is a process designed by central bankers for the benefit of central bankers.  It is insidious and builds up over the years during which time the central banks are skimming the productivity from the workers.  As the interest begins to build over time it takes more productive effort to service the interest and that becomes an anchor to economic growth.

Q: Some political economists blame Keynes…

A: Keynes advocated deficit spending during down cycles – it’s true, but he ALSO advocated saving during up cycles to pay for it.  This has been distorted to today’s spend more than you take in during bad times and still spend more than you have during good times.  This “stimulus” spending, or using debt to cure a debt problem leads to an exponential function that underlies both our debt and our money.  Thus the function of the multiplier is not linear, it is exponential.  The equations used to model our economy do not account for these phenomena.  Their models appear to work relatively well when debt levels are low in an economy, but as you move closer to debt saturation they begin to break down. If deficits were instead covered with the creation of sovereign money, an asset, versus debt backed money, a liability, then the relationship would be closer to what they described and it would have a linear function instead of an exponential one.

Q: Debt saturation seems to be a recent “black swan” event. The evolution from the 1960s is clear, the diminishing marginal productivity of debt in the US is a trend, although until recently in the positive side. Recently it went down in negative field. This happened because of the context of this Great Recession?

A: Indeed, the marginal productivity of debt recently went below zero in quarter three of 2009 inside the U.S.  It has been negative before, but not to this degree.  You’ll note that each new high with each cycle is lower than the previous high.  That reflects the weight of carrying debt loads.  In the early stages of monetary development debt works to add to productivity, but is less effective the more debt there is.  Once the point of debt saturation is reached, adding more debt leads to negative output and to higher unemployment.  This is why each recent up cycle has produced a “jobless” recovery.  The real economy is languishing, but the paper economy gets fluffed higher and higher. It’s only a “black swan” if you didn’t see it coming, no?  This was relatively easy to see coming, one only has to look at the escalating levels of debt and see the transition of budgetary numbers that go from millions to billions, and now on to trillions.  The exponential function is at work all through the US economy, this is why there is never any solution that works for the unfunded liabilities of Social Security, Medicare, and for huge deficits.  When the underlying numbers have constant growth, they very quickly get away from you when looking over long time spans.

Q: How we sort out from this mess?

A: The root problem is that the entire world is living in a debt backed money box.  You cannot find solutions that work inside of that box, that’s because the math of never ending debt does not work.  The only real solutions will be found by changing WHO controls the money and by nations producing their own sovereign money that is produced as an asset, not a liability.  I contend that the original designers of the Federal Reserve ACT (1913) knew what they were creating; they use debt to obtain power and control.  This is what the IMF and BIS are doing now, trying to create ever larger quantities of debt by going world-wide with it into failing economies and by beginning to saturate emerging economies.  This is the modern version of what was slavery that turned into share cropping, and now has morphed into control by generating pieces of paper – debt obligations.

Q: Can we “link” this “behavior” of the productivity of debt in the US with the declining trend of the real growth annual average, from more than 4% in the 50s to less than 2% in the most recent decades?

A: Absolutely.  But it is far worse than those statistics show.  The statistics coming from the U.S. have been so massaged that they simply do not reflect reality.  The inflation numbers are so badly massaged that any “real” statistic (corrected for inflation) is not real at all.  Our GDP numbers vastly overstate the productive output of our economy.  If we want to get serious about understanding economics we must ensure that we are using good data, and I can assure that we are not.

Q: In a saturation phase transition what can happened?

A: It depends on the reaction of those in control.  If they continue to pour debt into a debt crisis then eventually confidence will be lost and there will be a currency crisis and/ or crisis in government.  Should they attempt to institute “austerity” measures, then the economy will suffer.  Either way the final destination is the same, failure.  The system has forced us into a corner of the box were we are darned if we do and darned if we don’t.  There is a clear escape route that can only be found by jumping outside the walls of the debt money box.  History shows that failures of this nature can lead to extreme events such as world wars, revolution, terrorism, etc.  Are we smart enough to simply change our construct and understand what we are doing to ourselves, or do we push ourselves into those other events?  History says that we are not proactive, rather we are reactive, but in the end we tend to advance over time.  I would like to think that we could be proactive and advance first, before complete breakdown occurs.  There is hope as global communication definitely makes people more aware.  You will not find actual solutions, however, emanating from central bankers or governments who are beholden to them. There will be no escaping the failure of our current monetary system until we escape from the paradigm of the debt backed money box in which we have all been placed.   It could very well be that failure must occur first in order for people to understand that they must take action to break out of that box, to change WHO controls the production of their money.

