Here’s a question for the macroeconomists.

“Sticky prices” are the foundation of “Great Moderation” monetary policy, the core justification for why we have inflation stabilizing central banks. As the bedtime story (or DSGE model) goes, if only prices were perfectly flexible, markets would always clear and the great equilibrium in the sky would prevail and all would be right and well in the world. Hooray!

Unfortunately there are… rigidities. Shocks happen (economists are bashful about that other s-word), and prices fail to adjust instantaneously. Disequilibrium persists or oscillates and all kinds of complex dynamics occur, because the system, once outta whack, doesn’t get back in whack very quickly. Disequilibrium is followed by its terrible twin distortion, which shrieks through the night, ravaging the villagers with suboptimal resource utilization, most especially suboptimal utilization of the villagers themselves who are let to starve because their wage expectations are too damned sticky.

If my tone betrays a certain disdain for this account, that is because, in my view, central bankers have used it to harm people and blame the victims. The policy regime that we have crowed over from Volcker through Bernanke and Trichet “naturally” led to the conclusion that (1) central banks should stabilize inflation, so that predictable price adjustments are mostly sufficient to keep things in equilibrium; and (2) that central banks ought to focus especially on stabilizing the stickiest prices, leading to distinctions between overall and “core” inflation. Among the stickiest prices, of course, is the wage rate. In practice, from the mid 1980s right up through 2008, the one thing modern central bankers absolutely positively refused to tolerate was “inflation” of wages. God forbid there be an upcreep in unit labor costs, implying that a shift in the income share away from capital and towards workers. Central banks jack up interest rates right away, because what if the change in relative prices is a mistake? We wouldn’t want that to stick, oh no no no no no. But when the capital’s share of income shifted skyward while deunionization and globalization sapped worker bargaining power? Well, we learned the meaning of an asymmetric policy response.

Even today, now that it has all come apart, economists maintain a laser-like focus on the stickiness of wages. Why can’t Greece compete? Because its “cost structure” has grown too high. In English, that means people expect to be paid too much. The solution is “adjustment”: workers’ real wages must be reduced to restore competitiveness. American economists, following in the footsteps of Milton Friedman, trumpet the glory of floating currency regimes, with which one can reduce the wages of a whole nation of workers with a single devaluation (and without the workers having much opportunity to object). The Greeks, of course, must suffer, because they are part of a fixed currency regime, and workers and employers are unable to organize the universal wage collapse that would be good for them in the way of vegetables at the dinner table.

Now, not all economists are heartless. Left economists love workers. They urge governments to devalue if possible, to chop the broccoli into chocolate cake and hope that nobody gags. These economists rail against the fixed exchange rates, because nominal wages cuts usually occur only alongside the human tragedy of unemployment. They beg governments, if they can, to just borrow money and pay workers their accustomed wages (to do some important thing or another) and hope that things work out well.

But it is always about the workers. Workers are the core problem. Macroeconomic policy, as a practical matter, is mostly about finessing “rigidities” associated with workers’ stubborn wage expectations.

Yet there is an even stickier price in the economy, a price economists have mostly ignored although it is at least as ubiquitous as wages. The price of a past expenditure, the nominal cost of escaping a debt, is fixed in stone the moment a loan is made and then endures in time, perfectly rigid, while the economy fluctuates around it. It is certainly a price, but can only be made flexible via bankruptcy — a disruptive institution, rarely modeled by macroeconomists, and rarely deployed at scale. Surely, the price of manumission must be as nimble as the price of petrol if the economy is to keep its equilibrium while being battered and buffeted by shocks.

This is an odd way of putting things, but no great insight. Everyone knows that we are loaded to the gills with debt, the real burden of which has grown as the business cycle turned. Disinflation has left us teetering on the edge of mass default and deflationary spirals, distortion, depression, destruction. The holograph sputters to life and Princess Leia implores, “Help us Obi-wan Bernanke, you’re our only hope.”

So, macroeconomists: For at least 40 years sticky wages have been a central concern, perhaps the central practical concern, of your profession. (In the models, yes, it is abstract goods prices that are sticky. But in practice, it was always and obviously about sticky wages.) You justified ending Bretton Woods gold convertibility and moving to a floating-rate regime specifically in terms of frictions associated with innumerable downward wage adjustments. Your central triumph was “beating” the inflation of the 1970s. You pretended that was a painful but technocratic exercise in monetary policy, but the durability of “price stability” had everything to do with Reagan’s breaking of union power and a free-trade regime that put pressure on the wages of all but the special. (Economists are very special, of course.) Back in the Great Moderation, central bankers chose not to emphasize the role of these political choices in explaining their “success”. It was all about targeting the interest rates cleverly, just like the DSGE models say. It was “scientific”, “independent”.

Don’t worry! I’m with you. I think unions are a poor means of supplying labor bargaining power, and wish them good riddance. I am proglobalization and free trade, or would be, if we had sense enough to subject our free trade to a balance constraint. I’ll keep your secrets. We’ll keep telling the little people that all we do is interest rates and blame whatever went wrong on Wall Street.

But here’s my question. Looking forward to the next thirty years, after we have decisively defeated wage rigidity by ensuring that the unemployed are numerous and miserable, don’t you think we should devote just a bit of our attention to tackling that other sticky price? As we reduce the bargaining power of labor, perhaps we should think about the bargaining power of creditors as well, so that if we get ourselves into a pickle where the “cost structure” of honoring debts is high, we have technocratic and politically acceptable means of managing the burden of loan contracts just as we’ve developed mechanisms to control wages.

In the 1970s and 80s, we threw away an international monetary regime and revamped the practice of central banking in order to give leaders the tools to push down hard on any upward creep in sticky wages. (Notice how there is never any talk of having Germany raise, rather than Greece reduce, its wages to “restore balance”?) Our new monetary system also made the price of escaping of some debt less sticky, specifically debt owed to international creditors foolish enough to lend in borrowers’ now-unredeemable currency. And that has helped, a lot! We’d be living in Mad Max USA already if dollar debts could be redeemed for anything other than more dollars.

But the job is not done. Domestic creditors, and international creditors who lend in their own money, still have sufficient bargaining power to make past prices stick, regardless of whether those prices remain appropriate. If renegotiating down labor contracts is hard, renegotiating down millions of debt contracts via bankruptcy is nearly impossible. Perhaps debts should be enforceable only in a pseudocurrency whose convertability to current dollars is routinely adjusted as a policy variable by the wise, technocratic central bank. Perhaps we should develop less disruptive means than bankruptcy for writing down or equitizing onerous debt. Perhaps since sticky-priced debt contracts have less rigid near substitutes called “equity”, macroprudential policy should heavily favor the latter. Put Trichet and Bernanke in a room together, and let ‘em figure it out. They’re brilliant, both of ‘em. Surely they can come up with something. But do they want to? Do they, as their models suggest, think that any pervasive sticky price is dangerous, or is it only uppity workers that trouble them?

A naive noneconomist might imagine that consistently suppressing one sticky price while assiduously supporting an even stickier price is not a way to avoid distortion, but a means of introducing it.

Isn’t it time macroeconomists stopped beating down wages and turned their attention to the stickiest price?

Related — elsewhere:

• Tim Duy — Why is the American jobs machine broken?
• spencer — Labor’s share
• Stephen Williamson — Real Business Cycles
• Nick Rowe — What would count as a satisfactory explanation of sticky prices? (ht Mark Thoma)

Related — here:

• Asset inflation, price inflation, and the great moderation
• Relative Prices, Trade, and Inflation (oh my!)

Brad DeLong periodically reproduces the following bit from Keynes:

While some part of the investment which was going on in the world at large was doubtless ill judged and unfruitful, there can, I think, be no doubt that the world was enormously enriched by the constructions of the quinquennium from 1925 to 1929; its wealth increased in these five years by as much as in any other ten or twenty years of its history….

Doubtless, as was inevitable in a period of such rapid changes, the rate of growth of some individual commodities could not always be in just the appropriate relation to that of others. But, on the whole, I see little sign of any serious want of balance such as is alleged by some authorities. The rates of growth [of different sectors]… seem to me, looking back, to have been in as good a balance as one could have expected them to be. A few more quinquennia of equal activity might, indeed, have brought us near to the economic Eldorado where all our reasonable economic needs would be satisfied….

It seems an extraordinary imbecility that this wonderful outburst of productive energy [over 1924–29] should be the prelude to impoverishment and depression. Some austere and puritanical souls regard it both as an inevitable and a desirable nemesis on so much overexpansion, as they call it; a nemesis on man’s speculative spirit. It would, they feel, be a victory for the mammon of unrighteousness if so much prosperity was not subsequently balanced by universal bankruptcy. We need, they say, what they politely call a ‘prolonged liquidation’ to put us right. The liquidation, they tell us, is not yet complete. But in time it will be. And when sufficient time has elapsed for the completion of the liquidation, all will be well with us again.

I do not take this view. I find the explanantion of the current business losses, of the reduction in output, and of the unemployment which necessarily ensues on this not in the high level of investment which was proceeding up to the spring of 1929, but in the subsequent cessation of this investment. I see no hope of a recovery except in a revival of the high level of investment. And I do not understand how universal bankruptcy can do any good or bring us nearer to prosperity…

I won’t comment on the “wonderful outburst of productive energy” Keynes attributed to the late 1920s. But I do have an opinions about the quinquennium from 2004 to 2008.

It was stupid. We were profoundly stupid. We mismanaged resources catastrophically, idiotically. We substantially oriented our economy around residential and retail development that was foreseeably excessive and poorly conceived. We encouraged ordinary consumers, rather than entrepreneurs, to take on debt, and let the credit thus created serve as the kitty in a gigantic casino of egoism. We saw the best minds of a generation destroyed by madness, glutted hysterical in suits, dragging themselves through the Street at dawn, looking for an angry bonus. We accelerated the unraveling of physical, social, and intellectual infrastructure that took a century to build and that we will desperately need some day, perhaps quite soon. We celebrated our stupidity. Based on some back-of-the-napkin theorizing, we turned virtues like planning and prudence into cost centers, and eliminated them. We idolized “the market” while at the same time reorganizing it so it would tell us exactly what some privileged groups found convenient to hear.

I am sure someone will shout “20/20 hindsight”. That’s bullshit. Everything I am saying now was obvious five years ago, and lots of smart people knew and understood it. Some of us even bought into “arbitrage” fairy tales and tried to profit from getting our views “impounded into market prices”. We learned to take a different Keynes quote seriously, the one about markets remaining irrational longer than you can remain solvent. [Shlieffer and Vishny's famous coinage, "the limits of arbitrage" is not strong enough, because it suggests that efficient arbitrage is the norm subject to some exceptions and limitations. It is more accurate to view efficient arbitrage as the unusual special case, in bond markets as well as in equity markets.]

John Hussman, in an excellent weekly note, has a very mean quote:

The true debate in economics is…between economists who care about the productivity of resource allocation and those who only pay lip service.

That is harsh, but not wrong. I’d draw the lines a bit more mildly, and say that the core argument is between people who think we are in a financial crisis that has engendered an economic crisis, and others (like me) who think that the financial crisis is the outgrowth of longstanding and continuing economic mistakes.

Don’t worry. Even if you think the economic problems preceded the financial crisis, you still get to be mad at bankers. I feel about the financial sector the same way I would feel about my morphine dealer after looking down to find piranha feeding between my ribs. It’s worse than that. It’s like you pay some guy to find the best swimming holes in the Amazon and not only is he clueless, but he anesthetizes you so you don’t notice when he screws up and he eventually starts taking kickbacks from the fish. The financial sector failed three times. First it screwed up real capital allocation, throwing money at housing and consumer lending rather than finding and funding projects that would situate us well going forward. Then it failed again by seeming to succeed, when a good financial system would quickly render poor investment decisions unmistakably noxious. It’s best not to find yourself swimming among piranha in the first place, but if it happens, you want the very first nibble to hurt like hell. Finally, the financial sector failed by keeping itself rich and its creditors whole, which, despite protestations to the contrary, amounts to a failure at an institutional level to understand how badly it fucked up and make corrections going forward.

If “malinvestment” (and related maldistribution) is at the root of our problems, does it follow that austerity is the solution going forward? Not at all. Past poor investment is a sunk cost, our task now is to maximize the usefulness of resources that we still have. Failing to use perishable resources, especially resources that decay with disuse, is terribly dumb. “Stimulus” and “austerity” are both simpleminded and poorly specified strategies. In theory, we have two overlapping systems, a financial system and a political system, whose shared purpose is to make information-dense decisions about how best to use or conserve our resources. It’s not clear how we should make these decisions when both systems seem badly broken. But you go to the future with the institutions you have, not the institutions you might want or wish to have at a later time.

