Paul Jorion's blog

Here an English translation of La machine infernale, my monthly column for March in Le Monde – Économie.

A DEVILISH DEVICE

Only five years ago, we were led to believe that the advertised model of the economic and financial apparatus represented a system that was finally mature: stable because thoroughly predisposed to self-regulate and practically safe thanks to super-efficient risk-spreading.

Self-regulation did not happen. Risk, although atomized, was nonetheless concentrated by the more astute players into enormous portfolios of financial products with, influenced by the economic climate, inflated risk premium; an unavoidable downside correction triggered the implosion of the Bear Stearns, Lehman Brothers, AIG, Fannie Mae, and Freddie Mac.

Computers brought complexification to the credit-based world of finances which from then on prevented it from functioning in anything but bubble mode: euphoria concealed the non-existence of self-regulation, while concentration of risk, for a time minimal, went undetected.

By contrast current events highlight the dysfunctional nature of the economic and financial workings outside the dynamics of an economic bubble. Thus, in the case of the speculation against the Euro, a collection of harmful elements combine in a potent toxic mix.

Sometime during 2001-2002, the European Union turns a blind eye to Wall Street’s currency swaps-disguised loans to member states in order to allow them to comply with the terms of the Euro zone Stability and Growth Pact (SGP). Yet, the increasing complexity of financial products makes it impossible for rating agencies to correctly assess the underlying risk. When the subprime crisis breaks in 2007, rating agencies are rapidly discredited. Vague attempts to reform those agencies suffer the fate of all proposed regulations at the time (with the exception of some, sufficiently innocuous): they are shelved into oblivion. Meanwhile, scientific rigor proving elusive, rating agencies will do with inflexibility.

The downgrading of Greece tainted currency swaps put them just a notch above the trigger for a margin call that that nation is unable to honour. Speculation on the, by now, strong likelihood of Greece defaulting gets under way. By taking long positions in Credit-Default-Swaps (CDS), speculators are “insuring” against a risk they don’t face, but by so doing, increase the likelihood that it materializes. Rising CDS prices, considered as an objective measure of risk, according to the prevailing “efficient market” economic theory, generate a proportional increase of the coupon required upon issuance of new debt by Greece, further penalizing her. A vicious spiral snaps in place that nothing can stop. Like so many dominoes, other Euro zone states are being lined up. Once one is in default, the rest of those still unscathed would be weakened, and speculation will immediately target the next most exposed.

When banks were failing, States provided help. The heat is now turned on States. Only the IMF will be left to stage a rescue. On February 26, an announcement was made, through its president, Dominique Strauss-Kahn that the IMF was ready to take up its role. We count on it: the IMF is surely the last defence line.

Many thanks to “bb”.

An English translation of Le capitalisme (I) – Les nervures de l’avenir posted on my French blog on March 2nd.

In Reason in History (1837), a posthumous work composed from lecture notes, Hegel observes that “ … what experience and history teach is that peoples and governments have never yet learned from history, let alone acted according to its lessons”. This is true: had it been otherwise, no civilization having preserved the memory of those that preceded it would ever have died.

While failing to learn from history, men have never stopped however trying to decipher it and when reading it, our focus is either on what keeps reappearing under an identical shape or on what has never been seen before. Grasping to what extent these two ingredients are mixed: the same and the different, is fundamental of course, especially in those times of transition. We will not know where we’re heading if we fail to determine whether the times we live in are characterised by the brand new or by the eternal return. With the former, the processes observed are nearing completion, with the latter, they are bound to persist. We need distinguishing ruptures from continuities. When the first outweigh the second, then change is radical. This is why the ability at reading history is less crucial when in the early days of a new era than when, as currently, an exhausted era is coming to an end.

When cracking a chrysalis, a dark and thick liquid comes to light, revealing neither the shape of the larva in the process of being dissolved, nor that of the perfect insect which will emerge one day. Turbulent times are of this nature. Saint-Just was once forced to admit that: « Perhaps the force of circumstance leads us to outcomes which we had not thought of ahead. » Shortly after this admission, he surrendered without a fight to a fate of impending death, acknowledging his inability to understand the whirlwind that had overtaken him.

Should times evolve in a radical fashion, there will exist within them « veins »: rectilinear trajectories connecting the past to the future through the mesh that the present is made of. Other areas will remain unchanged but, for as long as the transition takes place, being part of the general effervescence, they will nonetheless be subjected to disquieting turbulence. Being able to detect the underlying presence of such “veins” amounts to reading the future written as of now in the present.

