economics

“The Big Takeover: The global economic crisis isn’t about money – it’s about power. How Wall Street insiders are using the bailout to stage a revolution,” by Matt Taibbi, in Rolling Stone:

In essence, Paulson and his cronies turned the federal government into one gigantic, half-opaque holding company, one whose balance sheet includes the world’s most appallingly large and risky hedge fund, a controlling stake in a dying insurance giant, huge investments in a group of teetering megabanks, and shares here and there in various auto-finance companies, student loans, and other failing businesses. Like AIG, this new federal holding company is a firm that has no mechanism for auditing itself and is run by leaders who have very little grasp of the daily operations of its disparate subsidiary operations.

In other words, it’s AIG’s rip-roaringly shitty business model writ almost inconceivably massive — to echo Geithner, a huge, complex global company attached to a very complicated investment bank/hedge fund that’s been allowed to build up without adult supervision. How much of what kinds of crap is actually on our balance sheet, and what did we pay for it? When exactly will the rent come due, when will the money run out? Does anyone know what the hell is going on? And on the linear spectrum of capitalism to socialism, where exactly are we now? Is there a dictionary word that even describes what we are now? It would be funny, if it weren’t such a nightmare. [more...]

And:
“No Return to Normal: Why the economic crisis, and its solution, are bigger than you think,” by James K. Galbraith in Washington Monthly.

The oddest thing about the Geithner program is its failure to act as though the financial crisis is a true crisis—an integrated, long-term economic threat—rather than merely a couple of related but temporary problems, one in banking and the other in jobs. In banking, the dominant metaphor is of plumbing: there is a blockage to be cleared. Take a plunger to the toxic assets, it is said, and credit conditions will return to normal. This, then, will make the recession essentially normal, validating the stimulus package. Solve these two problems, and the crisis will end. That’s the thinking.

But the plumbing metaphor is misleading. Credit is not a flow. It is not something that can be forced downstream by clearing a pipe. Credit is a contract. It requires a borrower as well as a lender, a customer as well as a bank. And the borrower must meet two conditions. One is creditworthiness, meaning a secure income and, usually, a house with equity in it. Asset prices therefore matter. With a chronic oversupply of houses, prices fall, collateral disappears, and even if borrowers are willing they can’t qualify for loans. The other requirement is a willingness to borrow, motivated by what Keynes called the “animal spirits” of entrepreneurial enthusiasm. In a slump, such optimism is scarce. Even if people have collateral, they want the security of cash. And it is precisely because they want cash that they will not deplete their reserves by plunking down a payment on a new car.

The credit flow metaphor implies that people came flocking to the new-car showrooms last November and were turned away because there were no loans to be had. This is not true—what happened was that people stopped coming in. And they stopped coming in because, suddenly, they felt poor.

Strapped and afraid, people want to be in cash. This is what economists call the liquidity trap. And it gets worse: in these conditions, the normal estimates for multipliers—the bang for the buck—may be too high. Government spending on goods and services always increases total spending directly; a dollar of public spending is a dollar of GDP. But if the workers simply save their extra income, or use it to pay debt, that’s the end of the line: there is no further effect. For tax cuts (especially for the middle class and up), the new funds are mostly saved or used to pay down debt. Debt reduction may help lay a foundation for better times later on, but it doesn’t help now. With smaller multipliers, the public spending package would need to be even larger, in order to fill in all the holes in total demand. Thus financial crisis makes the real crisis worse, and the failure of the bank plan practically assures that the stimulus also will be too small. [more...]

From TPM:

Earlier today, we highlighted some excerpts from a 2004 deposition given by Joseph Cassano, who was then the head of AIG’s financial products unit — the division whose massive losses on credit default swaps would later bring the company to its knees. But the story of the underlying case, as summarized at the time by a trade publication, is just as revealing as Cassano’s testimony.