As we evaluate financial reform and political change, we should keep in mind that it is not 2008 that we must struggle to prevent. It’s 2006 that was the worst of times, the piranha were feeding while we splashed and giggled in our water wings.

Some notes: If you didn’t catch the references, I’ve mutilated quotes from the Alan Ginsberg poem Howl and from former US Defense Secretary Donald Rumsfeld in the text, and sourced them only via links. Regarding my own experience trying to help “arbitrage away” the credit bubble, I was short US equities from around 2005 until late 2008. The market was irrational until I was almost, but not quite, insolvent. Eventually I took a decent profit, but it was sheer luck that the market didn’t remain irrational just a bit longer and force me from my positions at a terrible loss.

Update History:

• 13-July-2010, 7:40 a.m. EDT: Added missing “what” as in “exactly what some privileged groups found convenient to hear”.

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First and foremost, I owe Rob Parenteau a big apology. Parenteau is the originator and first user of the clever term “Austerian”, which I erroneously attributed to Mark Thoma. Thoma never claimed parentage. I first encountered the term on his blog and a quick Google search turned up no antecedents, so I went with that. But Google does not index everything. I apologize for the error, and thank Marshall Auerbach who first pointed it out to me.

Parenteau’s contributions go far beyond a catchy neologism, however. I recommend his most recent post at Naked Capitalism, which is the best use of the “sectoral balances approach” to economic analysis that I have seen in the blogosphere.

The “sectoral balances approach” (frequently attributed to Wynne Godley) decomposes financial stocks and flows by virtue of a tautology. Every financial asset is also some entity’s liability. The sum of all financial positions is by definition zero. So we can write:

NET_WORLD_FINANCIAL_POSITION = 0 [0]

Suppose that, quite arbitrarily, we divide the world into a “foreign” and a “domestic” sector. Then we have:

NET_FOREIGN_FINANCIAL_POSITION + NET_DOMESTIC_FINANCIAL_POSITION = NET_WORLD_FINANCIAL_POSITION = 0 [1]

NET_FOREIGN_FINANCIAL_POSITION + NET_DOMESTIC_FINANCIAL_POSITION = 0 [2]

Suppose that, again arbitrarily, we decompose the domestic economy into a public and private sector:

NET_PRIVATE_DOMESTIC_FINANCIAL_POSITION + NET_PUBLIC_DOMESTIC_FINANCIAL_POSITION = NET_DOMESTIC_FINANCIAL_POSITION [3]

Substituting into our previous expression, we get

NET_FOREIGN_FINANCIAL_POSITION + NET_PRIVATE_DOMESTIC_FINANCIAL_POSITION + NET_PUBLIC_DOMESTIC_FINANCIAL_POSITION = 0 [4]

We can also write this in terms of changes or flows. Since the sum above must always be zero, it must be true that any changes in one sector are balanced by changes in another:

ΔNET_FOREIGN_FINANCIAL_POSITION + ΔNET_PRIVATE_DOMESTIC_FINANCIAL_POSITION + ΔNET_PUBLIC_DOMESTIC_FINANCIAL_POSITION = 0 [5]

Two of the flows in the equation above have conventional names, so we can rewrite:

CURRENT_ACCOUNT_DEFICIT + ΔNET_PRIVATE_DOMESTIC_FINANCIAL_POSITION + CONSOLIDATED_GOVERNMENT_SURPLUS = 0 [6]

Rearranging…

ΔNET_PRIVATE_DOMESTIC_FINANCIAL_POSITION = -CURRENT_ACCOUNT_DEFICIT + -CONSOLIDATED_GOVERNMENT_SURPLUS [7]

ΔNET_PRIVATE_DOMESTIC_FINANCIAL_POSITION = CURRENT_ACCOUNT_SURPLUS + CONSOLIDATED_GOVERNMENT_DEFICIT [8]

This decomposition has been quite prominent in the blogosphere. I first encountered it in conversation with the always excellent Winterspeak, and associate it with the “Modern Monetary Theorists” or “chartalists”. But it’s been used widely, very recently for example by Martin Wolf.

The usual argument goes something like this: In the aftermath of a terrible credit bubble, in most countries, the private sector is desperate to “delever”, or reduce its indebtedness, which is equivalent to increasing its net financial position. As a matter of pure arithmetic, equation 8 must always be in balance. If the private sector of a country is to force the left-hand term positive, the country must either run a current account surplus (e.g. by exporting more than it imports) or else its government must run a deficit. Some countries may “export their way” to financial health, but not all can, since every current account surplus must be matched by a deficit elsewhere. If we put “beggar thy neighbor” strategies aside and set the current account to zero, any improvement in the financial position of the private sector must be offset by a deficit of the public sector.

This is true by definition. Once the terms have been defined, there is nothing to argue about. If we want the financial position of the private sector to improve (defined as increasing total financial assets less liabilities), and we consider a country whose external account is in balance or deficit, then the public sector must run a deficit.

However, a thing can be true but still misleading. The catch is an assumption, that an increase in the net financial position of the private sector is a good thing, something that we should encourage or at least accommodate. This is where Parenteau is great. He decomposes the domestic private sector into a household and business sector:

Δ(NET_HOUSEHOLD_FINANCIAL_POSITION + NET_BUSINESS_FINANCIAL_POSITION) = CURRENT_ACCOUNT_SURPLUS + CONSOLIDATED_GOVERNMENT_DEFICIT [9]

ΔNET_HOUSEHOLD_FINANCIAL_POSITION + ΔNET_BUSINESS_FINANCIAL_POSITION = CURRENT_ACCOUNT_SURPLUS + CONSOLIDATED_GOVERNMENT_DEFICIT [10]

(Note that “business” here means any non-household private entity that could have a financial position. It would include, for example, non-profit organizations.)

Let’s try to come up with better names for ΔNET_HOUSEHOLD_FINANCIAL_POSITION and ΔNET_BUSINESS_FINANCIAL_POSITION.

ΔNET_HOUSEHOLD_FINANCIAL_POSITION is just net household financial income.

NET_BUSINESS_FINANCIAL_POSITION is, by definition, all business financial assets minus all business liabilities (including shareholder equity). On a business’ balance sheet, “all business liabilities (including shareholder equity)” is necessarily the same as “total business assets”. So we can write:

NET_BUSINESS_FINANCIAL_POSITION = BUSINESS_FINANCIAL_ASSETS – BUSINESS_FINANCIAL_LIABILITIES_AND_EQUITY [11]

NET_BUSINESS_FINANCIAL_POSITION = BUSINESS_FINANCIAL_ASSETS – TOTAL_BUSINESS_ASSETS [12]

NET_BUSINESS_FINANCIAL_POSITION = -(TOTAL_BUSINESS_ASSETS – BUSINESS_FINANCIAL_ASSETS) [13]

NET_BUSINESS_FINANCIAL_POSITION = -BUSINESS_NONFINANCIAL_ASSETS [14]

Now use our new definitions to rewrite equation [10]:

NET_HOUSEHOLD_FINANCIAL_INCOME + Δ(-BUSINESS_NONFINANCIAL_ASSETS) = CURRENT_ACCOUNT_SURPLUS + CONSOLIDATED_GOVERNMENT_DEFICIT [15]

NET_HOUSEHOLD_FINANCIAL_INCOME – ΔBUSINESS_NONFINANCIAL_ASSETS = CURRENT_ACCOUNT_SURPLUS + CONSOLIDATED_GOVERNMENT_DEFICIT [16]

NET_HOUSEHOLD_FINANCIAL_INCOME = CURRENT_ACCOUNT_SURPLUS + CONSOLIDATED_GOVERNMENT_DEFICIT + ΔBUSINESS_NONFINANCIAL_ASSETS[17]

Now we can tell what I think is a much more informative story. It is not the “private sector” whose financial position needs to improve. Businesses exist to increase the value of their liabilities to shareholders and creditors. They do not “delever” by reducing the sum of those liabilities. “Leverage” properly refers to the ratio between different sorts of liabilities, debt versus equity, not the total quantity of claims. In a good economy, the financial indebtedness of business entities will be increasing, as the value their real assets grows! Growth in the “net private sector financial position” could come from an increase in household income (yay!) or a decrease in the value of real business assets (yuk!). We certainly shouldn’t make policy decisions based on promoting or accommodating such an ambiguous outcome. Instead, we should craft our policies to be consistent with what we actually want, which is household financial income. (Note that this analysis necessarily excludes nonfinancial income, such as unrealized gains or losses on the value of a home.)

Reviewing equation [17], there are three ways a nation can improve the financial positions of its household sector. It may (i) run a current account surplus, usually by exporting more than it imports; (ii) have the government run a deficit, improving household financial position by having the government run a deficit, or (iii) increase the value of business nonfinancial assets. Approach (i) can’t work for everyone, of course. Assuming external balance, it is obvious (at least to me) that approach (iii) is ideal. Parenteau, I think, agrees:

Remember the global savings glut you keep hearing about from Greenspan, Bernanke, Rajan, and other prominent neoliberals? Turns out it is a corporate savings glut. There is a glut of profits, and these profits are not being reinvested in tangible plant and equipment. Companies, ostensibly under the guise of maximizing shareholder value, would much rather pay their inside looters in management handsome bonuses, or pay out special dividends to their shareholders, or play casino games with all sorts of financial engineering thrown into obfuscate the nature of their financial speculation, than fulfill the traditional roles of capitalist, which is to use profits as both a signal to invest in expanding the productive capital stock, as well as a source of financing the widening and upgrading of productive plant and equipment.

What we have here, in other words, is a failure of capitalists to act as capitalists. Into the breach, fiscal policy must step unless we wish to court the types of debt deflation dynamics we were flirting with between September 2008 and March 2009. So rather than marching to Austeria, we need to kill two birds with one stone, and set fiscal policy more explicitly to the task of incentivizing the reinvestment of profits in tangible capital equipment.

So what is the role of approach (ii), which stimulus proponents and MMT-ers frequently advocate? Note how Parenteau phrases things: because “capitalists [fail] to act as capitalists”, because businesses are not increasing the value of their nonfinancial assets, fiscal policy must be employed to avoid “debt deflation dynamics”. Here we reach the formal limits of the sectoral balance approach. This style of analysis gives us no insight into the dynamics or distribution of financial positions within any of the categories we have carved out.

Nevertheless, consider the following (counterfactual) thought experiment. Imagine that the NET_HOUSEHOLD_FINANCIAL_POSITION is negative, and that people go nuts in a harmful way when they are formally insolvent. Suppose also that the current account cannot be brought to surplus, and that businesses cannot expand the value of their nonfinancial assets in a short time frame. Under these conditions, by running a deficit, government could create financial income for households until their net financial position turns positive and people stop behaving like antisocial lunatics. In this scenario, fiscal policy does nothing to change the real asset position of the economy. But by shifting around financial assets and liabilities, government alters the behavior of agents in the economy in a manner that improves future performance, increasing overall wealth.

In real economies, people may well behave in ways that are harmful to the economy when their financial positions are very tenuous, although their actions are more likely caused by illiquidity than lunacy. But in real economies, some people have strong financial positions while others have weak financial positions, and the sort of intervention described above would be useless if the income created by a stimulus went primarily to households that were not financially stressed. Government funds spent purchasing goods and services from existing firms, or deficits created by income or payroll tax cuts, go first to people who are already employed, or who already have financial claims on businesses, and these may not be the most stressed groups. Designing a “good” stimulus where the object is to alter the character of real behavior by shifting financial variables is well beyond the scope of this post, but it would necessarily involve distributional questions and complex behavioral assumptions. If you target a stimulus to the deeply indebted, you may improve their behavior, but damage the behavior of others who feel aggrieved that prudence went unrewarded. If it was me, I’d make flat transfers unrelated to income or employment status, so that on the one hand the program seems “fair” — the prudent benefit along with the bankrupt — yet on the other hand it is guaranteed to improve the financial position of even the worst-situated households.

What about approach (iii)? What could cause an increase in the value of business nonfinancial assets, improving household financial positions? Fundamentally, there are two ways: Businesses could borrow or use their own cash to purchase real assets from the household and government sectors (holding the public sector deficit constant), or else the value of existing business nonfinancial assets can somehow be made to increase. Parenteau suggests policies that would push businesses to purchase real assets. But note that any sort of increase in the valuation of business nonfinancial assets, including intangible assets, would be sufficient to improve the household-sector financial balance. That would include events as insubstantial as a pure inflation, but also real improvements in business productivity. Again, looking beyond where sectoral balances can take us, distribution matters. If “debt deflation dynamics” occurs primarily through households whose weak financial positions include few claims on businesses, then increasing the value of business nonfinancial assets might not help very much.

p.s. Edward Harrison offered a response to Parenteau’s piece that is very much worth reading. In particular, he focuses on the quality of business investment, a topic about which sectoral balance decomposition can tell us very little. Mechanically, low quality investment should improve the valuation of business nonfinancial assets less than high quality investment, and should therefore exert a drag on household financial balances. Harrison uses an Austrian (though not Austerian!) perspective to suggest that stimulus may reduce the quality of business investing, implying a trade-off between approaches (ii) and (iii) above.

