Moving Beyond the Unwisdom Of "Too Big To Fail"
Lost in the European debt shuffle has been a much larger conversation that needs to take place. Mainstream economics has given some cursory thought and half-hearted lip service to rethinking the wisdom of "too big to fail" (TBTF). That might be a start and moral hazard is a deal with the devil, undoubtedly, but we need to think far beyond that, all the way to the core of the modern fiat economy.
Any debate about TBTF is essentially an argument for re-allocating intermediation capacity within the overall framework of the larger financial economy, such as it may be called. Before even getting to moral hazard, I believe a larger problem must first be solved: the overall size of the financial economy itself. I agree that there is too much debt in the developed world, but the real problem is that there is just too much finance.
Somewhere within the history of monetary management penetrating the actual economy, the role of intermediation transformed into something that hardly resembles the traditional sense of the word.
The word intermediation means to simply match two opposing sides. In financial terms, it means finding borrowers for lenders, and vice versa. The value added of professional intermediation is expertise. In general, intermediaries are far better at estimating the risks and rewards of engaging in credit transactions than savers themselves. Traditional intermediation should lead to expanding economic efficiency through a rigorous, higher level screening and discernment process.
Intermediation is a rather simple, fundamental process of flow allocation. Banks are supposed to be a gateway that redirects capital toward the best uses of scarce money, operating solely within the framework of the larger system of properly apportioning limited resources. With that in mind, it is hard to see how something like a synthetic CDO fits within that traditional characterization.
The securitization of subprime mortgages, no matter how irresponsible they may have been, were at least products of the real economy. A borrower received actual cash payments to purchase an actual house. That simple, intermediated transaction had real, tangible impacts on the economy, both good (short-term) and bad (longer-term). Packaging similar loans into bespoke tranches to match individual lender risk appetites takes this one step further, but it still involves the real economy at its origination.
A synthetic CDO, on the other hand, has absolutely no impact on the real economy. A package of credit default swaps, designed originally to enhance the risk profile of issuing a kind of credit insurance, involves no actual loans to anyone remotely connected to the real economy. Instead, they piggyback on real loans. With synthetic credit "products", a single loan's financial characteristics get replicated many times over, with each synthetic security simply mimicking the real thing.
This makes synthetic products systemically risky since a single loan problem gets magnified across every synthetic holder with that particular exposure, or class of borrowers as it turns out. This leads to some obvious questions about the current role of money and savings. Amplifying the impact of one loan to many different places necessarily means that the real economy has been dwarfed by financial exposures. A tiny country in Europe should not be able to hold the global economy hostage to its idiosyncratic economic imbalance.
Synthetic CDO's are not the only example. Interest rate swaps are another "risk control" product that is not part of the real economy either. Swaps are, by definition, replicants of real bonds that forgo the need of ever creating a transaction in the real economy. With net exposure to swaps in the trillions of dollars (with notional amounts in the hundreds of trillions), does finance even need the real economy anymore? Perhaps the first synthesized product to reach a quadrillion will open enough eyes.
This is not to say that swaps, securitizations and credit products have no place. But I think we have to ask whether we have progressed (I will argue regressed) to the point that money and the real economy can part company in such complicated and sizeable ways? It should be far more unsettling to policymakers and "experts" that intermediaries can create financial products with little actual need for real transactions, outside of a seemingly trivial benchmark. Is money now a goal unto itself?
In the movie Wall Street (the first one), Gordon Gekko sermonizes this Wall Street ethos succinctly, "It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another."
All these synthetic products are designed for exactly that, to transfer money from one perception to another. There is no thought anymore, no consideration for where this money actually comes from. Intermediation was supposed to be a method for putting real savings to work, to grow real wealth in a real economy. True wealth is not money; wealth is productive assets. The current enormous size and purpose of transferring money between perceptions is an addictive, Faustian bargain.
Capitalism is supposed to be about capital, not money. It is a powerful distinction that apparently needs to be relearned the hard way. A financial economy is not a free market economy, particularly when markets become less concerned about productive ventures than with managing asset prices. Capital means owning something productive. Money, especially in the age of fiat, is only a perception, and is, in fact, the very first financial derivative.