Q: Can we extrapolate this pattern for other developed countries?

A: Absolutely.  We have yet to do so for other countries just because of the difficulties in comparing numbers.  It’s a straightforward calculation, but we need solid total debt and GDP figures in order to do it.

Q: Are the emergent countries far away from this trend?

A: Certain countries that have stayed away from debt are much farther away from debt saturation.  Central bankers are well aware of this and are working to press debt into countries that are currently not saturated.  Their idea of developed means creating a government that is in debt and where the workers work to pay taxes that funnel up to the bankers.  It doesn’t have to be like that; a government can produce their own sovereign non debt-backed money and thus can avoid the long term ills of debt.  The trick to doing so, however, is creating methods to keep the quantity of money under control so that confidence is never lost.  I have spelled out how to accomplish that at www.swarmusa.com and believe that all countries of the world should progress towards such a system.  This puts control of humanity back into the hands of the people and their elected representatives instead of the central bankers who are at the top of a long list of special interests who are currently controlling the direction of the planet.

TECHNICAL INFORMATION

Q: When you refer to debt, you mean total debt, public and private?

A: Yes, the diminishing productivity chart is based upon total debt.  But even that number is difficult to pin down now with derivatives distorting the view.  The private sector became completely debt saturated and the debt began to collapse so the government stepped in to compensate.  By doing so they transferred the private risk into sovereign risk.  The governments of the world are now also debt saturated.  The U.S. could not sell all the debt we produce and have thus resorted to tricks to mask that fact.  On this cycle interest rates hit zero and we had to take extreme measures.  The next low point will be far worse and may lead to a crisis of confidence in the public sector.  This loss of confidence is already occurring throughout the world.

Q: When you refer to debt, you mean external debt or domestic debt?

A: Both.  There are a couple of rules to keep in mind about debt.  All debts get repaid in one way or the other.  There are only two ways to discharge it; pay it back or default.  There is no such thing as “inflating away debt,” that is a myth.  Any attempt to do so will result in less purchasing power by the people who hold the currency and thus their productive efforts will get fewer goods in return and thus those productive efforts are used to repay it.  The loan always gets repaid with interest unless defaulted.

COMMENTS ABOUT THE CHART OF DEBT SATURATION BY NATHAN MARTIN

1-     Note that since the 1960s that each high on the chart is progressively lower than the previous which produces the overall downslope.  This is despite the fact that interest rates were in a rising trend going into 1980 and were in a falling trend from 1980 until 2008.

2-     What can be expected is that the line will rise again, but produce another lower high, probably significantly lower as the amount of debt in the system is much higher.  This means that a much larger percentage of productive effort goes to paying interest on the debt and to servicing existing principal.  That’s what drags down the productivity over time; it is a function of the interest and of having to service the debt.

3-     If it were possible to keep adding debt into the system, eventually all income would go directly to servicing the debt and interest.  There would thus be no velocity in the monetary system, as all money would simply circle immediately back to the bank.  This is why our process of bringing all money into being as a debt creates an impossible math situation that guarantees the eventual demise of the monetary system.  The only way to keep such a system going is by allowing the debt to get cleared out via default.

HIGHLIGHTS

The risk of an overlap
“There could be another overlap. In the previous case the overlap was due to (and the cause of ) a changing of the core country from Britain to the US.”

The uniqueness of the recent financial crisis

“But never before as in this [last] surge has the technological revolution been so directly relevant to financial innovation and to its spread across the globe. That is why I think this financial boom is different from the 1907 one. This one was also about innovation, but in financial instruments. All other financial bubbles are about leverage, arbitrage, asset inflation, etc. but not necessarily about financial innovations (although there are always some, of course).”

