The Discount Rate Mismatch

. . . or, how finance is like quantum mechanics.

This guest post is contributed by StatsGuy, an occasional commenter and contributor to this blog.

Many pundits like to discuss the issue of Maturities Mismatch – that banks borrow short (at low interest), lend long (at higher interest), take the profit and (allegedly) absorb the risk.  We often hear talk about how the Maturities Mismatch is integrally linked to liquidity risk – the sometimes self-fulfilling threat of bank runs – which the FDIC is designed to fight.  Rarely if ever do we see anyone making the connection to the Discount Rate Mismatch . . .  In fact you’ve probably never even heard of it, and neither have I.

What is the Discount Rate Mismatch?

It is the difference between the risk-free return on investment that investors demand, and the risk-free return on investment that can be generated by real world investments.  And by investors, I do not just mean individual retail investors or hedge funds.  I also mean retirement accounts and state pension funds as well, which rely on massive 8% projected returns in order to avoid officially recognizing massive fiscal gaps between their obligations and funding requirements.

It has been well documented that the existence of these gaps implicitly forces state and municipal retirement agencies to engage in risky investments to hit target asset appreciation goals.  This strategy sometimes works.  And, sometimes, it does not – as Orange County well remembers.

What drives the Discount Rate Mismatch?

Many things drive it – including behavioral and cultural factors that deter savings and encourage short term time horizons – but it’s worth noting that it’s built into modern institutions.  Recently, I helped assemble a couple business plans, and was (again) reminded of the fact that standard net-present-value calculations use a 5% or 6% discount rate.  That’s a real rate (which translates into a 7%-8% nominal rate given typical 2% inflation assumptions).

What does this mean?  Even after controlling for inflation, getting $100 next year is worth only $94 this year, and the value of $100 in thirty years (controlling for inflation) is a mere $15.6 dollars today.  Of course, these calculations extend beyond money.  The value of 100 megawatts of electricity in 30 years is only 15.6 megawatts today.  The value of 100 lives lost in 30 years (holding age constant) is equal to only 15.6 lives today.  Wow.  Future life is cheap!

Yet that leaves a conundrum – with such dramatic needs for long term investments, how is it that my savings account is paying essentially 0% interest?

How does the Discount Rate Mismatch relate to Maturities Mismatch?

Let’s imagine a society where everyone demands 6% real returns before committing money to an investment, but society really needs some long term investments – things like the Hoover dam or the Golden Gate Bridge that pay out over 80 years.  Let’s say these investments are truly risk free, that there’s a lot of money sitting in bank accounts unused, and that the broader economy has lots of unused productive capacity (e.g. low capacity utilization).  Why is it unused?  Because many people, given a choice between an illiquid investment with 3% real return and holding liquid cash, would rather hold liquid cash.  That liquidity offers insurance against unforeseen needs (like losing a job, or a health expense).  But if that cash sits in bank deposits, it takes a lot of money out of circulation, and that can cause problems with things like the price level.  That’s where the banks come in.

If I were to ask you where the money in your savings deposit account is, you might say at the bank.  That is not quite right.  In truth, your money is in several places simultaneously.  In this sense, finance is like quantum mechanics.  Money is like Schrodinger’s cat – you never know where it is until you actually observe it.  (And if everyone tries to observe their money at the same time, that’s called a bank run.)

But how can money be in multiple places at the same time?  Simple – because you think you have the money, the bank agrees, and so does everyone else – and since everyone believes it, it’s true.  The money you deposit is lent out, then deposited by borrowers, then lent out again – many times over until it eventually sits in vault cash or on deposit with the reserve or in your pocket.  We called this fractional reserve banking, and there used to be a limit on how far this cycle could go (the reserve ratio), but this limit was rendered worthless by technological innovations like sweeping, and Bernanke recently hinted at getting rid of it altogether.

By pooling deposits and making loans, banks “borrow” from deposits at 0% and lend it for 3%, thus they make a profit even though the social discount rate (the rate a retail investor would charge for giving up their liquidity for a long period of time) is 6%.  That’s because banks care primarily about the spread (sometimes known as the yield curve).  Recently, the yield curve was as sharp as it’s ever been.

By engaging in inter-temporal arbitrage, banks allow society to continue to make investments even during periods of high discount rates – at least for a time.  Banks essentially create temporary money to make investments without savings.  So long as money is continually created, savings are not necessary to sustain investment – credit supplants savings.  Citizens don’t need to buy municipal bonds or pay taxes to support public infrastructure – the banks can.

To the uneducated masses, replacing savings with credit may sound a bit frightening, but economists can demonstrate – mathematically – that this credit-based money system is far more efficient than injecting money through the crude process of “printing” and government spending.  That’s because endogenous money creation is decentralized – anyone with an opportunity and willingness to take risks (and collateral) can (theoretically) get credit to fund an investment.  This, presumably, is why Larry Summers is so infatuated with the credit system, and why Obama argues that credit – not money – is the lifeblood of a modern economy.

Astute readers have probably sensed some danger in the system described above.  For example:

  • Doesn’t credit dependency to sustain investment give banks a lot of power?
  • If credit creation by banks is replacing cash printing by government, doesn’t this have distributional consequences?
  • Isn’t credit fueled, leveraged investment rather unstable?
  • Doesn’t this system punish cash-based savers?  If banks no longer have a reserve requirement, then why should they pay ­anything for deposits?  (Hint – they don’t.)
  • Doesn’t all of this mean that the only real limit on lending right now is capital-asset ratios, and willingness to absorb risk?  What if weak regulation and financial innovation allow evasion of capital-asset ratios, and banks are not adequately pricing risk for any number of reasons (TBTF, agency problems, bad math, etc.)?

Yes, well, those are all valid concerns.  But if there’s ONE THING we should have learned in the past 18 months, it’s that we the people are a lot less courageous when we’re facing unemployment, impoverished retirement, and foreclosure.  It’s easy to curse Goldman Sachs and the credit-breathing financial dragon of Wall-Street, but what would we do without them when most people would rather consume or hold liquid cash than make investments in the future?  Consider:

  • The huge level of debt means that if nominal GDP growth fails to hit targets, the system may collapse spectacularly.
  • The Discount Rate Mismatch problem is real – without relying on credit, how do we fix it?
  • Without the certainty of anticipated consumption, what will drive new investment?  With the savings glut in countries like Japan, what will sustain global demand if the US decides to start saving more?
  • If our under-funded pension and retirement funds can’t hit their 8% returns, how do they meet obligations (especially when those obligations are indexed to inflation but not indexed to life expectancy or medical costs)?  How do we cover the federal debt if tax revenues fall?

Make no mistake – until we solve the latter set of problems, we are stuck with the credit based system.  Banks know this too, and they hope very much that we lack the political will to do what is necessary to fix our structural problems.  That’s why any talk of financial reform rings hollow unless it’s accompanied by serious proposals to fix the discount rate mismatch problem and deal with unfunded obligations.

But maybe – if we’re lucky – we’ll get a modern day Pecora who will haul Lloyd Blankfein to the witness stand, and taunt him till he breaks.  Imagine, for a moment, Mr. Blankfein losing his cool while ranting in Jack Nicholson’s voice . . .

“You want the truth?  You can’t handle the truth.  Son, we live in a country with an investment gap.  And that gap needs to be filled by men with money.  Who’s gonna do it?  You?  You, Middle Class Consumer?  Goldman Sachs has a greater responsibility than you can possibly fathom.  You weep for Lehman and you curse derivatives.  You have that luxury.  You have the luxury of not knowing what we know: that Lehman’s death, while tragic, probably saved the financial system.  And that Goldman’s existence, while grotesque and incomprehensible to you, saves pension funds.  You don’t want the truth.  Because deep down, in places you don’t talk about at parties, you want us to fill that investment gap.  You need us to fill that gap.

“We use words like credit default swaps, collateralized debt obligation, and securitization…  We use these words as the backbone of a life spent investing in something.  You use ‘em as a punchline.  We have neither the time nor the inclination to explain ourselves to a commoner who rises and sleeps under the blanket of the very credit we provide, and then questions the manner in which we provide it!  We’d rather you just said thank you and paid your taxes on time.  Otherwise, we suggest you get an account and start trading.  Either way, we don’t give a damn what you think you’re entitled to!”

As with any great villain, what makes Goldman Sachs so compelling is that their vision of the world is not entirely without a twisted kernel of truth.

91 responses to “The Discount Rate Mismatch

  1. Nick B from DC

    Woot! Another Statsguy post! Thanks for shedding light on something I never really thought about. Loved the Schrodinger’s cat analogy btw, it’s more apt the more I think about it.

  2. readerOfTeaLeaves

    Ditto the admiration for the Schrodinger’s cat analogy.

    This post is a tour-de-force.
    I think that I’ll have to re-read it twice to make sure that I have the relationships correct.

