Paul Krugman on Resilience Economics

On Paul Krugman’s Blog he presents a graphical model of the current financial crisis in the US that implicitly discusses how the system lost resilience. He identifies leveraged investments as a slow variable which can lead to the creation of alternative regimes, the possibility for a shock to flip the system from one regime to another, and now possibly a new regime.

Krugman RS

The other day I realized how much the Fed’s attempts to resolve the financial mess resemble sterilized foreign exchange intervention. That set me thinking about other parallels — and I realized how much the stories now being told about “systemic margin calls” and all that resemble the stories we all tried to tell about the Asian financial crisis of 1997-98. Leverage, balance sheet effects, self-reinforcing financial collapse — the details are different, but there are some clear common themes.

…Think of the demand for “securities” — lumping together all the stuff that’s in trouble, from subprime to Alt-A to corporate bonds, as if it were all the same. Ordinarily we’d think of a downward sloping demand curve. At a given point in time, there’s a fixed supply of these securities that has to be held by someone [Normal Situation]

But in the current situation, a lot of securities are held by market players who have leveraged themselves up. When prices fall beyond a certain point, they get calls from Mr. Margin, and have to sell off some of their holdings to meet those calls. The result can be a stretch of the demand curve that’s sloped the “wrong way”: falling prices actually reduce demand.

In this case, there are two equilibria, H and L. (there’s one in the middle, but it’s unstable) And this introduces the possibility of self-fulfilling panic: if something spooks the market, you can get a “systemic margin call” that causes the whole financial market to go to L, and causes a big, unnecessary price decline. [Highly leveraged investment]

Implicitly, Fed policy seems to be based on the view that if only they can restore confidence — with extra liquidity to the banks, Fed fund rate cuts, whatever — they can get us out of L and back to H. That’s the LTCM model: Rubin and Greenspan met a crisis with a rate cut and a show of confidence, and the whole thing went away.

But at this point a series of rate cuts and other stuff just hasn’t done the trick — which suggests that maybe there isn’t a high-price equilibrium out there at all. Maybe the underlying losses in housing and elsewhere are sufficiently large that the situation really looks like this [current situation?]

And in that case, the Fed can’t rescue the financial markets. All it — and the feds in general — can do is to try to limit the effects of financial crisis on the rest of the economy.

4 thoughts on “Paul Krugman on Resilience Economics”

  1. A thought I have about this situation is that perhaps the present form of capitalism is reaching the end of its Conservation or K phase in the Adaptive Cycle. It may be that all its energies are being put into massive take overs that exceed the take overs of the colonial era when whole countries annexed. In searching for increased efficiency are they not decreasing their flexibility and therefore their relience. Currency speculation may be another indicator. In 1997 2 trillion dollars was traded each day, real economy transactions accounted for 2.5%. I do not more recent figures to hand. It seems to me like most of the resources are bound up in the systems as most of the resourses in a mature forest are bound up in the trees.
    Perhaps we should be more concerned with how to harness and use the newly available resources when the economy moves into the Release or Omega phase. Ofcourse it is not essential that the system to move into the release phase it could return to a new Rapid growth phase. This later would require more wisdom and less greed than demonstrated to date.

  2. http://video.aol.com/video-detail/the-long-johns-the-last-laugh-george-parr-subprime/483770241

    A “sub prime” example of how the wealthy are destroying the world we inhabit ???

    Buddy, Can You Spare a Billion?
    By Dana Milbank
    The Washington Post
    Friday 04 April 2008

    Meet Alan Schwartz, welfare recipient.

    As the chief executive of Bear Stearns, he’s getting rather more public assistance than your typical welfare mom – specifically, $30 billion in federal loan guarantees to help J.P. Morgan Chase take over his firm. But then, Schwartz has had rather more than his share of suffering of late.

    As his firm collapsed, he was forced to forgo his entire 2007 bonus, leaving his compensation for the past five years at a paltry $141 million, according to Business Week. Things have become so bad that, the Wall Street Journal discovered, Schwartz has had to rent out his 7,850-square-foot home on the ninth green of a suburban New York golf course – leaving the poor fellow with only his 17-room, seven-acre home in Greenwich, his condo in Colorado and the athletic center he built for Duke University.

