Financial Fragility Archives

Be Humble, Acknowledge Uncertainty, and Don’t Assume A Happy Ending

Rob Johnson, President of the Institute for New Economic Thinking, is not your average economist. He’s got heart and soul, or if you’ll have it, the blues! With his deep connection to the arts and humanities, Rob leads the new economic thinking not just with a sharp mind, but also with sensibility.

This article is part of an ongoing series in which Rob shares his life experiences, and biggest lessons learned. If you’re an aspiring expert in economics or a related field, this is for you. It might mitigate the depth and duration of your mid-life crisis. Earlier articles in this series can be found here.

Today, we pick up at Rob’s time at MIT, and see what lessons economists might be able to learn from sailors.

2 – Be Humble, Acknowledge Uncertainty, and Don’t Assume A Happy Ending

“MIT was tough. I had weird stuff happen to me there. One day, in a computer lab, I was sitting next to this black guy. He told me he’s working on his Ph.D. in medical engineering. And he’s 20 years old. I’m 19, an undergraduate. He’d been at MIT since he was twelve. He told me he’d bet me that he could multiply two numbers in his head faster than he could type them into an HP calculator. And he was right! I said how do you do that? He said he converts everything to base 2. He transformed the numbers in his mind like this. Not even a scratchpad! I just sat there and figured there’s a lot of people here smarter than me. It was humbling. And invigorating.

So everyone found out real fast that they were not the smartest person in the room. For some people, that was hard, especially for people who were a bit socially awkward, and didn’t have much other than their intellect. They had been a valedictorian at home and an average guy here. So for some time, MIT saw a lot of suicides among freshmen. But then they adapted and made freshman year pass-fail. That gave people a longer runway. More room to explore. But it was humbling to be there nonetheless.

The sea also taught me to be humble. When you go offshore, sailing, you know you don’t know. If you go way offshore like into the arctic ocean, you feel small. And you feel grateful that whatever there’s up there didn’t take your soul. There’s humility. When economists say things are uncertain, they still pretend to know. But when sailing, you can’t pretend. You have to function despite the fear. You do not have the power to extinguish the uncertainty you have to cope with. You can’t escape. There are things you do, of course, that are prudent. You wear life jackets, safety harnesses, you keep the more novice sailors off the deck. You decide who should go on the voyage because of needing competent people in a crisis to keep everybody safe. But at the end of it, you are coping with something that’s more powerful than you are.

So when I went to my first economics classes at MIT, I heard them talk about equilibrium. I raised my hand and, not trying to be a smart-ass, I said “isn’t that like assuming a happy ending?” I knew that the same math worked in engineering. But it doesn’t work that great in economics. We were doing Fourier transformations–looking at things in time and frequency domain. In an engineering lab, you can do that on electrical signals, and it fits like a glove. But if you use that stuff on economics data, it looks like mud. So I thought: what are these people doing? What they are doing is pretending to have certainty when they don’t have it.

For me, having experienced the social turmoil of growing up in Detroit, and knowing the uncertainty of the sea, this was crazy. But the work with Kindleberger resonated. I worked with him on Manias, Panics, and Crashes, which is a historical account of financial crises, and the radical uncertainty that underpin them.

In the end, I got a scholarship to go to Princeton, with Solow and Kindleberger backing me. And they told me the rising star at Princeton was going to be Joseph Stiglitz, and the faculty there was going to be amazing. I had applied to Harvard and Berkeley and all these places, but MIT had told me that if I got into Princeton, I had to go there. So I went to try graduate school…”

Enjoy sound with the story!

This playlist, put together by Rob, captures the spirit of the Sea.

Read along!

Recommended Read:
Charles P. Kindleberger – Manias, Panics, and Crashes: A History of Financial Crises

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In Defense of Dodd-Frank

It’s been nearly a decade since we first felt effects of the Great Recession. While the recession officially ended, its consequences still affect us. Some are beneficial, others (like sluggish growth and the number of people leaving the labor market) not so much. One of the better side effects of the 2007-2008 crash, however, is likely to disappear rather soon: the Dodd-Frank act. The newly inaugurated White House is eager to scrap that set of financial regulations.