[MMT Note] Agree or disagree, the “MMTers” are among the most interesting and provocative thinkers in the economics blogosphere. In addition to Winterspeak, I’d include Bill Mitchell, Warren Mosler, Scott Fullwiler (who occasionally writes at Economic Perspectives from Kansas City), Marshall Auerbach, and perhaps Parenteau himself in this group. I agree with much but not all of what the MMTers have to say. I have learned profoundly much from disagreeing and squabbling with them. I do hope that Kartik Athreya will someday have the pleasure.

Update 2010-07-01, 6:40 am EDT: For reasons I do not understand (my big fat finger?), this post “disappeared” for a few hours. It reverted from “published” to “draft” in WordPress. The post is back, and the comments seem to be intact, but my apologies to all for the disappearance!

I’ve been on whatever planet I go to when I’m not writing. Don’t ask, your guess is as good as mine.

When I checked out out a few weeks ago, there was a debate raging on “fiscal austerity”. Checking back in, it continues to rage. In the course of about a half an hour, I’ve read about ten posts on the subject. See e.g. Martin Wolf and Yves Smith, Mike Konczal, and just about everything Paul Krugman has written lately. While I’ve been writing, Tyler Cowen has a new post, which is fantastic. Mark Thoma has delightfully named one side of the debate the “austerians”. [Update: "austerians" was actually coined by Rob Parenteau.] Surely someone can come up with a cleverly risqué coinage for those in favor of stimulus?

Here are some obvious points:

Austerity is stupid. Austerity is first-order stupid whenever there are people to whom the opportunity cost of providing goods and services that others desire is negative. To some economists, that sentence is a non sequitur. After all, nothing prevents people from providing goods and services for free, if doing the work is more beneficial to them than alternative uses of their time right? Economists who make this argument need to get out more. Doing paid work has social meaning beyond the fact of the activity, and doing what is ordinarily paid work for free has a very different social meaning. It is perfectly possible, and perfectly common, that a person’s gains from doing work are greater than their total pay, so that in theory you could confiscate their wages or pay them nothing and they would still do the job. But in practice, you can’t do that, because if you don’t actually pay them, it is no longer paid work. The nonmonetary benefits of work are inconveniently bundled with a paycheck. Under this circumstance, having the government pay for the work is welfare improving unless the second-order costs of government spending exceed both the benefits to the worker in excess of pay and the benefit to consumers or users of the goods and services purchased.

Stimulus is dangerous. The second-order costs of government spending are real, and we are very far from being able to understand or estimate them. Here are some second order costs:

1. Transfers of relative purchasing power from other citizens to the beneficiaries of government spending may call into question the legitimacy of the distribution of opportunity, wealth, and influence and of the government itself. Perceptions of make-work or corrupt contracting are deeply corrosive. Deficit spending commits government to future transfers that may come to seem undesirable or illegitimate.

2. Government spending choices may lead to lower quality uses of real resources than would have occurred if the government had not acted. Since economic activity is habit forming and temporary interventions become permanent, the cost of poor government choices can be high. It matters very much what work the government is paying for. Work must be well-tailored to the talents, interests, and future prospects of individuals. Employing people badly is much worse than just giving them money.

3. If funds are spent, directly or indirectly, on resources in scarce supply, prices may be harmfully propped or bid up. That might take the form of a general inflation, or a narrower effect on the prices of specific commodities or assets.

4. High levels of government debt may have a destabilizing effect on prices, increasing price volatility and impairing economic calculation even in the absence of a general inflation, or even in a deflation. Government obligations are liquid and hypothecable, and the availability of good collateral increases the degree to which subjective changes in relative valuation translate to changes in nominal pricing.

5. There exist theories of government solvency which suggest that the safety and value of currency is related to the indebtedness of the issuing government. Those theories may or may not be reasonable. They may or may not find support in the historical record. Regardless, to the degree they are widespread, they may be self-fulfilling. Whether sensible or sunspot, loss of confidence in a currency is possible. Currency crises represent a “tail risk” whose likelihood and cost are difficult to estimate.

There are second order benefits to stimulus as well as costs: multipliers, consumer confidence, etc. But these are also difficult to estimate.

Lying is optimal. The debate among public officials about austerity cannot be taken at face value. Savers really could flee the euro, dollar, yen or yuan. Interest rates here or there could suddenly spike. A sudden dash to gold is possible. None of these financial market events would directly affect the real resources at our disposal, but any of them could devastate our ability to organize economic behavior, and would call into question the legitimacy of economic outcomes and the stability of governments. For policymakers who seek positive short-to-medium term outcomes, the optimal strategy is to avoid the first-order costs of austerity by spending and avoid second-order costs #1 and #5 by obfuscating their spending as much as possible. Costs #2, #3, and #4 tend to bite over the medium-to-long term, leading policymakers to discount them. I think we should expect a lot more austerity theater than actual austerity, for better and for worse. Expect central bankers especially to preach austerity while intervening madly in the shadows. That’s just what they do. By the same reasoning, we should expect policymakers to justify their actions with a lot of intuitive but awful theory. As the Modern Monetary Theorists remind us, the analogy between a fiat-currency-issuing government and a budget-constrained household is poor. It is, nevertheless, the framework under which most citizens and savers understand government accounts, and forms the basis of conventional discourse. Irrespective of what is a better or worse description of reality, it is safer for policymakers to frame their communication in terms of conventional theory than to promote a profoundly destabilizing paradigm shift. Expect President Obama to keep talking about how we are “out of money” even though he knows better.

Economic choices are not scalar. I think the austerity debate is unhelpful. There are complicated trade-offs associated with government spending. If the question is framed as “more” or “less”, reasonable people will disagree about costs and benefits that can’t be measured. Even in a depression, cutting expenditures to entrenched interests that make poor use of real resources can be beneficial. Even in a boom, high value public goods can be worth their cost in whatever private activity is crowded out to purchase them. Rather than focusing on “how much to spend”, we should be thinking about “what to do”. My views skew activist. I think there are lots of things government can and should do that would be fantastic. A “jobs bill”, however, or “stimulus” in the abstract, are not among them. If we do smart things, we will do well. If we do stupid things, or if we hope for markets to figure things out while nothing much gets done, the world will unravel beneath us. We have intellectual work to do that goes beyond choosing a deficit level. The austerity/stimulus debate is make-work for the chattering classes. It’s conspicuous cogitation that avoids the hard, simple questions. What, precisely, should we do that we are not yet doing? What are the things we do now that we should stop doing? And how can we make those changes without undermining the deep social infrastructure of our society, resources like legitimacy, fairness, and trust?

FD: I’m long precious metals and short long-term Treasuries. (My exposure to both is primarily via futures.) So perhaps I am thinking my book when I take the tail risk of currency crises more seriously than others do.

Update History:

• 29-June-2010, 11:50 p.m. EDT: Added update attributing coinage of “austerians” to Rob Parenteau. Thanks to Marshall Auerbach for pointing this out in the comments, and Barry Ritholtz for investigating.

Regular readers know that I have few nice things to say about Goldman Sachs lately.

Goldman fully deserves the attention that the SEC has brought to it, and the attention that the Department of Justice may soon bring to it. The conduct that the firm is trying to defend is inexcusable, and its unwillingness to acknowledge that even more so.

However, it is unlikely that bad conduct was limited only to Goldman. The fact that others were misbehaving is no defense. A high crime rate doesn’t make burglary okay. But I fear that Goldman Sachs may have become a shield and lightning rod, deflecting scrutiny from other firms also in need of disinfection.

Financial firms are fragile in at least three different ways. They are financially leveraged, so they are vulnerable to deteriorating asset values. They fund illiquid assets with short-term money, so they are vulnerable to runs. A less widely appreciated fragility has to do with the degree to which the boundaries of the state and financial institutions blur. A financial institution that is at odds with the state is a freakish, frightening thing. It may suffer a loss of confidence for reasons that can’t be fully explained in economic terms. Famously, “no major financial firm has survived criminal charges.“

I think it entirely possible that Goldman could go the way of Arthur Anderson or Drexel. If so, the firm will have no one to blame but itself.

Nevertheless, there is a danger that we will make a ritual sacrifice of Goldman and pretend to have exorcised our demons, while other firms that have engaged in similar conduct continue undisturbed. It would be a sad irony if, in single-minded pursuit of Goldman Sachs, we not only let other perps escape unscathed, but also hand them the windfall of a less competitive industry. Rather than forcing traumatic self-appraisal and reform at surviving banks, Goldman’s fall might lead managers elsewhere to congratulate themselves for savvy positioning, for playing the system. Competitors would swallow the corpse of Goldman Sachs, thinking they had eaten what they’d killed.

I have no reason to think that the government’s focus on Goldman is motivated by anything other than having discovered particularly bad conduct there. Nevertheless, the cynic in me cannot help but notice that, according to media reports, Jamie Dimon and the Obama Administration have been very close at times. Dimon’s bank, JP Morgan Chase, has much to gain from Goldman’s misfortune. The more reasonable me is sure that there is no connection, that the mere suspicion is crank conspiracy theory. Still, less-than-exemplary conduct by investment banks during the bubble was widespread. It would be comforting to see evidence that the cops on the beat are walking the Street, and not just holing up in front of Goldman Sachs. Call it avoiding an appearance of impropriety.

Usually when people accuse law enforcement of a “fishing expedition”, they are asking the police to stand down. I do not want the police to stand down. The SEC and the Justice Department should treat Wall Street the way big city cops treat “open air drug markets”, with engaged and loving attention. But instead of a “fishing expedition” we need a “trawling expedition”. There are a swarm of piranha in the swimming pool, not just one vampire squid.

Goldman Sachs may die. If it does, I will shed a tear. My feelings about the firm are not unmixed. Nevertheless, if Goldman dies, it will be the fault of its own managers, and there will be some justice in it.

But let’s not imagine that Goldman’s passing somehow redeems JP Morgan, or Deutsche Bank, or Citi, of their sins.

The excellent Ezra Klein has ruined his electoral career for nothing. That’s a shame; I’d vote for him. Ezra writes:

If an investment bank is structuring a trade for two clients, it has an obligation to serve its clients. That is to say, it needs to structure the trade they want to be part of and disclose all relevant information necessary for them to evaluate the trade. But if the firm, or the employees structuring this trade, think that one side is going to win and the other is going to lose, I don’t think they have an obligation to warn the losers… The SEC’s case against Goldman simply says that they failed to disclose relevant information that one side needed to decide for themselves whether going long on the Abacus deal was a good or bad trade. That is to say, the issue isn’t whether Goldman acted in the client’s best interest but whether they made it unnecessarily difficult for the client to act in his own best interest.

Goldman wasn’t structuring a trade between two clients, as far as IKB and ACA were concerned. It was working to form a business entity called ABACUS 2007-AC1, LTD and underwriting an issue of securities by that entity. The only clients formally involved were IKB and ACA, and they were on the same side of the deal.

If this had been an adversarial deal, Goldman would have had no obligation to inform the side that wasn’t paying it whether they were making a good trade. But if this had been an adversarial deal, Goldman would have been advising one party or the other. Both parties could not have been its customers.

Imagine you are trying to buy a house. It is contentious. Disputes arise over price, warranties, settlement terms, etc. You would hire an agent, and the other party would hire an agent. Those agents would be different people. The hazards of relying on the same advisor in a difficult negotiation are obvious.

IKB/ACA may have been “sophisticated”. They may have been dumb, or corrupt, or unlucky. But, in an adversarial negotiation with John Paulson, they would not have shared the same agent with him. A knife fight is not a mediation.

The whole issue is that IKB/ACA did not know that they were in an adversarial negotiation and that the other guy had Goldman Sachs as its agent. They thought Goldman Sachs was working for them, underwriting securities of a special purpose entity it was putting together to satisfy investor interest. If IKB/ACA had been negotiating a very complex $192M custom trade with John Paulson, there would not have been a “flipbook” and a “prospectus”, just sign the dotted line. There would have been conference rooms and long hours and thousand-page paranoid contracts scrutinized and initialed in triplicate.

There is no circumstance where an investment bank “structures a trade for two clients” whose interests are opposed when the terms are anything but standard. I mean, really. Think about it. It’s Orwellian — Goldman calls a practice that is absurd on face “market making”, and suddenly it’s normal except for technical questions about who picked what securities or who should have suspected something.

