Neoclassical economics

For examples of the kind of thinking which arises from these assumptions one need look no further than the IMF. I have been reading about "safe assets" and that is a topic which has interesting ramifications in itself. But here I just want to show the sort of language which serves to confirm those of us who are not economists in the view that it is all too complicated. So I am using the summary of their paper about safe assets as illustration of what I think is the problem. This is the document

www.imf.org/external/pubs/ft/gfsr/2012/01/pdf/c3.pdf

In the first paragraph it states that


What are we to make of this? It appears to say that sovereign debt was in the past presumed to be a risk free investment. That is interesting in itself: because the question then arises why they are a source of profit for the private investor. Vninect has questioned the idea that these people deserve their rewards because they are "risk takers": but if their money goes into a completely risk free instrument, there can be no possible justification for those rewards, can there? What the investor is doing is putting his money in the bank, effectively. When I put money in the bank I get some interest, and that is because the bank, in theory, uses my money (which is a loan to the bank) to make other loans to other people, and it charges higher interest than it pays me: that is where the profit comes from. What I do not do, is trade my bank book in order to make more money than the interest I get from the bank. How could I? As I see it, if I have surplus money I can put it into investment vehicles, which are risky but possibly profitable, if I guess right: or I can put it into the bank to keep it safe. I will get less but I will get certainty. Assuming the banks are safe, that is a trade off we are all familiar with, surely?

If I have enough surplus and I can lend to the bank for a long time I get more interest: that is because it is more use to the bank in terms of their own lending. That is sort of peculiar as well, because short term borrowing often costs more than long term borrowing. If we still think of money as somehow a commodity, then my long term deposit goes out to a long term borrower (say on a mortgage) and the return is relatively low: but the bank still makes a profit presumably, so the interest on my money is still lower than the bank gets from the mortgage it has advanced: and it gets that income for a long time. It can't lose because the mortgage is a secured asset, and so this part of the banking system is, or should be, the basis for seeing them as safe in the first place. If they take my long term deposit and lend it out for short periods unsecured (say on a credit card) they take the risk of losing some of it: but they charge enormous interest and make sure that covers the normal rate of default. That is the banker's skill.

So how does it come about that something which is equivalent to putting money in the bank becomes a source of profit? Well it is used as collateral. If I have put my money into a deposit account which only yields the higher rate of interest because I have promised to leave it there for 10 years, it might happen that I was wrong when I decided I did not need that money for 10 years: something might happen so that I do need it. If I close the account I will typically lose money (if I can do it at all): but someone else will lend me money because I have that account, and I will probably lose less if I do it that way. What I cannot do is sell my deposit account: because it is tied to me. Government bonds are not like that: they are not issued to individuals, they are redeemable by anyone. So they can be sold. If you sell them in those circumstances you save the interest on the loan you would otherwise take out: and forego the interest you were getting. Probably makes sense for you. But note that the bond is not now collateral. So what is it?

The paper says that "safe assets" wear a number of hats


That is one definition of money, as it happens: so the bonds become money at least in some circumstances.

You then have to consider why people buy and sell money: it is a strange concept, however you look at it. For you and I, we do it if we are going on holiday to a place where the money is different from our own: we buy dolllars in exchange for pounds, if we are going to america, for example. We lose on the transaction: always. If the rate of exchange is stable there is still commission for the person who makes the swop for us: and that is understandable. Stable exchange rates are a central aim of the IMF but of course those rates do vary from day to day: that is reported every day in the financial media. For you and I it means that sometimes when we go on holiday our holiday is cheap: sometimes expensive. That is really our only direct contact with this: but it is a source of profit for currency market traders, who can make millions buying cheap and selling dear.