My goal with this post is to present a very simple explanation of what Dodd-Frank is, why some people want it gone, and why we should fight to keep it and strengthen it. Hopefully, this accessible explanation will motivate more people to join the fight. Maybe then we can have our voices heard. With this objective in mind, I am aware that some details will not be pursued to their full extent, but the overall message should still be whole.

Let me start with a very simplified analogy. Think of the financial system as a system of highways. In a modern highway, there are usually a few lanes on each side, separated by a median. There are many regulations put in place to make sure that the people zooming past each other inside two tons of metal–all the while sitting inches away from gallons of gasoline–do it safely. In this analogy, your average American with their savings, retirement account, mortgage, student debt and credit cards is driving north on the “commercial” lanes in their Peel P-50 (click the link, it will help you understand where I am going with this). Besides them are other entities such as big banks, hedge funds, insurance companies and the like. Those are heavy 18-wheelers and tanker trucks, so the massive gusts of wind that they create will shake smaller cars as they pass by. Of course, whenever a P-50 gets into a crash (like when a head of household goes bankrupt) it is tragic, but it does little to the overall flow of traffic. However, when one of those big vehicles crashes, it often leads to a chain reaction of other accidents, which affects all other drivers and overall makes everyone’s day a lot worse.

After the great crash of 1929 (the financial crash, I’m unaware of any major vehicular crashes from back then), a set of fairly stiff regulations were designed to keep the drivers of that industry–namely the banks and other financial institutions–from getting in other accidents of similar magnitude. Those regulations were known as the Glass-Steagall Act of 1933, enacted as an answer to the failure of almost 5,000 banks. The legislation was put in place to strengthen the public’s opinion towards the financial sector, to curb the use of bank credit speculation, and to direct credit towards more “real economy” uses. In our analogy, Glass-Steagall introduced a number of norms to the ‘financial highway’. Most notably, it created a solid median between the financial and the commercial banking lanes. Now, commercial banks could not use their clients’ funds to engage in risky investments in the financial markets. In our analogy, it means that before Glass-Steagall those big trucks were free to go across the road to the “wrong way” whenever they felt like doing so would be beneficial for them. In addition, Glass-Steagall also created the FDIC, which insures bank deposits; think of it as the weight-per-axis limitations that help preserve the roads from the damage caused by overloaded trucks.

Fast forward to the Clinton presidency, 1999 to be exact. By then, the broad belief that separation between financial and commercial banking was necessary had lost force, even though it had kept the American economy away from any significantly serious recession/depression for over 70 years. That year the barrier between the financial and commercial lanes was brought down. Now, banks and other financial players were free to drive on whatever side of the highway they wanted; banks (and others) are now able to use their clients savings and retirements accounts to buy and sell toxic financial assets such as CDOs. As a result, they were able to take bigger risks, which brought–in many cases–good rewards. This is the era of leveraging, or what Minsky called “Money Manager Capitalism.” To some, it was clear that such an environment would eventually lead to a big crash; a few smaller ones serving as a warning. Indeed, with 2007 came the worst financial and economic ‘accident’ in almost 80 years.

Financial regulations are naturally reactionary. As Minsky stated, the economy is inherently unstable, and in good part that is due to the financial sector’s insatiable thirst for financial innovation. Regulators need to remain attentive to the markets and introduce rules to curb too-risky behaviors as they surface. This is especially true in the days and weeks following a crisis. Once the dust has settled we can look into the causes for the downturn, and put in place measures that are supposed to keep it from happening again, not unlike the way traffic regulations are designed. As such, the Dodd-Frank Act was drafted to put a stop to some of the recklessness that drove us to the Great Recession.

In short, Dodd-Frank ended Too Big to Fail Bailouts, created a council that identifies and addresses systemic risks within the industry’s most complex members, targeted loopholes that allowed for abusive financial practices to go unnoticed, and gave shareholders a say on executive pay. It aims to increase transparency and ethical behavior within the financial sector, both of which are good things.

In no way is the Act perfect. Some, like me, would have advocated for much stiffer regulatory practices like rebuilding the division between financial and commercial banks, or taking a more definitive approach to dissolving Too-Big-To-Fail institutions. Therefore, during its somewhat short existence, Dodd-Frank has received much criticism. While some of those critiques were fair and well founded, the loudest critics were the ones coming at a wrong angle. As it happens the loudest critics now have the opportunity to scrap those safeguarding regulations altogether.