Globalization

“Full globalization will not happen unless there are measures taken to induce investment across all continents and stop the marginalization that leads people to migrate or adopt violence.”

FRAMEWORK OF THIS CONVERSATION

Carlota Perez developed in her book Technological Revolutions and Financial Capital (2002, Edward Elgar) a hypothesis of the long-term pattern of modern capitalism based in great surges of development driven by technological revolutions: five great surges until now since the beginning of the Industrial Revolution. Each surge represents a process of propagation of a tech revolution across the economies and societies during more than a half a century, from installation phase to deployment and maturity. In each surge we saw boom and bust episodes that constitutes a recurring endogenous capitalist phenomenon, caused by the way the modern market economy absorbs tech revolutions.

Carlota Perez found that the major tech bubbles regularly occurs midway along the process of assimilation of each tech revolution, after a generation of 20-30 years of market experimentation.The collapse of these major bubbles creates the conditions for enabling a Golden Age.

In the case of the fifth surge of capitalist growth – driven by the information and digital communications revolution from the 1970s and the 1980s -, we have seen a double bubble, first the dot.com mania from 1994 until 2000 Nasdaq crash, followed a few years later by a financial boom around new financial vehicles and a crash mid 2007 with a financial panic in 2008 and a world Great Recession.

For people interested in the technical side of this pattern, Carlota Perez published in the Cambridge Journal of Economics (2009, number 33, pp.779-805) an article titled “The Double bubble at the turn of the century: technological roots and structural implications”. Perez hypothesis is different from the notion of Kondratieff long waves that have been applied by several researchers to economic history and forecasting. An article by Tessaleno C. Devezas, Harold Linstone and the late Humberto Santos pictured a similar analysis for the tech bubble and the innovation and consolidation structural cycle of a long wave. “The growth dynamics of the Internet and the long wave theory” was published at the Technological Forecasting and Social Change review (2005, number 72, pp. 913-935).

In this interview we do not develop two other aspects of the long waves of modern capitalism or surges of growth that professor Carlota Perez mentioned directly or indirectly in her paper referred above: a) the financialization waves studied since Hilferding and Hobson and stylized by late Giovanni Arrighi and late Hyman Minsky, and b) the David Harvey’s “switching crisis”.

PROFILE

www.carlotaperez.org

Venezuelan, researcher, lecturer and international consultant, specialized in the social and economic impact of technical change and in the historically changing conditions for growth, development and competitiveness. She is Visiting Senior Research Fellow at CFAP (Centre for Financial Analysis and Policy), Judge Business School, Cambridge University, U.K., Professor of Technology and Socio-economic Development at the Technological University of Tallinn, Estonia, and Honorary Research Fellow at SPRU, Science and Technology Policy Research, University of Sussex, UK.

INTERVIEW by Jorge Nascimento Rodrigues, Janelanaweb.com, 2010 ©

Q: The double bubble and crash patterns of the 1990s and 2000s are unique in modern capitalism’ history or we can visualize the same pattern before in the double bubble and crashes from 1890-93 (a major technology based type) and 1906-1908 (a financial type)?

A: That’s a very interesting point. Apart from the 1907 panic, there was also the “rich-man’s panic” of 1903 and they were both mainly financial. I have always seen them as a manifestation of the fact that the third surge [the third great surge of development] did not really have a Golden Age but only a gilded age (see Chapter 12 of Technological Revolutions and Financial Capital, TRFC). And this is the danger we are running now. Every major technology bubble is unique, among other factors because every technological revolution is unique. In the third surge, which was the first globalization, there were major technology bubbles in most of the emerging countries of the Southern hemisphere and in the USA. In each the frenzy was about the new infrastructure for long distance trade, especially the railway network. In most of those cases the whole funding process was centered in London which was also the center of world trade. But never before as in this surge has the technological revolution been so directly relevant to financial innovation and to its spread across the globe. That is why I think this financial boom is different from the 1907 one. This one was also about innovation, but in financial instruments. All other financial bubbles are about leverage, arbitrage, asset inflation, etc. but not necessarily about financial innovations (although there are always some, of course).

