Monday, January 19, 2009

Financial Evolution and Zombies

Bailouts affect more than simply the company being rescued.  They also have an impact on the economy as a whole, particularly on the sector in which the new zombie lives.  What are the macro effects of our new undead friends?

Financial Evolution

I'm not sure whether the concept is raised elsewhere -- and would appreciate better-read readers informing me here -- but I'm fond of an idea I call financial evolution.  I think it lies outside Minsky's work, but I haven't read enough original text to know.

Let's imagine a world where risk is underpriced, and those firms and individuals more willing to assume risk also receive outsized rewards.  Over time, as the risk premium adjusts to its normal level, these daredevils will receive just compensation for their gambling proclivities in two crucial forms: higher profits, and a greater propensity to stay employed.

Minsky made the key observation that as the risk premium subsides, more businesses and individuals will be comfortable assuming more and more risk.

Financial evolution is the second order here: the survivors, and particularly the survivors with the most capital, are the units who were most predisposed to risktaking.  More profits accruing to risktakers gives them more raw capital to work with, and hence control over a greater portion of the financial system.  In tandem, exceedingly cautious individuals risk firing for repeatedly missing profit targets.  Together, there's a strong cyclical reinforcement in not just the Minskian risktaking of individuals and firms, but which individuals and firms are strongest.

At the end of a boom, capital will be excessively controlled by people who base jump on the weekend.  Conversely, at the end of a bust, those who spend their weekends hovering over 10-Q's and doom-mongering on eschatological financial blogs will command too much of the economy.  I believe this forcing function is a strong component of the business cycle.

The Rise of the Zombies

As our present business cycle reverses itself sharply, we would normally expect to see a culling of the excessively bullish and a reassertion of balance.  Those who were too optimistic lose all their money, those who were too cynical are wealthy -- but still cynical -- and a lot of firms go under.

Government intervention, ostensibly to save the system, introduces a deus ex machina to our story.  This is true to a lesser degree with common interest rate setting, but more evident today.

The unfit are not culled by their own bad decisions in our too-big-to-fail world.  Instead, they're given a fresh breath of un-life.  These zombies return only as caricatures of their original selves, with the notable institutional aspect of willingness to assume risk at a low cost exacerbated by extraordinarily deep capital pools, an exemption from P&L considerations, and political rules that trump economic rules.

Taxation is another feedback loop.  Governments and their undead minions are generally unconcerned with profits, as their revenue comes primarily from seigniorage and direct taxation of profitable concerns.  As the ranks of zombies grow, the burden of supporting them on surviving enterprises grows heavier.  This parasitic behavior is another feedback loop damaging healthy companies and bolstering the zombies.

We must particularly look at the international ramifications of this strategy.  Having healthy, efficient industry is a strong benefit to any nation in good times; competition is good for a country.  However, during times of deficient aggregate demand such as a severe recession, the temptation will always exist to devalue and export your way out of the problem.  Put another way, in times of excessive competition, a little collaboration will be very appealing.

Governments and corporations have strong mutual interests to collaborate in those times.  Countries that are accessible to foreign zombies will generally need to zombify themselves, as they otherwise risk destruction of their domestic competitors by these artificially strong rivals.  Eventually, a country that is sufficiently undead is likely to fall, but that can take some time, and take a lot of healthy entities out with it.

Implications

Prudent businesses face now not only the lingering competition from careless competitors, but their stronger reincarnate forms.  Countries that enforced vigilant regulation now face those competitors too.

AIG has been repeatedly accused of undercutting competitors with offers that are simply not profitable or viable for private sector enterprise.  It will be exceptionally difficult for anyone to match a public sector insurer with such deep capital.  From the government's perspective, rebuilding AIG into a viable enterprise is key to its offloading, so these Faustian bargains will appear cheap.  All insurers who are not state-sponsored will face extraordinary battles to survive.

GM and Chrysler, joining a long parade of global auto bailouts, will reinforce the excess capacity worldwide in car production and exacerbate the un-viability of the entire sector.  Fitter competitors not accessories to the groveling, such as Tesla, first protest the unfair advantage, then stoop to their level out of pure economic necessity.

The same issue is strongly present in banking.  Competitors without sovereign backing will eventually find it difficult to compete, and many may either fold into the government or fold entirely.

Financial evolution will cause competitors with no access to government funding, or a reluctance to accept it, to gradually fall victim to the zombies or become undead themselves.  In the end, the nationalized system will create an entire breed of unfit competitors.  This will allowing truly efficient profit-oriented private enterprise to regrow eventually.  It will just happen far later and far worse than it ever had to.

The Icelandic economy, and probably that of the UK, are likely to collapse soon, but the zombie US and Eurozone will probably survive a lot longer, with reanimation and collapse both possible outcomes.

As noted by many commentators, Ayn Rand and Karl Marx appear more prescient than they ever did in any previous time.  When two philosophers with such different takes are so harmonically prescient, it may be time to listen.

8 comments:

cap vandal said...

We had true Zombie banks in the 1980's. The S&L's tended to have large portfolios of 6% mortgages and a cost of funds of well over 6% depending on the year.

