Below is a provocative line of thought from an anonymous reader. It supports a gut feeling that I have been unable to prove, namely, that lowering of boundaries between markets (ranging from the large number of global macro hedge funds to the large number of retail currency speculators in Japan) is destabilizing. I’ve found the occasional supporting bit of empirical evidence (for instance, Kenneth Rogoff’s and Carmen Reinhart’s recent paper on financial crises, which found that greater financial integration was correlated with crises) but no theories. Conventional economic wisdom would tell you arbitrage is always and ever good (it supposedly improves price formation which leads to better allocation of capital), and inefficiencies are bad. However, complex systems theory provides a very different perspective:

http://www.nakedcapitalism.com/2008/05/hoisted-from-comments-greater-liquidity.html

Listen to this article The Financial Times reports that that $45 trillion figure that most of us have been using for the size of the credit default swaps market is woefully dated. The International Swaps and Derivatives Association will announce today that outstanding contracts now total $62 trillion, up from $34.5 trillion a year ago.

Institutional Risk Analytics gives some useful commentary on credit derivatives and the related issue of bank gearing, focusing on JP Morgan’s counterparty issues (and a sobering bit of Bernanke gossip):

http://www.nakedcapitalism.com/2008/04/credit-default-swaps-and-bank-leverage.html

Tin hats anyone?

The Madness of Ben Bernanke
By Gabor Steingart in Washington

The dollar is in a tailspin, the trade deficit is growing and a recession is on the horizon. The American way of life is in serious danger. But the head of the Federal Reserve keeps on pumping easy credit into the system — a crazy policy that will worsen the crisis. ….

http://www.spiegel.de/international/business/0,1518,547317,00.html

FED PLAN IS SPOILT BY ITS BACKING OF HYPOCRITES

Woe unto you, scribes and Pharisees, hypocrites! for ye are like unto whited sepulchres, which indeed appear beautiful outward, but are within full of dead men’s bones, and of all uncleanness. Matthew 23:27

Think of the main US banks and dealers, along with their regulators, as the Iraqi government – though without the same unity, purpose or long-term planning. The cash positions and liquidity of both are better now. The Iraqi government is not squandering its money on food for the ration system, medicine, electric plant or water treatment.

The US banks and dealers are through the first quarter, and are backstopped by a Federal Reserve that has gone from vestal virgin to camp follower. Some of the accountants would have appended the above quote from Matthew’s gospel to their opinions on the banks’ and brokers’ quarterly earnings statement, but it did not fit the guidelines of SFAS 157, the accounting standard.

It is not fair to say the Fed does not have a plan. It does. The plan is for the banking system to recapitalise for a new on-balance sheet world by raising a minimum of $200bn in a short period of time, not longer than two quarters. That way, there is no credit crunch, according to the model. A credit crunch, in Fed chairman Ben Bernanke’s own language, is: “A significant leftward shift in the supply curve for bank loans, holding constant both the safe real interest rate and the quality of potential borrowers.” ( The Credit Crunch , Brookings Institution, 1991) That means you can have a decline in the demand for credit as part of a business cycle without a “crunch”.

http://www.ft.com/cms/s/b70d152a-0a86-11dd-b5b1-0000779fd2ac.html

Sounds familiar:-)

Economies in crisis: There is a dearth of politicians able and strong enough to learn the lessons of history and keep banking in check

Ann Pettifor

In debates about the financial crisis – on the left and right – there are five oft-repeated economic fallacies.

The first of these is that ‘economic fundamentals are sound’ and that the crisis is limited to a finance sector previously celebrated as vital to prosperity but now somehow detached from the real economy. The second is that the crisis is caused by ‘turbulence’ in the housing market. The third: that the crisis was caused by low rates of interest, in particular monetary easing since 2001. The fourth: that the UK government was guilty of profligacy during the good years. The fifth: that we should remain fearful of inflation.

These fallacies arise because our leaders have not learned from parallels in history; and because they refuse to correctly analyse the long process that has led us to the end-game that is today’s systemic crisis.

The parallel with the Great Depression is frequently drawn, while parallel events that were the cause of the disaster are ignored. After 1918 policymakers liberalised finance under the banner of the gold standard. Winston Churchill reflected on the consequences:

http://commentisfree.guardian.co.uk/ann_pettifor/2008/04/economies_in_crisis_1929_once.html

“The financial sector must to return to its role as servant, not master of the global economy.”

Saving banking from the bankers

This week the world’s leading banks – represented by the Institute of International Finance – concurred with a conclusion long ago reached by the rest of the world: they screwed up, the credit crisis is largely their fault, and everybody else is suffering for their errors. The admission may not be enough to prevent a dangerous backlash.

Bankers may have realised, too late, the dangers of the banker caricature many people now believe. The popular perception is of an industry populated by clever crooks who manufactured toxic derivatives of subprime loans, repackaged them to look succulent, and sold them to greedy fools.

http://www.ft.com/cms/s/0/d912a4fc-07f5-11dd-a922-0000779fd2ac.html