    I wish Statsguy could be called before the FCIC, or some highly publicized Congressional hearing — I mean that as a compliment. More people need the information provided in this post.

    But I’m keeping GS as a trenchant villain for the foreseeable future. Emphasis on the ‘twisted’ with respect to their kernels of truth.

  3. None of this explains why we should permit banks to create fifty, seventy, one hundred, two hundred trillion in credit default swaps, all so they can report bogus profits (promtly withdrawn in bonuses), bringing the credit market to the brink of collapse and forcing the Fed to create $23 trillion electronic dollars just to keep business humming at 60% of capacity.

  4. I think he’s not suggesting they should be allowed to do it in to eternity. As we’ve seen as system like you mention will always eventually collapse on itself. Rather, I think he’s suggesting that you can’t simply kick the legs out from under it overnight and expect society to keep running in any sane fashion. Further, the banks are aware of this and of public reticence to even make gradual sacrifices for change, and are using those as a lever to keep things right where they want it.

    Rock -> us <- Hard Place

  5. Understand this is to be made into a movie.

    Prospective title: “A Few Good Denari”

  6. The technical term for the “Schrodinger’s cat”-like aspect of money is “statistical multiplexing,” or statmux. And, curiously enough, the exact same mechanism is also the primary productivity/efficiency driver behind that other globe-spanning intermediary/liquidity-producing institution, the Internet. Statmux is one of the foremost features that makes both the fractional reserve system and the Internet superior to their respective predecessors — i.e., direct person-to-person lending and direct point-to-point telecommunications circuits). And in both systems, the potential for many independent, competing entities to apply statmux techniques to their own (monetary, data transport-bearing) assets, and to use that enhanced productive capacity to support the productive/entrepreneurial activities of many (more) third parties is what makes these two liquidity systems in particular so dynamic and attractive — it’s why they each ultimately swept the field of competitors, resulting in the world of ubiquitous fractional reserve banking and packet-switched data exchange in which we live today.

    Unfortunately, this particular mix of elements also gives rise to the same basic, and probably unavoidable systemic risks in both domains. In the presence of serious competition, liquidity providers will inevitably face private incentives to oversupply (or at least to overpromise) liquidity, while in the absence of competition, they often face private incentives to allocate their resources elsewhere, or perhaps to internalize them and enter other markets directly, rather than bankrolling others’ endeavors. The risk of insolvency for an individual liquidity provider (financial or digital) is not the only reason for reserve requirements to exist; they also help to keep the entire economy from constantly tipping into or oscillating between inflationary and deflationary extremes. In addition, the collateral requirement for the existence of a neutral authority capable of monitoring and enforcing such standards also makes it possible for a common liquidity mechanism to exist and be shared across all economic agents within the same scope of authority; without that — or alternately, the existence of absolute, universal, continuous transparency of liquidity provider balances (or perhaps an even more fundamental/less likely improvement in human nature) — it’s not obvious that any durable liquidity-intermediation function could even be established.

    So while it may be demonstrably true in economic theory that a pure “credit-based monetary system” composed entirely of diverse private currencies, merchant credit extension arrangements, and other private liquidity instruments would be superior to the current imperfect arrangements, in practice (and history, c.f., the various “Free Banking” moments therein), that truth is far less apparent.

  7. Hey Statsguy.

    Are you basically saying that the future productive capacity of the system will never be enough to pay back the sum of its liabilities meaning that running a Casino is the only option left? Is a brutal financial collapse the only way out (as opposed to a controlled deflation?) Did the World only recover from the Great Depression thanks to WW2 and the wholesale physical destruction of most of Europe and Japan?

    If the present system is to endure.. should I not be able to walk into Goldman Sachs and ask them to lend me $80 million so I can make Hydrobeef – about a distopian future that depends on hydroponic cows – and then let them find “investors” who would like to bet against me?

  8. Finance IS like quantum mechanics in reverse where the Law of the Land no longer applies once institutions reach a certain scale.

  9. I don’t understand this article, so many ideas. FWIW, we typically say the real risk free rate is a pure time premium (time value of money) before any liquidity premium, term premium. (no risk except waiting)…beyond that, you lost me.

  10. the pragmatist

    What Statsguy doesn’t fully explore is the effect the “expected” 8 percent return has on CEOs and other managers of companies outside the financial sector. Of course this is not the point of the piece, but these managers feel a great deal of pressure to achieve this kind of return. This motivates them ton engage in behaviour that is often bad for society.

    For example. In the food industry they have discovered that the more they process the food they sell the more money they can make. This can be great in terms of convenience, but it help moves the consumer ever farther from fresh food nad ocally produced food and towards products that require enormous amounts of energy to process and transport and which require artificial additives to supply neccessary nutrients.

    At least as bad is that managers spend much of their time trying to manage the price of their stock, rather than managing the business that creates real returns. Big name investors often push comapnies to buy back their own stock. This requires considerable time and effort, but does not contribute one thing to the products the company makes or the profits that arise from them, all it does is increase the stock price.

  11. Indeed, quantum mechanics function well within a finite vacuum,a nutured controlled environment predicated upon the parameters of spectrum analysis. Alas,…what happens with a spectrum-fadeout,and the experiment implodes….as is the paradox today!

  12. Technically speaking, StatsGuy is correct. But then again, we run a society, not a time-bomb. That means our banking&insurance companies ought to put the money it rakes from us back into investments–this is the unwritten social contract of the place where people hate direct taxes.

    Unless our society has grown so dysfunctional that the economy has no place to grow and the bankers learned this before anybody else.

  13. Leaps! Yes,… LT Leaps ironically are the equalizer – the common denominator that most retail investors neglect,and for that matter the fund managers for its cost,picks their pockets.

  14. Say I want a loan, and the bank asks what my collateral is. I say, “My house.”
    Say the government sees GS with all these leveraged instruments and says, “Where’s the collateral?” And they say, “Here, we have insurance.”
    Well, the house has been assessed. Have the complex instruments been assessed?
    Worse, is there any true value anywhere on the planet behind the IOU that is under the microsope? Does AIG own an island or so it could sell off in a pinch, to back up the assortment of bundled mortgages if they defaulted somewhere up the line?
    Say that fictitious money is considered true collateral. So I tell the bank I have such and such a fund of monies available to me, but no house. I just mention this here because no bank has ever asked me about financial assets, only about real estate. It’s as though they, of all people, don’t count paper assets. And it makes me doubt that requiring banks to limit their risks by requiring actual holdings (Schroedinger’s cat in their vault) makes any difference.
    We could tell them that “my true value is my skills and capacity to earn money.” The rest I own can burn: paper, or plastic. This is the only good approach I’ve been able to find to the “discount rate mismatch,” so far. (You gamble or you fall behind; no point in planning.)
    Capitalism is using me, not vice versa. I say thank you and pay my taxes, as someone here puts it.

  15. Dear Statsguy–

    Why don’t banks worry about unforseen events like the rest of us? Like you say, we worry, so we require higher rates of return. Your argument is that banks don’t, they’re brave like Col. Jessep. So no problem if they make bad loans, or take on massive interest rate risk (what’s gonna happen to the short rate when you’re getting 3% on the other side for a long period?), because they’re so manly, so tough they can do it. We need them.

    But actually they only do it because they have the government put. Because they believe the government will stand behind them, if, oops!, their required rate of return wasn’t high enough, ex post.

    Cute post though. Love the Schroedinger’s cat analogy. But the apologia for GS is a bit much.

  16. StatsGuy wrote…
    “But how can money be in multiple places at the same time? Simple – because you think you have the money, the bank agrees, and so does everyone else – and since everyone believes it, it’s true.”

    Oh how wonderful that our entire economic/monetary system is now no more than another form of religion predicated on yet more baseless and nauseating belief. Pardon me while puke! At least those chunks have substance, are tangible and require no “belief.” I guess when Lloyd B. said he was “doing god’s work” he was referring to himself. This is a system that has failure and collapse written all over it and, as with any mythology, the sooner the better. Then someone can “test” the gods on Wall St. to see if and how much they bleed.

  17. Please elaborate how/why you perceive society currently “running in any sane fashion.” Your last line, and I have no doubt as to its veracity, seems to preclude any such “sanity.”

  18. Statsguy – excellent post…and using Jack Nicholson’s tirade in one of my favorite scenes in any movie is outstanding!! I can hear him saying the words while I reread it!!!

  19. Amen. Except maybe there are mountains of taxes, state and federal, that fall like magic out of the bogus profits.
    If “60 percent capacity” is the equivalent of the current state of employment — well, clearly credit default swaps do not boost employment, period, exclamation mark.

  20. Mr. James Kwak wrote:

    “The huge level of debt means that if nominal GDP growth fails to hit targets, the system may collapse spectacularly.”