They had also effectively unlimited access to insured deposits via the new $100k limit and brokered deposits.

Their only hope was to make enough new loans at rates greater then the cost of funds to get their spread to a positive (profitable) number. Otherwise they were simply bleeding to death.

This led to a "race to the bottom" and the ubiquitous see through suburban office tower.

I don't think we are seeing anything remotely like this today. In addition, if you look at the largest banks, C is stabilized but not really bailed out -- it is no longer seriously competitive. BAC stayed out of the worst excesses and would have been in good shape if they had either skipped the CFC and MER deals, or at the very least, made better deals on them. WB - the forth largest bank is gone. BSC, LEH, and MER are gone. It isn't like the largest banks that caused the most problems were totally bailed out. It would have been better if all the worst of them had been more severely punished, but there has been some pain.

Stevie b. said...

"The Icelandic economy, AND PROBABLY THAT OF THE UK, are likely to collapse soon"

WHAM! Just like that! The end of the British economy. How about WHY the UK exactly (and not e.g. the Swiss or at least 1/2 the other countries in the world)? And when is "soon", would you say?

S said...

it is fascinating to watch what GS is doing. Qui=etly they are buying or are rumored to be buying up pieces of broken empires (Germany, etc.). It is utterly fascinating to watch as they use US taxpayer money to try and buy up assets on the cheap. This is not to condemn GS or make them the enemy, rather it is to highlight that this is the US business model. The US is hoping for this escenario and the possibily that is frankling privialege will aloow it to execute the same trade it did after WWII only this time froma position of relative weakness.

Detroit Dan said...

I agree we're in an era of unusually perverse incentives. This has been case since before the government bailouts started, in my opinion. Financial and housing companies were being rewarded for screwing up the economy. The market failed in the first place, and there is no putting Humpty Dumpty together again. If the government stayed out of it, we'd be living in Hoovervilles like hobos in the '30s...

Stevie b. said...

ndk - perhaps this is part of how you could have justified your statement I quoted above:

http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/4299883/UK-cannot-take-Icelands-soft-option.html

IMO it's a race to the bottom and on this lap the UK is winning. But it's premature to assume that at the finishing line, the UK wont be challenged for 1st place by many others.

ndk said...

Sorry to all my commentators over the slow posts and responses -- I've got a major presentation I've been preparing for. Fortunately, it'll all be over today(in your choice of the meaning of the phrase) so I should become more interactive for a bit.

I don't think we are seeing anything remotely like this today. In addition, if you look at the largest banks, C is stabilized but not really bailed out -- it is no longer seriously competitive. BAC stayed out of the worst excesses and would have been in good shape if they had either skipped the CFC and MER deals, or at the very least, made better deals on them. WB - the forth largest bank is gone. BSC, LEH, and MER are gone. It isn't like the largest banks that caused the most problems were totally bailed out. It would have been better if all the worst of them had been more severely punished, but there has been some pain.

You make a very good and interesting point, cap vandal. The bank zombies, particularly the fully nationalized ones, have behaved pretty well so far. IndyMac Financial's main focus was foreclosure mitigation, which harms primarily themselves and MBS/CDO holders, but could help homeowners and the competition.

I expect that to change at some point as the imperial imperative to just loan money at any price takes hold. Whether or not the total borrowing volume goes up, I'm not sure. But I do suspect the Federal-backed banks will gradually take share in such a world. We'll see.

The US is hoping for this escenario and the possibily that is frankling privialege will aloow it to execute the same trade it did after WWII only this time froma position of relative weakness.

I'm not privy to any inside information at all, but remember that large banks are closer to the state than you'd ever imagine, powers that can be used for both good and evil. The overseas liabilities of major US banks and corporations bother me, but not as badly as they bother me for countries like Switzerland, South Korea, or the UK.

ndk - perhaps this is part of how you could have justified your statement I quoted above:

Yeah, that's the precisely the gist of it, Stevie b. The mismatch between foreign held debt and assets/equity is particularly important.

I suspect the US suffers from the same mistake, though I don't know to what degree. C's overseas depositors are the first rain in the bucket. This won't come home to roost for the US unless and until China changes its pegging philosophy, but it certainly can happen to the UK more quickly than that.

If the government stayed out of it, we'd be living in Hoovervilles like hobos in the '30s...

I don't think the face of this depression will look like the face of the last one, Detroit Dan (though it may be awfully close seen from a chair in Detroit). The world has made some tremendous breakthroughs since then, and the set of constraints on the US are wholly different. History's rhyming, but not repeating here.

Back to presentation preparations, and thanks to you all again for coming by.

Detroit Dan said...

Thanks for the responses, ndk. I hope the presentation goes well!

I guess I've subconsciously been thinking of my 401k. I've put my life savings in the safest option -- a money market type fund. I'm afraid if the Fed & Treasury wouldn't have taken such aggressive action to save the banks (and turn them into zombies), I might have lost a significant portion of these savings...

john bougearel said...

ndk,

thanks for the email subscription add first of all.

And secondly, thanks for a rich post and literary innuendos "deus ex machina," and "Faust."

Inferior solutions and selling one's soul to the devil complete with the unintended consequences they usher in.