AIG was being sued for breach of contract by a former employee, Rob Feilbogen. Feilbogen claimed that when the unit he worked for, AIG Trading, was put under the control of Cassano’s AIG Financial Products, he was informed in writing by an AIGFP executive that the company’s previous guarantee to pay him a bonus of $1.3 million would no longer be operative. Feilbogen said he was told he would still be eligible for a bonus, but the $1.3 million figure would not be guaranteed.

In a letter to Cassano, Feilbogen insisted on receiving his $1.3 million bonus. In response, Cassano played hardball, telling Feilbogen he could agree to the new deal, or resign. Feilbogen continued to resist, and was soon informed by an AIGFP lawyer that his employment had been terminated “as a result of his decision to resign.” [more...]

March 10 (Bloomberg) — Citigroup Inc. Chief Executive Officer Vikram Pandit said his bank is having the best quarter since 2007, when it last posted a profit. The shares rose as much as 27 percent and helped spur gains for finance company stocks.

“I am most encouraged with the strength of our business so far in 2009,” Pandit wrote in an internal memorandum obtained today by Bloomberg. “In fact, we are profitable through the first two months of 2009 and are having our best quarter-to-date performance since the third quarter of 2007.”

“I am, like you, disappointed with our current stock price and the broad-based misperceptions about our company and its financial position,” Pandit, 52, said in the memo, adding that the price doesn’t reflect the New York-based bank’s capital strength and earnings potential. The company had $19 billion of revenue in January and February excluding writedowns that have already been disclosed, Pandit said. [more...]

vs.

The Wall Street Journal reports that Citibank (C) has become the latest recipient of a government bailout – this one to the tune of $300 billion, or thereabouts, depending upon how you do the math which, in this case, appears to be quite complicated. [more...]

In my post about the the stock market bubble(s) of the past 15 years, I asked what kind of policy shift happened in the 1990s to allow such a significant change in stock asset valuation. The answer comes from Niall Ferguson, in this fabulous (and scary) interview in the Globe:

“Monetary policy evolved in a peculiar way in the 1990s towards de facto or de jure targeting of inflation, an increasingly narrow concept of inflation – core CPI. I thought it was a mistake at the time because it seemed to me crazy to ignore asset prices. Why differentiate? What’s the difference between pricing a loaf and pricing a house? Why do we care about one and not the other? In fact, we should probably care more about the price of a house than the price of a loaf, certainly in developed societies. I think there was a flaw in the theory there, that essentially you could call the Jackson Hole consensus. When the central bankers got together at Jackson Hole, the view that emerged from the debate in the late 90s was, we shouldn’t really pay attention to asset prices in the setting of monetary policy.” [more...]

Check this little gem of a tectonic shift, found in Wired’s The Netbook Effect: How Cheap Little Laptops Hit the Big Time (see page 3):

The Taiwanese firms, Shih argues, now have enormous clout in the PC industry. In the US, we regard branding and
marketing—convincing people what to buy—as core business functions. What Asustek proved is that the companies with real leverage are the ones that actually make desirable products. The Taiwanese laptop builders possess the atom-hacking smarts that once defined America but which have atrophied here along with our industrial base. As far as laptop manufacturing goes, Taiwan essentially now owns the market; the devices aren’t produced in significant volumes anywhere else.

If you had asked Taiwanese hardware CEOs a few years ago about their relationship with Dell, HP, and Apple, they’d have told you that the American companies did the branding and sales while outsourcing their design and production to Taiwan. Today the view from Asia is increasingly the reverse. “When I talk to them now,” Shih laughs, “they say, ‘We outsource our branding and sales to them.’” [more...]

Wealth ought to come from the creation of value. That is, by designing and selling a better shovel, you make it easier for farmers to dig irrigation trenches which increases their yield. With your shovel, their output goes from 100 to 200 units a year, and so you, as shovel-maker get to benefit from a proportion of that 100 increase. It’s “worth” giving you a cut, since your shovel added the value to their output. That, more or less, is the basis of capitalism. As time goes by, technology and methods improve, adding value, meaning we get more widget output per unit of resource input, and wealth increases.

