[OPE] Willem Buiter and the troubles of our times

Prof. Willem Buiter (LSE) has quite an interesting piece: "Standard macroeconomic theory did not help foresee the crisis, nor has it helped understand it or craft solutions." http://www.voxeu.org/index.php?q=node/3210 He cites three false ideologies:

1) complete markets paradigm: "In a world where there are markets for contingent claims trading that span all possible states of nature (all possible contingencies and outcomes), and in which intertemporal budget constraints are always satisfied by assumption, default, bankruptcy and insolvency are impossible." This says, basically, that if you can trade in anything at all and insure yourself against anything, then the system can "roll over" any hiccup in the trading process.

2) efficient market hypothesis: "asset prices aggregate and fully reflect all relevant fundamental information, and thus provide the proper signals for resource allocation." This is actually a particularly bad ideology, especially since the bankers themselves say openly they are uncertain about the hypothetical value of many financial assets, or how exactly to account for their value - the yield assumptions are conditional on an array of factors that can vary greatly in different timeframes.

3) linear general equilibrium models proceeding from fixed coefficients, used to project future trends, but featuring really deformed views about economic causation and very unreal assumptions.

Marxian and heterodox economists would probably want to add a few other aspects. At least, I would...

Anyway, the long and the short of it is, that it is impossible to predict accurately what the overall limits of credit expansion will be, until credit facilities actually start to collapse, and once they do collapse, it is impossible to model very accurately how exactly the repercussions will pan out, because the uncertainty and panic itself causes investors to react in a strongly exaggerated way, holding or shifting funds in ways disproportional to real events. Mainly, market confidence collapses, and then capital shifts quickly to ultra-safe, low-yield placements, with the effect that production slumps for a prolonged time. Making capital insurance a lucrative business, has ironically wreaked havoc for the whole of society.

Common sense analysts unbothered by "macroeconomics dogma" did however anticipate a crisis, the possibility was being discussed by many people, and in fact in 2004 I quoted Doug Noland (Prudentbear.com) on this very subject, for example: http://archives.econ.utah.edu/archives/marxism/2004w44/msg00205.htm Personally I underestimated the loss of market confidence that occurred recently, quite possibly because I did not fully understand the incredible size which the volume of leveraged capital reached, especially in the last half decade or so, in other words, the total size of the debt overhang compared to the income that has to pay it off.

Prof. Buiter himself argues essentially another variant of the idea that heavy restrictions should be placed on those dealers who take "bets" on the basis of knowledge which cannot possibly be adequate for the investment purpose, and on top of that insure those bets as well. But it is not really clear to me how those restrictions can work, unless you say simply that dealers cannot take that kind of bet at all. But if you do that, it isn't clear that you could prevent other kinds of financial operations with similar aims. The "regulation rhetoric" tends to boil down to the idea, that the "punters" should be more careful and conscientious in placing bets, but presumably they know that already by now. Just one striking example: one-third of all the billionaires in the world is no longer a billionaire. You cannot prevent a rerun in the future, unless you say simply that some deals are not permitted at all. And it is substantially not feasible to split out ordinary bank services and speculator's games, as if they don't live in the same society, and use the same currencies and resources. If speculators lose large amounts of money, you cannot prevent this from having repercussions for the rest of society.

According to Blackstone Group CEO Stephen Schwarzman, "Between 40 and 45 percent of the world's wealth has been destroyed in little less than a year and a half." http://www.reuters.com/article/wtUSInvestingNews/idUSTRE52966Z20090310 That is much exaggerated, if taken literally, but it is very true that even the share values of very large and successful companies have been practically wiped out, and thus the market capitalisation of the world's stock markets has shrunk enormously. You can get that data, from the World Federation of Exchanges http://www.world-exchanges.org/statistics/ and this shows that Schwarzman is approximately correct, if "wealth" means "stock values". But a lot of that, is due to the fact that investors panicked heavily, which made everything so much worse. For one example, General Electric stocks are now worth only 10% or so of what they were in 2000. Just as the stocks were overvalued before, now many are undervalued, but few people are buying, because they are all scared and pessimistic about the future.

The chatter at the moment is about the "state regulation of capital". But probably much more decisive is going to be: the "social regulation by the state": you get millions of unemployed out in the street, because they have lost their jobs and their property, and many of these people will do "anything" to survive. The serious question then is, how states and communities can absorb and manage all that, and what happens if they cannot (lacking resources) or will not (because of moral-political distaste). People have their limits, and beyond those limits, they become very, very conservative.

Jurriaan

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Received on Wed Mar 11 23:01:36 2009