Does Socialism Make Smarter Capitalists?

I think that to understand the present crisis - I mean even to wrap your mind around it - you have to have been schooled in Marxism for at least some time. I really do. It's not that Marxism itself is so informative here, although highly selected and re-interpreted portions can be. It's that to understand what is happening now, you have to have learned - at some time - to look at the capitalist system from outside of it. You have to have wondered "what's next?" and tried to come up with something positive, rather than just catastrophe.

And it really helps if you have had the experience of rejecting doctrinaire Marxism and thus developing a deeper appreciation for capitalism. I theorize that this is why Jim Cramer has had such good instincts about this crisis. He was a red for a while back in his college days, I understand. And of course George Soros - another devout capitalist schooled, if unwillingly, in Marxism - has done really, really well.

Meanwhile his old partner Jim Rogers is floundering. High-powered investment bankers - like Henry Paulson - are confused. America's greatest living expert on deflationary crises - Ben Bernanke - has been slow to react after making an entire academic career around the observation that people in government - in his very position - were too slow to react in the 1930's. But European leaders - schooled in socialism, whether right wing or left - are acting with increasing clarity. Meanwhile high-powered people who have gotten so many things right - like Brad Setser, Nouriel Roubini and even Warren Buffett - seem increasingly baffled.

What they seem almost unable to really understand is simply this:



...and why it's happening.

That is a chart of the Dollar Index - a measure of the value of the U.S. dollar against major currencies. During this period, the U.S. government and now other governments have been pouring an supply of dollars and dollar credit onto the market that is not just unprecedented, but previously unimaginable. And these governments are doing nothing but announcing plans to keep on providing dollars as fast as they can for the foreseeable future. And during this period, the value of the dollar is going up - fast.

The law of supply and demand seems broken when it comes to the U.S. dollar. They supply and the world just keeps demanding.

I think the misunderstanding is based on some fundamental misconceptions, but who am I to explain things to the smart set? Let them figure it out for themselves, the big show-offs. I'm just going to predict that it's going to keep happening for a while and that is going to be really scary and bad. At the same time, the dynamic is forcing us to re-think the structure of our financial system and put some solid government backing behind it, which is a good thing. I think most of the major traded commodities and currencies are probably going to fall versus the dollar for quite a little while. Maybe even the renminbi will fall, although that is a currency highly subject to government intervention. Maybe even the yen will fall, although that is the currency of arguably the most-productive nation - person for person - in the history of the world. And, yes, maybe even gold will fall, although panic-buying gives gold the potential for incredible volatility, as we've seen. If you're not looking at the system from outside the system - questioning some of the common assumptions - I just don't think you could even be expected to see this coming.

Brad Setser has a wonderfully informative article about the "End Of Bretton Woods 2." on his blog. It's very good, although I'm not sure it explains why we've seen the reverse of some of his most important predictions. But in economics the same dynamic can have effects that seem the opposite of each other, particularly if they involve foreign exchange. He did get the timing of his crisis call very right. Nouriel Roubini did also and Roubini doesn't really need to get mechanisms quite right. He observes so many things about the world that he's incredibly informative and flexible. And Warren Buffett? I dunno, maybe his call on stocks isn't so bad, although I'm not sure his predictions of record profits in 5 years for some American corporations is necessarily all that meaningful if the majority are in the soup. Certainly unprecedented volatility looks like something we're going to have to get used to and people don't usually like having so much of their principal at risk.The point is that even people who saw a lot of risk in the American economy have consistently misidentified the likely results or come to make predictions that seem to ignore obvious risk.

To me, what looks clear about the world looks very clear and it's a strange experience. Every morning I wake up expecting everything to reverse course, but it doesn't. I'm usually terrible at making specific calls on markets and now even my call on gold doesn't seem so bad. Even the yen looks like it might be turning. That's pretty wild.

I hope I'm not right. I hope I'm really not seeing something important. Although the future does ultimately look bright to me, it's going to be pretty scary and people will be hurt. What can you do, other than...

...live in interesting times

The Panic of '08

Well, that's it. This is one of those "history book" moments. The weird part is that it will all be blogged

I almost wasn't going to write this story until I read a piece from Bloomberg that made it clear to me we were truly in the soup. The relevant paragraph is here:

Banks and investors who are losing money on the record $1.7 trillion of high-yield, high-risk loans made in 2006 and 2007 are charging borrowers an average of 1.64 percentage points more in interest to amend borrowing agreements and avoid default, according to Standard & Poor's. That's the highest since 1997 and almost eight times more than the first half of last year.

On the face of it, it doesn't seem like much. But if you know the history of this crisis, it's very disturbing indeed.

The break in the credit markets came first in the market for leveraged loans. These are loans made to companies that already have a lot of debt so there is very little capital backing them up - hence the leverage. The secondary market for leveraged loans was actually a pretty quiet place until July-August of 2007 when it just blew up. It was, Wall Street later told us, the financial equivalent of a 500-year flood. The first levee-breaks at the end of July 2007 was taken to be the first sign that subprime mortgage loans were destabilizing the credit markets.

But hang on, what's the connection between loans to companies and mortgages to people with poor credit? Well, the explanation that came out of Wall Street - very quickly - was that losses in the subprime market were forcing banks to reign in their lending and so they started this reigning-in in the leveraged loan market. The economy was doing well. The companies were sound. It was a credit crisis in another place that was causing the trouble in these loans. We didn't know that could happen. Interesting

First, Wall Street told us of a global market for debt. Then they admitted that the labyrinth of mutual bets the banks all made with each other in the derivatives market - particularly the Credit Default Swap market - made it so that trouble in one area of credit could quickly go to another. Then the story got wonkier. It was all about "mark to market accounting" which had been a very good thing the industry was pushing governments to adopt but was now a very bad thing the government was forcing on them. Wonkier still, they admitted that "actively-managed balance sheets" were moving credit losses from one area of business to another. In retrospect, they came up with all of it a little too fast. It should have struck me how quickly came the explanations, all supporting the story about how German banks were being sunk by California mortgages because we have all been made one big, happy family, by - yes, over-exuberant and certainly geeky, but business-sound - financiers....except that American mortgage borrowers are a bunch of deadbeats and ruined everything. I should have been even more skeptical and - given the people telling the story - even more cynical

Now it turns out that these maniacs in the financial industry were not only setting records in mortgage lending and derivatives, they were also setting records in risky loans to businesses. It's now becoming clear that the crash in the leveraged loan market has had quite a little bit more to do with the underlying soundness of those businesses than their banks first admitted. It looks like leveraged loans were the Business Class version of subprime.

If so, that's that. We're screwed. And I think it's so.

The only saving grace is that because these loans were made to businesses with plenty of lawyers and accountants, there was probably a lot less outright fraud than there was in the mortgage market. At the end of the boom, I'm not sure there were always even existing houses underneath some of the mortgages people wrote. We know for a fact they lent to dead people in some instances. It's harder to do that with a leveraged loan - but I'll bet they came as close as they could.

And I say we're screwed because it looks like - on top of all the other insanity - the genius-idiots of The City and Wall Street loaded up our most economically-sensitive businesses with piggy-back debt they were at pains to repay in good times. This assures us that as soon as the real economy turns down significantly, a wave of defaults from that supposed "500-year flood" will crash onto the financial sector. I had heard something about corporate loans having hurt one of the large banks recently in the news, but I thought it was a smokescreen for their mortgage losses. Now it looks likely they were getting killed by both mortgages and corporate loans.

And now so are we all.

May you live in interesting times