2008/10/14

Informational Cascades and the Financial Crisis

Mark Thoma posts an extract about Informational Cascades and the Financial Crisis from Wall Street's Lemmings, by Cass R. Sunstein, TNR.

To get a sense of how cascades work, imagine that a group of people is deciding whether to invest in real estate or instead the stock market. Assume that group members are announcing their views in sequence. From his own knowledge and experience, each member has some private information about what should be done. But each member also attends, reasonably enough, to the judgments of others.

The author wants to believe that things are so simple:

As behavioral economist Robert Shiller has shown, ... people were greatly influenced by a process of social contagion that amounted to an informational cascade. ...

This is just simplified version of the Tipping Point theory. My conclusion was:

For us Communists, the message is that the mass-marketing of selling the party newspaper and mass rallies is still important.

There are no short-cuts: no magic viral marketing campaign waiting to be unleashed once get to the right people. The tipping point is just an anarchist pipe-dream of an influential event that triggers a magical transformation of society. People can be panicked for a time but then revert to old habits.

As the evangelists keep pointing out, change starts from the heart and moves outward into the world.


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2008/10/12

Saving The System

The Economist wants to implement item #5 of the Communist Manifesto in Saving the System

Centralization of credit in the hands of the State, by means of a national bank with State capital and an exclusive monopoly.(Marx 1959, 342)

The magazine diagnoses the problem as:

... Today’s failure of confidence is based on three related issues: the solvency of banks, their ability to fund themselves in illiquid markets and the health of the real economy. The bursting of the housing bubble has led to hefty credit losses: most Western financial institutions are short of capital and some are insolvent. But liquidity is a more urgent problem. America’s decision last month to let Lehman Brothers fail—and the losses that implied to money-market funds that held its debt—prompted a global run on wholesale credit markets. It has become hard for banks, even healthy ones, to find finance; large companies with healthy cash flows have also been cut off from all but the shortest-term financing. That has increased worries about the real economy, which itself adds to the worries about banks’ solvency.

Emphasis Mine

Credit allows the early conversion of commodities into money. Instead of waiting for the goods to be sold to the ultimate consumer, and money returned to the manufacturer, credit allows for the partial realization of profits at every stage of the movement of goods from the factory to the consumer.

Credit, in itself, is not the problem: it is the management and allocation of credit among the various debtors.

In a banks run along capitalist lines, credit is allocated where the preceived profit is the greatest, not where the need is the greatest. The enterprise must do this in order to survive otherwise another enterprise with a larger capital base innovate and undercut it.

The negative feedback to this progression is risk. The higher the rate of profit should be correlated with the risk that the investment may fail. Government regulation tends to make banks aware of what types of risks they can undertake.

The specifics of the plan are:

This analysis suggests that governments must attack all three concerns at once. The priority, in terms of stemming the panic, is to unblock clogged credit markets. In most cases that means using central banks as an alternative source of short-term cash. This week the Fed took another step in that direction: by buying commercial paper, it is now in effect lending direct to companies. The British approach is equally bold. Alongside the Bank of England’s provision of short-term cash, the Treasury says it will sell guarantees for as much as £250 billion ($430 billion) of new short-term and medium-term debts issued by the banks. That is risky: if left for any length of time, those pledges give banks an incentive to behave recklessly. But a temporary guarantee system offers the best chance of stemming the panic, and if it were internationally co-ordinated it would be both more credible and less risky than a collection of disparate national promises.

The second prong of a crisis-resolution strategy must aim to boost banks’ capital. A new IMF report suggests Western banks need some $675 billion of new equity to prevent banks from rapidly reducing the number of loans on their books and hurting the real economy. Although there is plenty of private capital sloshing around, there is a chicken-and-egg problem: nobody wants to buy equity in an industry without enough capital. It is becoming abundantly clear that government funds—or at least government intervention—will be necessary to catalyse the rebuilding of banks’ balance sheets. Initially, America focused more on buying tainted assets from banks; now it seems keener on the “European” approach of injecting capital into their banks. Some degree of divergence is inevitable, but more co-ordination is needed.

Third, policymakers should act together to cushion the economic fallout. Now that commodity prices have plunged, the inflation risk has dramatically receded across the rich world. With asset prices plummeting and economies shrinking, deflation will soon be a bigger worry. The interest-rate cuts are an important start. Ideally, policymakers would not use only monetary policy. For instance, China could do a lot to help the rest of the world economy (and itself) by loosening fiscal policy and allowing its currency to appreciate more quickly.

Emphasis Mine

This is socialist intervention of a colossal scale but without taking control of the banks. The governments are intending to be passive investors which means that the risk of moral hazard increases not decrease (as noted above).

References

Marx, Karl. 1959. Capital, the Communist Manifesto and Other Writings. Ed. Max Eastman. New York: The Modern Library.


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System not immune to shocks

Heather Ridout, chief executive of the Australian Industry Group, says that the System not immune to shocks and urges a more socialist approach to the crisis.

The Federal Government has a vital role to play. Economic management has got a lot tougher and the Government should be ready to take up the slack in the economy as business investment and consumer spending retreats. It should prepare to bring forward key investment projects.

Perhaps the most difficult thing will be for the Government to keep an eye on the need for longer-term reforms in areas such as the federation, skills development, innovation, infrastructure planning and taxation. We may be in a period of crisis management but these require attention now if they are to underwrite a sustained recovery and a new era of prosperity.

Emphasis Mine

Back in 2005, BCA Admits Failure of Capitalism - Calls For Socialist Intervention. The on-going lies are about how Capitalism is the superior economic system (except when it goes down big time!) And yet, these business groups are all in favour in the government getting involved once the Capitalist system seizes up.

This free market ideology is unstable because of the positive feedback loops where investment follows profit not need.


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