    MONDAY, APRIL 19, 2010

    Greece: Bond spreads widen as Bundesbank President says Greece may need more aid

    by CalculatedRisk on 4/19/2010 07:21:00 PM

    An update on Greece: The IMF team was delayed arriving in Greece because of the ash from the Iceland volcano, meanwhile the Bundesbank president was quoted as saying Greece may need more aid.

    Also the German Finance Minister was quoted in Der Spiegel: “We cannot allow the bankruptcy of a euro member state like Greece to turn into a second Lehman Brothers.”

    From Bloomberg: Weber Said to Tell German Lawmakers Greece May Need More Aid

    Bundesbank President Axel Weber told German lawmakers that Greece may need more aid than the 30 billion euros ($40 billion) promised by the European Union as the government in Athens struggles to push through planned spending cuts, two people present at the briefing said.

    An interview with German Finance Minister Wolfgang Schäuble in Der Speigel: ‘We Cannot Allow Greece to Turn into a Second Lehman Brothers’

    Schäuble: [W]e have experienced a financial crisis from which we in Europe must draw a clear lesson: We cannot allow the bankruptcy of a euro member state like Greece to turn into a second Lehman Brothers.”

    SPIEGEL: You are exaggerating. In past years, it’s happened again and again that a country couldn’t pay its debts, and yet that hasn’t led to a collapse of the global financial system. Why should this be different in Greece’s case?

    Schäuble: Because Greece is a member of the European monetary union. Greece’s debts are all denominated in euros, but it isn’t clear who holds how much of those debts. For that reason, the consequences of a national bankruptcy would be incalculable. Greece is just as systemically important as a major bank.”

    http://www.calculatedriskblog.com/

  21. Son, we live in a country with an investment gap. And that gap needs to be filled by men with money. Who’s gonna do it? You? You, Middle Class Consumer?

    Well, actually this is exactly what happens. When the Fed lowers the interest rate to help banks fill the investment gap, all those average middle class Joes Schmoes end up subsidizing banks and other institutional borrowers with their lower yielding savings accounts. The fact that it happens without Joe Schmoe’s consent and understanding does not change the wealth-shifting nature of the story.

  22. Hey ColinC,

    It’s really not as mysterious as all that, and is certainly nothing so complex or counterintuitive as to merit comparison to quantum mechanics. “Statistical multiplexing” is actually a very well understood (and if used prudently, extremely beneficial) engineering method for optimizing the load or demand that one can safely place on a specific quantity of underlying resources. It’s the same technique that enables you and the rest of us to enjoy things like the Internet, the very existence of which would probably have been prohibitively expensive before statmux techniques were adapted to the data networking domain (ala “packet switching”).

    See for example:

    http://en.wikipedia.org/wiki/Statistical_multiplexing

    http://www.cargocultist.com/?p=594

  23. Middle class America can, for the most part, continue to pretend they’re middle class for the moment. That will continue to deteriorate if we keep going the same route we’re going and don’t get banks under control. For the moment, it is sane, as precarious as that sanity might be. To reach sustainable sanity, people at all levels of society will have to make sacrifices. Less credit, less insane gaps between wealthy and middle class, less perks and “stuff” in general. Nobody’s willing to make that sacrifice, which is the current insanity threatening to run us off a cliff. (And from your question, I assume you were wondering if I was paying attention to that last fact; yes, I am painfully aware of it)

    However, were you to overnight try to fix the system to something that is sustainable in the long run, it would be equally messy. Possibly more, I’m not sure.

    Socially yes, we’ve been running insane for years. Home equity loans against vastly overpriced houses to finance vacations or buy jet skis. ARM loans on houses well out of our financial reach with teaser rates that jack to a payment you give up on the first month you see it. Maxing out one credit card then paying it off with another while continuing to buy crap built to fall apart in no time that we don’t need anyway…

    Financially, the insanity started to take hold a couple years back and is steadily threatening to become very permanent and far more damaging. It’s not too far gone yet, but it’s given us a prelude of what’s to come if we don’t quit building impossible societies on credit that will come due one day, and it’s close and ugly.

  24. CBS from the West

    Let’s look at this another way.

    As Per Kurowski has often asserted on this blog, in its earlier days, socially productive investments often require taking risk. If as a society we are unwilling to take those risks and make those investments, then our future must be one of decline and decay. But rather than facing up to that reality, we have concoted a finance system that creates the illusion of filling the investment gap. The “money” it invests is itself illusory and lacks any connection to real value: it is just one possible state of Schrodinger’s cat. So long as we all believe it is in a certain state, it works. But once belief falters the entire system implodes.

    Even if we find new ways to regulate bankers and limit their power, it seems that we must ultimately confront a more fundamental contradiction. If we are unwilling to take risks and invest real resources in our future, we can expect nothing but exploitation by those who would lead us with smoke and mirrors.

  25. This posting is unfortunately fraught with errors regarding risk-free rates, the concept of arbitrage and discounting. Given the length of my response, I have posted a critique at http://www.fragileequilibrium.com/2010/04/unusually-poor-posting-on-usually-great.html

  26. That was excellent, thanks.

  27. Quantum mechanics is a set of scientific principles describing the known behavior of energy and matter that predominate at the atomic and subatomic scales.

  28. Susan Jordan

    When will the White House contact Mr. Johnson for his
    advice?
    Those close to Mr. Obama should become objective and
    listen to Mr. Krugman and Mr. Johnson.
    Thank you.

    Susan J/ Ann Arbor, MI

  29. “What drives the Discount Rate Mismatch?

    Many things drive it – including behavioral and cultural factors that deter savings and encourage short term time horizons – but it’s worth noting that it’s built into modern institutions.”
    When considering governments, wouldn’t the DRM be driven by tax avoidance, especially of the oligarchs, sold to the general population via the seeding of distrust of the government, which found its greatest voice in Ronald Reagan?

    In order for the State’s employees to have a viable retirement, their union manages to negotiate adequate retirement benefits. The State’s oligarchs don’t want to kick in enough money to fund the retirement benefits, so they convince the legislature to let the State’s financial analysts take more risk. When it blows up, the oligarchs create a campaign to blame it on the greedy unions. Meanwhile, the non-union workforce of industry, not having the benefit of the expert retirement planning of the unions, settle for compensation packages that will leave them subsisting on social security if their primary investment, their home, goes boom. Of course, they have little choice since the government, at the urging of the oligarchs, manipulates the money supply/fiscal policies/immigration policies/trade policies so that the balance between the supply and demand for labor usually favors the oligarchs.

    If families and States weren’t always scrambling to make ends meet, via the oligarchs adequately supporting the systems that have provided them with so much, perhaps enough revenue could be dedicated to funding long term obligations that this synthetic financial realm wouldn’t exist.

  30. Where did the Federal Reserve get the authority to allow sweeping? It seems to nullify reserve requirements established by law.

  31. “•The huge level of debt means that if nominal GDP growth fails to hit targets, the system may collapse spectacularly.”
    May take car of itself if the other questions are answered well.

    “•The Discount Rate Mismatch problem is real – without relying on credit, how do we fix it?”

    Tax the oligarchs to provide an adequate revenue stream to the State so that the States don’t need to rely on unrealistic rates of return.
    Legislate a viable wage for the non state workers so that planning for their needs future needs is feasible. I haven’t looked at the per capita income for a while, but in 1996, a family of 4 would of had an income of $90,000 if they captured said amount. The problem is income distribution.

    “•Without the certainty of anticipated consumption, what will drive new investment? With the savings glut in countries like Japan, what will sustain global demand if the US decides to start saving more?”

    If you distribut today’s per capita income to each individual, you won’t have to worry about demand.

    “•If our under-funded pension and retirement funds can’t hit their 8% returns, how do they meet obligations (especially when those obligations are indexed to inflation but not indexed to life expectancy or medical costs)? How do we cover the federal debt if tax revenues fall?”

    Tax the oligarchs so that adequate revenue provides for the currently unfunded mandates, and redistribute the income will increase the tax revenue.
    Oh! Did you want something that can happen? On the other hand, if fantasy is working for the financial world, maybe we should fantasize a bit to find a better solution.

  32. “…but economists can demonstrate – mathematically – that this credit-based money system is far more efficient than injecting money through the crude process of “printing” and government spending.”

    So the end justifies the mean?

    Why is “efficiency” to be valued more highly than anything else? “Efficiency” in this context is solely a value embraced by people living within a particular paradigm.

    I personally value justice, fairness, integrity, and well-being above economic efficiency. Call me crazy.

    AND I don’t care if the economy we currently have collapses in spectacular fashion. If you take away all the money and credit in the world, there are still people and natural resources…do we really need anything more? The financial system is just a social construct. Another can be fashioned – hopefully, it will be one that is fairer and better for society as a whole.