What happened here is nothing like what a market maker does. A market maker takes the other side of client-initiated trades, and then lays off the risk. ABACUS was initiated and sold by Goldman Sachs, at a hidden party’s request. Goldman was unwilling to make a market for Paulson at a price he would have accepted, so it manufactured an entity willing to do so. Investors in that entity were not informed that they were dealing with an active, involved adversary. And Goldman has the nerve to call both sides of the arrangement “customers”.

This was a high finance version of the same pump-and-dump schemes you get by e-mail. Paulson needed buyers for what he was selling. Goldman sent around the flipbook until it found some, and without revealing that a hidden counterparty wanted to dump. This is not an ethical practice. I don’t know whether it’s illegal. But if really smart, well-intentioned people like Ezra can’t quite see that it’s disreputable, if it seems like a he-said, she-said technical kind of thing, we are in deep trouble.

P.S. For this deal to be okay, Paulson’s role would have had to be disclosed plainly and in writing. His name need not have been mentioned, although it would not have remained hidden for long. But Goldman would have had to reveal that a party wishing to take a large short position had initiated the deal and would be involved in its design. Goldman would also have had to make clear, in writing, that this party was its client.

Like many Goldman apologists, I suspect that by the time the deal closed, some of the ACA guys probably knew or had guessed what was going on. Maybe the IKB guys knew too. That doesn’t matter. Individuals taking bonuses for deals at ACA and IKB were not the “investors”. ACA and IKB’s shareholders were the investors, and ultimately British and German taxpayers. Goldman had an obligation to put important facts in writing. By not doing so, Goldman created plausible deniability for employees at ACA and IKB who had a personal interest in closing the deal. The wink-wink/nudge-nudge act mitigated career risk, helping to enable corrupt stupidity. Informal disclosure does an end run around risk managers at both firms, who would have expected discussion of an active, adversarial counterparty in the documents they reviewed. Even if some people at ACA knew, the deal might never have gotten done had ACA or IKB formally known. $192M deals that become $1B deals should be fully documented, in ink.

Related — here:

• Goldman and “hope”
• Deconstructing ABACUS
• Synthetic securities are not so strange
• L’affaire Goldman in price/information terms
• Goldman-plated excuses

Update History:

• 28-April-2010, 10:10 a.m. EDT: Changed “sharing the same agent” to “relying on the same advisor”.
• 29-April-2010, 7:00 a.m. EDT: Shortened first link to Ezra Klein’s piece. Removed one “really” where there were two in last sentence before postscript.

On Friday, Goldman published a letter called Goldman Sachs: Risk Management and the Residential Mortgage Market . Here’s a bit of it:

In a “synthetic” CDO, two parties enter into a derivative transaction, which references particular assets. By the very nature of a synthetic CDO, one counterparty must be long the risk (i.e., hoping to benefit from an increase in the value of the referenced assets), and the other counterparty must be short the risk (i.e., hoping to benefit from a decrease in the value of the referenced assets).

I have made this point before, but I will bore with repetition. Both in theory and in practice, there need be no identifiable party “hoping to benefit from a decrease in the value of the referenced assets”. Historically, in the vast majority of deals, there was no such party. Does anybody wish to dispute this as a factual matter? Mr. Blankfein?

Synthetic CDOs began as a tool for balance sheet management by banks. In these deals, a bank issues a synthetic CDO whose reference portfolio is composed of debt that the bank actually holds. The bank retains the first-loss “equity” tranche, but sells mezzanine and senior tranches. It may or may not retain the risk of the “super senior” tranches.

Banks derive two advantages from this arrangement:

1. They limit losses with respect to their loan portfolio. When all senior tranches have been sold away, banks total exposure to loan losses is limited to the size of the first-loss tranche, usually a very small fraction of the total assets. It is as if they have bought insurance on their loan portfolio, but the policy includes a small deductible. When banks retain the risk of “super senior” tranches, the structure becomes analogous to an insurance policy with a small deductible and a lifetime cap that is less than the total value of the loans. In either case, banks effectively lay off some of the risk of their porfolio.

2. Banks don’t need to hold regulatory capital against debt that is insured by a CDO with sufficient collateral to guarantee that insured losses will actually be covered. If investors in a CDO require a smaller premium than a bank pays to holders of regulatory capital, the bank profits by shifting credit risk to the structure (either by redeeming excess capital or, more likely, by using the capital to make new loans). This is called “regulatory capital arbitrage”.

As long as the yield investors demand is not too high, banks gain from issuing synthetic CDOs. If investors and rating agencies pay more attention to the correlation structure of portfolios than the characteristics of the underlying debt, the ability to cheaply lay off risk to CDOs might encourage banks to make riskier loans than they otherwise would. Like a John Paulson, banks doing these deals would try to cram the riskiest debt they could into reference portfolios. (Rating agencies are said to be particularly attentive to the debt selection process in bank balance sheet deals.) But in no sense do banks, the short counterparty, hope the deals go bad. Their best case scenario by a long shot is that every penny of debt gets paid, so that they earn a good yield on the equity tranche.

During the 2000s, for a lot of familiar reasons, AAA debt with a yield premium to Treasuries could be sold very easily, so entrepreneurs began structuring synthetic CDO deals based on debt they did not actually hold. In these deals, arrangers sold credit protection to investment banks, who may then have been economically short the credit, depending on how they were initially positioned. If investment banks retained those unhedged short positions, then there would, as Goldman alleges, have been a party “hoping to benefit from a decrease in the value of the referenced assets”. But investment banks were market makers and underwriters for these deals; they were not typically speculative counterparties. If you don’t believe me, here’s Goldman:

Goldman Sachs did not engage in some type of massive “bet” against our clients. The risk management of the firm’s exposures and the activities of our clients dictated the firm’s overall actions, not any view of what might or might not happen to any security or market…We maintained appropriately high standards with regard to client selection, suitability and disclosure as a market maker and underwriter. As a market maker in the mortgage market, we are primarily engaged in the business of assisting clients in executing their desired transactions. As an underwriter, the firm is expected to assist the issuer in providing an offering document to investors that discloses all material information relevant to the offering.

A market maker takes reactive positions dictated by customers who seek liquidity. The essence of market-making is accepting a risk that one might not otherwise choose in exchange for a fee or a spread. Since another party forces ones positions, and that other party might know something that the market maker does not, market makers usually strive to avoid carrying “inventory”, risk that accumulates as a byproduct of taking the other side of customer trades. The business of market-making is the art of hedging, of laying off risk forced onto the market maker by her customers. For large, complex positions, it is rarely possible for a market maker to find a single party to take the other side after it has assumed the risk of a client-initiated bet. [1] The market maker’s expertise is decomposing risk forced upon it by clients into smaller, more easily marketed positions, and neutralizing that risk via arms-length exchanges.

In synthetic CDO deals prior to 2006, the investment banks that served as market makers and took the initial short position on the CDO credit usually strove to be neutral or long the deals. They did as market makers do, and laid off their initial exposure by hedging, statically when possible, dynamically when necessary. Investment banks also frequently went long the deals they issued by retaining exposure to the super senior tranches. Out there, somewhere in the world, there may have been parties that stood to gain from events that would also have harmed CDO investors. But there was literally no one “hoping to benefit from a decrease in the value of the referenced assets” in totality. If you die, a whole bunch of people whom you don’t know and who don’t know you might benefit from buying your crap cheaply at your estate sale. There are even professional estate sale vultures, who make a business of taking the other side of estate liquidations. But it’s quite a jump from dispersed market interest to a claim that there is someone out there hoping to benefit specifically from your death. Dispersed market interest by estate sale junkies is not “material” to how you conduct your life. But if someone in particular really hopes you will die so that they can take your shit, you’d want to look over your shoulder.

I won’t go so far as to say that Goldman is lying, when it claims that “[b]y the very nature of a synthetic CDO”, one party hopes to benefit from an increase and another party hopes to gain from a decrease in the value of the referenced assets. But I will say that that the statement is factually wrong, and that Goldman knows very well it is factually wrong. If we are generous, we might categorize the statement as a sloppy simplification, a rhetorical imprecision that happens to flatter Goldman Sachs.

[1] If a position is not client-initiated, but initiated by the bank in response to some other party’s wishes, then the bank is not acting as a market maker but as an agent for the initiating party. An investment bank is free to act as an agent for a client when it trades at arms-length in public markets. But it may not act as an agent of a client while transacting with underwriting clients, unless it discloses the nature of the relationship. This failure to disclose is the essence of Goldman’s ethical foul in the ABACUS deal. It is also, I think, why Goldman is fighting the case so hard. Goldman gains competitive advantage by letting underwriting-driven demand take on customer risk that Goldman itself is unwilling to accept. There is, in the lingo, a synergy. But it is also an unethical practice, in violation of Goldman’s duty to its underwriting clients. I think Goldman is fighting so hard because it benefits from this synergy and wants to keep it. Goldman wants to normalize the practice, and rhetorically attempts to do so every time it protests that market makers don’t disclose the identity of counterparties. When Goldman is shifting risk that it did not wish to bear or hedge to an underwriting client, it is not acting as a market maker. Rather it is acting as an agent for a client wishing to take a position, while imposing the burden of liquidity provision on uncompensated and uninformed underwriting clients. When a bank arranges and underwrites deals to meet its own hedging needs, or especially to take an opposing speculative position, that is also ethically questionable if not plainly disclosed.

Related — here:

• A knife fight is not a mediation
• Deconstructing ABACUS
• Synthetic securities are not so strange
• L’affaire Goldman in price/information terms
• Goldman-plated excuses

Goldman’s controversial “ABACUS 2007-AC1″ synthetic CDO turns out to be a very complicated deal. This is not your grandfather’s vanilla mezzanine RMBS synthetic CDO. It is, in some sense, a supersynthetic CDO.

There’ve been some excellent posts dissecting the deal, including…

• Alea: Abacus for Dummies
• Bionic Turtle: Goldman’s Abacus illustrated
• Sandrew on Finance: Reverse Engineering the ABACUS Timeline

Also, the formal prospectus is now available, as well as a marketing “flipbook“.

In what way was ABACUS a “supersynthetic CDO”? Despite notionally having seven classes of investors, just two classes of notes were actually sold. When I read this at Alea, it blew my mind. The only notes that were sold were AAA debt, from senior (but not “super senior”) tranches. I didn’t understand how this could work. CDOs turn low-class debt into AAA gold by segregating losses. Senior notes are made safe by shifting losses to junior tranches, and remain safe until the junior tranches are wiped out. I had seen synthetic CDOs with unfunded senior classes, in which case the issuer retains some risk if the CDO fails catastrophically. But if there are no junior tranches, who takes the first loss? Who stands in the line of fire to protect AAA noteholders?

I spent some time squinting over the prospectus to understand. But there is no clearly stated explanation. On the contrary, there is a lot of language like this:

On (i) each Payment Date and (ii) any other Business Day on which Currency Adjusted Notional Principal Adjustment Amounts are paid by the Issuer to the Noteholders, the Class SS Notes will be senior in right of payment to the Class A-1 Notes, the Class A-1 Notes will be senior in right of payment to the Class A-2 Notes, the Class A-2 Notes will be senior in right of payment to the Class B Notes, the Class B Notes will be senior in right of payment to the Class C Notes, the Class C Notes will be senior in right of payment to the Class D Notes and the Class D Notes will be senior in right of payment to the Class FL Notes.

That sounds like the standard CDO waterfall. But in reality there was nowhere for the water to fall, because no B, C, D, or FL notes were sold. If losses were allocated to any investor, they would be allocated to AAA tranches. So what was going on?

The ABACUS prospectus doesn’t say. But there is a hint. Rather than buying credit default swaps on the aggregate reference portfolio, then dividing the cash flows among the tranches based on seniority, the CDS payments are calculated separately for each “series” of notes (where the series are subdivided by class). In other words, each class of notes writes its own distinct insurance policy.

As best as I can tell, there are two distinct levels of abstraction in the ABACUS deal. First there is the reference portfolio, a hypothetical portfolio of debt. Then there is a notional CDO, a hypothetical entity that we imagine to have purchased (or synthesized) the reference portfolio. We pretend that this notional CDO is “fully funded”, with a $1100M SS tranche (“super senior”), a $200M Class A-1 tranche, a $280M Class A-2 tranche, a $60M Class B tranche, a $100M Class C tranche, a $60M Class D tranche, and a $200M FL tranche (“first loss”). In reality, no one has purchased any of the reference portfolio, and the notional CDO, which would have required $1.8B $2B of investor interest to build, was never constructed. Instead, the notional CDO forms the basis for a thought experiment: Given any performance scenario for debt in the reference portfolio, we can compute the loss that would have been experienced by holders of the various tranches. So, we could write a kind of swap (somewhat different from an ordinary credit default swap), whereunder a “protection buyer” pays a predetermined, fixed spread and a protection seller pays the losses that a hypothetical holder of a tranche in the notional CDO would have experienced.

