Diatribes of Jay

This is a blog of essays on public policy. It shuns ideology and applies facts, logic and math to economic, social and political problems. It has a subject-matter index, a list of recent posts, and permalinks at the ends of posts. Comments are moderated and may take time to appear. Note: Profile updated 4/7/12

09 June 2013

Financial Stampedes: Positive Feedback inside the “Invisible Hand”

Why the “bubble” is a bad analogy
Fear-induced financial stampedes
Greed-induced financial stampedes
Stopping the greed stampede
Today’s interest-rate stampede


Not quite three months ago this blog published a post explaining positive feedback in global warming. Because positive feedback is non-linear, it can act far more quickly than anyone expects. It could cause a climate catastrophe that, in the best case, could devastate our global economy. In the worst case, it could devastate our global civilization, in which the vast hordes of humanity are just now pulling themselves out of poverty.

Positive feedback is something that only systems engineers understand well. Why? Because it takes engineering math to get a precise handle on it. Its near-instantaneous spasms are counterintuitive. The only way to understand them, let alone predict them, is with non-linear math.

Systems engineers go to great lengths to avoid positive feedback. Instead, they design negative feedback into their systems to keep them stable. (As a scientist/engineer, I once designed such a system to keep the temperature of a small experimental apparatus constant within 10 microdegrees Centigrade, or 0.000010 ˚C).

To help non-specialists get their minds around positive feedback, my global-warming post offered three examples from everyday life. The first was amplifier screech, in which small sounds get amplified and fed back into a nearby microphone. The second was my own, personal learning-to-drive experience, in which my body’s forward inertia, sans seat belt, caused me to stomp even harder on the brakes than I had intended, producing a panic stop.

But the third example presaged the subject of this essay: positive feedback in finance. The so-called “Flash Crash” of May 2010 was the example. Multiple computer algorithms for stock trading, kept secret from each other but connected together an an automated trading system, had each been designed to beat the others to the trading punch. So a small erroneous order caused a major cascade of positive feedback. It was just like a small sound that gets amplified, fed back into the amplifier, and re-amplified again, to produce an ear-splitting amplifier screech.

The result? A precipitous “market” drop [search for “flash crash”], in which the Dow lost 1,000 points and stocks like Apple’s dropped 90%, in less than an hour. I put the word “market” in quotes because there was no active human intelligence behind the Flash Crash. It was a case of automated electronic systems badly programmed to permit, if not encourage, positive feedback.

The Flash Crash of 2010 is far from the only example of positive feedback in finance. In fact, most financial crashes in human history are examples. They include the Crash of 1929 that triggered the Great Depression and the Crash of 2008, which started our recent Great Recession. So, I think, is the precipitous rise in mortgage interest rates from around 2.5% to nearly 4% in just the last two weeks.

You can call it “mob psychology.” Or you can call it positive feedback in financial systems involving people. But in either case the result is the same. Small market fluctuations—or mere perceptions or expectations—cause the system to go unstable because human nature, namely, greed and fear, magnify and remagnify them, just like sound passing through a speaker and back into a microphone. The result is nonlinear and sudden—an unexpected spasm.

Why the “bubble” is a bad analogy

Today the most popular metaphor for financial crashes is a bursting bubble. But that’s a poor analogy. A bursting bubble is a well-understood phenomenon, at least in physics. When the pressure inside overcomes the surface tension of the liquid, the bubble bursts.

The molecules of liquid have some random motion, in accordance with the laws of thermodynamics. So predicting precisely where and how the bubble will burst is a bit of a challenge. But if you can measure the pressure inside it and know precisely the composition of the surface, you can predict precisely when the bubble will burst with relative ease.

Not so financial crashes. The hardest thing to predict is when they occur. If any of us could do that, he or she would be obscenely rich. If our regulators could, we might make a dent in the so-far-infinite series of financial panics and crashes that have plagued modern economies since the Dutch tulip craze of the seventeenth century. So far, no such luck.