The most common criticism of the Act (and the main reason the administration has given to overrule it) is that it has made it harder for people and businesses to borrow. That criticism is untrue. For example, Fed Chair Janet Yellen showed in her latest address to the senate that “lending has expanded overall by the banking system, and also to small businesses.” A survey from the National Federation of Independent Businesses, cited by Yellen, shows that only 2 percent of businesses that responded cited access to capital as a great obstacle to their activities. Furthermore, to claim that Dodd-Frank has a macro impact on lending is, at least, sketchy. As Yves Smith puts it:

“For starters, big corporations use bank loans only for limited purposes, such as revolving lines of credit (which banks hate to give but have to for relationship reasons because they aren’t profitable) and acquisition finance for highly leveraged transactions (and the robust multiples being paid for private equity transactions says there is no shortage of that). Banks lay off nearly all of the principal value of these loans in syndications or via packaging them in collateralized loan obligation. They are facing increased competition from the private equity firm’s own credit funds, which have become a major force in their own right. Otherwise, big companies rely on commercial paper and the bond markets for borrowing. And with rates so low and investors desperate for yield, many have been borrowing, for sure….but not to invest, but to a large degree to buy back their own stock.”

In fact, the amount of cash held by American corporations reached an all-time high in 2013. This shows that companies are sitting in liquidity without investing in the real economy. The hoarding of liquidity could even be considered an actual fail of Dodd-Frank; unlike the stiffer Glass-Steagall act it did not focus on pushing investment into the production of real goods and services.

The publicized reasoning behind repealing Dodd-Frank is untrue, so what is the motivation for lobbying against the regulations? In my opinion, there are two main arguments. The less malicious one is that there is still people out there who believe than an unregulated, free-for-all financial sector is effective, benevolent, and will serve the greater good. It is almost a dogmatic position based mostly on circular logic, and unrealistic economics modeling (which often does not even take the financial sector into account!), and lack of supporting evidence. It should be put aside. The second argument seems to be popular among lobbyists and government officials: reducing regulations will allow (at least in the short run) for immense profits.

Without Dodd-Frank, Wall Street will most likely revert to the risky and reckless practices that led to the Great Recession. The repeal of the act would, in Minskian terms, act as a catapult launching us towards the Ponzi state of finance, in which risky borrowing and lending end in a financial crisis. Doomsday predictions aside, repealing Dodd-Frank would hurt the common folk like you and I. For example, the Fiduciary Rule is likely to also be erased, and it requires that investment advisers put their clients’ interests above their own. This puts people’s retirement savings at great risk. If money managers do not have to act in their clients’ best interest, they will make decisions that allow them to maximize their commission even if it means losing money for their clients. Additionally, to some extent, the repeal would kill thousands of jobs across the nation; because of Dodd-Frank, financial institutions had to create and staff entire departments focused on quality assurance and compliance, without the rules these employees are not longer needed. Finally, without the rules, banks can go right back to targeting the most vulnerable and financially illiterate among us, offering them loans, mortgages, and other predatory instruments they cannot possibly afford; it would be disastrous.

Reverting back to our simplified analogy. Since the repeal of the Glass-Steagall Act, the highways of the financial systems do not have a median, separating investment traffic from going the ‘wrong way’ into the commercial lanes. Further repealing rules such as the Dodd-Frank Act, without substituting with a set of better regulations, is like removing the usage of turning signals, the requirement for turning the lights on at night, and speed limits – all the while releasing the Bull from Wall Street right in the middle of heavy traffic. Accidents will happen, and in the case of our financial highway it does not matter if we are inside the vehicles involved, we are all going to become casualties of the crash.

Carbon Trading, Sustainable Development and Financial Fragility

The response to climate change is one of the most pressing policy issues of our time. Carbon trading assets are currently worth more than $100 billion. This market is expected to reach $3 trillion by 2020. In Stabilizing an Unstable Economy Hyman Minsky notes that the markets for financial assets are inherently unstable, leading to the cyclical behavior of the economic system. How effective then are market-based solutions to solving climate change? It might just be that carbon markets have not reduced environmental instability and may increase financial instability of the entire economic system.

The core of carbon trading isnot trading of physical GHGs, but the trading of the right to emit GHGs and the unit of account is a ton of carbon dioxide equivalent (tCO₂e). The carbon market stems from the Kyoto Protocol, and its specifics are target of discussion as scholars debate about the legal characteristics of the carbon unit. Some countries view it as a commodity while others see it as a monetary currency.