Q: Despite the actions taken and J.P. Morgan leadership in the financial panic of 1907 and after, until the establishment of the Federal Reserve in the US, we assisted 20 years later to a renewed bubble and then to a big crash and the most severe Great Depression so far. Can this pattern repeat in the next 20 years after this Great Recession of 2007-2009?

A: That was already the fourth surge which began in the US with Ford’s model T before the third surge deployment was over in Europe. This is a case of overlap. The real regulation should have happened in the end of the 1890s to enable a proper Golden Age. I do expect another major technology bubble with bio, nanotechnologies, bioelectronics, custom materials or whatever but a couple of decades after some major breakthrough in them comes and after the whole potential of this revolution has reached maturity. But, of course, there could be another overlap. In the previous case the overlap was due to (and the cause of ) a changing of the core country from Britain to the US.

Q: You refer that technology waves, or great surges of development of a new technology platform and subsequent techno-economic paradigm, are the “drivers” of economic growth and society shifts. Toffler referred in the 1970s the so called Third Wave. Despite 20 years of “third industrial revolution”, only after the Nasdaq crash (the cleanup of the infant mess) and the crises of the 2000 decade we are truly entering in an new age? We need always this financial and economic destruction as a bridge to a golden age?

A: Yes, we do, unfortunately.

Q: At the time, when the “irrational exuberance” of the so called “new economy” assets picked, what was your mood, your perception?

A: I was in the middle of writing the TRFC book and was “predicting” the crash. When it happened, I had to rewrite everything in the past tense. But it was good because now the book is timeless. It can be read at any moment of the surge. It explains how the system works across the centuries.

Q:  In the new deployment phase of the present fifth tech wave, which kind of companies will see an asset valuation boom?

A: Every deployment is about shaping the potential that was installed during the previous decades and especially during the boom. The mass production boom was shaped by suburbanization, the Welfare State (through income distribution making it possible for the workers to become middle income consumers) and the Cold War. I believe this potential will be strongly shaped by the environmental imperatives, not only global warming but also the limits to availability of natural resources, oil, water, etc. But that will depend both on market forces (price changes) and on regulation. The other force that could be extremely important in shaping the direction in which the ICT potential transforms products in all the other industries is full globalization. The more countries and people are incorporated into modern consumption the greater the possibility of catering to the “bottom of the pyramid” and to the people that gradually climb up the pyramid, rather than to the top layers, as happens during installation (because of income polarization). But, again, full globalization will not happen unless there are measures taken to induce investment across all continents and stop the marginalization that leads people to migrate or adopt violence.

HIGHLIGHTS

«The sense is that the participants expected each decision to be sufficient to return markets to normalcy; but of course, they were not.  The ad hoc, short-term nature of policy process, as described in the book, carried with it the risk that not all decisions would be good and would carry with them unintended consequences.»

«By now, it is apparent that the crisis was misdiagnosed [by policy makers] as a liquidity problem when in fact it was a solvency crisis.»

«After all, if FOMC participants can freely talk to the press in violation of their own security rules, surely Congress has a right to know what is going on as well.»

«Perhaps in the debate that surrounds regulatory reform of the financial markets, the basic management issues of decision-making process design and planning should become a priority.» 

REVIEW

“David Wessel’s book, In Fed We Trust: Ben Bernanke’s War on the Great Panic, is the definitive chronicle of the 2007-2009 financial crisis, but it is much more.  The book gives us an inside view of how policy making took place in response to the striking events

Wessel provides insights into the key players and decision makers, and conveys a very real sense of what they were thinking as those events unfolded.  In doing so, however, his account triggers serious questions about the Treasury/Federal Reserve decision-making process

Here, we emphasize three serious flaws in the policy-making process that Wessel describes:  a) the consistent lack of a plan and short-time horizon of the decisions, b) the insularity of the decision makers, c) and the apparent disregard for FOMC information-security rules governing meetings and associated documents.