There’s another way to make wealth though, which is easier: by cutting costs, or essentially extracting value. Cutting staff, for instance. That means you spend less money per shovel, meaning profits increase, for a while anyway.

The third way to make wealth is to borrow lots of money. The problem is, eventually you have to pay it back.

Value creation should be a long-term and sustainable wealth-generation technique; value extraction is a short-term, unsustainable wealth-generation technique. Borrowing to make wealth is probably the worst way, since it creates bubbles that burst.

I’ve been thinking about value vs wealth in the context of the global economic meltdown. I don’t have any answers at all but I am struck by the shape of the stock market curves for the past 40 years. Below is the S&P 500, between 1970 and 2009, a good proxy for the value of the economy.

It looks to me like there was a historically stable amount of value creation, reflected in the indexes, that for some reason in 1993/94 started to go a bit nuts. Two things drive it, I believe: low interest rates, meaning cheap debt flooding the market with money – corporate, personal, housing, financial; and increased global trade, namely with China, which kept prices and inflation low.

But it looks to me, based on this graph, that the wealth of the past 10-15 years was illusory, and that in fact the markets have dropped back to where they “should” be.

Does anyone have a better analysis of what happened in 1993/1994 when the whole thing started to go a bit nutso, in historical terms? I have a pretty surface understanding of financial policies, but this graph looks pretty telling to me.

As a start-up, I’ve complained about how conservative the Canadian business culture is, especially banking and finance. But boring has it’s benefits, when things get shaky. From Newsweek:

In 2008, the World Economic Forum ranked Canada’s banking system the healthiest in the world. America’s ranked 40th, Britain’s 44th.

Canada has done more than survive this financial crisis. The country is positively thriving in it. Canadian banks are well capitalized and poised to take advantage of opportunities that American and European banks cannot seize. The Toronto Dominion Bank, for example, was the 15th-largest bank in North America one year ago. Now it is the fifth-largest. It hasn’t grown in size; the others have all shrunk.

So what accounts for the genius of the Canadians? Common sense. Over the past 15 years, as the United States and Europe loosened regulations on their financial industries, the Canadians refused to follow suit, seeing the old rules as useful shock absorbers. Canadian banks are typically leveraged at 18 to 1—compared with U.S. banks at 26 to 1 and European banks at a frightening 61 to 1. Partly this reflects Canada’s more risk-averse business culture, but it is also a product of old-fashioned rules on banking. [more...]

Given that we lost 129,000 jobs in January alone, I don’t think it’s fair to say our economy is thriving. But certainly our banking sector appears to be in decent shape.

Speaking of which: 60:1 leverage in European banks? God help us.

When I worked at Prebon in 2000 (on financial/insurance products that would financing greenhouse gas reductions while hedging against the risk of greenhouse gas legislation), I remember trying to figure out the credit default swap market. At the time, it was a relatively new product, and it was where Prebon – a broker, not a trader – was making a killing. Generally in the financial business, new products are where all the profits are. Once your clients and competitors figure out what they’re buying, transparency comes into the market, efficiency, and prices/margins drop. But in the early days of a financial product, the margins are huge – because if you are offering something people want, and no one else is offering it, and no one else understands it, you can strip out enormous profits.

Anway, at the time the CDS market was pretty new and pretty hot. A credit default swap, nominally, is an insurance policy against the issuer of a financial product (say, a bond) defaulting. What it became was something else altogether, a massive commodity trading scheme where the underlying commodity (the CDS) had come completely uncoupled from the underlying assets. By the time things started collapsing last year, the CDS market was $30 trillion dollars. It’s a massive liability that no one’s really owned up to yet. NYTimes has a good article explaining things and asking when the next shoe will drop:

Any honest assessment must include the role that credit-default swaps have played in this mess: it’s the elephant in the room, the $30 trillion market that people do not want to talk about.