Under the Kyoto Protocol trading mechanisms were made up of three types: international emissions trading, the Clean Development Mechanism (CDM), and Joint Implementation (JI). The European Union Emission Trading System (EU ETS) is the world’s largest carbon market. According to the 2016 ICAP worldwide emissions report, there are 17 emissions trading systems operating around the world, which are currently pricing more than four billion tons of GHG emissions. In 2017, two new systems will be launched: China and Ontario, the former will become the largest of such systems, and will drive worldwide coverage of ETSs to reach seven billion tons of emissions by 2017.

Voluntary markets exchanges (carbon markets outside the Kyoto) are also on the rise because they make trading, hedging and risk management easier by providing liquidity. Furthermore, they develop sophisticated financial instruments such as CER futures, options, and swaps, which will help establish a price forecast for carbon. Some of these markets are the Chicago Climate Exchange (CCX), Multi-Commodity Exchange of India (MCX), and Asian Carbon Trade Exchange.

Sustainable Development

From their foundation, carbon markets have failed to address the underlying root causes of climate change. They divert money from technological investment that will actually reduce the use of fossil fuels towards the financial markets. Furthermore, they are causing instability in the environment through the use of carbon offsets, which have caused massive green grabs to occur in the global South, and through outsourcing emissions to developing nations. Carbon offsets were created by Kyoto to describe emissions reductions projects that are not covered by an ETS. For instance, tree plantations, fuel switches, wind farms, hydroelectric dams…etc.

The world’s richest have over-consumed the planet to the brink of ecological disaster. Instead of reducing emissions within their own countries, they have created a carbon dump in poorer regions. As such, emissions trading system represent the world’s greatest privatization of a natural asset. The Kyoto protocol is set up in a way that carbon sink projects (forests, oceans, etc.) are only accepted when people with official status manage them. Hence, it expands the potential for neocolonial land-grabbing to occur. Rainforest inhabited by indigenous people will only qualify as “managed” under the Kyoto when they are run by the state or a registered private company.

Furthermore, carbon trading has also failed to reduce global GHGs emissions. When a country claims to have reduced its carbon emissions, one must question whether it is by adopting low-carbon technologies, like how Sweden used well-crafted public policies and market incentives to decarbonization, or by outsourcing its emissions to another country, most likely to developing nations. For example, the Chinese government has questioned whether the emissions coming out of Chinese smokestacks were really ‘Chinese’ or should they be accounted to those in Western countries who are consuming Chinese goods or are owned by joint venues with developed countries. The question arose because Europe claimed that it was making progress on climate change based on tabulating the physical locations of molecules. Larry Lohmann phrased it perfectly when he said that Europe’s statistical claim “[conceal[s] an important fact that it has offshored much of its emissions [to China].” Take the UK, it has not in fact reduced its emissions it merely offshored one-third of its emissions by not accounting for emissions of imported goods and international travel.

Carbon markets have had many fraudulent activities within them. In 2002, the UK had a trial emissions trading scheme worth £215 million, which resulted in fraud. Three chemical corporations had been given £93 million in incentives when they had already met their reduction target. Another famous fraudulent activity revolved around international offset projects whereby companies would create GHGs just to destroy them and make money off of the credits.

As nature is being commodified and privatized,the current policies for sustainable development, under the guise of conservation, are alienating the poor from their means of livelihood by securing resources for organizations. These indigenous people — land users — are seen as needing to be saved from their primitive ways and to be educated on utilizing sustainable development within the bounds of the market. If it sounds like colonialism that is because it is.

For example, there exists specific types of green grabs known as conservation enclosures where the market is seen as the best way to conserve biodiversity. Hence, authorities are privatizing, commercializing and commoditizing nature at an alarming rate through payment for ecosystem services to wildlife derivatives. The Convention on Biological Diversity (CBD), a multilateral treaty set up at the 1992 UN Earth Summit has a target the protection of 17 percent of terrestrial and inland water and 10 percent of coastal and marine areas. For instance, Conservation International (CI) pushed the government of Madagascar to protect 10 percent of its territory, while in Mozambique a British company negotiated a lease with the government for 19 percent of the country’s land. President Elizabeth Sirleaf Johnson of Liberia called for the extradition of a British businessman accused of bribery over a $2.2 billion carbon offsetting deal. The deal was to lease one-fifth of Liberia’s forests, which account for 32 percent of its land. In Uganda, a Norwegian company leased land for a carbon sink project, which evicted 8,000 people in 13 villages.

