Wednesday, September 26, 2012

"The Next Panic" by Boone & Johnson

Very worthwhile piece in the Atlantic by Peter Boone and Simon Johnson. Don't miss it. Johnson is former chief economist of the IMF; currently, he is at MIT. Boone is an economist and money manager.

The nub of their position is that the natural order of things, economically, is a series of booms and busts. These periodically wipe out financial institutions and creditors. We have been spared most of this since the Great Depression, but the tools used to moderate the cycle have run their course. The financial bacteria are, one could say, increasingly immune to antibiotics.

Here are some key sentences, lightly re-ordered, to bring out the thrust of their article:
The on-again, off-again euro turmoil has already proved immensely damaging to nearly all Europeans, and its negative impact is now being felt around the world. Most likely there is worse to come -- and soon.
[O]ur financial systems appear to be returning to their inherently unstable nature, which plagued the 19th and early 20th centuries. Financial institutions back then were not too big to fail -- they were too big to save. 
Devastating crises characterized the pre-war global financial system; these would typically raze banks and other institutions to the ground. 
Through the development of central banks and active fiscal and monetary policy, the rich world has managed to avoid serious depression for seven decades. Yet big finance -- which tends to grow ever larger when crises are rare and credit risks seem muted -- hides deep political flaws.... 
Bankers and politicians seem to enable the worst characteristics and behaviors of the other. The past few years have led us to focus on half of that phenomenon: the degree to which government guarantees have facilitated irresponsible risk-taking on Wall Street.
[J]apan illustrates the other half of the phenomenon -- the extent to which finance has allowed and encouraged politicians to make attractive short-term decisions that are eventually damaging. 
Those whom the gods would destroy, they first encourage to borrow cheaply. 
In recent decades, financial sectors throughout the rich world grew at historically unprecedented rates; now they are dangerously outsize relative to the rest of the economy. Changing that dynamic in any orderly way looks extraordinarily difficult. Yet history suggests it will change, and soon. The era of large-scale, uncontrolled financial booms and busts -- last seen in the 1930s -- is back.
I advise reading, sleeping on, and re-reading their whole piece.

Are they right about the return to old-style cycles? I don't know, but they are raising the right issue. The older I get, the more I appreciate a well-formed question. Often, that is the answer. If capital-N Nature is, at some level, chaotic, then a well-defined set of possibilities may be the most we can actually know.

It is difficult to manage financial assets in a world in which people seem, almost continually, to use overly-optimistic assumptions. My tool kit would work better in the world they say we are heading into. And occasional forest fires are better for all than decades with no fire, and then a huge one that burns completely out of control. So, in a sense, I actually like the gloomy things they are saying.

My guess is that we will have more volatility than we got used to before 2007. Sovereign balance sheets are weaker. I doubt it will be as wild as the booms and busts of the 19th Century, however. I suspect that, in the long run, fiat currencies drain off some of the boom-and-bust energy into slower growth, bouts of inflation, and, in weakened countries, currency crises. Some of the energy; not all.

[Reflects a few edits on 9/28/12]