I May Be Drunk, But You're A Nincompoop.
...and tomorrow I'll be sober.
July 10, 2008
I have to read an awful lot of stuff in the course of a market day. Most of it is swill, some of it's useful, and now and then I come across a real gem that inspires a new insight into the nature of markets and investing.
But occasionally I stumble onto a piece of writing that is so jaw-droppingly, mind-numbingly idiotic that I must thrust aside the potato-chip bags and empty Jim Beam bottles and clear my workspace for an all-out keyboard assault on the offending cretin. And today is one of those days.
Most often, the source of these appalling imbecilities is either (a) an op-ed writer in a major financial publication or (b) a chaired professor at some illustrious school of business. In this case, the perpetrator is (c) both of the above.
In the June 22, 2008 edition of the Financial Times I stumbled over an article entitled "Our need to sustain the great moderation" by one Stephen Cecchetti, who bears the weighty title of Barbara and Richard M. Rosenberg professor of global finance at Brandeis International Business School.
The outrage-challenged can find the offending article here.
Cecchetti's article is a tour de force of boneheadedness. If this is the sort of stone-blind hoodooism that passes for financial education these days, there is no longer any need to wonder how Wall Street dug itself into the derivatives hole. Our professor begins by bemoaning the collapse of the U.S. housing market, and worries that the event signals the end of 20 years of "extraordinary prosperity". Cecchetti opines that the entire world has enjoyed an era of unusual growth and "this higher growth has come with a remarkable stability." But despite her stability, the S.S. Global Prosperity is foundering in a sea of credit troubles. Man the pumps, fellow professors! The Fed must not pump alone!
The good professor pretends to be in a quandary over this excess of stability: "There are a variety of possible explanations for this unprecedented stability. It could be that a modern monetary policy, with its focus on price stability, is less destabilising. Alternatively, information technology has increased the flexibility of companies to adjust production and employment quickly to changes in the business environment. Or, it could be we have been lucky and faced fewer disruptive shocks." Here he drops the charade and names the culprit: "There is something to each of these but the one that I put most weight behind is that financial innovation has allowed companies and individuals to smooth consumption and investment in the face of fluctuations in income and revenue." [Emphasis mine]
Let's consider these points by succession. "It could be that modern monetary policy, with its focus on price stability, is less destabilising." I don't like to contradict the professor, but price stability is the very last thing desired or accomplished by the architects of modern monetary policy. The Fed's actions of the last two decades have been targeted specifically at knocking prices away from stability and toward ever-increasing apexes of aberration. The excessively loose monetary policy of the 1990's drove the Dow Jones Industrial Average from 2,600 in 1990 to 12,000 in January of 2000. How can stock prices be called stable while they increase by a factor of 4½ times in ten years?
The muck gets deeper. "Alternatively, information technology has increased the flexibility of companies to adjust production and employment quickly to changes in the business environment." There may be argument over the real net increases to productivity spawned by the Digital Age, but what Information Technology has yielded for most businesses is endless rounds of unproductive noodling with balky networks, crashed servers and increasingly infuriating incarnations of Microsoft Windows, not to mention countless employee hours wasted on personal emails, forwarding the latest jokes and perusing a plethora of gambling and porn sites.
But never mind, says the professor. "It could be that we have been lucky and faced fewer disruptive shocks." Let's see: The 1998 collapse of Long Term Capital Management that almost wrecked the world's financial system, the destruction of 200-year-old Barings Bank by a single unsupervised trader, $600 billion spent worldwide to fend off the dreaded Y2K Legacy Code Meltdown, the Dot-Com crash and the Tech Wreck, the September 11, 2001 terror assault that destroyed the World Trade Center and nearly erased the Pentagon and the White House, the War on the Afghan Taliban, the War in Iraq, the Twin Hurricane disasters of Katrina and Rita that all but destroyed New Orleans and the Gulf of Mexico oil and gas production corridor. Yes indeed, it's been a very quiet decade. Hardly a shock worth mentioning.
Undeterred, the professor pushes the lever from Dingbat Mode to Full Doofus: In Olden Times, prosperity was restrained by the inconvenience of only being able to buy stuff when you had money, since "for households to keep purchases smooth from month to month they need savings or access to loans, which many of them do not have. As a result of this constraint, consumption follows income more closely than the simple theory says it should."