In fact, financial crashes have much more in common with stampedes. When people begin to smell smoke in a crowded theater, they all react at different rates. Some think, “It’s just some bastard breaking the rules and lighting up.” The more high-strung ones say to themselves, “I’ve got to get out of here!” As more and more people notice the smell of smoke and react to it, human communication—both verbal and nonverbal—accelerates the perception of danger.

The result is a stampede to the exits. That kind of stampede can trample people to death. It can do so even if the exits and time are adequate for escape, and even if the fire turns out to be easily controlled and hardly dangerous in retrospect.

The key phenomena here are perception and communication. Reality takes a back seat. The fire may not be a real danger: the smoldering curtain may actually be fireproof and in the process of self-extinguishing. But the smoke and small flames can motivate a deadly stampede nevertheless.

Like those caused by fire in crowded spaces, financial stampedes are collective phenomena. And lest we aggrandize our own species unjustly yet again, I should note that animals have them, too. The reaction of horses or cows trapped in a burning barn is much the same as ours. They seem to survive stampedes better than we—whether because they are more durable or more intelligent science has yet to say.

Our stampedes do differ from animals’ in one important respect. We have much greater imagination. So much more than reality can influence our perceptions and expectations, which can lead to stampedes. Ideology can be a powerful goad for stampedes, especially today.

Fear-induced financial stampedes

Now that we have a better analogy than a “bubble,” we can apply it to real financial panics. As we will see, they fit the fire-in-crowded-theater model quite well.

a. Runs on banks. Our first example is runs on banks. They don’t happen much anymore because federal deposit insurance removes the perception of danger. But runs on banks were a major cause of the Great Depression.

A few banks failed, and depositors began lining up (literally) outside banks to withdraw their money. Some lined up outside shaky banks. Some lined up outside sound banks. The state of the banks’ actual financial health didn’t much matter.

Depositors all knew a basic fact of life: banks don’t keep your deposited money in a vault somewhere. They lend it out, keeping only a small fraction as “capital reserves,” as required by regulators. Knowing this made depositors ever more anxious. If their bank failed, its reserves might suffice only to return the capital of just the first few claimants. So you had to be early in line, just like the theater goers escaping a fire.

b. The Crash of 1929. The Crash of 1929, which triggered the Great Depression, was depressingly similar. There the cause was buying stock on margin.

“Margin” is just a financial term for buying stock with borrowed money. If you think a stock will rise, you can borrow money (usually from your broker) to buy it and sell it later at a leveraged profit.

But if it goes down, your lending broker won’t want to take the risk. So as your stock goes down, she will ask you to pledge additional collateral: money or other stock to cover the shortfall. When you can no longer provide additional collateral, the broker will sell the margined stock and all your additional collateral to reduce her lender’s risk and/or losses. If the stock falls far enough and fast enough, you may lose everything and still be liable for the balance on the loan.

It doesn’t take much imagination to see how a system like that can produce positive fear feedback and trigger a stampede. A few people start to sell. The market goes down. The “first responders” sell their leveraged stock, too, in order to cut their losses. If they are quick and lucky, they might still retain some of the capital they put up to get the margin loan and buy leveraged stock. (They would be like the early withdrawing depositors, who tap into the failing bank’s reserves.)

But once they sell, the stock drops further. Other margin players see their stake and their capital evaporating, so they sell out in an increasing panic. You then have a true crash.

That’s precisely what happened in October 1929. The result was the worst stock-market crash in history, an unprecedented and never-repeated (yet!) stampede toward the bottom.

In this case, there was little the government could have done. As is usually the case in financial panics caused by positive feedback, the whole thing happened far too fast for government action, let alone in today’s gridlock.

More important, the government could hardly have guaranteed investors against their margin losses, even in theory. To do so would only have encouraged more gambling and speculation. It’s one thing to guarantee depositors getting their own money back. It’s quite another to guarantee that speculators (aka gamblers) will win, or at least not lose.