(To be followed …)

[Thanks to Bernard Bouvet for having had a first shot at translating this piece!]

An English translation of Feu en la demeure !, posted on my French blog on February 25.

Ladies and gentlemen of the European regulatory authorities, I am today turning to you: the house is on fire!

Demands that Greece lowers its civil servants’ wages will not save her. Your prodding Greece to tackle tax evasion will not save her. Your offer to establish a… piggy bank (how laughable an idea!), will not save her either. All that is far too little, far too late. It is also beside the point.

On February 3rd, I happened to be one of the guests on the English show of France 24 TV channel, ”The Debate”. For our sake, I beg you to hear what I had to say when the discussion bogged down on whether or not Greece cooked the books on its economic statistics. This is how I then summarized my address:

I am saying, we are witnessing again someone playing a little game with Credit-Default-Swaps (CDS). But this time, it is not, 1) Bear Stearns, 2) Lehman Brothers, 3) Merrill Lynch, it is, 1) Greece, 2) Portugal, 3) Spain. The doings of the financial markets, these past days, are not unlike George Soros’ coup that sank the British Pound in 1992 (and some think that the economic « science » renewal lies in his hands!).

Your little piggy bank in support of Greece, established after such travails, will last but a few hours in the storm, and immediately following that, four more will be required, one for Portugal, one for Ireland, one for Cyprus, and the next, for Spain, a much larger penny bank than the others put together.

Then, you will have a few days in order to catch your breath, the next target not belonging to the euro-zone: I am speaking of the United-Kingdom.

We are not dealing with wages being too high: what we are facing here a domino effect, in the same way Lehman Brothers’ name was spelled out in the sky the day of the fall of Bear Stearns, so will the name of Portugal be carved in heavens when Greece defaults.

What is to be done? Aim the spotlights towards the source. Towards the lethal combination of national debts rating by credit rating agencies with naked Credit-Default-Swaps positions, those bets taken by some with absolutely no personal risk but in the process creating systemic risks by the tonne, all but for one goal: enormous personal gains.

It is time, Ladies and Gentlemen, to consider outlawing speculation on price fluctuations (also known as financial spread betting).
Do not object it is complicated: it is not, it is already written in the spirit, if not yet the letter, of the Statements of Financial Accounting Standards No. 133 (FAS 133).

Do not mention it is going to affect liquidity: my usual response to this argument is that bettors only create liquidity for other bettors and in that it is of no importance whatsoever. But today I am going to add something else: at the present stage of a probable disintegration of the euro-zone: “Who gives a damn about liquidity!”

(Many thanks to Bernard Bouvet!)

We will ponder: “Might the financial crisis be followed by national crises?”

Alessandro Giraudo – Chief Economist, Tradition Viel (in the studio like myself)
Ondine Smulders – The Economist (calling in from Athens)
A (to be determined) Reuters Breakingviews’ journalist (calling in from London)

Podcasts :

First part.
Second part.

Conceptual artist Little Shiva who helped me design Santa Crisis last year informs me she went to Copenhaguen in her capacity of a polar bear.

Cityislander’s imaginative translation of “La nuit du 4 août” at the French end of this blog. Many thanks to him!

Exactly 220 years ago (the French Revolution), on the night of August 4th, 1789, the question certainly was not about systemic risk. Yet, on that very night, an event of systemic magnitude occurred: the French assembly ended the feudal system and its privileges.

Keeping this historic event in mind, we have to reflect on the fact that we have not yet fully grasped that when systemic risk became an issue in 2007, capitalism wasn’t just going through a rough patch. Rather, it had been mortally wounded. Our politically correct attempts to see green shoots in the economy and marvel at them epitomizes wishful thinking.

The old fashion way to save capitalism, the socialization of losses, proved insufficient, this time to absorb the sheer size of the systemic shock, only matched by the enormity of the debt binge that caused it over the past 35 years. Tax havens had allowed the wealthy to evade the IRS, leaving the middle class to pay for the bailouts. This time, however, the price tag is simply unaffordable.

Without a viable solution, we look the other way and comfort ourselves with the illusion that things will heal over time; a propaganda, that is generously fed by the establishment. Isolated havens of prosperity have emerged, the pitiful benefits of the purported trickle down economics behind the massive bailouts.