We conclude by noting some oversights in Wessel’s account of the Great Depression [of the 1930s] and the Panic of 1907.

Lack of a Plan

The insider’s view of the policy making is the unabashed strength of this book, and Wessel provides an extensive chronology of how the crisis unfolded.  It is not a pretty picture.  His most telling observation is that the principals seem to have lurched from event to event without a plan, even after it should have been apparent that one was needed.

The discussions among key participants – namely Chairman Bernanke, Secretary Paulson, then-president Geithner, and Governors Kohn and Warsh – seem rushed, from Wessel’s descriptions of them.  The policy discussions tended to focus on short-term problems, pushing off potential longer-run consequences of the policy responses as a matter of expediency

The sense is that the participants expected each decision to be sufficient to return markets to normalcy; but of course, they were not.  The ad hoc, short-term nature of policy process, as described in the book, carried with it the risk that not all decisions would be good and would carry with them unintended consequences.  For example, the problems of exiting from many of the policies are now significant and have yet to be addressed

Wessel alleges that the policy makers continually underestimated the crisis and that there was no long-range planning undertaken from the time that the crisis initially erupted.  This should come as no surprise to anyone reading closely the financial press throughout the crisis, and yet it remains disappointing

It is important to note that not all the decisions had the time constraints that surrounded the issue of the Lehman failure in the fall of 2008.  That event was preceded by almost a year of financial turmoil, serial reports of losses, failures or mortgage related institutions, and market disruptions that should have signaled to policy makers that something serious was at hand and that they weren’t simply facing a short-term liquidity problem

By now, it is apparent that the crisis was misdiagnosed as a liquidity problem when in fact it was a solvency crisis.  Funds didn’t suddenly dry up and markets did not stop functioning because there were no funds available.  Rather, because of the trail of losses and preceding events, financial markets finally became wary of the solvency of key counterparties, as the Bear Stearns episode clearly demonstrated.

This was long before the problems in Lehman Brothers emerged.  Market participants’ concerns, as subsequent events proved, were well-founded.  It took policy makers too long to recognize the capital deficiencies relative to the risk exposures of major primary dealers, which then left them with insufficient time to design resolution plans.  Most of the largest financial institutions – both domestic and international – proved to have inadequate capital.  Some failed, and many were bailed out by their respective governments

Wessel’s description of the decision-making process reminds one of a perpetual Chinese fire drill rather than a considered, analytic approach to the problems as they unfolded over time.  The latter implies a systematic plan, and the former implies a sequence of ad hoc responses to unrelated shocks. Even if an initial plan proved inadequate, the experience would have permitted corrections as events evolved.    And lacking a plan, it is harder to see if and when a decision was wrong.

Delegated and Concentrated Decision Making

The second issue that emerges from Wessel’s account is the insular and concentrated nature of the decision-making process, which excluded many members of the Board of Governors and FOMC. Three governors and the president of the NY Fed apparently took on the decision-making responsibility for the central bank in the midst of the crisis. From the narrative, it seems as if this core group effectively froze out the remaining two members of the Board and FOMC members from both decision making and access to key real-time information.

Why did it happen?  Under what authority did this happen?  One plausible answer is that the core group felt that the existing structure was too cumbersome to effectively coordinate policy among so many principals, and so they simply exploited a loophole in the law governing open and closed meetings of government agencies.

Let us explain.  Normally, there are seven members of the Board of Governors, so that a gathering of four would constitute a majority and could officially make decisions.  According to the 1976 Government in the Sunshine Act, which sets out the rules meetings of federal governmental agencies, official Federal Reserve Board meetings in which policies are considered must be announced in advance and,  at a minimum, an agenda must be provided.  For this reason, only three governors can get together in the same room without it constituting a “meeting” and invoking the provisions of the Sunshine Act.   But during the entire crisis there have only been five governors on the Board, with two vacancies.  (David Kotok has written extensively on this issue in previous commentaries.)