So the “fix” for 1929 could only come after the fact. Today we have strict limits on margin that brokers can offer or investors accept. We limit the risk by limiting the leverage.

c. The Great Recession. Today everyone knows the trigger for the Great Recession, from which we are just now slowly emerging. It was the Crash of 2008, in which highly leveraged financial professionals stopped trusting each other and the financial system. The whole system nearly froze, depriving real businesses and ordinary people of credit and liquidity for their day-to-day needs. Credit is so vital a medium of exchange today that it was almost as if money itself had become worthless overnight. Hence the extraordinary bailout, still ongoing.

What set up this awful house of cards was a case of positive feedback of another sort, which we’ll get to later. But what brought it down was a fear-induced financial stampede, pure and simple. The only thing notable about it was that the stampede occurred among the professionals, who should know better, rather than among the rubes like the depositors lining up outside their banks in the early 1930s.

The mechanism was easy to state. Banks and mortgage brokers had made innumerable worthless “liars’ loans.” They knew or should have known that the loans were worthless because they massively violated their own credit standards in making them. But they sold them off to investment banks, which packaged them as “mortgage-backed securities,”—still just as worthless as the underlying liars’ loans—and sold them to innocent and clueless investors.

This sophisticated Ponzi scheme went sailing along until a few investment houses, caught up in their own promotional rhetoric, began to take positions in this trash. When Lehman Brothers failed, all the banks started looking suspiciously at each other and doubting. They began to wonder whether the CDOs and swaps they had bought to cover their own losses would be worth anything. They all smelled smoke, and they all started rushing for the exits. That’s when credit and our economy froze up.

Here again, as in 1929, once the house of cards had been built, there wasn’t much the government could have done to prevent the stampede. The network of derivatives was then in the tens or hundreds of trillions in face value (the Fed has not yet disclosed the sum, even if it knows). Today it is reportedly some $700 trillion. Not even the government has, or can print, that much money.

Moreover, the moral hazard problem was the same as in the margin crisis of 1929. The government couldn’t step in and guarantee the mortgage-backed securities or their derivatives or swap “insurance,” because it would thereby encourage the very kind of gambling and speculation that had motivated the Ponzi scheme in the first place.

All that government could do was to pick up the pieces after the stampede. That the Fed did, at great cost but with considerable success so far.

Greed-induced financial stampedes

For most, but not all, fear-induced financial stampedes, there is a precursor: a greed-induced financial stampede whose reversal induces the fear. Greed builds the house of cards and fear blows it down. They work in tandem to produce the crashes and panics that periodically destroy an otherwise well functioning real economy. Here are three examples:

a. The Crash of 1929. The Crash of 1929 is easy to diagnose. Fear of “margin calls” (to sell margined stock or demand more collateral) caused the fear-induced stampede that triggered the Depression.

But what built the mountain of margin whose avalanche caused the Crash? A greed-induced orgy of buying stock on margin, in the hope of getting rich in a bull market that would never end. Sound familiar?

The orgy of leverage through margin started, as it always does, with professionals. But it quickly spread to semi-pro stock punters and eventually to ordinary people and workers. The great financier Bernard Baruch was smart enough to sell out and save his fortune after his cab drivers started offering him stock tips.

The orgy of leveraging through margin to buy stocks was a stampede induced by greed. It took several years to build to the breaking point. So it offered a tempting target for regulators and pols, if they had had the courage to get ahead of events.

But in that twilight of the Guilded Age, no one wanted to spoil the party. The result was the biggest global hangover in human economic history, whose consequences included World War II and the first use of nuclear weapons.

b. The savings-and-loan crisis. The savings-and-loan crisis of the 1980s and 1990s was a rare bird. It was a crash caused almost entirely by greed, not fear. Ideology also played an important role.

The essential facts are simple and easy to state. Congress created savings-and-loan associations as a separate class of financial institutions for a single purpose. They were to serve as collectors of deposits to be lent out as mortgage loans so that ever more people could own their own homes. They were to be “local” institutions which, unlike the big banks, would understand and serve their local communities’ needs.

Congress created these financial institutions in 1932, during the Great Depression. At that time and for decades afterward, a regime of strong government regulation was in force. The prevailing ideology was far different from today’s.