Credit-default swaps are insurancelike contracts that Wall Street created in the early 1990s. They allow bondholders to protect themselves against losses if a company or a debt issuer defaults….

Sellers of C.D.S.’s spent years raking in premiums while underestimating or simply ignoring the possibility of rising defaults. Regulators let the market grow unchecked.

In the end, far too much of this insurance was written at way too cheap a cost. Now, with Wall Street and the economy in tatters, the fear that already-hobbled financial companies may have to pay off huge amounts on C.D.S. arrangements hangs like a cloud over the markets.

C.D.S.’s have already figured prominently in taxpayer bailouts. The $150 billion rescue of the American International Group, for example, came about because of swaps the insurer had written on mortgage securities. And the $100 billion taxpayer backstop handed to Bank of America on Jan. 16 had a good bit to do with soured credit-default swaps that the bank inherited when it acquired Merrill Lynch. [more...]

Good, safe investment these banks, eh? The blue circle represents market capitalization of banks in Q2 2007; the little green peas are the same banks’ market caps in Jan 2009:

[via zig]

Canada’s feisty copyright lawyer, Howard Knopf, explores how good intellectual policy could help Canada thru the economic mess:

Most governments are now taking decisive steps towards decisions on and implementation of major stimulus/investment packages to rescue, resuscitate and even reinvent national and international economies. Canada, apparently, is going about this in its own way, with no such decisions yet announced. In Canada, things are actually getting “curiouser and curiouser” as we head towards a political crisis.

However, following the Rahm Emanuel maxim that “Rule one: Never allow a crisis to go to waste”, here are some bold ideas that would probably never fly or even be seriously considered in normal times in Canada about using IP and IP policy to help fix up the economy. Some of these would require legislation or regulations. Some would not and would only require sufficient leadership, will and skill at the political level – which are not necessarily any easier to come by [more...]

Remember when you thought $700 Billion was a lot of money for the US government to chip in to the economy? Now multiply by 10. From Bloomberg:

The U.S. government is prepared to lend more than $7.4 trillion on behalf of American taxpayers, or half the value of everything produced in the nation last year, to rescue the financial system since the credit markets seized up 15 months ago.

The unprecedented pledge of funds includes $2.8 trillion already tapped by financial institutions in the biggest response to an economic emergency since the New Deal of the 1930s, according to data compiled by Bloomberg. The commitment dwarfs the only plan approved by lawmakers, the Treasury Department’s $700 billion Troubled Asset Relief Program. Federal Reserve lending last week was 1,900 times the weekly average for the three years before the crisis. [more...]

[via Mike Cane]

What happens if (or, rather, when) China decides to stop financing US debt to create export demand for its manufactured goods, and instead starts to spend that money on creating consumer demand in China?

Peter Schiff gets it right in 2006/07 about the US economy, and gets howled off the stage by the other “experts.” What’s funny is how sensible his arguments are (there is no real wealth in the US, no production, no savings; just foreign & consumer debt), and how they are totally dismissed by the rest of the panelists.

(Mind you he got his gold call wrong).

[via Derek Sivers]

One part of the recent economic picture has been the too-cheap credit that has kept us all feeling really rich for the past decade. In the most famous story about this problem, cheap credit meant many people bought houses they couldn’t afford, and we all know what happened there. When the bad mortgage market collapsed – as it had to do, since it was built on fantasy demand – the housing market went with it, wiping out apparent wealth people had invested in their homes. Initially people here talked as if it was a problem specific to the USA, and that the Canadian real estate market and economy would be fine, since our banking and real estate sectors are significantly more conservative. The fundamentals of the Canadian economy were fine (whenever you hear that, you can assume the opposite).

The problem is that while our banking and mortgage systems might have been in better shape, the underlying demand for real estate is driven by the health of the overall economy. 30% of our GDP is generated by direct exports (not counting the significant spinoff economic activity that comes with those exports). 81% of our exports go to the ravenous USA. So, with a little bit of math you can conclude that if the US stops buying, Canada’s economy is up the creak.