Effectively, the seven tranches of the notional CDO serve to define seven new kinds of bets that one could take on the reference portfolio. Since these bets are designed to mimic the experience of investors in a real CDO, S&P and Moody’s were able to associate ratings with these bets. However the bets themselves — highly customized variants credit default swaps — are not securities.

For a regulated entity that wished to hold AAA debt, securities had to be constructed based on these bets. The actual “ABACUS 2007-AC1″ legal entity offered synthetic securities designed to mimic the experience of tranches in the notional CDO. It did so in the usual way, just as a commodity ETF or “vanilla” synthetic CDO would: The entity accepts money from investors, and uses those funds to purchase ordinary, low-risk debt. (In this case, the low risk debt was not so ordinary; it was itself a synthetic security. But we’ll set that aside.) The entity then takes a side bet. Investors’ earnings are interest on the low risk debt adjusted by the gains or losses they experience on the side bet. The net effect of all this is that buyers of “notes” from the entity experience outcomes that are almost exactly as if they had invested in a tranche of real CDO. However, notes synthesized this way do not need to be backed by a funded CDO structure (cash or synthetic). In fact, the scheme completely eliminates all constraint on the quantity of funding invested in a given tranche, and severs any relationship between the quantity of funding and the characteristics of the securities. Goldman could have sold $1 worth of Class A-1 notes or a $1T dollars of Class A-1 notes, as long as it was able to make itself comfortable with taking the other side of the Class A-1 side bet. It happened to sell $0 worth of Class C notes, but it could have sold any quantity, without altering the characteristics of the notes or the structure of the notional CDO.

Once you “get it”, the scheme is not very difficult to understand, and it is clever. But it is not clearly described in either the ABACUS pitchbook or prospectus. I don’t know why the three-level structure is not clearly diagrammed (reference portfolio -> notional CDO -> funded entity that replicates the experience of arbitrary tranches in the notional CDO). “Notional CDO”, by the way, is my term. It is nowhere in the prospectus or pitchbook. The distinction between the notional CDO and the actual funded entity are blurred in the documentation. Perhaps the structure of this sort of deal would be obvious to insiders, or perhaps there are clearer descriptions elsewhere, in documents that have yet to be made public. Both Alea and David Harper have pointed out that this structure is similar to a “bespoke” or “single-tranche” CDO. Effectively ABACUS describes a hypothetical cash CDO with seven tranches, then chops it up into seven “single-tranche” CDOs, only three of which were ever actually invested. But in none of the documents is it represented as a bespoke CDO.

A remaining issue that has not received much scrutiny is how the deal was priced. IKB earned LIBOR + 0.85% on its Class A-1 tranche, prior to any credit events. Both ACA and IKB earned LIBOR + 1.10% on Class A-2 notes. In a cash or more vanilla synthetic CDO, the above-LIBOR cash flow to CDO investors is determined by the credit spread on the underlying debt, potentially plus a “basis” if demand for insurance has pushed the market price of protection above the underlying’s credit spread. Effectively, cash flows into the structure are market determined. (The allocation of spread between the tranches is an internal matter among the CDO’s investors.) With ABACUS or a bespoke CDO, there is no market in the tranche-specific credit default swaps and no security with an observable credit spread that can serve as a basis for pricing. So the price of protection must be negotiated between the protection seller (the ABACUS SPV and its investors in this case) and the protection buyer (usually the deal’s sponsor) without a very clear benchmark. Disclosure of the fact that there was an adversarial counterparty on the other side of the deal would likely have affected the character and perhaps the outcome of those negotiations. Since investors may have believed the ABACUS deal was offered and underwritten at Goldman’s initiative, it’s unclear whether there were active negotiations at all, or whether ABACUS investors simply accepted spreads computed by Goldman on the theory that as customers of a reputable bank they would be given reasonable prices. (“Fair” prices would have to be modeled, and modeling a fair price of a bespoke CDO tranche might be within the competence of an investment bank but beyond the competence of even “sophisticated” institutional investors.) Sponsors of bespoke CDOs often hedge their exposure in public markets, so ABACUS investors need not have suspected that there would be an identifiable counterparty, who was also a customer of Goldman’s, negotiating against them on price. Alternatively, Goldman undoubtedly had more efficient means of hedging its exposure that it otherwise would have, since it could just lay off the risk on Paulson. So Goldman might have been able to offer unusually good pricing to ABACUS investors. We cannot say a priori whether ABACUS investors ended up receiving better or worse pricing than they would have had Goldman underwritten this deal on its own initiative and hedged its exposure. But investors did not have the opportunity to negotiate price in full awareness of an adversarial counterparty, so the fairness of the spreads investors received merits further examination.

To summarize, ABACUS defined seven “side bets” based on the performance of the reference portfolio. Under each bet, one party would insure the losses of a hypothetical tranche of a notional CDO in exchange for fixed payments from the other party. The ABACUS legal entity synthesized securities based on two of those side bets, and sold those synthetic securities to IKB ($150M) and ACA ($42M). But as Alea points out, the largest “investment” — by ACA via ABN-AMRO — was not actually a purchase of notes from the ABACUS SPV, but an unfunded side bet. ACA/ABN took a $909M “long” positions in one of the seven side bets, with Paulson (via Goldman Sachs) on the other side. This was an unfunded CDS-like arrangement that occurred some time after the ABACUS legal entity was formed and funded.

I think in judging Goldman Sachs’ behavior, the fact that the ACA/ABN “investment” was a side bet arranged after the deal closed is important. The SEC’s main allegation, that Goldman was less than candid about Paulson’s role during the selection of the reference portfolio, would have affected all parties, IKB, ABN-AMRO, and ACA, both as noteholders and bond insurers (side bettors). But the question that I find most interesting is whether or not Goldman mistreated investors by virtue of a conflict between its roles as market maker and underwriter. That conflict directly affected only IKB and ACA as purchasers of newly underwritten notes. The ACA/ABN “wrap” of the super senior tranche occureed after the ABACUS LLC had been underwritten, so Goldman was only a counterparty to ABN/ACA at that point in time.

Update: Correction: IKB invested the A-1 tranche, not ACA as originally stated. Many thanks to commenter gennitydo for pointing out the error.

Update 3-May-2010: Yves Smith publishes a note from an anonymous correspondent claiming that ABACUS was just a failed underwriting of a vanilla CDO, not several “singe tranche CDOs” as described above. I think her correspondent is mistaken, and stand by the post as written.

If ABACUS had been constructed as a vanilla synthetic CDO, but the junior tranches had been left unfunded, Goldman would have been on the hook for that risk (as well as the risk of the super senior tranche and the unfunded portion of the Class A-1 and A-2 tranches). Goldman would have lost at least $708B on the deal if that had been the case, probably much more, depending on how worthless the super senior tranche turned out to be. Goldman could have synthesized the full reference portfolio and then dynamically hedged its exposure to the whole unfunded portion of the structure, but that would have been an elaborate and inefficient means of reaching an economically identical result. The prospectus notes that the structure would sell CDS by series of note, where series are within-tranche groupings, which it would not have done if it were synthesizing the full reference portfolio. ABACUS was built from single-tranche CDO’s, with Class A-2 notes covering a 21% – 35% slice of a notional CDO built from the reference portfolio and Class A-1 notes covering a 35% – 45% slice, while the unfunded but eventually insured super senior tranche was 45% – 100%. No one funded or ever bore the risk of the 0% – 21% bit.

Many thanks to the indispensable jck of Alea for great comments on an early draft of this post. All the dumb mistakes are mine; the smart stuff is jck’s benign influence.

Related — here:

• A knife fight is not a mediation
• Goldman and “hope”
• Synthetic securities are not so strange
• L’affaire Goldman in price/information terms
• Goldman-plated excuses

Update History:

• 26-April-2010, 6:45 a.m. EDT: Corrected misstatement of which parties invested which tranches, with thanks to commenter gennitydo.
• 3-May-2010, 3:00 a.m. EDT: Added update re a purported debunking of this description published at Naked Capitalism.
• 3-May-2010, 3:45 a.m. EDT: While reviewing the piece after its alleged debunking, I notice that I am arithmetically inept. It would have taken $2B, not $1.8B to fully fund the structure. Corrected in the text with the old value scratched.

Synthetic securities are not so strange. Many retail investors own them.

If you hold a commodity ETF or a equity ETF that tracks its benchmark via futures, you hold a synthetic security. Like a synthetic CDO, commodity and equity ETFs are investment vehicles that hold very vanilla “collateral securities” (like Treasury bills), but simulate exposure to some other thing by taking positions in derivative markets. For example, if you were to purchase the PowerShares DB Agriculture ETF (DBA), you would hold an interest in an entity that holds T-bills and takes futures positions in commodities like corn, wheat, and sugar. Despite the fact that this entity is synthesized in part from “zero-sum” derivatives, your shares of DBA constitute “securities” in every common sense: They are standardized, transferrable, claims on a business entity. The fund holds assets (the T-bills) that serve to secure claims that may arise against it in the course of doing business. Shares are limited liability instruments; investors can not be held liable for amounts beyond what they have invested.

It is possible to borrow and sell short shares of DBA, but at the fund level, the statement “for every long there is a short” is no more true of DBA than it is of IBM. It is true that the long futures positions held by the ETF are necessarily matched by short positions by some other investor. Formally, the short counterparty is likely a single clearinghouse. But the clearinghouse is just an intermediary; in an economic sense, the positions opposite DBA are held by a wide variety of market participants whose motivations may include both speculation and hedging, who may or may not have information or strong beliefs about future price movements.

The fact that DBA is “synthetic” may or may not have economic significance. If you review the prospectus of a synthetic ETF, you will be informed of various risks relating to the structure of derivatives markets. But the ETFs are intended simply to offer exposure to a basket of commodities more efficiently than a fund that physically warehoused the goods would. Commodity ETFs track the experience of an entity holding real goods with varying degrees of accuracy, but most investors view their positions as simply being long the commodity.

There are lots of important differences between a commodity ETF and a synthetic CDO. Synthetic CDOs are usually leveraged. Some synthetic equity ETFs are also leveraged, although they manage leverage very differently. Unlike ETFs, claims on synthetic CDOs are divided into multiple tranches, which is intended to create different classes of shares that are more or less speculative. The derivative positions held by synthetic CDOs are usually over-the-counter credit default swaps, and are likely to be less liquid than the futures positions held by a typical ETF.

I don’t mean to overstate the analogy. A synthetic CDO built from credit derivatives on the hard-to-digest bits of mortgage-backed securities is very different from an ETF that provides exposure to commodities. To the degree that it is important to draw inferences about the nature and intentions of a fund’s counterparties, one would conclude that the CDO and ETF trade with very different populations. A synthetic CDO is constructed in a manner intended to provide stable and predictable cashflows to more senior investors. Commodity ETFs are volatile all around.

However, the statement “a XXX transaction necessarily included both a long and short side” is as true for commodity ETFs as for synthetic CDOs. That statement may or may not have some economic significance. But it does not in itself imply that there are one or a few counterparties taking concentrated speculative bets specifically against the holdings of the fund.

This piece is inspired by comments of James Kwak, despite his poor taste in pundits. It is also intended as a bit of an answer to Arnold Kling, who wonders whether claims on a synthetic CDO could be considered securities.

Related — here:

• A knife fight is not a mediation
• Goldman and “hope”
• Deconstructing ABACUS
• L’affaire Goldman in price/information terms
• Goldman-plated excuses

I have found it helpful to pull away from the details of the Goldman/Paulson/ABACUS deal and think through the issues abstractly. In the unlikely event that others will find it helpful, I present the tale below…

Let’s suppose there is a trader, whom we’ll call “Trader X”. Trader X wishes to take a very large position on a bunch of related and correlated financial instruments. But Trader X has a problem. The size of the trade he wants to make is large relative to ordinary turnover in the asset. The market would almost surely move against him before he executed more than a fraction of his trades. Market-makers are very sensitive to the balance of order flow. If Trader X starts calling dealers and executing trades, they would observe one-sided flow and quickly adjust the price until trades on the other side were attracted and the flow returned to balance. This “adverse price action” would significantly reduce the profitability and increase the risk of X’s trade. It would also reveal his information or belief about future price movement to the market, enhancing market efficiency perhaps, but reducing his edge.

Trader X’s problem is well-known: sporadic large trades are known as “block trades”, and naively executed block trades are inefficient and expensive. If Trader X was buying and selling stock, he could make use of various tools that have been developed to circumvent this problem, “dark pools” that try to match big buyers and sellers without revealing strategic information about either party, to one another or to the market at large. Unfortunately, block trading platforms haven’t yet evolved for what Trader X wants to buy. The instruments he wants are similar and correlated, but not quite as standard as stocks, and “block trades” like his are sufficiently rare that even if the infrastructure existed, he’d be unlikely to find a counterparty quickly. Trader X could try to trade strategically and build a position over time, but given the thinness of the market that would take too long, the opportunity will disappear. Trader X is in a bind.