Price regulation then prevailed not only in finance but in the airline industry as well. The Civil Aeronautics Board treated airlines like public utilities and set airline fares (called “tariffs”). The Federal Home Loan Bank Board (now defunct) governed savings-and-loans and fixed their interest rates. Both regulators set rates so that the institutions they regulated could make a good and reliable profit, thereby insuring their stability, continuity and growth.

Then, in 1980, Ronald Reagan got elected president, and the era of deregulation began. By the end of his sleepy reign, the airlines and savings and loans had been deregulated, and the latter had nearly died.

I will not even attempt to characterize the consequences of deregulating airlines. They were and are extremely complex and various, some good, some bad. But the consequences of deregulating savings-and-load institutions were immediate and bad.

The primary consequence was an orgy of greed among savings-and-loan managers, who previously had been focused on serving their communities within a narrow range of regulated options. Direct regulation had put a ceiling on rates that they could pay depositors. It had also influenced, if not controlled, the rates that they could charge homeowners for home loans.

These two rates determined (and still determine) the institutions’ profit. Take the rate earned on home loans, subtract the rate paid on deposits (for the same tranche of money), and further subtract administrative and other expenses. That’s earnings. If the result is positive, you make money. If it’s negative, you lose money.

This is hardly rocket science. But the managers of savings-and-loans were a bunch of less-than-brilliant local ol’ boys, who had cut their teeth in a strictly regulated environment. Now they were told, with all the enthusiasm of a football cheerleader, that their mission in life was to go out, compete for customers, expand, and get rich. Unfortunately, the were told this in an era when prevailing interest rates and inflation were at historic highs.

So like the Japanese car makers in the eighties, they went straight for market share. They raised the interest rates they paid depositors, in order to attract new deposits. Then they lowered the rates they demanded from home borrowers, in order to attract new business. (They couldn’t lower them much because of the extraordinarily high general interest rates then prevailing, at times well over 10%.) They attracted a lot of new business, but they lost money.

They lost money in droves, and quite rapidly. By 1996, they had collectively lost over $160 billion, and many had been through or were facing bankruptcy. So our government bailed them out.

Notwithstanding this bailout, some refugees of the industry still blame government for the crisis. They claim the Fed Chief Paul Volcker was at fault for raising Fed interest rates to control inflation, forcing the savings-and-loans to fund current operations from long-term mortgage loans made previously at much lower rates.

This claim makes little sense on analysis. As long as previous loans did not default, they provided a steady stream of positive income, albeit perhaps less than the lenders might have desired. And new loans would of course be at the much higher prevailing rates. So losses had to come from setting rates paid on deposits too high, or from incurring expenses higher than before.

Rising general interest rates did not kill the savings-and-loans, any more than they killed the banks with which they competed. Bad management and ideology-inspired greed did.

So the direct cause of the savings-and-loan crisis was not government. It was greed-induced stampede of sleepy, once highly regulated managers, who saw a release from regulation as a chance to compete against banks, for which fixed-rate mortgage loans were a smaller fraction of their portfolios. In their rush toward this illusory pot of gold, they forgot the most basic principle of business: if your expenses (interest on deposits plus administrative expenses) exceed your income (interest earned on home loans), you will lose money. The taxpayers paid for their forgetting that simple lesson.

c. The Crash of 2008.

This segue brings us quite naturally to our current predicament. What cocked the trigger for the Great Recession from which we are just now emerging? A similar orgy of greed, but with a difference.

The similarity is the greed stampede, this time toward profits from selling securities backed by liars’ loans. The difference is a dearth of simplicity.

The touchstone of the latest crash was risk, not the simple profit-and-loss or competitive miscalculation that triggered the savings-and-loan crisis. And there was another difference: the perpetrators of the Crash of 2008 were not a class of local ol’ boys emerging sleepily from a highly regulated environment. They were the nation’s most sophisticated financial professionals, operating in an environment (derivatives) that they themselves had created, and in which there was no financial regulation at all, and never had been. (The whole field was far too new to be regulated.)