  33. “…but economists can demonstrate – mathematically – that this credit-based money system is far more efficient than injecting money through the crude process of ‘printing’ and government spending.”

    So the end justifies the mean?

    Why is “efficiency” to be valued more highly than anything else? “Efficiency” in this context is solely a value embraced by people living within a particular paradigm.

    I personally value justice, fairness, integrity, and well-being above economic efficiency. Call me crazy.

    AND I don’t care if the economy we currently have collapses in spectacular fashion. If you take away all the money and credit in the world, there are still people and natural resources…do we really need anything more? The financial system is just a social construct. Another can be fashioned – hopefully, it will be one that is fairer and better for society as a whole.

  34. Great post

    Stats Guy, do you think part of what puts stress on the system is the desire for instant liquitidy with true AAA safety of principle from depositors/savers/short creditors, while simultaneously investors require the outsized real return. The chasm between the two, as you call discount rate mis-match, is how the Goldman’s of the world earn their meals, and also forces them to take outsized risks to “jump the chasm”. Furthermore, this thirst from debt investors for AAA assets also lead to the over-creation of AAA secutiries (crap CDOs comprised of CCC individual mortgages, etc).

    Could part of this “chasm”, (or “mismatch) be addressed if the providers of funds (depositors, savers, etc), were willing to accept some of following:
    1. Less than instant liquitidy in return for AAA principle protection
    2. A bit more risk appetite among savers/debt investors – perhaps a willingness to take on AA debt in return for marginally better than returns than deposits.

  35. “The average life of the cash flows of pension funds is much better represented by 30-year Treasuries (which are yielding 4.7% – much closer to his stated 6% target) than by money market funds.”

    Much of that 4.7% is an inflation premium – 30 Year TIPS recently auctioned at ~2.2%. Pension funds often model 8% returns in determining funding needs.

    http://www.treasurydirect.gov/RI/OFNtebnd

    “The sheer fact that buying and selling is not occurring simultaneously (inter-temporal) precludes the possibility of arbitrage”

    Although I wish I could lay claim to the term intertemporal arbitrage, I know it at least dates back to Merton’s 77 article, and I believe is used in his book.

    Re the 5%/6% real rate – this 5%/6% (which is used in the risk adjusted net present value calculation) is often handled separately from failure risk in project planning. If we were to use a Hurdle rate, real-world values are typically much higher than 5%/6% – closer to 12%. For example of near riskless projects, in long term renewable energy projects (wind or solar installations), 6% real discount rates are used, even though the risk of project loss is negligible (due to insurance) and electricity rates may be guaranteed. So I do contend the 5%/6% is usually portrayed as the time value (a reflection of ‘opportunity costs’, due to the mythical abundance of high-paying alternative investments). But thank you for forcing clarity here.

    http://en.wikipedia.org/wiki/Hurdle_rate

    Moreover, although the monetary value of human life or electricity may vary over time, federal agencies are mandated to use certain discount rates.

    http://129.3.20.41/eps/othr/papers/9602/9602003.pdf

    “OMB’s Guidance requires using an annual real discount rate of l0 percent.” Under the Bush administration, I believe it was 7%.

    http://cyclingprof.blogspot.com/2009/11/new-oira-regulations-on-regulatory.html

    While there’s flexibility in the “real” discount rate applied to agency rules subject to OMB review, as a practical matter similar discount rates are indeed applied to quantities like human lives lost and electricity saved. The presumption is that government should only invest when it can achieve 7% (real) returns because that is the interest rate one could expect to get in “normal times” through low risk private investment.

    You are correct that in equillibrium we can’t have investors with a time value of money of 6% per annum (at the margin), but available investments only yielding 3% – they must be equal. If the market were allowed to clear without intertemporal arbitrage, this “gap” would indeed close, but the economy would be running well below capacity. One could look at the fact that Treasury currently sells 2.2% 30 year TIPS as proof the gap does not exist (someone is buying those notes), but this is actually a great example of banks filling the gap by creating money (recycling deposits) and holding long/safe/low-yielding securities on their books (with very generous capital requirements, courtesy of Basel and some creative financial engineering).

    On the flip side, one could argue that the secondary bond market would exist without banks, and this would effectively close the gap by providing liquidity to long term bond holders. In effect, an individual who would normally be unwilling to buy a 30 year Bond for less than 6% returns (due to short term needs) might accept lower returns knowing they could liquidate in the secondary market, however such an individual would find themselves exposed to extreme risk if the bond value drops and s/he needed to liquidate.

    By contrast, a bank can always just hold the bond to maturity even if its Mark-to-Market value declines, so long as it’s borrowing money cheaply from depositors (or other banks) and is not deemed “insolvent” by the FDIC.

    Let me close with some comments to address many other good points from earlier commenters –

    If we assume branks are truly risk-neutral (perhaps due to the government’s implied put, or risk-encouraging agency problems), then in the presence of a ZIRP, banks should arbitrage nearly the entire risk-adjusted return (the alpha). That would leave retail investors with nothing left but a decision to trade liquidity for risk – in other words, to invest in a pure casino.

    Sadly, although we hate it, society as a whole might be better off with the casino than with 25% unemployment. But that’s a second-best solution, which comes at a hideous cost – paying off a giant non-productive financial sector that benefits from government insured risk. Yet if we remove the government backstop, who funds the investments and provides expected consumption? Who closes the gap?

  36. “The money you deposit is lent out, then deposited by borrowers, then lent out again – many times over until it eventually sits in vault cash or on deposit with the reserve or in your pocket. We called this fractional reserve banking, and there used to be a limit on how far this cycle could go (the reserve ratio), but this limit was rendered worthless by technological innovations like sweeping, and Bernanke recently hinted at getting rid of it altogether.

    By pooling deposits and making loans, banks “borrow” from deposits at 0% and lend it for 3% …”

    At first glance, I don’t believe that is correct.

    I recommend this comment (Posted by: JKH | November 29, 2009 at 05:32 PM) at this link:

    http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/11/money-banks-loans-reserves-capital-and-loan-officers.html

    Basically, deposits are not supposed to be lent out as risky loans.

  37. “Yes, well, those are all valid concerns. But if there’s ONE THING we should have learned in the past 18 months, it’s that we the people are a lot less courageous when we’re facing unemployment, impoverished retirement, and foreclosure. It’s easy to curse Goldman Sachs and the credit-breathing financial dragon of Wall-Street, but what would we do without them when most people would rather consume or hold liquid cash than make investments in the future?”

    I consider that nonsense. How about stop price inflating with debt and start price inflating with currency?

    What % of the population can only consume because they don’t make enough in wages and corporate america/the rich/the fed don’t want them to get a raise?

  38. “You want the truth? You can’t handle the truth. Son, we live in a country with an investment gap. And that gap needs to be filled by men with money. Who’s gonna do it? You? You, Middle Class Consumer?”

    Really? Other than cheap oil, what is in short supply?

  39. “Goldman Sachs has a greater responsibility than you can possibly fathom.”

    More nonsense. They are only out for themselves and their spoiled, rich friends.

  40. “And that Goldman’s existence, while grotesque and incomprehensible to you, saves pension funds. You don’t want the truth. Because deep down, in places you don’t talk about at parties, you want us to fill that investment gap. You need us to fill that gap.”

    I don’t need goldman yacks/the fed for ANYTHING!!!!!

  41. “To the uneducated masses, replacing savings with credit may sound a bit frightening, but economists can demonstrate – mathematically – that this credit-based money system is far more efficient than injecting money through the crude process of “printing” and government spending.”

    It seems to me that you have bernanke/greenspan syndrome. You are assuming a supply constrained economy.

  42. From obama / white house link:

    “You see, the flow of credit is the lifeblood of our economy. The ability to get a loan is how you finance the purchase of everything from a home to a car to a college education; how stores stock their shelves, farms buy equipment, and businesses make payroll.”

    I don’t see any reason an all currency economy could not exist other than the “banksters” would make a lot less.

  43. StatesGuy Said:
    “. . . or, how finance is like quantum mechanics.”

    Quantum science, resting upon mathematics, is proven to be an incomplete science: (1) informally by Einstein’s complaint that its discipline that depends upon probability is absent a physical measurement of its complete phenomena and (2) that Curt Gödel, Alan Turing, and Alonzo Church each has proven, using different techniques, that the axiomatic method — the foundation of the mathematical discipline — though logically consistent, is nonetheless incomplete.

    In Curt Gödel’s proof there is a note #9 where he informs his reader that the metamathematics that he uses to support his proof is code that is set isomorphic to the mathematical formulas drawn from Principia Mathematica. Gödel’s proof does not maintain that isomorphy that he calls to our attention.

    There is in fact a language that does maintain that isomophy. That language is double-entry book-keeping.