In Oxfam Australia’s 2016 report on land grabs, palm oil has become “responsible for large-scale deforestation, extensive carbon emissions and the critical endangerment of species… India, China and the European Union (EU) are the largest consumers of palm oil globally.” The European Union’s renewable energy policy being a significant driver of global palm oil demand due to its aim to source 10 percent of transport energy from renewable sources by 2020, which has increased its palm oil usage by 365 percent.

Reducing Emissions from Deforestation and Forest Degradation (REDD+) is an effort to create a financial value for the carbon that is stored in forests. It is used to justify green grabbing and is expected to be one of the biggest land grabs in history. By using REDD+ as a conservation mechanism and a financial stream, “the CDB is both legitimating the commodity of carbon itself and helping to create the market for its trade.” The CDB is forming new nature markets along with new nature derivatives whereby investors speculate on future values encompassed in, for instance, species extinction like that of tigers.

Financial Fragility

Hyman Minsky was fully aware that a capitalist system was a monetary system with financial institutions that were prone to instability. Minsky is famous for saying that the strength of capitalism is that it comes in at least 57 varieties. The last and current stage is Money Manager Capitalism, which was made up off highly levered profit- seeking organizations like that of money market mutual funds, mutual funds, sovereign wealth funds, and private pension funds. The financial instability hypothesis argues that the internal dynamics of capitalist economies over time give rise to financial structures, which are prone to debt deflations, the collapse of asset values, and deep depressions. Minsky has always warned, “Stability is Destabilizing.”

Money managers act as agents. They pursue short-term profits by trading instruments that are not easily verifiable, which makes fraud likely possible in carbon markets. The dramatic rise in securitization has opened up national boundaries leading to the internationalization of finance. Securitization within the carbon markets increases the risk of leading to boom-bust cycles. At present, speculators are the major players in carbon trading and their dominance in carbon markets is growing at an alarming rate. Financialization is an important precondition for the rise and operation of carbon offsets. The financial innovation in this scheme is that it uses nature itself as a financial instrument. Moreover, it is selling nature to save it and then saving nature to trade it.

‘Green bonds’ are carbon assets that are sold to the Northern hemisphere, backed by Southern land and Southern public funds. Lohmann shares that financial speculation of collateralized debt obligations (CDOs) are at least based on specifiable mortgages on actual houses while climate commodity or subprime carbon cannot be specified, quantified, or verified even in principle. Even conservatives and Republicans have said, “if you like credit default swaps, you’re going to love carbon derivatives.” It has become apparent that carbon markets are not only driven by trade, but also by speculation. Carbon derivatives are growing at a fast rate as speculators are moving from other assets towards carbon. Whereas once investors bet on the collapse of the US housing market, there are some traders who are betting on the collapse of the carbon credit market.

As more investors, specifically hedge funds, enter the carbon markets, they increase market volatility and create an asset bubble or ‘carbon bubble’. Money managers by acting as agents trade carbons and increase financial fragility. Their income is driven by assets under management and short-term rates of return. Hence if they miss the benchmark, they will lose their clients. So they act on short profit bases by taking risky positions, and carbon trading provides those risks. In brief, using Minsky’s theory, we can predict with confidence that the carbon market is inherently unstable and that in addition to its not achieving its goal of reducing emissions, it is also heading to a financial disaster.

Even though Minsky pushed for regulation when it came to financial markets, regulating carbon markets will not solve the problem. Tighter regulation of carbon markets, particularly secondary and derivative markets is just a Band-Aid solution and will fail to affect fundamental change. Financial markets have had to be bailed out again and again. However, as a British Climate Camp activist said “nature doesn’t do bailouts.” On a global scale, GHG emissions have gone up. There is an offshoring of emissions. The best policy would be eliminating offsets, specifically from the developing world. Furthermore, there needs to be policies that encourage low-carbon technology as used in Sweden. Another policy recommendations would be a harmonized carbon tax.

Written by Mariamawit F. Tadesse
Illustrations by Heske van Doornen