But despite these important differences, the consequences were much the same. The savings-and-loans’ ol’ boys damned the losses and went full speed ahead. The nation’s finance big boys damned the risks and went full speed ahead. Some of them knew they were massively violating their very own credit standards. But everyone else in the “industry” was doing the same thing, and the rating agencies that they all paid to judge them said it was OK. More to the point, the risk would cease to be theirs once they got the toxic mortgage-backed securities off their books, or so it seemed.

The important point in all this is not bankers’ obvious fault. So far, they have managed to avoid any criminal sanctions, and they are in the process of watering down regulations not to their liking.

No one in government has even seriously proposed breaking the big banks up. There may be some room for private corporate raiders to perform that function, quite profitably, but so far no one has stepped up. Perhaps finance is such an obscure and esoteric field, dominated by such a close-knit clique, that even the boldest corporate raiders fear to take it on.

But the most important point is timing. A fear-induced stampede is, on a human and historic scale, nearly instantaneous. Fear is highly communicable, and (for evolutionary reasons) our strongest emotion. So it acts quickly, like a fire in a theater.

But greed is a slower seducer. It takes time. It took several years for the savings-and-loan managers’ greed to get their institutions in deep financial trouble. Likewise the bankers in the Crash of 2008. It took several years for liars’ loans and securities that packaged them with more traditional (and sounder) investments to gather steam and become a stampede.

Stopping the greed stampede

This timing point is pretty significant. Trying to stop a fear stampede in mid flight is nearly impossible. Whether you’re a horse or a human, if you stand in the path of a stampede, you are likely to get hurt.

But greed-induced stampedes are slower to develop. They often allow time to make corrections, as long as regulators and private market “correctors” are pro-active.

If you will permit me a highly mixed metaphor, financial stampedes are a bit like ballistic missiles. They are much easier to stop in their “boost” phase, when the conditions for the eventual fear stampede are just being established. They are much harder to stop in the “descent” or “ballistic” phase, when they move faster and faster as they approach impact and explosion.

So it behooves us to pay more attention to obvious preconditions for financial stampedes, like the margin orgy before 1929, or the dross of liars’ loans turned into the “gold” of mortgage-backed securities during the period 2005-2008. As it turns out, events like that are easily identified as stampedes, too. They are just stampedes of a different sort, motivated by greed, not fear.

Here I propose a new principle of economics, which I modestly call “Dratler’s Law.” Every greed-induced stampede has the potential to turn into a fear-induced stampede and thus to cause a serious panic or crash. But like ballistic missiles in their “boost” phase, greed-induced stampedes are much easier to stop than panic-induced stampedes.

So pols and regulators ought to focus more on the orgy of greed than on the stampede of fear. That’s hard, of course. Pols don’t like spoiling a party. But the public and history will appreciate them if they can avoid a hangover like the Great Depression and its cataclysmic aftermath.

Today’s interest-rate stampede

This brings us right up to the present time. We are in the midst of an interest-rate stampede, in which mortgage interest rates have risen about 1.5% (150 basis points) in about two weeks. These rates track interest rates on bonds, including the notes and bonds from our Treasury. So what is really driving the change is a greed stampede among bond buyers.

To say that this precipitous rise is anomalous would be an understatement of Obamanian proportions. Nothing real has happened in the last two weeks to justify such an astounding rise in mortgage rates—an increment equivalent to 60% of the starting rate two weeks ago. The Fed has not changed its accommodative monetary policy. Fed Chief Bernanke has only said he might start thinking harder about a change some time soon.

Nor has much changed in our real economy. We are continuing on the slow, steady, hard climb out of post-recession unemployment and stagnation that started four years ago. Our angle of attack has not changed noticeably in the last two weeks. Instead, there have been some ambiguous reports on jobs and retail sales, although housing is definitely on the rise.

But perceptions are a different matter entirely. For several years, a vast right-wing echo chamber has predicted massive inflation and economic angst as the inevitable consequence of the Fed’s accommodative monetary policy. Fox is the chief culprit here, but it is hardly alone. Lots of people who ought to know better have made the same prediction.

The people making these predictions are not economists. They are people with no special training. They apply the simplistic rule “more money, more inflation,” without the slightest understanding of macroeconomics, let alone at a quantitive level. They are not even particularly bright or observant. But they have a big megaphone and the protection of our First Amendment.