    When the double-entry book-keeping framework of rules is properly coded, that framework maintains an isomorphy between the measure of value in trade, set isomorphic to the rights to that value’s ownership in exchange.

    ‘Double-entry’ is a system|language relationship. The first entry is debtor value that uses a cardinal number system to measures the cash-value in a trade. The second entry creditor rights that uses an ordinal number language to express the capital rights to ownership’s potential in exchange.

    Evidence of the isomophy used in double-entry book-keeping dates back to about 1340 A.D. It received major structural changed that sped up the data flow, while using the same isomorphic principle, in order to deal with the complexities of the industrial revolution. Software driven book-keeping now needs a commensurate structural advancement today in order to track global trades whose data is moving at the speed of light.

    I have not seen a software driven book-keeping framework, other than the prototype model that I programmed myself, that includes the Gödel isomorphy.

    Isomophy introduces a formal science of control, set complementary to mechanical science. Only when the isomorphic relationship between the measure of cash-value in trade is set equivalent to the expression of ownership’s capital-rights in exchange, will commercial trade be following a provable science.

    What we have today is half-baked book-keeping. Ordinal numbers, typically used in derivative bets, are being treated as if those numbers are measuring a right to ownership as real value. Probable numbers are ordinal numbers expressing potential and not facts.

    What half-baked book-keeping fails to include in these transactions is the taxpayers guarantee that has allowed ordinal expressions to be translated into cardinal values, when the “house” cannot cover the bets.

    This is a failure of science: no math person has yet come forward with an understanding of a complete system|language relationship that is essential in a computer driven culture. To get the science right we need to bring book-keeping out of its traditional folk-science roots and into its proper place in the scientific tradition.

    How did finance became “like quantum mechanics.” Both disciplines are ignoring fundamental principles of science.

  44. Pragmatist,

    Good addition to the discussion. I’ve seen, first hand, what managing to a company’s stock price can do to sabotage the real interests of the company’s performance. Key decisions are made on a 90-day cycle rather than managing toward best longer-term goals. I think this has been a key catalyst to the dismantling of lots of what used to be US industry.

    It always bothered me. My simplistic view said the stock was sold to give the company money it could use to grow. But the 90-day feedback loop seemed to be really hurting long-term decisions.

    I had the sense that earlier in the 20th century, the bargain worked better.

    Sitting here tonight and thinking after reading your contribution, it just occurred to me that our biggest problem may be the giant growth of computers and the internet since the 80’s. Before they became commonplace everybody couldn’t examine the fine details of many companies on such a short time scale. Likewise the magic models would not be usable to create derivatives and especially complex, twisted, non-productive ones like collapse-feeding CDOs.

    Maybe what we really need to do is become Luddites or at least add some damping or slowing of the information system so that the instant and exact monitoring or over-trusted modeling can’t explode into systemic cancers.

  45. Yes, this is just the latest of many variations on that “Few Good Men” speech (starting with the original) which I rejected from the first sentences since I reject the basic premise underlying all of them, that America has to be this globalized, financialized entity building a Tower of Babel of consumerism and exponential debt.

    Dump that noxious premise and you can dump all versions of Colonel Jessup.

    I personally value justice, fairness, integrity, and well-being above economic efficiency. Call me crazy.

    I call that human.

    And the kicker is that the global debt economy isn’t even efficient. That’s simply a lie. What’s truly efficient includes robustness, resiliency, and simplicity.

    The only way globalization and financialization have been able to masquerade as “efficient” was by ideologically narrowing the definition to obsess only labor “costs”, and on minimizing these, while socializing or otherwise externalizaing all other costs, and not counting looting and vandalism as costs at all, simply lying all the way. Not to mention that it was all based on the one-off, utterly unearned, drawdown of the fossil fuel stores. Now that we’re reached Peak Oil, we’ll start to see how “efficient” this energy use really is. (Obviously the real measure of anything’s viability, sustainability, efficiency, shall be how it holds up as the fossil fuel blip descends and history returns to its normal course.)

  46. Thank you for filling in the technical details for my intuition, by describing just how thin the ice is getting as the economy thaws. Schroninger’s Cat, eh, yeah, no doubt about that analogy. The old saying, “follow the money” has never been more of a truism in the world dominated by the likes of Goldman and the Fed. I have really remonstrated at the Republicans for consistantly offering the tax cut as the only logical option to cure our fiscal ills. But, what you have presented here is actually a glorious argument against tax cuts as a way to spur growth. No, the problem is, so long as Goldman and the others can play the capital vs. asset game by changing accounting rules, political contributions and lobbies, and continue to churn the endologous money supply solely under their roofs, then the benefit of the creation of that does not spread through the economy but remains under lock and key, tied up by the greedy villians of finance. And, yes, in the past month I received 18 cents interest on my savings. But I am sure the my money achieved a very handsome return for someone, and not someone who would be a regular taxpayer, but be somewhere in the class paying a reinstated rate for next year as Bush’s tax cuts expire.

    I can just see some whitty tea bagger with a placard reading: Free up the Endogenous Money Supply!! So long as this goes on, the Fed will continue to lend to the villians at near zero interest so they can churn mammoth profits while we “eat cake?”

  47. Very clever argument, Stats Guy.

    However, IMO Dan Palanza’s argument is much better…

    From the daughter of a physicist

  48. From Dan Palanza’s argument
    Quantum science, resting upon mathematics, is proven to be an incomplete science

    Quantum mechanics and its relativistic extension, quantum electrodynamics, have proven to be the most precise physics theories ever created (see, e.g., http://en.wikipedia.org/wiki/Precision_tests_of_QED )

    Armchair philosophers can continue complaining about its philosophical shortcomings, but quantum mechanics remains the most precise practical tool describing the physical world.

  49. That’s Communism!

    If we cannot buy stuff we do not need and probably do not really want with money we definitely do not have we might as well just become Commies and be done with it!

  50. States Guy Wrote:

    “If I were to ask you where the money in your savings deposit account is, you might say at the bank. That is not quite right. In truth, your money is in several places simultaneously. In this sense, finance is like quantum mechanics. Money is like Schrodinger’s cat – you never know where it is until you actually observe it. (And if everyone tries to observe their money at the same time, that’s called a bank run.)”

    In a proper book-keeping, the assets side of a balance sheet is artifacts of value in the care and control of the entity. The liability side of the balance sheet is ownership rights to the potential in those assets.

    The issue of Schrodinger’s cat is directly related to Gödel’s incompleteness of the axiomatic method. One does not have a complete solution to an economic state until their is (1) a measure of value and (2) an expression of rights that validates ownership.

    The real-time measure of cash-value’s economic state is decided by a marketplace trade. That potential gain [loss] expressed as capital-rights, is the owner of those rights who was wise [dumb] enough to take the position of ownership.

    Schrodinger’s cat enters the equation as integral information when a scientist seeks a complete scientific truth, typical of the truth that Gödel found to be missing in the axiomatic method.

    The moral here is that both the mechanical interpretation of physical facts, as a science rooted in Newtonian physics, and the informational compilation of intellectual data, as the folk-science rooted in double-entry book-keeping, are simultaneously essential to a complete interpretation of unit-value set complementary to a compilation of boundary rights that ‘mark’ ownership.

    The entity owner getting screwed in today’s half-baked science of economic theory, is the taxpayer. We the people are letting the crafty play shell games with the monetary system we own.

    And, yes, we are having a very difficult time taking back control, where ‘control’ is the compilation of money’s changing ownership. In fact We The People may already be Schrodinger’s dead cat, but we simply haven’t the method in place to complete the calculation of ownership rights that we have given away to the hustlers.

  51. Valerie Gagnon

    Very complex yet not so much so. When bankers lend over a 30 to 1 ratio you have a predictable financial crisis in the offing.

  52. I think you are looking in the wrong place for the problem. SG claims that a paucity of real investment opportunity forces down interest rates and causes investors to reach for yield. But, it is the FED which is at the root of this problem: the Greenspan put, Bernanke’s perverse policy of paying 3% interest on reserves while maintaining a discount rate close to zero. For fifteen years, we have been subjected to a looting operation in which only banks and hedge funds have been allowed to make money. The markets are so structured that any time short term rates rise we have a crash. This problem is not caused by credit card loans or home equity loans or day traders working in their underwear. It is caused by regulatory capture at the highest level: Greenspan, Rubin, Summers, Bernanke, Geithner. All of them talk non stop BS while shoveling money into the banks. This is not being done so a few chumps can get car loans. It is being done to maintain an oligarchy.

  53. Well, today we have both the casino and 25% unemployment, and we are heading for another bubble and another crash.

    Perhaps you can explain why we got along without the casino very well up to at least 1990? What exactly has changed since then except the creation and enabling of a swaps and derivative market that only benefits the bankers and extracts rents from everyone else?

