April 15th, 2009

The basic problem, I believe, is that people forget that money is an abstraction. The “real” economy is making things; money is just a mechanism for the allocation of effort. The fundamental problem is far too much of our effort got allocated to the task of manipulating this abstraction in order to siphon off a rake while not contributing themselves anything of real value to the economy as a whole. This is just a fundamental drag on the economy.

In some sense we’re all hostages to this system, and I think it’s obvious the system needs to be dismantled. However, causing a panic in the market (which would happen if a major bank defaulted on its obligations, which I am quite certain would cause a massive and immediate series of cascading defaults) would stop the abstraction (money) from moving around nearly entirely, which would then stop actual production from occurring, leading to real damage which would take years to repair.

That’s why I am not upset at Geithner and Obama for saying, we can’t afford that. Even if your goal is to dismantle the system and recreate it, which I share with Galbraith and others, I believe that we need to find a way to do that which doesn’t cause real production to halt. Keep in mind that our circumstances differ this time: when FDR came to office unemployment was 25%. Now, it is below 10%. We have a little more breathing room.

I believe it will take time and delicacy to both dismantle the system as it exists today and not cause real production to come to a grinding halt, which would take years to recover from. It will take months to design and implement such changes. For example, one radical option might be to simply abrogate all credit default swap contracts, and then make most of them illegal. All the banks have these big guns pointed at each other — the CDSes, yet what if they all cancel each other out? Even if they do, if one of them defaults then they all default, in a cascade, but if they all “default” at once by government fiat? The problem is, many of these are international contracts so the US would have to act in concert with foreign governments, which is very likely impossible.

Another option is to simply make most of these instruments illegal going forward (particularly the totally synthetic CDSes, the ones not based on any underlying ownership of collateral) and move to gradually take them off the balance books of the banks. The irony of all this is that, high as foreclosure rates are today, they still represent a tiny fraction of the total number of outstanding mortgages. The reason this tiny fraction has created a total destabilization of the world economy is that the rules allowed the bankers to essentially multiply the risk by orders of magnitude through complex securitization that I believe even they didn’t understand, so even a small drop in housing value caused the entire market to come crashing down.

The end result needs to be getting rid of most of the gambling sector of the financial services economy, which is a drain not only on money but on talent and intelligence. However, I agree with Geithner’s instinct not to let this crisis spill over into the real economy at a rate even higher than it has so far, to give us time to dismantle the fantasy economy. I am not sure yet whether he and Obama have a plan that will dismantle enough of the fantasy economy as we need, but, I do believe both of them understand the need for something along these lines — it’s been something Obama has explicitly raised in a number of his speeches and also something Geithner has talked about in public, including his most recent public appearances.

There is a crisis in the real economy as well, insofar as we have a lot of industries (the auto industry, for instances) with outdated management practices, bad product design, undereducated and undertrained workers, etc. On the other hand, we also have some industries (tech) which remain far ahead of the rest of the world, and while our educational system is crap, we still have the best universities in the world, etc. All in all, a mixed bag.

But I believe the main reason for this came from the financialization of the economy. That is to say, more and more resources were siphoned off the top by the financial manipulators, which means less was available for investment in real innovation, research, development, training, education, and so forth. It also siphoned off the “worst and brightest” into the financial services sector, a brain drain into a largely unproductive sector of the economy. I say largely because I believe venture capital is an exception — they’re investing in the real economy, directly, which is generally quite salutary and something we ought to continue to support. As for most of the the rest of the financial services industry, it’s literally as though a large percentage of people just ended up, after graduating from Harvard and Yale, working for casinos in Vegas instead of startups in the Valley or auto companies or anywhere else.

But the crisis in the real economy is a slow, long decline. The immediate crisis is a blowup in the fantasy economy, the financial gambling economy. If we hadn’t had such massive deregulation we would have had more money and talent going into the real economy, and we would also not have this current crisis. What I think we need to do is dismantle and outlaw through regulation much of the fantasy economy, encourage and support investment in the real economy (including venture capital), and at the same time find a way to defuse the bomb that the fantasy economy has become without blowing up the real economy. My view is it would be better, if possible, to do this by trying to gradually neutralize and unwind the fantasy economy (get rid of the credit default swaps and get the CDOs off the balance sheets of the banks, etc.) without causing the real economy to come to a halt in the process. Maybe that isn’t possible, but given that the bubble is in an abstract economy I don’t see why in principle it isn’t possible.

If we make the fantasy economy far less large through regulation and by making many synthetic instruments illegal, then it seems to me the natural result will be the gradual recovery of the real economy, because resources will flow to the real economy by default.

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