Thus, the gathering of the three governors in the meetings that Wessel describes meant that while not technically meeting the legal requirement for a meeting, the three de facto constituted a majority of the sitting governors and could actually make decisions.  Coordinating policy with the entire FOMC would have been more cumbersome and likely would have also required that a written transcript be prepared.  It could be that the core principals felt that a smaller group would make decisions more quickly, and the sense of such a desire for quick decisions comes across in the narrative.

Nevertheless, one can’t help but feel that it might have been beneficial to have been able to tap the broader experience and expertise of the Federal Reserve Bank presidents, especially since so many of the key principals making the crucial decisions were relatively new to their jobs.

The Sanctity of FOMC Meetings

From the perspective of former senior officials of the Federal Reserve System, the details that Wessel reports about specific material in confidential FOMC documents and discussions that took place during FOMC meetings are especially discomforting.  FOMC security is governed by the FOMC’s Program for Security of FOMC Materials, which is a classified program that defines the security levels and handling of FOMC-classified documents.

The Program also sets out rules for how many people can have access to such documents.  At one time, only 10 people at each reserve bank (with the exception of New York and the Board) could have access to the Bluebooks, which contain the policy options presented by the staff to the FOMC.  The Bluebooks receive the highest level of security classification.  The procedures also require detailed record keeping and govern storage and delivery of both hard-copy and electronic documents.

Most importantly, it is also clear in the Program to every attendee that what goes on in that board room at the Board of Governors stays in that room until the transcripts are made public five years later.  In the past there have been a few leaks.  When that happened, staff who attended the meetings, as well as bank presidents, and presumably Governors, were interviewed under oath by the FBI in one case and by a representative of the Board’s Inspector General in another case in an attempt to smoke out the source of the leaks.  The penalties for divulging classified information are extremely severe and might even include criminal charges.

Against that background, the kinds of candid conversations that Wessel had and divulged in his book are indeed surprising.  There are at least a dozen revelations of what went on at various FOMC meetings, who said what, and even what was substantively covered, that rise to a level of severity far above that which triggered investigations by the FBI and Inspector General during the Greenspan era.

One might deduce by simply examining historical Bluebook documents released on the Board’s website that the staff typically offers three policy options for FOMC consideration at each meeting.  So in describing that process Wessel is merely drawing on public information. However, Wessel indicates that in one meeting during the crisis there were actually four options presented, and he describes what some of those options were.  Either there have been significant revisions in the Program for Security of FOMC Materials in the past couple of years or there is now blatant disregard, for whatever reason, of the rules and sanctity of the meetings.

One could view this as another example of how the rules are now being bent at the Fed.  In the near term, these revelations may further damage the credibility of both the FOMC and the Federal Reserve.  It certainly weakens the Federal Reserve’s arguments against additional Congressional auditing of Federal Reserve activities.  After all, if FOMC participants can freely talk to the press in violation of their own security rules, surely Congress has a right to know what is going on as well.

Prior Financial Crises: 1907

Wessel devotes Chapter 2 to describing what he believes are parallels between financial crises of the past and present.  In the interest of historical accuracy, even if it appears that we are nitpicking, it appropriate to point out a couple of factual oversights.

In the second chapter of the book Wessel mischaracterizes key events during the Panic of 1907.  Specifically, he notes that the suspension of Knickerbocker Trust on October 22, 1907, after several days of depositor withdrawals, was the catalyst for the onset of that crisis. Wessel refers to the Knickerbocker Trust as the “Bear Stearns” of its day, claiming that Knickerbocker had lent heavily to the copper speculators, who failed in an attempt to corner that market and brought that firm down, just as Bear Stearns’ mortgage activities brought it down.

But in fact, such allegations about Knickerbocker have never been substantiated, and Wessel may have drawn upon a flawed analogy.  Bear Sterns’ problems were of its own making and not due to the actions of its borrowers.  In discussing Knickerbocker’s failure, Wessel also suggests that Benjamin Strong, then a Morgan employee who was asked by Morgan to inspect the books of the trust company, said that Knickerbocker Trust was insolvent.  Rather, Strong said that he was unable to determine whether it was solvent or not, a subtle but important difference.  That uncertainty parallels the uncertainty that market participants apparently felt about counterparties during the current crisis.