  54. Economists are typically employed by people focused on “sucess”. The oligarchs live in an alternate mental universe,“efficiency” is part of their vocabulary. Humanity usually gets crushed or there are the ovens.

  55. 30:1 does sound pretty far afield from what I assumed to be the norm in banking, and also from what I observed first-hand over years of using statmux (e.g., to calculate the quantity of network inputs required to support various sub-population of Internet users with relatively consistent/predictable medium-term inter-temporal demand patterns). However, for those who are still uncomfortable with the very idea of statmux/fractional reserve banking, it’s important to remember that in many contexts, including banking, it’s perfectly safe (always/invariably) to leverage or “oversubscribe” underlying resources at ratios that are substantially higher than 1:1. In those contexts, a failure to capitalize on proven statmux techniques would be needlessly and inefficiently deflationary — sort of like requiring every parking lot in country X to have enough space to simultaneously accommodate every vehicle that is in use by anyone for any purpose within country X at that time.

    The ratio above which asset over-subscription is unsustainably risky, and below which under-subscription is equivalent to hoarding are matters of judgment that have no legitimate basis outside of careful observation of demand patterns over time under varying circumstances. In other words, they are necessarily matters of direct experience and “technical” “expertise,” a.k.a. “know-how.”

    IMO the problems that we’re facing today are *not* due to a failure of that expertise per se, but rather to the co-optation and subordination of such experience and reality-based capabilities to a widespread dogmatic faith in patently absurd but incredibly convenient, self-serving theories about how individuals and markets work. The true believers have got to go, but in the end if general recognition of the benefits of experience and observation-based liquidity management become collateral damage of that purge, then we’re all going to suffer (even more) unnecessarily as a result.

  56. That’s the measure of the “free market”

  57. Like earlier posters, I love the Schrodinger’s Cat analogy… nicely phrased. The statmux analogy introduced by Tom Vest is equally apt as is the observation by others that 30:1 leverage leaves little margin for error in both statmux’ing and maturity mismatches.

    But I think Glen Garry’s criticisms are also on the mark.

    You lost me entirely with the implication that pension funds seek, or expect, 8% risk-free returns. Yes, pension funds balance expected future pension liabilities with current pension assets by assuming 8-10% portfolio returns, but these are blended results, consisting of debt securities with a wide range of maturities, plus equities.

    And when you refer to business plans with a 5-6% risk-free rate assumption, this can only refer to intermediate or long-term treasuries, which include a hefty time premium.

    According to my Ibbotson SBBI report for 2007 (the latest copy I have at hand) the arithmetic mean return from 1926-2006 for the following asset classes were:

    Inflation: 3.1%
    T-bills: 3.8%
    Intermediate-term Treasuries: 5.4%
    Long-term Treasuries: 5.8%

    Assuming that expected future returns are consistent with past experience, the expected nominal return on long-term treasuries is 5.8% and the expected real return is 2.7% (the nominal return minus expected inflation).

    I’m speculating here, but if you recently worked on a project that used a 5-6% “long-term, real, risk-free” rate, your client may have confused real and nominal returns.

    Your “Discount Rate Mismatch” theory rhymes a bit with the <a href="http://en.wikipedia.org/wiki/Equity_premium_puzzle&quot;“Equity Premium Puzzle”, which questions why historical equity returns are so high relative to the risk-free rate. Alternatively, one could ask why the risk-free rate is so low.

  58. Mr Blankfein, Say the same thing to you I would have said to Jessup……’we’ll take our chances without you, if the only way to take you is to take you on your own terms.’

  59. I have configured and maintained more than a few routers and switches in the course of administering LANs and WANs and, as such, possess a fair understanding of multiplexing, but thanks for the links. However, I was NOT alluding to anything as “mysterious” or “counter-intuitive.” Merely that it should be obvious from StatsGuy’s article that our concept of money, like any religion and probably quantum-anything, is [now] the product of some profound, and probably irreversible, neurological disorder. Originally, “money” was a representation of the intrinsic “value” of something. Based on the above article, your comments and the alleged “value” of the derivatives market, among other factors, that now appears NOT to be the case. As with any superstition or indemonstrable belief system there is no inherent merit or sustainability and, sooner or later, like Odin, Zeus and other fictional entities, will collapse under the weight of its own nonsense. Either that or kiss Homo sapiens sapiens good-bye.

  60. “the expected real return is 2.7% (the nominal return minus expected inflation).”

    This is a nice example of banks filling the gap. You are correct about the parallel to the equity premium puzzle – and note that for “risk-free” securities, banks can extend vastly greater leverage, and therefore supply the market with credit that holds down the returns. They are (were) not allowed to do that with equities because of liquidity risk.

    Much of the recent crisis might be laid at the feet of financial institutions trying to arbitrage the equity/real estate premium in a search for yield, and it’s noteworthy that Shiller’s PE index (currently around 21) still implies a nominal return of ~5%, commensurate with long term securities in spite of high risk (and suggesting that ZIRP-supported bank arbitrage has squeezed out the alpha, leaving only the casino behind, along with a highly depressed time-rate commensurate with Treasuries).

    To be clear about the 5%/6% in the plan – it was viewed as indistinct from the risk-free rate. The model was a 20+ year payout for an insured solar field, with possible state backing for loans. Likewise, OMB guidelines for their 7% discount rate do not instruct agencies to model in a risk premium, but rather to conduct sensitivity analysis and present a range of cases, nor are there provisions for reducing that rate when the outcome is highly certain. The 5%-7% rate is institutionalized.

    But you raise good points – I effectively assert that the bank-less social discount rate is ~5%/6% based on social practices, but we have no good market measure of it because any asset that is truly riskless is absorbed by 30:1 leveraged bank balance sheets that are funded by short term deposits.

    I accept your point about diversification of pension investments, but note that asset correlation arbitrage in the last 20 years has made their investments far less diversified than they thought. The dangers are high – witness intra-CDO correlations. The 8-10% returns they relied upon were generated during the years of Post WWII growth, Boomer 401k expansion, and ballooning debt.

    There are other options – Anjon Roy suggests principle protection (a form of loan guarantee) – but we need to recognize that the required scale of such interventions would be massive. Others might argue loan guarantees helped cause the mess (Fannie/Freddie).

  61. That is true Jake, but I suppose my real concern is simple: when this has the potential to get really interesting is when everything comes crashing down and the NASCAR-entranced masses can no longer buy bread. Will they riot? Will they, in an orderly fashion, decide to just ignore the system that’s been built on top of them and go on about their lives? I guess that thought tends to distract me from what’s going on behind the scenes in government fairly easy, since at the end of the day that’s who all this is supposed to be serving.

  62. I guess I should have mentioned: the only way I see any type of regulation or downsizing of the banks (no matter the specifics of it) taking hold is for people to accept a downsizing of their own lifestyles. They have to accept that credit has built a fake life that we, as a society, cannot continue to afford.

    The current immediate problem, most definitely, lies on the back end with entities like the fed. However, if America as a people don’t have the stones to man up and realize that cutting the beast off is going to force us to live more realistic lifestyles, then we’ll just get caught up in mass euphoria the next time a strong financial sector starts promising free money and deregulate everything again. If the large majority of Americans don’t use anger and outrage as a weapon where lobbyists use money, nothing will get changed for the good of the majority instead of the oligarchy. But to bring lasting change, that anger has to be honest: we have to see where our OWN fault in all this is.

  63. Earl Killian

    James, do you ever worry that the economics you describe is fundamentally unsustainable? Exponential growth in a finite world runs into limits in a most spectacular way. People acts as if those limits are thousands of years away, when in fact they are only decades away. (The hard limits are hundreds of years away, but one never gets to any substantial fraction of the hard limits.) Without growth we cannot have compound interest and debt, which are the basis for our economics. When growth begins to stutter and then falter, will we suddenly abandon debt? No economist can describe the system that would replace one based upon debt; isn’t that a bit of a worry? The historical answer to limits has been punctuated exponential growth; growth followed by a grand crash (e.g. the Dark Ages). Given the horribleness of the historical “solution” isn’t it strange that economists are not working on a non-growth economics?

  64. Hi ColinC,

    Actually, “original” (aka commodity) money was not representative of anything other than itself; gold and silver etc. were the benchmark (and in-band bearers) of value in and of themselves. However, even at that time — and after, when the circulating medium came to be a mere token of that other “real stuff” (and later still, when the monetary tokens once again ceased to be representative of anything concrete apart from themselves), the essential functional role/raison d’etre that the medium plays has remained unchanged. That is to provide *liquidity* so that all of the other product and service markets that comprise the economy can operate relatively smoothly, quickly, and efficiently. If money were ever to cease fulfilling that critical purpose, then it doesn’t matter how faithful it might still be as a representation of some other value source, or how handy it might be is to store wealth of set comparable prices — it will be dead.