The less fortunate were left to face dire prospects on their own, while at the same time the available resources were given in priority to the few banks still standing, thereby confirming the oligarchy theory. Looking back, they seem to have been pulling the strings all along. Lehman Brothers, declared bankrupt on Sep 15 of last year, was a rival of “Government Sachs”. Wasn’t it meant to happen, then?

In the heydays of finance, competition was rife between banks, yet markets were deemed resilient. The high-jacking of capitalism by banks, however, eventually brought it to its knees. With the benefit of hindsight, we’d like to think that everything would get back to normal if only we got rid of the bad guys. Alas, our awakening comes after the fact. The goose that lay golden eggs is gone.

In spite of occasional rallies, under IV therapy by the government, Wall Street’s attempts to resurrect its glory are eventually deemed to failure and will only reflect the desperate attempts of its kings to stick to power.

When the new system takes over, we will not see it for what it is: the replacement of a broken system by a new one. Rather, we will clamor that reason won over a corrupt elite, that drowned in its own excesses.

A reader of my French blog has taken the trouble of translating my most recent Friday video in English. Many thanks to him!

NEWS is conveyed by letter, word or mouth
and comes to us from North, East, West and South” (Witt’s Recreations)

. . . but mostly from the Paul Jorion blog now that we have the Internet.

I want to talk to you about the stock market, because the stock market has been rising in France and in the United States. I am obliged to reflect upon this, because, as I have mentioned to you, I have agreed to prepare an afterword to a new edition of several works of Proudhon concerning stock-market speculation. It is important to understand what is happening at the moment. Does it mean that the economy is improving? To that end we need to look back at the events of the past two years.

In the summer of 2007 we witnessed the drying up of inter-bank credit, by which is meant that the banks stopped lending to one another. I remind you that the reason for this is that there was a depreciation, which began to become quite spectacular from February of 2007, in the value of securities consisting of large collections of individual mortgage debts, because many people were no longer able to keep up their monthly repayments. Consequently, the value of these securities plunged. In the summer an air of general suspicion arose from the fact that banks did not want to reveal whether they possessed these products, which could no longer fetch a price, because there was now no market for them. Everyone in the world of finance suspected everyone else of possessing these products and thus of possibly being insolvent. An unwillingness to lend developed, as no one could be depended on now to be credit-worthy.

I shall remind you of the first measure that was thought of to deal with this problem: the creation of what were known as ‘bad-value banks’ or ‘bad banks’. The possibility was envisaged of putting toxic derivatives into a form of quarantine so that the banks could get them off their balance sheets. So ratios of solvency were worked out, to see whether they were above or below the threshold of solvency. What happened, as has recently become known, is that the British, who were in much the same position as the Americans, came to the conclusion that it was impossible, as it would be too expensive.

The second idea, which was adopted in previous crises, is known as ‘privatization of profits with socialization of losses’. This solution, which had always worked very well before, means that the private sector gets whatever profits there may be when things are going well and then, when things go badly, the state, i.e. the taxpayer, forks out to cover the losses. The novelty in the crisis in which we find ourselves now is that this classic solution can no longer be considered, as that too would have cost too much, the level of debt which had been incurred having exceeded the capacity of states to absorb it.

Read the rest of this entry »

A blog gives you visibility, allowing people from all over with views akin to yours getting in touch. That’s what happened a couple of months ago with conceptual artist, Little Shiva asking: “What about a common project?” I told her of a possible allegory for the crisis, a symbol that you could copy here and there, whose name would be Santa Crisis.

After some going back and forth, here he is: a jolly old elf!

Make him known: that’s the idea. Just inform where he was born: here and there.

Click to enhance.

Here is the communication I made on March 3rd to the Socialist members of the European Parliament in Brussels as my contribution to the one-day conference entitled “Closing the casino: building a fairer and stronger real economy”

Modern societies of European origin were historically built according to a tripartite structure composed of warriors-raiders, priests and commoners. By the time the new concept of democracy emerged, the land and the wealth buried in it had already been distributed by the warriors-raiders between themselves. Inheritance of property had contributed at strengthening this pattern. Bourgeois revolutions of the eighteen century condoned the addition of the power of money to that of strength only. From then on cash buttressed the power balance that the sword had first put into place. In the twentieth century, colonialism and paradoxically communism, ensured the full globalization of that order of European origin. Current appeals for “leveling the playing field” ignore the lack of evidence that the field was ever level.

