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Blogs by Erik Hare
Compound Interests 12/10/2007 7:49:43 PM
This week I’ve gotten quite a few letters, and I picked out one that I thought was fairly representative.
With the financial mess that we see, I think there are two problems with what you have been saying. First, hasn’t this all been hyped in the media already so we know all about it already? Second, the people in the banks and so on have a very big interest in sorting this out so why do you think that they can not or will not do it?
Great questions. I’m going to start by deferring a bit to Stephen Gross of Pimco, who is a widely respected money manager. He said recently,
“Forward-looking bond investors should understand that the shadow banking system has been built on leverage and cheap financing and that to keep it from imploding, a return to Fed Funds levels closer to those of 2003 may be required. While the Fed is not likely to repeat its 1% "deflation insurance" levels of that year, current Fed Funds futures which predict a 31⁄4% bottom are not likely to be correct either. Standby for a tumultuous 2008 as the market struggles to move from the shadows back into the sunlight of sounder banking and financial management, accompanied by Fed Funds levels at 3% or lower.”
My summary? This isn’t over, and it isn’t even priced into the market yet. In fact, I’m writing this on Monday night, before the Fed meeting. If we see a Fed rate cut of 1/2 point, you will know that they are indeed starting to panic. Starting. If they only cut 1/4 point, the Stock Market will tank – meaning that they are panicking.
That gets us to the second question, which was framed in terms of interest. I love it when people are looking at the interests involved, because that’s how you do a proper analysis of power. Why won’t the people with interests in this sort it all out?
I don’t think they can. It’s not just that the problem is too big, it’s that it’s been divided up in ways that no one has the ability to do something about it – and they would have by now if they could.
Investment houses tend to handle just about anything, but the people that make them up have to specialize. The world of finance has gotten so complicated that no one can pretend to understand all of it, so they don’t. If you handle something really boring like currency swaps, you might think that the subprime implosion has nothing to do with you. One day, however, you come into work at the dollar has dropped and suddenly your life is messed up bad – for reasons that you really don’t understand.
While it is very much true that it is in the investment houses’ interests to get control over this and fix it, it is also likely that they simply can’t. They don’t have control over enough of the variables to make it work. Investment has been separated into sectors that operate with a relentless industrial efficiency, but that is a very different thing from stability. Efficiency is a short term thing, stability requires long term strategic planning. They often, but not always, are in conflict.
The real problem here is that the tremendous number of new financial instruments that have come into being in the last 20 years has made chain reactions that influence every financial sector a very real threat at the same time it has made it impossible for anyone to understand those threats that are being posed. This is the first really big meltdown since all these fancy new tools came into being.
Which do you want in your nation’s financial system – efficiency or stability? You don’t always have to pick one, but do we really know when we’ve even made these choices, let alone what they mean? I agree it’s in the interests of the people with money, but it’s also in all of our interests. I promise you, no one really knows where this is going, regardless of all this deep and abiding interest.
So if no one even knows their own interest, let alone how to properly care and feed it, who has the power? Ah, that’s a topic for another day (when I figure it out, that is).