Finally, in contrast to Bear Stearns, which was rescued, Knickerbocker Trust suspended operations but eventually reopened as a going concern in March of 1908.  Ironically, the corrected analogy is likely a closer parallel than the one Wessel draws.  It is precisely the lack of clarity about financial-market solvency in 1907 that parallels the opacity that existed in 2007-2008.

Regardless of perspective, we do not really know how close the financial market came to collapse in 2008.  Whether letting Lehman Brothers fail was good policy or not, it is clear that timely resolution is critical when systemic issues are of concern.  If policy makers, present and future, draw their insights from past attempts to alleviate crises, they should distinguish the successes from the failures during those episodes.  Allowing Knickerbocker Trust to fail was likely a mistake, and one that arose from the lack of timely information about its solvency to the existing lender of last resort at the time (Morgan).

In another section, Wessel suggests that the Federal Reserve System’s creation was largely based on an earlier plan written by investment banker Paul Warburg.  The statement overlooks the overarching point that the Federal Reserve Act was not the work of one person, but was in fact the outcome of several years of careful research, discussion, and debate.  In particular, the National Monetary Commission and its proposal for banking reform, named the National Reserve Association, did incorporate many of Warburg’s ideas.

But Wicker (2005) emphasizes that the Federal Reserve Act bore a striking resemblance to the National Reserve Association legislation.  More importantly, the process was completed nearly five years after the Aldrich-Vreeland Act created the commission to study the reform of the monetary system.  The larger point about the time taken to appropriately reform the financial and monetary system is especially relevant today, as the Congress seems to be in a great rush to reform our financial regulatory system in response to the current crisis.

The Great Depression vs. Depression 2.0

Wessel’s treatment of the Great Depression era is essentially in accord with the standard views regarding that period.  There are two minor points of difference, however.

First, some of the Reserve Bank presidents (governors, as they were then called), most particularly Eugene Robert Black of Atlanta, were consistently supporting the extension of liquidity, rather than policies to enforce the gold standard.  It was this policy that Friedman and Schwartz document and that resulted in a one third contraction in the U.S. money supply, thereby exacerbating the depression.

Bottom Lines

Wessel’s book confirms that the process of saving the financial system was, to no one’s surprise, ad hoc.  Further, the decisions were imperfectly informed by the principals’ perceptions of what was actually occurring.

Clearly, Chairman Bernanke understood the big risk of a financial meltdown and made bold moves to ensure that we didn’t experience another Great Depression.  President Geithner, now Treasury Secretary Geithner, is described as an interventionist whose main concern was the short run and who was willing to deal with the unintended consequences as they arose. Finally, Secretary Paulson seems to have been solely a markets person, long on the bravado associated with a deal maker and short on the analytics required to formulate good policy.

Whether all the actions taken were necessary we will never know, because we can’t observe what might have been had other policies been followed.  But it is clear that the process of dealing with the crisis might have benefited from additional inputs and analysis by people who held responsible positions within the Federal Reserve, but who, for whatever reasons, were not actively involved in the policy-framing process.

Perhaps in the debate that surrounds regulatory reform of the financial markets, the basic management issues of decision-making process design and planning should become a priority.  If not, then we may in the words of Yogi Berra experience déjà vu all over again.”

Note: We would like to note that we benefited greatly from the comments of Kenneth Kuttner who is the Robert F. White Class of 1952 professor of Economics, Williams College.

The reviewers: Bob Eisenbeis is Cumberland’s Chief Monetary Economist. Prior to joining Cumberland Advisors he was the Executive Vice President and Director of Research at the Federal Reserve Bank of Atlanta. Bob is presently a member of the U.S. Shadow Financial Regulatory Committee and the Financial Economist Roundtable. His bio is found at www.cumber.com.  He may be reached at Bob.Eisenbeis@cumber.com. Ellis Tallman is the Danforth-Lewis Professor of Economics, Oberlin College, and was formerly Vice President, Federal Reserve Bank of Atlanta.