In a nutshell

By a fortunate coincidence, I received a letter from Dr. Kapital today. He is living in his beloved Austria:

Dear Front,

I hope this finds you well. I was sorry to hear that every executive at your leading banks must be punished with a special tax. I was particularly amused by the 'household income' means testing. Nothing could be more incriminating than the fact that a financial professional has a highly-compensated wife.

Down at the monthly von Hayek coffee klatch in Salzburg it became apparent to me that even well-read and literate observers may be confused about what has happened. Here is a brief outline of my views, which I hope will be of some interest. Of course everything is contingent and even the best analysis is a mere abstraction of reality. While the models economists use assume a great deal, they do not assume things like tumbrils and guillotines. You have been warned:

• The best summary on the preconditions of the crisis is Martin Wolf's recent book Fixing Global Finance. His columns in the Financial Times (latest example here) are among the few pockets of rational thought in the current environment. He observes that the world economy this decade was dominated by massive imbalances, mainly those between the U.S. and a few export-based economies (e.g., Japan, Germany, and China). These countries ran trade surpluses by policy, and the U.S., having no trade policy, took the other side of the trade. Abundant credit flowed to U.S. consumers, who did what U.S. consumers always do. When the U.S. consumer woke up broke one morning, a global economic crisis ensued.
• Milton Friedman once supposedly said (then denied saying) "we are all Keynesians now." Whether it was true then, it certainly is true today. Stimulus is needed. Strong technical economists on both left and right believe the stimulus passed so far is inadequate. And yet recent polls show Americans will not stand for more. If something does not change quickly there, the phrase "downgrade to schtupped" comes to mind.
• But don't worry, lots of countries are worse off than you, including all of Europe. Mr Krugman explains the Spanish case here.
  
• As for Asia, who knows? Singapore has stopped, Japanese exports have fallen off a cliff. Amusing isn't it, that the Chinese would like their money back? They remind me of a Madame whose best client has run up a huge tab, and now is having potency issues. It is hard to prioritize the questions: are you going to keep visiting here (we need your business)? are you going to pay us (we can sort of see why you wouldn't want to)? are you doing something to fix your problem (we might be partly responsible, but hope you don't notice)? Even harder to put them delicately.
• Once the crisis began, it exposed a massive failure of oversight. While Bernie Madoff and our friends at AIG have become emblematic, the fact is that the SEC was warned about Madoff many times and never did a serious investigation. And AIG operated as a giant unregulated hedge fund in plain sight, with the tacit endorsement of senior policy makers. Michael Lewis discusses the subsequent sheisssturm here.
• I do not agree with many of the things they say, but Akerlof and Shiller's new book is one of those things you must read, whether you want to or not. Fortunately it is well-organized and well-written. Unfortunately, it says much of the eventual recovery will depend on factors that are not easily controllable, such as crowd psychology.
  

This mess - it has all been so sudden... If only we had been warned by some credible expert! Well, if you really want to understand what happened at AIG, you might read this 2005 warning from their most formidable competitor, a man with an outstanding long-term track record in markets. I find long quotations tiresome, but suggest you read every word of this epilogue to the unwinding of his derivatives business:

In a sense, we are a canary in this business coal mine and should sing a song of warning as we expire. The number and value of derivative contracts outstanding in the world continues to mushroom and is now a multiple of what existed in 1998, the last time that financial chaos erupted.

Our experience should be particularly sobering because we were a better-than-average candidate to exit gracefully. Gen Re was a relatively minor operator in the derivatives field. It has had the good fortune to unwind its supposedly liquid positions in a benign market, all the while free of financial or other pressures that might have forced it to conduct the liquidation in a less-than-efficient manner. Our accounting in the past was conventional and actually thought to be conservative. Additionally, we know of no bad behavior by anyone involved.

It could be a different story for others in the future. Imagine, if you will, one or more firms
(troubles often spread) with positions that are many multiples of ours attempting to liquidate in chaotic markets and under extreme, and well-publicized, pressures. This is a scenario to which much attention should be given now rather than after the fact. The time to have considered – and improved – the reliability of New Orleans’ levees was before Katrina.

Well, too late now. Your best chance, and the world's, is that the causes of this crisis are seen aright by the national leadership and corrected. America once had very good financial regulation, and certainly could again. But I must note, your stock market was at 1,000 (S&P 500) on Election Day, and now hovers in the mid 700s. Government action so far has been too slow, too small, and only marginally well-aimed. Meanwhile, Rome burns. For now we have a triumph of experience over hope.

There are reasons to think things will get better. Bernanke appears capable (this 60 Minutes interview is worthwhile), Krugman's star is rising, and stocks are the cheapest they have been in decades (ceterus paribus, lower prices --> higher expected returns). If you are looking to put your spare cash to work in the market (and why not?), this book (and the accompanying website) would be a good place start.

Best regards,

Doktor Kapital


PS - It is good to see Obama leaving Duke out of his Final Four. They suck.