I was playing with a stick the other day - trying to balance it on my finger. It occurred to me that this problem is not a bad analogy to the financial system. The financial system is far more complex than a wooden stick, but the essential aspects are worth talking about.
Both the balancing stick and the financial system are unstable. What does unstable mean?
A stick pivoting at the top is a stable system. If you poke at the stick from the side, it will swing away, but the force of gravity acts to pull the stick back to a vertical position (negative feedback).
If you balance the stick on your finger and move your finger around to keep the stick vertical, you are 'controlling' an unstable system. If you stop moving your finger, the stick will fall over. In other words - the upside down stick is an unstable system that needs 'control' to stay upright.
The Financial system is like an upside down stick. Prices increasing with time will stimulate demand (people want to buy before the price increases more, or they think they can sell at an increased price). This increase of prices continues until all of a sudden, future prospects change and demand collapses.
MBA students are taught about 'The Business Cycle' - A period of growing business activity, followed by a crisis, followed by decreased demand, followed by unemployment, followed by recovery. This cycle repeats itself, creating periodic recessions. You can think about this as the stick being balanced on your finger, but then you don't move your finger, or you move it in the wrong direction, or move it too late. The result in all cases is that the stick falls over.
Economically speaking, it is relatively easy to wind up in recession.
Another point of analogy between the Economy and the stick: the mathematics of crash recovery and the mathematics (?) of putting the stick back on your finger are much different than the mathematics of a normally operating economy and a balancing stick.
During the last few decades, the Federal Reserve, under Volcker/Greenspan, developed computer models of the economy. These models helped the Fed to 'move their finger' better - thus keeping the economy, and by analogy, the stick - balanced upright.
Controlling an unstable system is not new. A rocket launch is a common example of the stick balancing problem. Because of the tight analogy, 'Rocket scientists' have been recruited for work on Wall Street.
Sometimes there are big shocks, like the Asian currency crisis of the late 1990's, or the Long Term Capital Management crisis. Each time, the Fed was able to move the finger far enough and fast enough to keep the stick from falling over. The economy was still an unstable system, but the control system was good enough and the range of motion required was within the capabilities of the Fed.
This long period of success, and the quick action of the Fed, resulted in relatively smooth growth in the economy.
The success of the Fed in controlling the economy depends on the accuracy and visibility of economic variables. You would not want to balance a stick with a blindfold over your eyes. Similarly, budget cuts to the Bureau of Labor Statistics do not help to control the economy. Ideological blinders do not help either.
The model the Fed uses to control the economy depends on visibility. The off-balance sheet trillions and the astronomical leverage ratios used by investment banks to increase their profits were not visible enough to the Fed. Under this scenario, it became impossible to keep the stick balanced.
After the crash, the question is 'How to restore the economy'? The current problem is twofold - banks don't want to lend to customers who might go bankrupt and consumers are afraid and would rather save than buy.
If the banks don't want to lend, even at attractive interest rates, the government can COMPETE with those timid banks - by either coercing one bank to lend (with govt. guarantees) or by lending directly. The threat of competition for those loans will get other bankers to move. Also the stick of government takeover and coercion is also helpful. This must be carefully managed by the government - the END GOAL is to have the private sector doing what it did in the past, but in a more responsible way, and the government no longer deeply involved.
If consumers don't want to buy, flooding the economy with dollars will start to heat up inflation - and therefore re-establish the consumer stimulus to buy now rather than later at higher prices. This also must be managed very carefully so real inflation does not occur at the end of the corrective action. It is a very tricky maneuver with speedy action required. It is questionable whether the government can do this job! But who else?
Looking at the stick analogy, it takes an outside hand (the government) to put the stick back up on the finger. But once the stick is balancing again, the outside hand is taken away.
The Future is always a difficult place. Things change unpredictably. Earthquakes, hurricanes, terrorism.. All these things can happen in the next few seconds.
Even the usual predictors of the future can fail - advance Broadway ticket sales, Boeing and Airbus backlogs, advance airline reservations..
A control system for the economy must be 'robust' in the words of the engineer. It must provide for control even when unexpected things happen. Robust control does not necessarily mean increased rules and regulations, but it means good Design.
Supply - Demand - Price Competition - - have existed since the beginning of recorded time. If prices go up, demand is reduced. To sell more, a competitor must reduce their price. Prices are 'discovered' in competitive markets. Archaeologists are always finding market places in old ruins, so we know market economies have a long history. This story is true only if change is slow. (A more correct story needs the 'time' variable and rates-of-change. These are introduced in Econ 102).
Competitive markets are good.
A new wrinkle in the study of markets was discovered by George Akerlof, Michael Spence and Joseph Stiglitz in their 1970s research which was honored by the 2001 Nobel Prize in Economic Sciences. The wrinkle was that markets have asymmetric information. (The used car salesperson knows more about the car than the buyer).
Creators of markets and products to sell in these markets are very aware of the advantages of information asymmetry. The biggest new market has been in financial derivatives. The asymmetries are staggering. The creator/seller knows everything about the components of the derivative (the details of individual mortgages), the derivative has been sliced and diced on the seller's supercomputer, the terms and conditions tailored by the seller's lawyers. The buyer just doesn't have a clue.
One could charitably say that government and rating agencies were too slow to react.
Under these extreme asymmetries, why did buyers buy? Perhaps the biggest reason is that someone they knew bought derivatives last week and are saying it was the best investment they ever bought. They were using these 'investments' as collateral with banks so they could buy more. The banks were buying these derivatives for their own account. The returns from these investments were far greater than raw mortgages, or oil futures, or ..