If the financial professionals really believed these self-appointed pundits, you might call this a fear stampede. But it’s hard to see the professionals themselves as true believers. They know what the cost of insuring debt through CDOs and “swaps” is. They see it every day on their computer screens. And they know that the price of this insurance has budged only a smidge (a few basis points) in the last few weeks.

So why are they jacking the prices of bonds up so that mortgage rates have risen 60%?

The answer has to be greed. The buyers have the money, and they know that many people (rightly or wrongly) expect rampant inflation. So they are using their financial power (and cultivating public perception) to demand that bond sellers, especially corporations, pay more rent. They are the theater goers sitting quietly in their seats, saying “That smoke sure smells strong!” and watching the others stampede. But unlike the theater goers, they get a direct financial benefit: more interest, plus their usual commissions.


The current greed-induced interest-rate stampede could have some pretty nasty consequences. By raising the cost of money and reducing liquidity, it could choke off our slow recovery. It could even send us back into recession—something the much-feared Sequester hasn’t done yet.

By increasing the interest rates on government debt, the stampede could widen the deficit. In the worst case, it could bring back that old horror from the seventies and eighties: stagflation. In other words, this greed stampede could upset our whole real economy and hobble our government, just as did the Crash of 2008.

The bond traders who will profit from this misery comprise a tiny, close knit clique of probably no more than 250 individuals worldwide. (I write, of course of the managers and decision makers, not the dispensable peons in the trading pits.)

So why are we prostrating ourselves, once again, before the Masters of the Universe, to use or abuse us and all our economic effort at their will and whim? Do we never learn?

Underlying all this willing economic subjugation is a key error of thought. We worship a false god. Not only is he a harsh god. He is in fact rather transparently controlled by self-interested people, like most of the gods throughout human history. These people speak for him, and when it serves their interests they manipulate him. The wonder is that we continue to worship him while his avatars on Earth steal our substance from right under our noses.

This false god is of course “The Markets” and their so-called “Invisible Hand.”

As I have reasoned in another post, the effect of these phrases upon most pols, let alone ordinary people, is a sense of godlike reverence, a surrender of control, and an abdication of skepticism. To them, “The Markets” are ineluctable, powerful, unfathomable forces, like the weather. That is precisely the impression that the self-interested bond traders want them to have.

In reality, when Adam Smith wrote that famous phrase, he had nothing in mind even remotely like our present-day financial markets. He observed (and sometimes assumed) markets in manufactures and tangible commodities that were so large that no producer, seller or buyer had any individual power to influence prices or output.

That is indeed a fundamental assumption of classical free-market microeconomics. A competitive, free market only exists when no individual or group of individuals acting collectively has the power to force or manipulate it. In other words, the “Invisible Hand” only works when individuals’ real hands are powerless. If you doubt this point, then open up any undergraduate textbook on fundamental microeconomics, where you will find this assumption laid out explicitly and explained at length.

By this measure, nothing in our finance sector even remotely resembles a market that Adam Smith would recognize as such. Nor does it fit the definition of classical microeconomics. Why?

Because so called financial “markets” are all operated and controlled by small cliques of highly specialized, self-interested individuals. They communicate with each other every day, through their e-mails, their trades, their computer screens, and the algorithms they set up. They live in a different world from the rest of us, and one much richer.

The bond buyers, underwriters and traders who control today’s bond interest rates are likely a group of less than 250 people. They are concentrated in four cities worldwide: New York, London, Hong Kong and Shanghai. Do they explicitly conspire? Probably not.

They don’t have to conspire because they all think alike. Under normal circumstances they compete. They try to outdo and outthink each other for the special “win” or profit, while everyone makes a normally abundant profit. (Have you ever heard of a bond buyer or trader on skid row?)

But when they collectively see an opportunity to make extraordinary profit, by exploiting a rare coincidence of changing economic circumstances and misguided public perception, what do you think they’ll do? What would you do in their position, leave money on the table?

And who or what can stop them from exploiting economic and political conditions that favor their extraordinary profit, in a free-market economy that believes fervently in the God of the Invisible Hand? No one and nothing.