And the problem is that the “cheap credit” problem was hardly confined to the real estate market. It’s in every bit of the economy. Credit was sloshing around everywhere, and that means spending everywhere: corporate mergers and acquisitions, new business, expansions, small business loans and student loans, car financing, luxury good purchases, lots of jobs for lawyers, accountants, and every kind of supplier to the big and little companies you can imagine, including web designers. Credit sloshing means we all feel rich, since there’s lots of cheap money to invest in new projects, lots of money and work to spread around.

But starting with the mortgage crisis, credit started drying up. All of a sudden the the rosy prospects for the whole economy contracted greatly. With credit expected to be no longer cheap, all the big spending ways of companies and governments and individuals, and all the VC money starts to tighten.

Imagine you have a platinum card, $100,000, and you spend accordingly, assuming you’ll be able to pay it off later. Then all of a sudden your card gets cut to a $1,000 limit. You’re going to spend less money: fewer trips, fewer gold necklaces, fewer iPhones. And each company that used to benefit from your largesse will feel the pinch too.

That’s why the stock markets have plunged. Because as each company’s credit has dried up, they are likely to buy less (services, materials etc). And since each company is likely to buy less, each supplier sees drops in their orders across the board. So everything is going down down down.

Since the stock market has long been a proxy for “health of the economy,” at least in the media, a shudder of terror went through just about everyone as the Dow, Footsie and TSX (and the rest of them) started to tank. But in some sense I get the feeling that people still think this is an abstract problem, with impacts on their RRSP statements, mutual fund holdings and stock portfolios, robbing them of significant paper wealth, but not quite linked to the day to day of life.

Of course it is: the result will be job losses across the board.

And then there is another problem: China.

While cheap credit was one reason we’ve all felt so rich the last decade or so, the other part of the equation is China’s manufacturing sector. Ever notice how cheap things are these days? You look at an item, say a BarBQ at Costco, and you just can’t figure out how something with so many components, materials, weighing tens of kilos, could have been assembled, built and shipped to you for such a low price. It often doesn’t make any sense, but we haven’t really bothered to care about that, we’ve just happily bought and bought more.

I worked for an environmental tech R&D company for a while, and one of our main products was a power inverter for alternative energy sources. A major part of the inverter was printed circuit boards. To get prototypes built here in Canada cost about $350 a piece, and took several weeks. To get the same thing from China too several days, including shipping, and cost $35 a piece.

That’s 10% of the Canadian price, and while I’m sure workers are paid poorly in China, I had trouble squaring such a price difference.

And the problem is that our whole economy is built on Chinese imports – of consumer goods sure, but just about everything now has Chinese components somewhere or other, especially anything in the hightech sector.

So if there is a problem in Chinese pricing, and if there is a real readjustment, then we’re all going to face the consequences. Here’s what Avner Mandelman has to say in today’s Globe:

You see, China, like Nortel and Japan and Soviet Russia, has been selling most things below true cost – which is the direct cost of production plus the cost of capital – and thus lost money on much of what it produced, and so destroyed much of its capital. A company that does so must eventually lay off workers and go bust. China, in my opinion, now faces similar risks, which Mr. Wen finally admitted.

Why does China sell below true cost? Because it is a dictatorship that wants to keep its restive people employed, and so, like (democratic) Japan before it, it keeps throwing good savings at bogus products. I say bogus because if you sell below true cost you create fictitious demand that otherwise wouldn’t be there had the product been priced realistically. Thus the large factory you built to satisfy the goosed-up demand cannot be rebuilt once it wears out because you didn’t include depreciation in the product’s price.

What this means is that we’ve been rich based on two simultaneous fantasies: cheap credit and cheap goods from China. But cheap credit eventually dries up, and the cheap goods from China have essentially been sold at below cost, meaning China’s whole economy could come tumbling down.