    Hi ColinC,

    Actually, “original” (aka commodity) money was not representative of anything other than itself; gold and silver etc. were the benchmark (and in-band bearers) of value in and of themselves. However, even during the age of commodity money — and after, when the circulating medium came to be a mere token of that other “real stuff” (and later still, when the monetary tokens once again ceased to be representative of anything concrete apart from themselves), the essential functional role/raison d’etre that the medium plays has remained unchanged. That is to provide *liquidity* so that all of the other product and service markets that comprise the economy can operate relatively smoothly, quickly, and efficiently. If money were ever to cease fulfilling that critical purpose, then it doesn’t matter how faithful it might still be as a representation of some other value source, or how handy it might be is to store wealth of set comparable prices — it will be dead.

    As you rightly note, some myths tend to be very maladaptive; believe in them, and your chances of survival are substantially reduced. Others however are quite adaptive, if not essential to the persistence of complex systems. Having some familiarity as you do with network engineering, I could imagine that you might be somewhat skeptical of the so-called “end-to-end principle.” We both probably know of countless examples that clearly violate this principle, and yet a general underlying expectation (aka “faith”) that applications and services will generally work even across multiple independently administered domains is a necessary prerequisite for almost all Internet innovations.. and people do keep innovating…

    Belief in e2e roughly corresponds to what monetary historians and economists tend to describe in terms of the “acceptability” of a given currency, and just like belief in e2e, both it’s emergence and its persistence over time is somewhat mysterious, if not quite inexplicable. Acceptability seems to be extremely difficult to directly “engineer in” (at least based on the number of failures in monetary history as compared to the number of long-term successes), but considerably easier to squander away. I’m not sure sure that I’d be so quick to wish for an end to all such less-then-empirically-bulletproof beliefs in the current system, at least not until I had very high confidence that a more durable successor or fall-back mechanism was already in place. Otherwise, the conventional economy might end up in a situation like the one the Internet sector is now facing, with the only globally acceptable liquidity mechanism within months of depletion, albeit with 90% +/- of current liquidity industry members still on the fence about whether or not to adopt the long-established designated successor medium.

    Belief in e2e roughly corresponds to what monetary economics tend to describe in terms of the “acceptability” of a given currency, and just like belief in e2e, both it’s emergence and its persistence over time is some somewhat inexplicable, if not quite “irrational.” Acceptability seems to be extremely difficult to directly “engineer” — or at least the number of failures in monetary history seems to dwarf the number of long-term successes.

  65. (apologies all for the message garbling above — obviously the first and last paragraphs were not meant to be duplicated… if the BaselineScenario admins wanted to delete those portions, that would fine with me…)

  66. Home equity loans and credit card loans may be imprudent, but credit default swaps are insane. The difference is both qualitative and quantitative.

    You think it was ‘people living beyond their means’ that created two hundred trillion dollars in CDS contracts? Wall Street sells itself as an engine of economic growth. Actually it is a con, nothing else. The models are phony, the profits are phony, the justifications are phony. Only the bonuses are real. And of course the bribes to the politicians.

  67. The gaps or mismatches have been filled by:
    1. It is just a function of how we measure production and manipulate outcomes. In an economy where the basic goods accounts for probably less than 20% of the GDP, there are many ways to influence the outcome. Simply increasing the value of financial services by 10% will do. Are we better off? No. But is the GDP larger? Yes. Just think about the growth in the proportion of financial services in our economy then you see this point. Or government services. Or security serviecs. Our living standards have been deteriorating since the 60s and 70s. Most families have two income earners and are just breaking even. Yes, they all enjoy more financial services, government services, as well as all the “things” that are pushed on us. Somehow they say that the GDP grows on average 3-4% a year.

    2. Finding enough suckers to do work for us in return for our IOUs. Think China and the emerging markets. Our deficits have been purely consumption driven and therefore do not represent increase in our capital investment. So these IOUs are really just claims on the productions of our future generations that may or may not be endowed with the productivity to settle such claims. Falling dollars over the long term will settle it, but will also be matched by our falling living standards. So over the long term, you simply do not get the 8% return.

    3. Some of the expected returns (i.e. investments) will be destroyed. Think of pension destructions, Private and public companies going under. No overall 8% return. Regular destruction is a certainly, otherwise just think of investing $1 during the Roman period and compounding at merely 1%.

    4. Hope and pray for miracles, new energy sources, major scientific breakthrough.

    5. All the financial engineering and bank credits in the world will not solve the problem, they merely distort the measurements. There is always the chance that the foreigners will be willing to buy all these financial services from us with the IOUs. Financial services are needed for capital formation and as lubricant and carrots for the economy. Beyond that point, they become a net drain on the economy.

  68. “credit default swaps are insane” I fully agree with this statement, but think they are simply a magnified version of the unreality all Americans were trying to live in. The same “something for nothing” attitude that other Americans had, only with unimaginably gratuitous amounts of hubris and selfishness piled on top.

    The looting, via bonuses and payoffs did result in the looters holding real money when it was all said and done, but it was transferred to them via managing “money” that never existed. Overpriced goods and services that could only achieve their impossible “value” through the magic of credit people never should have gotten.

    I am not disagreeing with any of your statements. Indeed, I agree with basically every word you say. However, I am cautioning that ALL of us need to take a really good look in the mirror before we assuming just coming down on the current generation of thieves in the oligarchy will solve the problem.

  69. Stats –

    Thanks for the response. I think I understand what you’re trying to get at, but having re-read your original post and Glen Garry’s response (and your responses) I still think you’re referring to THE risk-free rate as if there’s no time or “term” premium related to the length of the loan.

    So, for counter-example, while banks may currently be paying approximately 0% on deposits, while lending out at 3% (overnight in the repo markets) I don’t see them offering 30-year loans at 3%.

  70. Well said.

  71. “Yet if we remove the government backstop, who funds the investments and provides expected consumption? Who closes the gap?”

    Very simple: we learn to accept that there’s far less investment and far less (or no) growth. The planet does not possess the raw resources to continually sustain the desired growth anyway. Humans learn to scale back their activities and stop trying to grow like bacteria with no self-control engaging in instinctual consumption that ultimately leads to their own destruction.

    Why is this option never on the table? Are we so blind as to think we’re exempt from the same limitations all other living creatures are?

  72. Growth has been sold by the plutocrats and their political stooges as an alternative to distributive justice. Consumers borrowed excessively because their real wages were gutted by globalization. The solution is not consumer self flagelation. That is like blaming women who are raped for wearing provocative clothes. Fashion doesn’t sell anything but provocative clothes!

    Do you think fortunes in the hundreds of millions, in the billions, are acquired honestly? They are acquired through financial monopoly, legalized looting, graft, outright fraud. One hundred years ago, everyone understood this. Today’s nonstop media propaganda has turned common sense on its head.

    We have REDUCED taxes on UNEARNED income. We allow global corporations to decide where their income is sourced, and most pay only trivial US taxes. We have a special preferential tax rate for hedge fund managers. We have eliminated estate taxes on monstrous fortunes out of sentimental concern for small business owners and family farms in the one to five million dollar class.

    Every word spoken on business or economics or taxes on every media outlet is bogus, corporatist propaganda. And the propaganda is working. Today people are terrified by rising deficits, but nobody suggests taxing the rich, the corporations, or reducing the size of the war machine.

    The Financial Reform Bill (Senate version) is 1156 pages of lipstick on the pig. Now, we have this daily political circus about whether or not it will pass. Don’t worry about it. The results will be the same either way.

  73. I am sorry I do not really understand what this post is all about… that we need banks? Has anyone here seriously doubted that?

    That capital is coward? It always is has been and will be… that is exactly why the market stampeded after the AAAs, only to discover these were fake.

    That false promises with respect to retirement funds are made? Well anyone who believes in that the system will provide him, for free and in a just and fair manner, 6 – 8 percent in real return, so he can safely save is fooling himself. That 6 – 8 percent if it existed, which it does not, would always be an average and he has no idea on what side of that average he will find himself. Some follow Paulson other follows Morgan Stanley!

    That Goldman Sachs might perform many good services? Absolutely, it might help to promote growth if there is room for growth, especially if regulators do not arbitrarily intervene in silly ways but, whatever …it is not in the business of “saving pension funds.”

  74. Re: @ RickK…..The game plan was to get the World Bank,or IMF involved from the beginning. The Germans were all too aware of the outcome but needed the little guys to help it through the reunification process (east&west)which is so, so long ago. The Germans are in control of Europe once again,….? “The “Pigs” will be slaughtered?

  75. Re: @ JS….. Mr. Bernanke (but I’m a hazy – read up months ago)

  76. Re: @ Mr.M…..unfortunately it’s incapsulated by “Dark Matter” that accelerates/rest in multi-direction unimpeded by gravity but is multi-dimensional whereas time has no factor ,married too N’th degree, alternate universes we call sporatic comatose-flashbacks de ie.)ja’vu,…?