    Schwartz’s tale of woe tugs at the heartstrings all the more because he and his colleagues at Bear Stearns were, he believes, blameless for the bankruptcy of two hedge funds and the subsequent collapse of the 85-year-old investment bank. “I am saddened,” Schwartz told the Senate banking committee yesterday. He was saddened that Bear Stearns was undone by “unfounded rumors and attendant speculation,” despite its impeccable balance sheet.

    “Due to the stressed condition of the credit market as a whole and the unprecedented speed at which rumors and speculation travel and echo through the modern financial media environment, the rumors and speculation became a self-fulfilling prophecy,” Schwartz told the senators. “There was, simply put, a run on the bank.”

    Sen. Richard Shelby (R-Ala.) asked the corporate-welfare recipient whether he shares any blame for his indigent circumstances. “Do you believe that your management team has any responsibility for the company’s collapse?”

    Schwartz could think of no missteps – not even his decision to remain at a conference at the Breakers in Palm Beach while his firm was imploding. “I just simply have not been able to come up with anything, even with the benefit of hindsight,” said the blameless chief executive, escorted into the hearing room by superlawyer Robert Bennett.

    Fortunately for Schwartz, he had a sympathetic audience in the banking committee, whose members have received more than $20 million in campaign contributions from the securities and investment industry, according to the Center for Responsive Politics. “I want the witnesses to know, and others, that as a bottom-line consideration, I happen to believe that this was the right decision,” Chairman Chris Dodd (D-$5,796,000) said before hearing a single word of testimony.

    “You made the right decision,” Sen. Evan Bayh (D-$1,582,000) told the regulators who worked out the loan guarantee.

    “The actions had to be done,” agreed Sen. Chuck Schumer (D-$6,162,000).

    Only a minority of senators, particularly those with smaller pieces of the campaign-cash pie, dissented. “That is socialism!” railed Sen. Jim Bunning (R-$452,000). “And it must not happen again.”

    To the extent the lawmakers objected to the Bear Stearns bailout, they worried that the Fed’s actions would create a “moral hazard” – an economic term of art – that, as Shelby put it, “encourages firms to take excessive risk based on the expectations that they will reap all the profits while the federal government stands ready to cover any losses if they fail.”

    Shelby’s notion was a curiosity for the senators, who don’t often spend a lot of time worrying about moral hazards. No fewer than five other senators invoked the phrase. “I think the moral hazard was minimized,” Federal Reserve Chairman Ben Bernanke, one of the witnesses, reassured the senators.

    No moral hazard, however, would interfere with the lawmakers’ compassion for the beleaguered Schwartz and his fellow witness, J.P. Morgan Chase’s Jamie Dimon, who had given a combined $260,000 in political contributions in recent years – a small part of the $1.7 million their co-workers contributed in this election cycle alone. That’s a sizable handout – but a good investment compared with the $30 billion federal hand-up.

    “On behalf of all of us here on this dais, our sympathies go out to your employees,” Dodd told Schwartz after his opening statement. “There’s no adequate way we can express our sorrow to them for what happened. Obviously, shareholders, same sort of feelings, but obviously the employees particularly. It’s a particularly hard blow.”

    Of course, some might consider $30 billion an adequate expression of sympathy, but Dodd was apologetic as he gently probed Schwartz. “You both will have forgotten more in the next 10 minutes than I’ll ever probably understand about all of this,” he told the witnesses, but didn’t the irregular trading at Bear Stearns mean than “more than just rumors” were behind Bear Stearns’s demise?

    “You could never get facts out as fast as the rumors,” Schwartz explained. “It looked like there were people that wanted to induce panic.”

    Sen. Bob Menendez (D-N.J.) reminded Schwartz that two of the firm’s funds went bankrupt in 2007. “It caused concern, not only here but on Wall Street,” the senator said. “Did that dramatically alter your behavior?”

    Evidently not. “I’m not sure I understand the question,” Schwartz

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