Not even Bernanke or the Fed can act. The Fed’s purview is economics, not public perception. It has no power to control or fix interest rates at which private bond buyers buy government or corporate bonds.

More generally, our species so far has discovered only three means to control bankers for the good of the rest of us: (1) regulation, (2) criminal sanctions, and (3) breaking the big banks up. So far, none of them has been much good in controlling modern bankers’ abuses of economic power.

You can’t regulate interest rates if you want to have a free market in them, and you certainly can’t do so in a single country in our global economy. Criminal sanctions have failed utterly to constrain bankers’ self-interested conduct, for reasons of law and practice that I have explained elsewhere in some depth. (In essence, criminal sanctions require hard-to-get evidence of criminal intent; the crime of negligence doesn’t yet extend to economic activity.)

So that leaves breaking the big banks up. Doing that might improve the current interest-rate situation somewhat. With more smaller players, the bond market might be more competitive on the buyers’ side, and there might be less chance for coordination and tacit collusion. But those salubrious effects would depend on a lot of other variables, and in any event it’s now far too late. By the time we unwound the current megabanks, interest rates could be in stagflation territory.

The problem is a fundamental one: the nature of banking. It’s an obscure speciality much like accounting. But accounting attracts people who like precision, order and control. In contrast, banking attracts people who like lots of money. Today it attracts smart people who want to get rich quick by any means that won’t land them in jail.

When you allow banks to get so big that they, in effect, control the economy more than any other force, including government, you put the fate of your society in the hands of people like that. And you put it in their hands so far that, when they screw up and cause widespread misery, the first thing you think you have to do, in order to save everyone else, is to bail them out. That’s where we are today.

This is a basic flaw in the structure of our society, what engineers call a fundamental design flaw. Next to it, Boeing’s smoking batteries were mere peccadillo.

We won’t cure it overnight, and we certainly won’t cure it before the current surge in interest rates reaches its conclusion. Unlike banks massively violating their own credit standards in the run-up to 2008, setting the price that bond traders voluntarily pay for bonds is not even arguably illegal. In a capitalist society, it’s not even immoral. Doesn’t every buyer or seller try for the best price he can get?

So we have several basic contradictions in our national values. We believe fervently in markets, but banking is nothing like any market that Adam Smith or classical microeconomics would recognize. Our economics assumes rational actors working with complete knowledge of events, while our banks exploit ignorant peoples’ misguided perceptions. They do so quite skillfully, in their own self-interest, to enhance their own profits.

We profess to believe in democracy. But we put the helm of global economic power, and the fates of our individual national economies, in the hands of a tiny global clique of bankers responsible to no one and nothing but their own profit (and desultory and occasional shareholder and board oversight), with the rare intrusion of diffident and much-derided regulators.

These are not easy flaws to correct. They are deeply entrenched in our national ideology and the way we do business. We might renationalize all the major banks, as many nations did in the last century. That might help the self-interest problem a bit. But it would bring politics back into economic activity—a bad idea that the rise of corporations ameliorated [search for “corporations are”].

And even if nationalization brought all these benefits (itself an uncertain proposition), it still wouldn’t solve the bond interest problem. If the government is to borrow money, it must do so from private investors, not from itself (at least not forever). And if it does so, those investors must at least have some say in the terms, including interest rates.

The best solution that I can think of right now is that smaller is better. Break the big banks up, and keep breaking them up as necessary to create a nationally and regionally distributed and therefore competitive market in finance. In Schumpeter’s words, generate a continual “gale of creative destruction.”

There might be other solutions as well. Imagine, for example, a rule that allowed only individuals, not legal entities, to buy corporate or government bonds. When a business or the government wanted to borrow money, it would have an auction on the Internet. If not enough people bought, it would have to lower the price or raise the interest offered. If the sale was oversubscribed, it could lower the interest rate for the next auction (which might be just a day later).

That would be a real market. The government and businesses could get all the money needed, at the lowest rate the market would bear. No one could control the market, and our economy and national future would not be placed in the hands of a tiny clique of bond dealers.