So, he goes to Investment Bank Y and explains the situation. Bank Y has many connections in the investing community, and could “shop the deal”, looking for a large investor to take the other side of the trade. But other investors are like market makers: they view strong demand to as an indicator of a counterparty’s information, and fear getting ripped off. Bank Y can find investors to trade with Trader X, but they would demand a large price premium over current quoted prices in order to take a position opposite a trader who acts like he knows something (whether he does in fact or not). If Trader X could persuade counterparties that he had no information — if it were clear his motivation was to hedge a risk, rather than gamble on a price change — then other investors might be willing to take the trade, and maybe he could find competitive bidders and get a decent price. Unfortunately, that just isn’t the case. Trader X is widely known to be a speculator, and by revealing the trade he wishes to make and the money he is willing to throw at it, he would reveal both his beliefs and his strong commitment to those beliefs. Other investors without special information would be wary of trading against such a certain counterparty, and would not offer favorable terms.

Bank Y asks Trader X what the ideal solution to his problem would be. Trader X thinks for a moment and says, “Ideally a counterparty would naturally appear who happens to want the opposite side of my trade. If they were buying while I was selling, order flow would be balanced, and we could transact at current market prices.”

Bank Y considers for a moment, and comes up with an idea. “Suppose we start a little investment company up, something like a mutual fund devoted to the kind of positions you want to trade. Since you want to take a ’short’ position, we’ll find a manager enthusiastic about the prospects of the ‘long’ side and help him start this little fund. There are lots of reputable money managers in the world, with a wide variety of views, so we can find somebody excited and capable of running this fund. We have lots of connections among investors, and we are in the business of drumming up interest in new investment vehicles, so there’s a reasonable chance we’ll find people to fund the strategy at a scale large enough to match your trade. Once we do, there will be a natural buyer of what you want to sell, and you can enter the market without impacting prices. In fact, since both you and this fund will use us as market makers, we’ll just cross the trades internally at prevailing prices, and neither you nor the fund will have to worry about adverse price action.”

“Hooray!”, says Trader X, “You guys are fabulous.” And it all worked out just exactly as Bank Y described.

Let’s suppose that this has all just happened, and asset prices have not moved at all. There has been no collapse of some gobbledygooky RMBS/CDS/CDO market. Today, everybody is happy. No harm, no foul, right? Was this little strategy okay?

Trader X has profited compared to all of his feasible alternatives. He acquired a position he desired very efficiently. Bank Y has earned a fee. But let’s consider the situation of the investors in the new fund, whom we’ll refer to as “the Investors”.

The Investors, as of this writing, hold a position they are pleased to hold at prevailing market prices. However, the Investors would not have taken the position at all had it not been for the intervention of Bank Y.

Let’s call the difference between the prevailing market price and the price Trader X would have had to pay a direct counterparty to take the other side of his trade “the Premium”. If Bank Y had simply shopped X’s trade to the Investors, they would have demanded the Premium. (If they would not have, why go to the trouble of starting the investment fund?) So, the net effect of taking the indirect route was a transfer of the Premium relative to the other feasible opportunity. Under the “full disclosure” scenario, the premium would have gone to the Investors. Under the “little investment company scenario”, Trader X keeps the Premium. The Premium is the value of the information not revealed, conditional on the trade getting done. (It is a maximum bound on that value if the trade would not get done at all under full disclosure.)

Note that this redistribution of wealth does not depend at all on how the investments ultimately perform. It doesn’t matter whether, in the future, Trader X is vindicated and the Investors go broke, or the Investors make a killing and Trader X moves back in with his mom. The Investors suffered an opportunity cost (and Trader X enjoyed a benefit) at the time the trade occurred, based on how the transaction was architected. Trader X might be an idiot or a genius. The Investors might have been duped, or they may have invested only after extensive due diligence (which revealed everything except the confidential involvement of Trader X). Whatever. We want to consider the only the events leading up to the trade, before market fluctuations confuse the issue. Did Bank Y behave ethically when, by withholding information, it got a deal done and caused a transfer of wealth to X?

If Bank Y had plainly represented itself as an agent of Trader X, perhaps there would have been no problem. Bank Y acted very effectively in Trader X’s interest, but in a manner that can fairly be described as adversarial with respect to the Investors. But if Bank Y had disclosed the relationship, the Investors might have inferred Trader X’s intentions and demanded the Premium (unless Bank Y actively misled them, which I’ll presume is bad). So was it okay for Bank Y to be a secret agent of Trader X while engaging in its conventional business of marketing a new investment fund?

In the story as I’ve told it, the undisclosed information was clearly material — the Investors would have received the Premium or would have preferred not to do the deal had the circumstances of the trade been plainly presented. When an investment bank is acting as an agent, to what degree can it withhold material information from other parties in order to benefit its client? And what is the relationship of an investment bank to those to whom it is marketing a new investment product? Clearly it is something less than fiduciary. Potential investors seem something less than “clients” as well. Are they simply adversarial “counterparties”? Perhaps they are “customers”? In any case, what duties are owed them?

I think I’ll just let these questions dangle. What do you think?

This exercise came from thinking through the excellent comments to the previous post, especially those of JKH. Thanks always to interfluidity’s exceptional readers.

Related — here:

• A knife fight is not a mediation
• Goldman and “hope”
• Deconstructing ABACUS
• Synthetic securities are not so strange
• L’affaire Goldman in price/information terms
• Goldman-plated excuses

My first reaction, upon reading about the SEC’s complaint against Goldman Sachs was to shrug. Basically, the SEC claims that Goldman failed to disclose a conflict of interest in a deal the firm arranged, that perhaps Goldman even misdirected and misimplied and failed to correct impressions that were untrue but helpful in getting the deal done. If that’s the worst the SEC could dig up, I thought, there’s way too much that’s legal. Had you asked me, early Friday afternoon, what would happen, I would have pointed to the “global settlement” seven years ago. Then as now, investment banks were caught fibbing to keep the deal flow going (then via equity analysts who hyped stocks they privately did not admire). The settlement got a lot of press, the banks were slapped with fines that sounded big but didn’t matter, promises were made about “chinese walls” and stuff, nothing much changed.

But Goldman’s PR people have once again proved themselves to be masters of ineptitude. Haven’t those guys ever heard, “it’s not the crime, but the cover up”? The SEC threw Goldman a huge softball by focusing almost entirely on the fibs of a guy who calls himself “the fabulous Fab” and makes bizarre apocalyptic boasts. Given the apparent facts of this case, phrases like “bad apple” and “regret” and “large organization” and “improved controls” would have been apropos. It’s almost poignant: The smart thing for Goldman would be to hang this fab Fab out to dry, but whether out of loyalty or arrogance the firm is standing by its man.

But Goldman’s attempts to justify what occurred, rather than dispute the facts or apologize, could be the firm’s death warrant. The brilliant can be so blind.

The core issues are simple. Goldman arranged the construction of a security, a “synthetic CDO”, which it then marketed to investors. No problem there, that’s part of what Goldman does. Further, the deal wasn’t Goldman’s idea. The firm was working to serve a client, John Paulson, who had a bearish view of the housing market and was looking for a vehicle by which he could invest in that view. Again, no problem. I’d argue even argue that, had Goldman done its job well, it would have done a public service by finding ways to get bearish views into a market that was structurally difficult to short and prone to overpricing.

Goldman could, quite ethically, have acted as a broker. Had there been some existing security that Paulson wished to sell short, the firm might have borrowed that security on Paulson’s behalf and sold it to a willing buyer without making any representations whatsoever about the nature of the security or the identity of its seller. Apparently, however, the menu of available securities was insufficient to express Paulson’s view. Fine. Goldman could have tailored a security or derivative contract to Paulson’s specifications and found a counterparty willing to take the other side of the bet in full knowledge of the disagreement. Goldman needn’t (and shouldn’t) proffer an opinion on the substantive economic issue (was the subprime RMBS market going to implode or not?). Investors get to disagree. But it did need to ensure that all parties to an arrangement that it midwifed understood the nature of the disagreement, the substance of the bet each side was taking. And it did need to ensure that the parties knew there was a disagreement.

Goldman argues that the nature of the security was such that “sophisticated investors” would know that they were taking one of two opposing positions in a disagreement. On this, Goldman is simply full of it:

Extensive Disclosure Was Provided. IKB, a large German Bank and sophisticated CDO market participant and ACA Capital Management, the two investors, were provided extensive information about the underlying mortgage securities. The risk associated with the securities was known to these investors, who were among the most sophisticated mortgage investors in the world. These investors also understood that a synthetic CDO transaction necessarily included both a long and short side. [bold original, italics mine]

The line I’ve italicized is the sole inspiration for this rambling jeremiad. That line is so absurd, brazen, and misleading that I snorted when I encountered it. Of course it is true, in a formal sense. Every financial contract — every security or derivative or insurance policy — includes both long and short positions. Financial contracts are promises to pay. There is always a payer and a payee, and the payee is “long” certain states of the world while the payer is short. When you buy a share of IBM, you are long IBM and the firm itself has a short position. Does that mean, when you purchase IBM, you are taking sides in a disagreement with IBM, with IBM betting that it will collapse and never pay a dividend while you bet it will succeed and be forced to pay? No, of course not. There are many, many occasions when the interests of long investors and the interests of short investors are fully aligned. When IBM issues new shares, all of its stakeholders — preexisting shareholders, managers, employees — hope that IBM will succeed, and may have no disagreement whatsoever on its prospects. Old stakeholders commit to pay dividends to new shareholders because managers believe the cash they receive up front will enable business activity worth more than the extra cost. New shareholders buy the shares because they agree with old stakeholders’ optimism. The existence of a long side and a short side need imply no disagreement whatsoever.

So why did Goldman put that line in their deeply misguided press release? One word: derivatives. The financially interested community, like any other group of humans, has its unexamined clichés. One of those is that derivatives are zero sum contests between ‘long’ investors and ’short’ investors whose interests are diametrically opposed and who transact only because they disagree. By making CDOs, synthetic CDOs sound like derivatives, Goldman is trying to imply that investors must have known they were playing against an opponent, taking one side of a zero-sum gamble that they happened to lose.

Of course that’s bullshit. Synthetic CDOs are constructed, in part, from derivatives. (They are built by mixing ultrasafe “collateral securities” like Treasury bonds with credit default swap positions, and credit default swaps are derivatives.) But investments in synthetic CDOs are not derivatives, they are securities. While the constituent credit default swaps “necessarily” include both a long and a short position, the synthetic CDOs include both a long and a short position only in the same way that IBM shares include both a long and a short position. Speculative short interest in whole CDOs was rare, much less common than for shares of IBM. Investors might have understood, in theory, that a short-seller could buy protection on a diversified portfolio of credit default swaps that mimicked the CDO “reference portfolio”, or could even buy protection on tranches of the CDO itself to express a bearish view on the structure. But CDO investors would not expect that anyone was actually doing this. It would seem like a dumb idea, since CDO portfolios were supposed to be chosen and diversified to reduce the risk of loss relative to holding any particular one of its constituents, and senior tranches were protected by overcollateralization and priority. Most of a CDO’s structure was AAA debt, generally viewed as a means of earning low-risk yield, not as a vehicle for speculation. Synthetic CDOs were composed of CDS positions backed by many unrelated counterparties, not one speculative seller. Goldman’s claim that “market makers do not disclose the identities of a buyer to a seller” is laughable and disingenuous. A CDO, synthetic or otherwise, is a newly formed investment company. Typically there is no identifiable “seller”. The investment company takes positions with an intermediary, which then hedges its exposure in transactions with a variety of counterparties. The fact that there was a “seller” in this case, and his role in “sponsoring” the deal, are precisely what ought to have been disclosed. Investors would have been surprised by the information, and shocked to learn that this speculative short had helped determine the composition of the structure’s assets. That information would not only have been material, it would have been fatal to the deal, because the CDO’s investors did not view themselves as speculators.

I have little sympathy for CDO investors. Wait, scratch that. I have a great deal of sympathy for the beneficial investors in CDOs, for the workers whose pensions won’t be there or the students at colleges strapped for resources after their endowments were hit. But I have no sympathy for their agents and delegates, the well-paid “professionals” who placed funds entrusted them in a foolish, overhyped fad. But what investment managers believed about their hula-hoop is not what Goldman now hints that they believed. Investors in synthetic CDOs did not view themselves as taking one side of a speculative gamble against a “short” holding opposite views. They had a theory about their investments that involved no disagreement whatsoever, no conflict between longs and shorts. It went like this:

There is a great deal of demand for safe assets in the world right now, and insufficient supply at reasonable yields. So, investors are synthesizing safe assets by purchasing riskier debt (like residential mortgage-backed securities) and buying credit default swaps to protect themselves. All that hedging is driving up the price of CDS protection to attractive levels, given the relative safety of the bonds. We might be interested in capturing those cash flows, but we also want safe debt. So, we propose to diversify across a large portfolio of overpriced CDS and divide the cash flows from the diversified portfolio into tranches. If we do this, those with “first claims” on the money should be able to earn decent yields with very little risk.