  77. Re: @ Earl Killian…..excellent post (as long as the population increase/explodes we will have modern day inflation such is literally inscribed by inflation,….unfortunately, deflation holds true, but with dire consequences)

  78. The yeild curve creates equillibrium,it is a paradoxical fixed variable,…”that floats the boat so to say”,and conceptually…just works. It’s that simple. PS. The only constant in life is change?

  79. Imagine, for a moment, Mr. Blankfein losing his cool while ranting in Jack Nicholson’s voice . . .

    ‘Hey, listen guys, I mean, well, buyer beware, you know? You can’t take everything we say for the literal truth, yeah? I mean, we’re bankers! Didn’t you see the sign on your way in?

    What did you expect? Rainbows, sunshine and lolly-pops? We employ people on the basis that they’re self-interested, avaricious bastards, you know? It’s in the job description for chrissakes!

    ‘Jeez, are you all frikkin idiots? That’s it, isn’t it. You’re all frikkin idiots and now we’re meant to say sorry because you’re too trusting. Well we’re not saying sorry, so there.’

    ‘Hey, listen, don’t even get me started on trickle down. We create a frikkin’ Niagra falls of trickle down. We’re the goddamn rain-makers baby, we’re like heathen voodoo witch-doctors of wealth-creation. We’re out there man, doing all the real work, all that work you lot are all to stupid and lazy to do. We’re like some massive hunter-gatherer eating up all the world’s wealth and shitting it out for you to eat…

    You should definitely be grateful – yesterday I worked 10 hours for you lot! More thanks, less questions, yeah? I mean, without us, imagine what the world would be like. Nightmare.’

    (Taken from commenter Krump @ http://www.guardian.co.uk/business/2010/apr/19/goldman-sachs-defence-fraud-allegations#start-of-comments)

  80. CBS from the West

    Yes. Since the early days of this blog, I have been posing the same question. Why do we need debt(except in limited amounts for exceptional circumstances)? I have yet to see a response that does not rely on circular logic.

  81. markets.aurelius

    You forgot, “Did you use Repo 105s!? Did you use Repo 105s!?”

    “You’re goddamn right I did!”

    Brilliant, all the same. Well done.

  82. The problem is not so much that the logic of debt is circular, but rather that the logic of capital accumulation is quite linear, and tends to move in a consistent direction, often for very long periods of time.

    Things are changing, but at present it’s still too soon to tell whether the old economics of scarcity or the new economics of abundance will prevail. These days the effects of “Moore’s Law” and other broad manifestations of technological change are becoming both more pronounced and more widespread across product and service sectors. The Internet itself represents a (rather large) microcosm suggesting the shape of things to come, perhaps, in one possible future. At the most fundamental level, the “conveyance” technology (packet switching) through which Internet-based content and services are shipped from place to place and exchanged between interacting parties is equivalent to and indistinguishable from a serial duplication technology. As a result, the things that are exchangeable over the Internet are, by default, nonrival in the formal economic sense. Note that that doesn’t mean that that Internet-based goods can’t be wrapped with additional protections to make them excludable, but simply that excludability is no longer the natural condition, as it is with conventional goods and services — nor do such restrictions need to be imposed as aggressively or pervasively simply to keep the economy from grinding to a halt, as is the case in the conventional economy. Basically it doesn’t matter how many Baseline Scenario readers look at these pages, or how many times we download one of the linked files — or any other files at are accessible over the Internet; they’re never going to be depleted in any way by our cumulative acts of consumption. This fact, coupled with the accelerating exponential year-over-year growth in the ratio of additional network transmission capacity created per dollar invested means that, at least as long as the Internet endures, the age of “content” scarcity has entered the history books; it only persists today to the extent that it does because it’s very hard for many people to conceive of business models based on anything other than the controlled rationing of discrete, real or artificial scarcity-priced (i.e., “excludability-enhanced”) goods. But that is gradually changing.

    While this might sound farfetched or seem orthogonal to the current discussion, consider the possibility that many of the changes that have occurred within the mega-banks are likely the result of the same or very similar processes working the same sort of disruptive magic on the sphere of liquidity production. Algorithmic trading, the role of advanced communication, information aggregation, and computational processing technologies in providing the means to transform formerly simple-ish securities into complex revenue and assurance multiplexing instruments, etc. etc. I am not a banker, but from the outside it looks as if the use of such tools made it possible for institutions to conjure up any technical justification that might be required to support a potentially infinite quantity of risky credit allocations.

    Perhaps these new capabilities, in conjunction with continued technology-driven productivity gains in the conventional economy, will one day result in the sort of “cash on demand” world that you seem to be describing, or at least one in which the provision and distribution of monetary liquidity is more utility-like, as arguably it is in the domain of Internet-based “digital liquidity.” But it’s also (at least) equally likely that old habits will prevail and the migration of economic paradigms will occur in the opposite direction, transforming the Internet into a liquidity system that more closely resembles the present (and future?) banking regime. Today the jury’s still out, but the verdict may be returned quite soon…

  83. CBS from the West

    Thank you. This is very thought-provoking!

  84. @3-D

    I like what the economist Michael Hudson told the Latvians: Repudiate your debt (owed mainly to British, Dutch and Swedish banks), refuse debt serfdom, you are the victims of neo-Liberal junk economics.

    Ordinary American consumers (at one time they were called citizens) might be similarly victimized.

  85. “Herman Daly: Toward a Steady-State Economy”

    http://www.theoildrum.com/node/3941

  86. An excellent post, this reply also helps get at the main question I had after reading it. Namely, is the discount rate mismatch a problem because;

    – Real returns have fallen, but expected returns have not (if so, why the fall? Global Savings Glut? Structural economic issues?)
    – Risk appetite has fallen (is so, why? Aging population? Great Moderation induced complacency)
    – Expectations on returns have risen (Because of the Minsky-ish credit cycle illusions created by asset inflation)

    In other words was the credit cycle papering over changes in the economy we didn’t want to face, or causing them with an asset price feedback loop. I think you’re leaning in the former direction based on this reply, personally, I am still very much undecided.

  87. As I see it, all of the above, but especially that the expected possible real returns were always impossibly high… and that even before the new constraints such as aging, climate change and energy difficulties are considered.

    In many ways, as many misunderstood investors out there, we are not really looking at how much to grow but at how much we can avoid falling.

  88. Reminds me of the final scene in Three Days of the Condor.

    Higgins: It’s simple economics. Today it’s oil, right? In ten or fifteen years, food. Plutonium. Maybe even sooner. Now, what do you think the people are gonna want us to do then?

    Joe Turner: Ask them?

    Higgins: Not now – then! Ask ‘em when they’re running out. Ask ‘em when there’s no heat in their homes and they’re cold. Ask ‘em when their engines stop. Ask ‘em when people who have never known hunger start going hungry. You wanna know something? They won’t want us to ask ‘em. They’ll just want us to get it for ‘em!

  89. Nobody wants to tax the rich because they have unrealistic fantasies of being part of them. Nobody wants to make cutbacks because somebody ELSE should have to sacrifice. Nobody wants to stop the wars because they might seem “weak on terror”. And nobody wants to tax the corporations because they work for them.

    The propaganda is a magnifying glass for these thoughts… I guess you’re right on that one. And I already expected the reform will be just a show to keep the masses from revolting before the next rip off is complete.

    That’s the real problem in all this: the crime stays hidden until well after the patient is in the hospital bleeding to death. It is, in a horrifyingly amazing sort of way, a system that functions entirely in the favor of the men wishing to control it. This, despite the fact that all the disparate pieces are working (in many cases) towards what they think are their own interests, but actually turns out to be hurting themselves. Emergent behaviors that roughly match what they’d have everyone do if they could just control them directly.

    Were I an expert in the field of social dynamics, the whole system would be a fascinating study I wager.

  90. Does anyone take into account that any system, no matter how well devised, will eventually become gamed by those who can? Systems need a reset and reconfiguration every now and then, ideally not too destructive.

    I am not sure about the cat analogies, but it seems to me that all economic models suffer from the same intrinsic inability to predict price, or willingness of buyer to accomodate sellerm and versa visa. Price is influenced by a multitude of factors, and the factors play on each other.

    It comes down to how we view human nature, and our belief in trancendent truth.

    For example, 3D’s comments are often framed by environmental concerns. But he neglects the possibility that they can be overcome and improved while, at the same time, improving the standard of living. While it is prudent to acknowledge limits, and be good stewards of earth, it does not automatically follow that a lower standard of living must be our fate.

  91. You are onto some bigger things there, obviously.

    From a different perspective, systems built on debt and inflation need indeed a reset from time to time. Deflation or worse…