Washington lobbyists are well paid by Wall Street to open new market possibilities. 'New' markets are always more lucrative than old markets because market asymmetries are greater at the beginning. After awhile, buyers become more educated and less gullible. This story (with different details) will repeat in the future.
The public needs to be quicker. Education is the key.
Read: "The Behavior of Crowds: A Psychological Study" published in 1920. The last chapter is a pointer for the future.
It is peculiar that a few hundred million dollars worth of troubled sub-prime mortgages is causing the spot value of trillions of dollars of derivatives to go down to tens of cents on the dollar. It should not be so big a hit. A reason is the asymmetrical knowledge between creators and current holders of the derivative contracts. There is too much distrust. To increase trust (and perhaps the value of the contracts) the creators can make public the inner details of individual mortgages in the mortgage backed securities. The computer algorithms used to value those collections may not have to be made public, but the first step is to uncover the mortgages.
In the past, at contract signing time, both sides would have their lawyers read over the contracts and suggest changes. In the future, it will be the lawyers AND their COMPUTERS, who will be looking over the contracts. This can be done only by releasing the details of the underlying assets prior to contract signing. If the buyer's lawyers (and computers) are underpowered relative to the seller's, well too bad. At least they had a fair chance.
Once asset details are made public, the public can educate themselves as to how these asset based securities really work, and their risks. There will be many web sites devoted to public valuation of various collections of asset backed securities. A public exchange of self developed algorithms. A substantial educational opportunity for whoever has an interest or talent in financial mathematics - to the benefit of the public at large (including interested security buyers). The market for derivatives will become less scary and will grow.
After the first disclosures of underlying assets for public evaluation, it will become possible to develop standard contracts and standard valuation algorithms so future derivative contracts can be traded and cleared more efficiently. Perhaps even traded on exchanges!
Transparency is good.
To balance the economy/stick, you have to be quick.
To visualize the movement of the economy in real-time, it is necessary that the government make public their own measurements on a more frequent basis. If this data were available, there would be less need for government corrective action because market players would be able to correct wobbles on their own.
Just as traders have moved from the telephone, to computer screens, to design of program trading rules; the world at large is moving from a human-in-the-loop mode to a human supervisory role with computers doing the grunt work. Time scales are shrinking from days to microseconds. A penny of profit every 100 microseconds adds up to more than $3 billion a year.
Government data released more frequently, even in raw form, would facilitate the speedup in the economy. Multiple players, acting independently on a fast time scale, will help to take the shock out of future unexpected events.
Imagine the stick getting shorter and shorter. The balancer must be quicker and quicker.
Over Alan Greenspan's tenure, it can be argued he did TOO WELL.
The economy prospered financially and the shocks to the system were handled in a reasonably good way. (The value of the dollar dipped a bit, but the fix for that problem was above Greenspan's pay grade).
Because of the benign behavior of the economy, the probability of companies defaulting on debt was much reduced. This gave rise to extraordinary leverage used to increase return on investment. If a given asset backed investment scheme earned 2%/yr, borrowing against the assets and buying more and borrowing again, so the original investment capital supported a debt of 20 times, would increase the return to almost 40% per year. (And it was all AAA and insured). Magic! Irresistible!
How do you legislate against this opportunity? How do you regulate Magic? - With great difficulty!
Taking a completely different tack, suppose the environment were not so perfect. This can be achieved by having the Fed CREATE VOLATILITY. The Fed can jerk around their levers of control in a random way. A lottery wheel number would be used to increase/decrease the Federal funds rate by a small amount every month (or other chosen interval). The lottery wheel would be spun in public, so no one would know ahead of time whether the levers are moved left or right.
This random movement would increase the volatility of economic variables and reduce the average payoff of highly leveraged investments. The amount and time interval of the random jerks could be decided ahead of time and made public. If the amount chosen were zero, the situation would be the same as it is now without any random jerks. By choosing an amount of 0.25%, the effect of the jerk could be detected, but only enough to wiggle the stick. If dangerous practices were detected in markets, the amount of the jerk could be increased. This may send a few players into bankruptcy, but only a few.
These random jerks would be in addition to the calculated control moves of the levers.
There are advantages to having random jerks on the levers of control. If the control is too smooth, it is difficult to detect changes in the economy that must be (re)modeled. The random jerks are known inputs (after the spin of the lottery wheel) and their effects should be predictable. If there is a difference between prediction and actual, it means the control model must be modified.
If you put cloudy glasses on a professional stick balancer, to retain control, they will wiggle the stick so as to 'feel' its orientation through their finger tips.
(The ECB, by keeping a steady hand on their economic levers, is throwing away an opportunity to learn more about the EU economic system).
There are other jerks in the economy that are not random. Everyone pays taxes based on the same fiscal year. Most juggle their investments near the end of their fiscal year to minimize taxes. These synchronized actions cause a jerk in the economy. It would be nice to eliminate the jerk by eliminating taxes, but unfortunately that is not possible. But it is possible to have different fiscal year-ends. This would also have the beneficial effect of smoothing the load for tax accountants and neighborhood tax preparation firms.
A smooth economic environment, with random jerks introduced by the Fed, would make it easier to continuously measure and formulate a more accurate model of the economy.
There are people who must gamble. If the Fed used random jerks on their levers, the gambling folks would be attracted and would make their bets in the financial markets. This would increase the liquidity of the markets, and provide a socially acceptable release for the gambling spirit. A roulette wheel without the '0' and '00' and no table limit. The gamblers of the world would love it.
The economic problems can be solved. The basic tools of Competitive Markets, Transparency, Education, coupled with rapid government action when needed, will fix the current problems.
For the future, the speed of transactions will only increase. To be effective, balancing actions must be equally rapid.
The introduction of random inputs by the Fed to reduce the attractiveness of leverage would be an interesting research project.