I don’t want to say anything nice about that story. The idea that an investor should earn perfectly safe, above-risk-free yields via blind diversification, with little analysis of the real economic basis for their investment, is offensive to me and, events have shown, was false. But this was the story that justified the entire synthetic CDO business, and it involved no disagreement among investors. According to the story, the people buying the overpriced CDS protection, the “shorts” were not hoping or expressing a view that their bonds would fail. They were hedging, protecting themselves against the possibility of failure. There needn’t have been any disagreement about price. The RMBS investors may have believed that they were overpaying for protection, just as CDO buyers did, just as we all knowingly and happily overpay for insurance on our homes. Shedding great risk is worth accepting a small negative expected return. That derivatives are a zero-sum game may be a cliché, but it is false. Derivatives are zero-sum games in a financial sense, but they can be positive sum games in an economic sense, because hedgers are made better off when they shed risk, even when they overpay speculators in expected value terms to do so. (If there are “natural” hedgers on both sides of the market, no one need overpay and the potential economic benefits of derivatives are even stronger. But there are few natural protection sellers in the CDS market.)

Goldman claims to have lost money on the CDO it created for Paulson. Perhaps the bankers thought Paulson was a patsy, that his bearish bets were idiotic and they were doing investors no harm by hiding his futile meddling. Perhaps, as Felix Salmon suggests, the employees doing the deal had little reason to care about whether the part of the structure Goldman retained performed, as long as they could book a fee. It is likely that even if Paulson had had nothing to do with the deal, the CDO would still have failed, given how catastrophically idiotic RMBS-backed CDOs were soon revealed to be.

But all of that is irrelevant, assuming the SEC has the facts right. Investors in Goldman’s deal reasonably thought that they were buying a portfolio that had been carefully selected by a reputable manager whose sole interest lay in optimizing the performance of the CDO. They no more thought they were trading “against” short investors than investors in IBM or Treasury bonds do. In violation of these reasonable expectations, Goldman arranged that a party whose interests were diametrically opposed to those of investors would have significant influence over the selection of the portfolio. Goldman misrepresented that party’s role to the manager and failed to disclose the conflict of interest to investors. That’s inexcusable. Was it illegal? I don’t know, and I don’t care. Given the amount of CYA boilerplate in Goldman’s presentation of the deal, maybe they immunized themselves. But the firm’s behavior was certainly unethical. If Goldman cannot acknowledge that, I can’t see how investors going forward could place any sort of trust in the firm. Whatever does or does not happen in Washington D.C., Goldman Sachs needs to reform or die.

Related — here:

• A knife fight is not a mediation
• Goldman and “hope”
• Deconstructing ABACUS
• Synthetic securities are not so strange
• L’affaire Goldman in price/information terms
• Goldman-plated excuses

It’s odd that I’ve ended up something of a China dove. My entrée into the fin/econ blogosphere was as a commenter at Brad Setser’s website, where some of my rantings verged on sinophobic. But somewhere along the line, I came to the conclusion that faulting China for America’s problems is a bit pathetic. While the jury is still out on the long-term wisdom of its dash to wealth, there’s a solid case that the China’s economic policies have served it well. The United States was and remains the world’s most powerful nation, not a fainting virgin. If China’s economic choices were indirectly harmful to the United States (they were and are), it was within the United States’ power to craft a response that would neutralize those effects. It is not China’s fault that the US did not look after its own interests. The United States’ self-destructive tolerance of unbalanced trade was relentlessly pushed by domestic groups — Wall Street and Wal-Mart — and was given plenty of cover by the economic establishment prior to the “Great Recession”.

Although I hold the United States responsible for its imbalances, I have no patience at all for the argument that “profligate Americans” were the root of the problem. American families responded quite reasonably to the price signals they encountered in goods, credit, and housing markets under an assumption that markets are stable and reasonably efficient. In making those assumptions, they were following the endlessly repeated advice of “experts”. Sure, you can toss out anecdotes about ugly Americans buying Hummers and taking cruises with cash-out refis. America has its share of credit-loving conspicuous consumers. But most families put their cash-out refis to more ordinary and defensible uses, as a supplement stagnant incomes. Absurd and unsustainable price signals (ungodly cheap imports, incredibly easy credit, monotonically rising home prices) were the failure for which the US must take reponsibility, and the blame for those falls squarely on the shoulders of lobbyists, politicians, and economists. It was a technocratic elite that fucked up, not Jane and Joe Six-Pack.

All of a sudden, though, part of that elite wants to make amends by forcefully confronting China. I think that’s a mistake, see here and here, or read Ryan Avent. The United States needs a comprehensive, nondiscriminatory balanced trade policy, not a bilateral trade spat with China.

But suppose the China hawks are right, that China’s mercantilism is uniquely harmful and must be forcefully addressed. The usual demand is that China let its currency appreciate sharply against the dollar. A depressed exchange rate functions as both a tariff on foreign goods and an export subsidy. The (accurate) case against China is that its currency policy amounts to protectionism in disguise. However, it is the real, not nominal, exchange rate that matters in this story. Most China hawks are agitating for a change in the nominal exchange rate, so that instead of buying 6.8 Yuan, a dollar should only be able to purchase 6 or even 5.5 Yuan. That approach has advantages: it would be a clear, visible change that can be implemented quickly. Holding wages in the US and China constant, a nominal appreciation becomes a real appreciation. However, there is another way that China’s real exchange rate could adjust: Chinese wages could rise more quickly than American wages while the nominal exchange rate stays put.

The US should prefer real appreciation via wage growth in China to appreciation via a sharp change in nominal exchange rates. Economically, the two approaches are similar, but politically they are quite different. The danger that the US might try to “inflate away its debt” is a live issue in China. A big nominal appreciation of the CNY implies huge paper losses on China’s hoard of dollar assets. That might create resentments, as China’s relatively modest losses on other US investments have. If China were to engineer a real appreciation while keeping the nominal exchange rate stable, it could avoid an accounting loss on its enormous investment. Avoiding such a loss is in the interest of both China’s economic managers and the United States.

It’s uncomfortable to make a policy recommendation based on what a cynic might claim to be deceptive spin. The economic effects of a revaluation via rising Chinese wages or via a nominal appreciation are similar. One could argue my suggestion amounts to colluding with China’s leaders to hide the degree to which they and we have expropriated wealth from China’s underpaid workers. (China’s workers are underpaid in international terms, for work of comparable productivity.) A nominal revaluation would render transparent the cost of China’s past subsidies to Western consumers and its own export tycoons. A wage-based revaluation would hide it.

But there is also a sense in which the paper losses that a nominal reval would occasion are misleading. The wealth represented by China’s reserves might never have been earned without its policy of exchange rate management. China’s development, in a broad sense, is much more valuable than its stock of reserve assets. Despite suffering a direct expropriation of international purchasing power from the policy, most Chinese are arguably better off than they would have been in the absence of that “theft”. Outrage over paper losses on reserve assets would be like shareholders in a business getting mad over a phenomenally profitable promotion because it involved selling goods at a discount.

Further, the US has not — yet — “inflated away” the value of a dollar in terms of domestic purchasing power. China’s reserve assets can be traded for roughly the same American goods and services as they could have on the day that they were purchased. America has changed over the past decade much less than China has. China’s workers have grown dramatically, incredibly, more productive, thanks to structural changes in their economy. So perhaps the most accurate way of accounting for these changes is to let the wages of Chinese workers increase to match that productivity growth, rather than restraining wage-growth but cheapening internationally-traded goods.

I don’t think there’s a clear case that one story is “truer” than any other. But I do know that a future in which the US and China are warm friends looks far better than a new cold war based on avoidable grievance. My first-best prescription for the US is to avoid singling out China at all, while using nondiscriminatory capital controls (or else “import certificates“) to unilaterally enforce a balance of trade. But if we must single out China, we should prefer revaluation via higher wages to nominal appreciation. If we are not stupid about how we frame the issue — if we don’t throw around accusations of sweatshops and slave labor as an offensive sort of cudgel — we might find that China’s leadership is more open to wage appreciation than currency appreciation. Higher wages balance the cost of reduced international competitiveness with the benefit of increased domestic demand. Giving ordinary people more money always has a political upside. Rising wages don’t attract self-defeating flows of “hot money”, like gradual nominal appreciation does. And China’s leadership, with its laser-focus on stability, prefers gradual experiments to bold, dramatic adventures.

As Joseph Wang used to point out (see e.g. his comments here), ultimately, the stability of America’s middle class depends upon the emergence of a wealthier middle class in China and other emerging countries. That’s what we should all be working towards.

Simon Johnson and James Kwak are absolutely right. Sure, “hard” capital and solvency constraints for big banks are better than mealy-mouthed technocratic flexibility. But absent much deeper reforms, totemic leverage restrictions will not meaningfully constrain bank behavior. Bank capital cannot be measured. Think about that until you really get it. “Large complex financial institutions” report leverage ratios and “tier one” capital and all kinds of aromatic stuff. But those numbers are meaningless. For any large complex financial institution levered at the House-proposed limit of 15×, a reasonable confidence interval surrounding its estimate of bank capital would be greater than 100% of the reported value. In English, we cannot distinguish “well capitalized” from insolvent banks, even in good times, and regardless of their formal statements.

Lehman is a case-in-point. On September 10, 2008, Lehman reported 11% “tier one” capital and very conservative “net leverage“. On September 25 15, 2008, Lehman declared bankruptcy. Despite reported shareholder’s equity of $28.4B just prior to the bankruptcy, the net worth of the holding company in liquidation is estimated to be anywhere from negative $20B to $130B, implying a swing in value of between $50B and $160B. That is shocking. For an industrial firm, one expects liquidation value to be much less than “going concern” value, because fixed capital intended for a particular production process cannot easily be repurposed and has to be taken apart and sold for scrap. But the assets of a financial holding company are business units and financial positions, which can be sold if they are have value. Yes, liquidation hits intangible “franchise” value and reputation, but those assets are mostly excluded from bank balance sheets, and they are certainly excluded from “tier one” capital calculations. The orderly liquidation of a well-capitalized financial holding company ought to yield something close to tangible net worth, which for Lehman would have been about $24B.

So Lehman misreported its net worth, right? Not according to the law. From the Valukas Report, Section III.A.2: Valuation — Executive Summary:

The Examiner did not find sufficient evidence to support a colorable claim for breach of fiduciary duty in connection with any of Lehman’s valuations. In particular, in the third quarter of 2008 there is evidence that certain executives felt pressure to not take all of the write‐downs on real estate positions that they determined were appropriate; there is some evidence that the pressure actually resulted in unreasonable marks. But, as the evidence is in conflict, the Examiner determines that there is insufficient evidence to support a colorable claim that Lehman’s senior management imposed arbitrary limits on write‐downs of real estate positions during that quarter.

In other words, the definitive legal account of the Lehman bankruptcy has concluded that while executives may have shaded things a bit, from the perspective of what is actionable within the law, Lehman’s valuations were legally indistinguishable from accurate. Yet, the estimate of net worth computed from these valuations turned out to be off by 200% or more.

Advocates of the devil and Dick Fuld will demur here. Yes, Lehman’s “event of default” meant many derivatives contracts were terminated prematurely and collateral on those contracts was extracted from the firm. But closing a marked-to-market derivatives position does not affect a firm’s net worth, only its exposure. There may be short-term changes in reportable net worth as derivatives accounted as hedges and not marked-to-market are closed, but if the positions were in fact hedges, unreported gains on other not-marked-to-market assets should eventually offset those charges. Again, the long term change in firm net worth should be zero. There are transaction costs associated with managing a liquidation, but those would be minimal relative to the scale of these losses. Markets did very poorly after Lehman’s bankruptcy, but contrary to popular belief, Lehman was never forced into “fire sales” of its assets. It was and remains in orderly liquidation. Last July, more than 9 months after the bank fell, Lehman’s liquidator reported that only a “fraction” of the firm’s assets had been sold and the process would last at least two years. Perhaps the pessimistic estimates of Lehman’s value were made during last year’s nadir in asset prices, and Lehman’s claimed net worth looks more reasonable now that many assets have recovered. But if Lehman’s assets were so profoundly affected by last Spring’s turmoil that an accurate September capitalization of $28B shifted into the red by tens of billions of dollars, how is it plausible that Lehman’s competitors took much more modest hits during that period? Unless the sensitivity of Lehman’s assets to last year’s markets was much, much higher than all of its peers, Lehman’s assets were misvalued before the asset price collapse, or its competitors assets were misvalued during the collapse.