The good professor has experienced an epiphany: Thousands of years of poverty in the human condition were completely unnecessary. Poverty turns out to be nothing more than the inconvenience of finding your consumption limited by your income. The clear answer is to furnish credit sufficient for unlimited consumption, as we spend and consume to our hearts' content without being cramped by our inconsequential and piddling paychecks.
Cecchetti explains how it works: "Advanced economics teaches that financial markets should provide consumption insurance, allowing individuals to borrow and lend, reducing the dependence of current expenditure on current income."
See? "Current expenditure" is unfairly and absurdly restricted to "current income". State-of-the-art financial markets remedy this by providing "consumption insurance". Are you fearful of a Consumption Disaster? Worried about an unexpected attack of Under-Consumption? You need Consumption Insurance. In ancient and unenlightened times the Consumption would land you in quarantine, in a sanitarium. Nowadays, the disease everyone fears most is Lack of Consumption. What we need is the ability to borrow at will, so that consumption can continue unimpaired by a lack of savings or a brother-in-law with a superfluous stack of Ben Franklins.
Not to worry--the Credit Gods have come through for us! A "revolution in finance" has delivered the keys to our prison of restricted consumption. What would those keys be? 20 years of "financial innovation" have brought forth "securitisation and the ability to separate risk and payment streams", the Holy Grail of Consuming without limits. "Active secondary markets for home mortgages, car loans, consumer credit and business lending enable both collateralised and uncollateralised borrowing. This dramatically weakens the link between income and expenditure for households and businesses." And even better, "Not only has the overall quantity of financing increased, but also these innovations have allowed high-risk borrowers access to financing." Got that? The more we're in hock for, the better off we are. And let's make sure the high-risk borrowers---the people who are most likely to self-destruct through debt---have access to all the credit they could want.
At this point, the last frayed threads of logical sentience part under the strain, and the professor's bloated Hindenburg of financial fantasy sails from its cognitive moorings up into Wonderland. The professor hasn't noticed that the collapse of the mortgage lenders and the bond insurers demonstrates that "risk and payment streams" were not separated after all, and never could be. Securitisation of debt certainly increased the velocity of money in the economy, but the money that accelerated to such startling speeds was not real money created by real work; It was bogus money beamed down from Tomorrow Land. Debt securitisation reached far into the future and dragged into the present wages that will not be earned for years, so they could be squandered on overpriced houses and worthless credit derivatives by people who should certainly have known better. Those malinvestments are now in the process of being destroyed, and that destruction is the natural and inevitable result of breaking "the link between income and expenditure for households and businesses." Allowing high-risk borrowers to get their hands on easy credit is akin to making sure mentally unbalanced people have ready access to automatic weapons.
"The result of the last 20 years of financial innovation is that we can insure virtually anything and engage in activities we would not have undertaken in the past." Yes, we can insure badly engineered credit derivatives based on mortgages to unemployed people with poor credit histories. But who's going to pay the claim when it comes due? And yes, we can engage in activities we would not have undertaken in the past. We always had that option, like the kid that rides down Main Street while playing air guitar on the roof of his buddy's jalopy. We can play Hot Potato with a live hand grenade, if we want. We didn't pursue those undertakings in the past because we used to have better sense.
Professor Cecchetti is living in a dreamland. Apparently he can't grasp the obvious: His vaunted "20 years of extraordinary prosperity" is merely 20 years of living beyond our means on every level. Who put this twit in the global finance chair at Brandeis?
Professor, the last thing this screwed-up world needs is more denial and wishful thinking. If you can't get anything else right, get this one thing straight: Income and expenditure are linked because they have to be, and ought to be. In the real world, consumers can only consume as much as they are actually producing. Any other route is a pathway to financial ruin and poverty.
Remember Dagny Taggart: "You can't go on and on consuming more than you produce." That simple truth should be obvious to anyone, even a university professor.
This kind of thing sends me diving to the bottom of a bottle of Southern Comfort. Tomorrow, however, I'll be sober again. But Steve Cecchetti will still be a nincompoop.
Gabriel Gray