If there was enough credit to create a nearly 20% surplus in the amount of residential dwellings (with how many millions more in the shadow inventory?), it might be fair to say that there was just too much money trying to find a use. A financial system that created enough credit to fund trillions in subprime mortgage products and then synthesize them dozens of times over, cannot be calibrated to the real economy and the real idea of capitalism. This is known as malinvestment, first thought to be a symptom of too few productive uses for money. Modern monetary thought has turned malinvestment on its ear, now it assures that too much money will be deliberately created relative to the reasonable spectrum of potential productive uses.
In the overall schematic of economics and finance, the role of savings has been reversed from its traditional place. It was once believed, through centuries of empirical evidence, that savings were derived from productive endeavors. In the latter part of the 20th century, monetary "science" has hubristically changed to policies that conjure "savings" in order to create productive endeavors. Modern economics not only puts the cart before the horse, it actually believes the cart will pull the horse along.
In practicing this "reverse" flow of savings, central banks are giving bad ideas new life at the expense of potentially good, efficient ideas. By stimulating credit creation during a contraction or dislocation, bad ideas continue to get funded. Without this "stimulation" bad ideas are extinguished, productive assets are re-allocated by price discovery into good (or at least better) ideas that move an economy upward in terms of efficiency, and therefore ignite sustainable growth. The dislocation is itself a product of scarce credit.
There has never been a serious discussion within policy circles on whether it is actually wise to dismantle the self-corrective mechanism of scarce credit. The Federal Reserve was founded on the idea of plentiful credit, or as they called it over a century ago, money elasticity. The banking system began to believe, or at least propagandize, that it was scarce credit that created banking panics. Since banking panics were bad, removing them had to be a good thing, so a central bank dedicated to money elasticity had to be a great leap forward in financial progress.
Disabling scarce credit means that as the ratio of outstanding credit to the real economy grows, something has to adjust: prices. Mainstream economics is unfit for the realization that asset inflation is just as harmful, if not more so, than consumer inflation. In the new system of money elasticity and the backward flow of savings, price action lures real economic participants (households and businesses) to take on debt that they would not otherwise. Confident in the "wealth effect" that prices confer, additional debt is not initially burdensome.
In the calculations of monetary science, there is no downside to marginal credit and price-induced activity. This, of course, violates even basic common sense. There is a vast difference between taking on debt due to expanding real income and taking on debt due to price gains or a wealth effect. The latter is far more likely to be reversed, leaving the debtor and creditor poorer.
Asset bubbles are simply the most extreme expressions of malinvestment and inflation. Credit scarcity is their anathema. Money created from capital and real capitalism does not easily follow the false promise of quick monetary fixes.
In the theoretical context of a productive economy, money elasticity removes a high degree of market discipline. Credit scarcity verifies that intermediation is focused on actual intermediation. Instead of allowing over-produced credit to be flushed out with market discipline, assigning losses and terminating unproductive endeavors, the Fed has opted for the continual transfer of perceptions.
The markets, briefly shocked by the Panic of 2008 into the economic reality of worthless money, can resume the dreamworld of the financial economy and refocus on prices and money. Capital can once again be forgotten as the incentives skew even further away from long-term, productive ideas. Stock buybacks are back in favor, while capital expenditures languish with labor.
That is the key to the mystery of the persistently weak recovery. Economic activity derived from money is an illusion and will eventually come undone (again). Without a foundation of real productive potential, monetary undertakings can only succeed so long as money and credit consistently grow. Prices have to be maintained at all costs. An entire economy that is detached from true wealth, one infested with the prevarications of backward savings and price action, is an economy that actually grows poorer, even in the "best" of times.
The last true, robust recovery was 1983/84. Can it be coincidence that recoveries have changed fundamentally entirely within the new age of monetary interventions? In an era dominated by transitional perceptions, it is no wonder that real growth is neglected. Hard work and economic innovation are too easily supplanted by cheap money and financial innovation.
A world that accepts and encourages synthetic financial products deserves to see some of its best and brightest diverted to creating ever more complex derivative perceptions, but it should be no surprise that it comes at the far too real expense of long-term, sustainable growth. In the end, the disproportionate size of the financial economy is really an indication of willful neglect.