It’s hard to figure out how all of this will play out. After all, China owns much of the US’s debt, and China can only keep it’s economy going if the US keeps buying. So everyone has an interest in keeping the fantasy going, but the laws of physics, I fear, are going to get in the way eventually.

All that to say, things might be much worse than we think they are. I hope not.

How did we end up in this mess of an economic meltdown?

The answer is pretty simple: too much cheap credit, and no regulation of derivatives.

Probably more than any other individual, Alan Greenspan is to blame for both. He was Clinton’s and then Bush’s wizzard Fed Reserve Chairman, who waved the wand of reduced interest rates to keep the economic pump primed. Basically, Greenspan was the rich daddy who kept replacing junior’s maxed out credit card with a new one, but never really paid off the old ones.

And hence we are where we are.

Today, a mea culpa. Reports the New York Times:

Facing a firing line of questions from Washington lawmakers, Alan Greenspan, the former Federal Reserve chairman once considered the infallible maestro of the financial system, admitted on Thursday that he “made a mistake” in trusting that free markets could regulate themselves without government oversight.

A fervent proponent of deregulation during his 18-year tenure at the Fed’s helm, Mr. Greenspan has faced mounting criticism this year for having refused to consider cracking down on credit derivatives, an unchecked market whose excesses partly led to the current financial crisis.

Although he defended the use of derivatives in general, Mr. Greenspan, who left office in 2006, told members of the House Committee of Government Oversight and Reform that he was “partially” wrong in not having tried to regulate the market for credit-default swaps.

And:

Mr. Waxman pressed the former Fed chair to clarify his words. “In other words, you found that your view of the world, your ideology, was not right, it was not working,” Mr. Waxman said.

“Absolutely, precisely,” Mr. Greenspan replied. “You know, that’s precisely the reason I was shocked, because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well.”
[more...]

It’s easy to be popular when you keep handing out money. Not so easy to be popular once you’ve run out, when you have to admit you bankrupted yourself, and everyone’s been expecting more.

From the BBC:

Germany’s finance ministry has agreed a 50bn euro ($70bn; £40bn) plan to save one of the country’s biggest banks. [more...]

Washington Post reports, the Director of the Congressional Budget Office warns that the bailout could cause things to get worse. Why? Because it might expose how bad things actually are under the hoods of the world’s financial powerhouses:

During testimony before the House Budget Committee, Peter R. Orszag — Congress’s top bookkeeper — said the bailout could expose the way companies are stowing toxic assets on their books, leading to greater problems. [more...]

From Harvard professor of economics and former IMF chief economist, Kenneth Rogoff, in the Financial Times:

Were the financial crisis to end today, the costs would be painful but manageable, roughly equivalent to the cost of another year in Iraq. Unfortunately, however, the financial crisis is far from over, and it is hard to imagine how the US government is going to succeed in creating a firewall against further contagion without spending five to 10 times more than it has already, that is, an amount closer to $1,000bn to $2,000bn. [more...]

From the Washington Post:

From the rescue of Bear Stearns to the takeovers of Fannie Mae, Freddie Mac and American International Group, all the key decisions have been made by Treasury Secretary Henry M. Paulson Jr., Federal Reserve Chairman Ben S. Bernanke and Timothy F. Geithner, the president of the Federal Reserve Bank of New York…

As they chart a government response to the crisis, the stakes could hardly be higher. If they succeed, they could tame the economic downturn and orchestrate a restructuring of Wall Street with minimal collateral damage. If they fail, the toll could be millions of jobs, trillions of dollars in lost wealth and a crisis of confidence in global capitalism. [more...]

Meanwhile, on Planet Mars:

At a rally in Ohio on Tuesday, GOP vice presidential candidate Sarah Palin told the crowd that she’d head up energy policy in a McCain administration.

“John and I, we’ve discussed some new responsibilities that I’m going to have as vice president,” Palin said. “First, I’ll help to lead the mission of energy security.” [more...]

Fasten your seat belts.