Stock options: the holy alliance between investors and company executives

In an infamous quote that Ben Stein had him concede for the New York Times, investor extraordinaire Warren Buffet stated: “There’s class warfare, all right, but it’s my class, the rich class, that’s making war, and we’re winning.” This statement marked the return in common parlance of an outmoded way of speaking. Indeed, with the rise of the Chicago School, the phrase “class warfare” got tabooed and the words “capitalists” (aka “investors”), “bosses” (aka “company executives”) and “workers” (“employees”, “associates”, “team members”, etc.) removed from the economic literature and replaced by the catch-all notion of “monetary mass” as part of a more general process where “physical forces” replaced “people” in explanations of the economy. That didn’t mean though that class warfare was over or had never taken place. The decisive and final move came in the late 1970s when McKinsey devised “stock options” by which the “interests of investors and company executives would henceforth be aligned.” The plan succeeded beyond both parties’ wildest dreams.

The distribution of wealth: what happened to it

Prior to stock options, wage-earners were part of a triangular power game where investors and executives kept each other at bay. With the introduction of stock options, those days were over: a holy alliance was born to which wage-earners were no match. Predictably, their piece of the pie dwindled down. Any attempt they would make to increase their share would be brutally countered by central banks concerned with monetary masses and raising interest rates – that is: raising unemployment – forcing wage-earners to pipe down.

With lower revenues, wage-earners were led to ever borrow more. Commercial banks graciously obliged. Meanwhile, companies had got in the habit of borrowing rather than reinvesting so that by now any money that anyone needed was borrowed. Interest payments were mushrooming, becoming a burdensome component of every price. “Capital” – being money you don’t have but still need – kept concentrating in fewer and deepening pockets. The more capital is concentrated the less likely it is though that it happens to be where it is actually needed.

Speculation: the ascent of the Speculative Society

What do you do then when you don’t have the money you need and you know that working harder won’t make much of a difference ? You buy a lottery ticket. By the end of the twentieth century everyone had come to that same conclusion and “bubbles” and growth had become synonymous notions.

You buy stock but not for dividends which are boringly your share in the surplus the company has made through the stock you purchased, no: you buy stock for capital gains. To insure that this happens the stock exchange needs to be turned into a casino. The price of Total or BP stock needs to change every five seconds. Not that there is anything in the business of Total or BP justifying that the price of its stock changes every five seconds or for that matter even every five days. But it is needed for the stock market to be run as a casino where huge capital gains may materialize. When the scheme stops working, it crashes, which happens indeed every eighty years or so.

Hunger riots stirred by museums and hospitals

If only people who have wheat to deliver or to take delivery of were trading wheat the price of that cereal would be determined by how much of it gets produced and how much is needed: what is commonly called supply and demand. But this is not how things work nowadays: the price of wheat gets determined by bets made by big institutional investors such as pension funds, university endowments, hospitals and museums. A reasonable social expectation is that they would focus on offering pensioners annuities, teaching pupils, curing patients or displaying art, but they are not: they are heavily busy pushing the price of wheat up or down with the goal of protecting their assets and no concern whether anybody would live or die as a consequence of their speculation.

Spot and futures markets allow those exposed to an actual risk (due to the weather, the economic environment, etc.) to cover their positions, hence reducing overall risk. Speculative “naked” positions on the contrary artificially create risk where there was none. Coverage provides an insurance while “naked” positions are risk-generating bets. Insurance protects the economy while bets kill it and measures should be taken accordingly. The means for banning betting on the fluctuation of prices are simple: they are spelled out in FASB 133, a rule issued by the American Financial Association Standards Board that establishes a fiscal differential treatment for coverage and naked positions. FASB 133 should be upgraded to a badly needed and clear-cut prohibition.

Recommendations

1. Break the unholy alliance between investors and company executives: the social fabric is being damaged as we speak. Ban stock options.

2. Free central bankers from monetarism: societies are not made of monetary masses but of people. Central banks have a more crucial role to play than systematically siding with investors and company executives against wage-earners.

3. Apply urgently appropriate fiscal policy so that the chances increase that capital happens to be where it is actually needed.

4. Close down the casino: stop continuous pricing on the spot and future markets.

5. Bar speculators from commodities’ markets: bar “non-commercials.” Let them focus on what they do best: teach pupils, cure patients and display art for the enjoyment and education of the public.

6. Encourage insurance but ban bets on the fluctuation of prices.