Such a system would mark a fairly substantial change from the one we have now. But that’s precisely the point. If we keep the system we have now, our nation’s and the global economy will remain in thrall to a tiny clique of probably no more than 250 people worldwide. In all but military matters (which are growing less significant in the nuclear age) our much-vaunted Third Millennium would resemble our Second. We again would be ruled by a small coterie of priests operating out of isolated institutions of immense real power, based on little more than blind faith in the God of the Invisible Hand.



  • At Sat Mar 29, 03:32:00 PM EDT, Blogger Jay Dratler, Jr., Ph.D., J.D. said…

    Following is a comment to another post that I’ve transcribed to this post, which is more pertinent:

    Anonymous said...

    Dear Jay.

    I searched your Blog for the term "bit coin" and had zero hits. What are your thoughts on Bit Coins? I bought a single bit coin for $ 540 yesterday. Any thoughts on this new form of currency? Given your vast array of thoughts. Do you have any thoughts on bit coins?

    Best Regards, Rod and Ben

    Wed Feb 26, 10:34:00 PM

  • At Sat Mar 29, 04:09:00 PM EDT, Blogger Jay Dratler, Jr., Ph.D., J.D. said…

    Dear Rod and Ben,

    Sorry for replying over a month late. Apparently I misread how Google counts pending comments. So I didn’t think there were any new ones for the whole last month.

    When something that has little or no intrinsic value suddenly increases dramatically in price, that’s a sign of what I call a “greed stampede” in the essay above, or what economists often call a “bubble.” In my view that’s precisely what happened with bitcoins.

    They have no intrinsic value: they are just tiny arrangements of magnetic domains on a hard drive somewhere. They also have no value by agreement or custom, as do most currencies, through a process I describe here. They are not directly related to any particular currency; that’s part of their attraction but also their Achilles’ heel.

    So bitcoins have no intrinsic worth and no direct relationship to any recognized form of money. So why should they be worth anything at all?

    Well, their main claims to fame are: (1) that they are uncounterfeitable (a dubious claim that so far the market has accepted); and (2) that they are untraceable and therefore untaxable (a more realistic claim).

    So who would find them valuable at all, let alone more valuable than money? Drug dealers, human traffickers, arms traders and proprietors of other criminal and marginal businesses who want to keep their transactions secret and untaxed.

    But these people already have Swiss banks and other legal and illegal offshore banks, whose reputations for reliability are infinitely better than bitcoins'. And these banks just charge reasonable fees for their services; the value of the currencies they handle doesn’t change wildly from day to day.

    So why would these businesses “invest” their hard but ill-gotten gains in a medium of exchange which is less reliable and less tested than money and gives every appearance of undergoing a bubble? I can’t think of a single good reason.

    So who does that leave to support bitcoins' rapidly escalating value? Speculators and geeks.

    In short, bitcoins’ rapid “appreciation” is nothing more than a greed stampede or bubble caused by speculators. It’s the precise modern equivalent of the Dutch tulip craze of the seventeenth century, with one exception. Tulips had some small intrinsic value; you could give them to your wife or girlfriend. (I suppose you can do that with bitcoins, too. But don’t be surprised if flowers garner more appreciation.)

    When you buy bitcoins expecting further appreciation in price, you are essentially betting that you can predict precisely when the greed stampede will turn to a fear stampede and sell out first. If you are especially smart, you might have better odds than at Vegas. But your own greed works against you. (“If I just hold on a few more days, I can make even more easy money!")

    Anything can trigger a fear stampede, as did the news a couple of weeks ago that lots of bitcoins went missing. I wasn’t at all surprised when that happened.

    The most basic and universal law of economics is, “There's no such thing as a free lunch.” But there are lots of ways to lose your money (and occasionally win) at gambling.

    Bitcoins are a way of gambling. They will never have intrinsic value, but they may some day have value by agreement if some nation, bank or group of real businesses recognizes them as currency. Right now, they’re Dutch tulips in the seventeenth century.

    I’m doubly sorry now that I posted this replay late, as an earlier reply might have saved you both some money.




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