We get lost in details and petty arguments. The bottom line is simple. The capital positions reported by “large complex financial institutions” are so difficult to compute that the confidence interval surrounding those estimates is greater than 100% even for a bank “conservatively” levered at 11× tier one capital.

Errors in reported capital are almost guaranteed to be overstatements. Complex, highly leveraged financial firms are different from other kinds of firm in that optimistically shading asset values enhances long-term firm value. Yes, managers of all sorts of firms manage earnings and valuations to flatter themselves and maximize performance-based compensation. And short-term shareholders of any firm enjoy optimistic misstatements coincident with their planned sales. But long-term shareholders of nonfinancial firms prefer conservative accounts, because in the event of a liquidity crunch, firms must rely upon external funders who will independently examine the books. The cost to shareholders of failing to raise liquidity when bills come due is very high. There is, in the lingo, an “asymmetric loss function”. Long-term shareholders are better off with accounts that understate strength, because conservative accounting reduces the likelihood that shareholder wealth will be expropriated by usurious liquidity providers or a bankruptcy, and conservative accounts do not impair the real earnings stream that will be generated by nonfinancial operations.

This logic inverts for complex financials. Financial firms raise and generate liquidity routinely. Many of their assets are suitable as collateral in repo markets. Large commercial banks borrow freely in the Federal Funds market and satisfy liquidity demands in part simply by issuing deposits that are not immediately withdrawn. For large financial firms, access to liquidity is rarely contingent upon a detailed audit by a potential liquidity provider. Instead, access to liquidity, and the ability to continue as an operating firm, is contingent upon the “confidence” of peer firms and of regulators. Further, the earnings of a financial firm derive from the spread between its funding cost and asset yields. Funding costs are a function of market confidence, so the value of a financial firm’s real future earnings increases with optimistic valuation. For a long-term shareholder of a large financial, optimistically shading the firm’s position increases both the earnings of the firm and the “option value” of the firm in difficult times. It would be a massive failure of corporate governance if Jamie Dimon or Lloyd Blankfein did not fib a little to make their firms’ books seem a bit better than perhaps they are, within legal and regulatory tolerances.

So, for large complex financials, capital cannot be measured precisely enough to distinguish conservatively solvent from insolvent banks, and capital positions are always optimistically padded. Given these facts, and I think they are facts, even “hard” capital and leverage restraints are unlikely to prevent misbehavior. Can anything be done about this? Are we doomed to some post-modern quantum mechanical nightmare wherein “Schrödinger’s Banks” are simultaneously alive and dead until some politically-shaped measurement by a regulator forces a collapse of the superposition of states into hunky-doriness?

Yes, we are doomed, unless and until we simplify the structure of the banks. When I say stuff like “confidence intervals surrounding measures of bank capital are greater than 100%”, what does that even mean? Capital does not exist in the world. It is not accessible to the senses. When we claim a bank or any other firm has so much “capital” we are modeling its assets and liabilities and contingent positions and coming up with a number. Unfortunately, there is not one uniquely “true” model of bank capital. Even hewing to GAAP and all regulatory requirements, thousands of estimates and arbitrary choices must be made to compute the capital position of a modern bank. There is a broad, multidimensional “space” of defensible models by which capital might be computed. When we “measure” capital, we select a model and then compute. If we were to randomly select among potential models (even weighted by regulatory acceptability, so that a compliant model is much more likely than an iffy one), we would generate a probability distribution of capital values. That distribution would be very broad, so that for large, complex banks negative values would be moderately probable, as would the highly positive values that actually get reported. If we want to make capital measurable in any practical sense, we have to dramatically narrow the range of models, so that all compliant models produce values tightly clumped around the number we’ll call capital. But every customized derivative, nontraded asset, or unusual liability in a bank’s capital structure requires modeling. The interaction between a bank holding company and its subsidiaries requires multiple modeling choices, especially when those subsidiaries have crossholdings. A wide variety of contingent liabilities — of holding companies directly, of subsidiaries, of affiliated or spun-off entities like SIVs and securitizations — all require modeling choices. Given the heterogeneity of real-world arrangements, no “one-size-fits-all” model can be legislated or regulated to ensure a consistent capital measure. We cannot have both free-form, “innovative” banks and meaningful measures of regulatory capital. If we want to base a regulatory scheme on formal capital measures, we’ll need to circumscribe the structure and composition of banks so that they can only carry positions and relationships for which we have standard regulatory models. “Banks’ internal risk models” or “internal valuations of Level 3 assets” don’t cut it. They are gateways to regulatory postmodernism.

Regulation by formal capital has a proud and reasonably successful history, but has been rendered obsolete by the complexity of modern financial institutions. The assets and liabilities of a traditional commercial bank had straightforward, widely acceptable book values. For the corner bank, discretionary modeling mattered only in setting credit loss reserves, and the range of estimates that bank officers, external auditors, and regulators would produce for those reserves was usually pretty narrow (except when all three colluded to fake and forbear in a general crisis). But model complexity overwhelms and destroys regulatory capital as a useful measure for large complex financial institutions. We need either to resimplify banks to make them amenable to the traditional approach, or come up with other approaches more capable of reigning in the brave new world of banking.

Some sources: Yves Smith has been phenomenal on the Lehman bankruptcy. Regarding estimates of the hole that appeared in Lehman’s balance sheet, see “$75 Billion Needlessly Lost in Hasty Lehman Bankruptcy Filing?” and “So Where, Exactly, Did Lehman’s $130 Billion Go?“. Neither Yves nor I remotely buy the “hasty bankruptcy” explanation, see my comments above, the previously cited article, and the always acerbic Independent Accountant. Comments on the pacing of the Lehman liquidation are from the CNBC video embedded in Yves’ piece. The $24B estimated tangible for Lehman is computed by taking its September 10, 2008 shareholder equity and subtracting intangible assets reported on Lehman’s last available balance sheet.

My discussion of financial firms’ incentive to lie was informed by the investor/blogger/super-cop John Hempton, see “Don’t believe what they say” and “Bank solvency and the ‘Geithner Plan’“.

This essay also owes something to Frank Partnoy’s excellent “Make Markets Be Markets” presentation.

Update: Somehow I managed to get the date of Lehman’s bankruptcy wrong. Takes talent, I know. Thanks to commenter mindbender for setting me straight!

Related — elsewhere:

• Ryan Avent: Who’s minding the store?
• Kevin Drum: The Dismal Outlook for Financial Reform
• Kevin Drum: Where the Real Action Is
• Kevin Drum: Blunt Rules
• Economics of Contempt: Regulatory Discretion and Prompt Corrective Action
• The Epicurean Dealmaker: Poachers Turned Gamekeepers
• Oliver Hart and Luigi Zingales: Curbing Risk on Wall Street
• Ezra Klein: FinReg’s killer app
• Ezra Klein: What does success mean on FinReg?
• Mike Konczal: Putting Stronger Limits into the Dodd Bill
• Mike Konczal: Greeks, Romans, and The Permanent Committee to Save the World Forever Bill
• Mike Konczal: Geithner’s attack on leverage requirements
• Paul Krugman: Greeks, Romans, and Financial Reform
• Paul Krugman: Don’t Be Narrow-Minded
• David Merkel: Dumb Regulation is Good Regulation — How to Regulate the Banks
• David Merkel: A Summary of What Bank Reform Should Be
• Warren Mosler: Proposals for the Banking System
• Reihan Salam: You’re Never Too Big To Fail
• Felix Salmon: Geithner vs. Congress on bank leverage
• Felix Salmon: Setting rules for capital and liquidity
• Simon Johnson: Volcker, Warren, and Kaufman: There Must Be New Law
• Simon Johnson and James Kwak: Capital Requirements Are Not Enough
• Shahien Nasiripour: Top Fed Official Wants To Break Up Megabanks, Stop The Fed From Guaranteeing Wall Street’s Profits
• Winterspeak: The Public Purpose of Banking
• L. Randall Wray: Bye-bye to Bernanke’s ‘Insidious Banks’: End ‘Too Big to Fail’ in 2 Easy Steps
• Matt Yglesias: Reducing Discretion in Financial Regulation
• Matt Yglesias: Why Not a Hard Leverage Cap

In the endless debates over stimulus and deficits, more “dovish” commentators frequently point out that debt markets appear sanguine about US borrowing. Despite some recent upward jitters, the Federal Government currently pays less than 4% to borrow for 10 years, and under 5% to borrow for 30 years. Those are bargain rates in historical terms, the argument goes, so investors must not be terribly concerned about inflation or default or any other bogeyman of “deficit terrorists”.

To make the point, Paul Krugman recently published a graph very similar to this one:

Since the financial crisis began, the US government’s cost of long-term borrowing has dramatically fallen, not risen. If we graph a longer series of 10-year Treasury yields, the case looks even more compelling. The United States government can borrow very, very cheaply relative to its historical experience.

However, there is another way to think about those rates. The US government’s cost of long-term borrowing can be decomposed into a short-term rate plus a term premium which investors demand to cover the interest-rate and inflation risks of holding long-term bonds. The short-term rate is substantially a function of monetary policy: the Federal Reserve sets an overnight rate that very short-term Treasury rates must generally follow. Since the Federal Reserve has reduced its policy rate to historic lows, the short-term anchor of Treasury borrowing costs has mechanically fallen. But this drop is a function of monetary policy only. It tells us nothing about the market’s concern or lack thereof with the risks of holding Treasuries.

But the term premium (or “steepness of the yield curve”) is a market outcome (except while the Fed is engaged in “quantitative easing”). How do things look when we graph the term premium since the crisis began?

The graph below shows the conventional barometer of the term premium, the 2-year / 10-year spread (blue), and a longer measure, the spread between the yield on 3-month T-bills and 30-year Treasury bonds (red), since the beginning of the financial crisis:

Since the financial crisis began, the market determined part of the Treasury’s cost of borrowing has steadily risen, except for a brief, sharp flight to safety around the fall of 2008. Investors have been demanding greater compensation for bearing interest rate and inflation risk, but that has been masked by the monetary-policy induced drop in short-term rates.

Taking a longer view, we can see that the current term premium is at, but has not exceeded, a historical extreme:

Note: There’s a gap in the 30-year rate series, probably because it became impossible to compute a “constant maturity” 30-year Treasury yield during the period when the Treasury stopped issuing 30-year bonds.

The present term premium is quite similar to those that vexed President Clinton during the heyday of the “bond vigilantes”. A glass half full story says that, despite all the stresses of the financial crisis and the sharp spike in Treasury issuance, the term premium has not become unmoored from its historical range. A glass half empty story says that the term premium is toying with the boundary of that range, and could break loose in an instant. I have no idea which tale is truer.

My politics on the deficit are centrist to dovish. I think that deficit spending is always an option, and that the Federal Government should absolutely spend on forward-looking, high-return investment projects. I also favor generous “safety net” benefits and would like to see a guaranteed income program in the United States. However, the only form of “stimulus” I support is very broad based transfers (e.g. I would support a payroll tax subsidy). I agree with many left-ish commentators that the deficits we’ve experienced are more an effect than a cause of our economic problems, and will take care of themselves if we create a strong economy and a broadly legitimate political system (neither of which I think we have right now). A nation as large and wealthy in natural resources and human capital as the United States need never be constrained by the vicissitudes of financial markets, if its government is capable of mobilizing its citizens’ risk-bearing capacity on behalf of the polity. [*]

But whatever my politics, I think there is a fair probability that the US will experience the thrilling uncertainty that attends a loss of confidence in its currency and debt. The argument that “markets don’t seem troubled by our deficits” is less persuasive than it first appears.

Full disclosure: Although my views are sincerely held, sincerity is cheap. Perhaps I am just talking my book! I am one of those people long gold and short Treasuries (although I am not a proponent of the gold standard).

[*] Remember, economic capital has nothing to do with money. Supplying capital is nothing more or less than assuming the burden of economic risks. Where do you think China’s ever-expanding capital base comes from, when it has been the world’s largest exporter of financial capital? China’s citizens assume great risk, in the form of below-world-market wages and social safety benefits, in exchange for the promise of a wealthier and more powerful nation. To some degree that capital is extracted involuntarily, but China’s government has had remarkable success at maintaining legitimacy and the consent of the governed despite the extraordinary costs citizens have borne in the service of an uncertain future. So far, citizens have seen consistent returns on their investment: the big question is how China fares in a persistent “bear market”, when it comes to seem as though much of their sacrifice has been wasted or stolen.