See: this …

I wrote a little bit about the subprime mortgage troubles a few months ago, and mostly we’ve all forgotten about it. Generally Canada has been well-insulated from the troubles, and probably most people have yet to be touched by the crisis directly.

But anyone who thinks we’ve heard the last of it is wrong, I’ll bet, and anyone who thinks Canada will be fine if the US economy takes a real hit is even wronger.

Chris Penn writes about his concerns for the overall financial health of the the US of A in an aptly titled post: We really are in trouble in this country. This is just the beginning of it.

The United States doesn’t -make- anything any more. For the last 5 years, our economy has been driven by increases in asset prices, namely housing. People cashed out equity and spent like crazy, driving the economy forward.

All good things must come to an end, and we’re seeing just the first inning of the housing bubble unwind in a game that’s going extra innings. As prices drop, equity vanishes, and mortgage owners owe more than the property is worth.

…

Anyone who promises a fix for this situation that isn’t “we have to ride this out” either has something to sell you or is running for office. Don’t believe them. This financial crisis took years to make and it will take years to unmake.

If you want to figure out what is all the fuss about subprime mortgages and the economic turmoil they seem to be inflicting, BBC’s Robert Preston has a good extensive summary.

Here’s the bottom line: for the past few years, Wall Street has operated a giant machine for turning mind-boggling amounts of US home loans – which are hugely vulnerable to losses from fraud and the inescapable cycles in interest rates and housing prices – into supposedly risk-free investments for risk-averse investors in Asia, the Middle East and (as it turns out) for Europe’s big banks.

He doesn’t explicitly mention hedge funds, but these are behind much of the complex debt restructuring, slicing & dicing mentioned here.

From the Pessimism file:

I’ve always been skeptical of hedge funds and sophisticated derivative products. In theory these financial instruments protect against risk, by playing potential movement of the market in one direction, off of movement in another. It’s high-powered math stuff, and it’s made many many people truckloads, billions of dollars. But I don’t really understand it – though I was tangentially involved in the derivative business for a while. And it’s always seemed to me that hedge funds, at their base, are about getting money for nothing. That is, getting money without accomplishing anything. Still the house that Enron helped build has gotten bigger and bigger, and has become to some extent the underpinning of the entire global economy. Basically, it’s flooded the world with lots of cheap money. That sort of thing, eventually causes problems, because the laws of physics will always beat out the laws of the market.

And, according to Steven Pearlstein in the WaPo, the whole thing might come tumbling down.

As it all unfolds, we are learning several painful truths about the new global financial system, which until recently was widely lauded for its ability to price and spread financial risk to investors willing to accept it.

One lesson is that the sophisticated strategies employed by bank and investment funds to “hedge” risk may not be as reliable as had been thought.

In recent years, for example, banks and hedge funds created elaborate investment strategies built around the presumption that Bond A would always go up when the price of Bond B went down, effectively limiting potential losses. But in recent weeks, many such strategies began to go awry as markets for mortgage securities dried up and fund managers began selling whatever they could to raise cash to pay lenders. As a result, Bond A and Bond B began moving in the same direction, creating losses on both.

Another popular way for sophisticated investors to hedge their bets is to buy insurance against the possibility that a particular company or set of mortgage holders will default on their loans. But in some cases, this insurance policy, known as a credit swap, has been issued by hedge funds that themselves had taken on similar risks. If things go bad, a hedge fund may not have the money to uphold its side of the insurance bargain.

and:

Australian analyst Satyajit Das makes the point that the main achievement of the new financial architecture has not been to spread risk so much as it has been to expand risk by vastly increasing the amount of borrowed money. Making loans to buy bonds secured by packages of other loans makes for big fees and exciting work for bankers. But as Das predicted last year in his book, “Traders, Guns & Money” — and as we all discovered yesterday — if the supply of credit suddenly dries up anywhere in the system, the elaborate new structure they’ve created can come crashing down on itself.

And chances are you and I will get caught under that crashing system, one way or antother.

Scary stuff.