One of the things which occurs to me about this is that the introduction of the euro reduced the scope for such profits: there were fewer currencies and so fewer opportunities to speculate in and on those currencies. There is a long history of such speculation and they have had profound effects on the real world: forced exit from the ERM was one example in the UK. One can argue that this was not pure speculation but just the actions of smart individuals who understood the realities of national economies and forced governments to face up to those realities: and that is a commonly told story. Or you can take the view that already markets were more powerful than national governments and that they made the weather: it was a self fulfilling prophecy in that view: and not a risk at all. That presupposes that the markets have more wealth than governments and that some individuals or corporations can use enough of that wealth to force an outcome: given that about half of the wealthiest bodies in the world are now corporations and not governments, that is at least plausible.

So I wondered about the fact that since the introduction of the euro,the focus has shifted from currency to sovereign debt. It seems to me that this is just more of the same. Money was not a "safe asset" before and profit was to be made because of that. In the euro that opportunity is gone, but it has been seized back through shifting the same process to government bonds.

When speculators attacked currencies they targetted one at a time: again it can be argued that this was based on a real appreciation of economic realities for the country involved and in that sense was not primarily focussed on profit at the expense of the people: that was just a side effect. I don't believe that, really. The reason I don't is that I cannot see any reason for the current attacks on sovereigns: as noted before, there is no real evidence that the problems we face are a consequence of government debt: at least not in the case of Spain or Italy. The problem is the banks, and so it would seem more logical for the markets to attack them. Bank borrowing costs should be through the roof: and indeed the LIBOR scandal is partly due to the fact that banks would not lend to each other at any price: so that seems to have some validity. Yet the cry is that this is a liquidity problem, not a solvency problem: and so sovereigns have lent very cheap money to the banks through taking over their debts; or through buying back bonds already issued (QE). This is because they are too big to fail. But with the debt transferred to the sovereigns it now appears that countries are not "too big to fail". And in all of this fortunes are made through the charging of ever increasing interest on government debt.

Which brings me back to the language in the summary linked.

Note this bold assertion


As we see, the billiard ball theory is alive and well in the IMF. But think about that. We are talking about the safety of assets here: in what universe is safety a function of supply and demand? A thing is either safe or it is not, surely? Perhaps what they mean is that the amount we are prepared to pay for safety is limited: that is true. We could probably make every car on the road a lot safer than it is: but it would cost a lot. So we trade off safety and price in many areas. Vninect has also talked about this in the context of crash helmets in ice hockey. And as he noted, regulation is required to reach a reasonable outcome. And there is nothing wrong with that at all. But for the IMF such regulation is called "market distortion". It is true that in the saner parts of the economic world it is acknowledged that "market distortion" can be a good thing: but in neoclassical economics it is a boo word.

It is quite interesting to note that the ratings agencies are not seen as a market distorter: they are merely objectively reporting the risk attached to various assets, in this narrative. That they did not accurately assess that risk and in fact were heavily involved in the crash for that very reason does not change this perception in any way. They were wrong and their ratings caused assets to be overpriced: but that is not "market distortion" apparently: and we are to continue to accept their judgements despite this abject failure. But when, in face of the consequences of that market failure to accurately price risk, we decide to demand more security or collateral for a given risk, that is market distortion. Excuse me if I tend to feel I am through the looking glass again. The market quite clearly did not "price risk efficiently": that is why we are where we are. Certainly there was some regulation so it can be said the market was not perfectly free: but the failure to price risk efficiently was inversely correlated with the level of regulation, so far as I can see. Correlation is not by definition causal: but it often is, as it happens. It would be folly to assume that it is not in this case: yet that is precisely what this piece implies.

And so we come to the conclusion of the piece: which is that better regulation, in the form of a demand for better collateral for the risks, will cause instability of itself. This is because there is a shortage of safe assets. And that is because the market and the ratings agenies say so. Assets previously seen as risk free are not: and so the supply has reduced. Regulation will increase the demand: so the price will go up. Apparently, in this case, that is not to be allowed. They say


And in face of that horror they recommend that


This is like saying that the trade off between the safety of bikes and the price of bikes cannot be altered too quickly: and if it is a matter of marginal adjustment you can see the point. It conveniently ignores the fact that these particular bikes do not occasionally suffer a brake failure: rather they frequently cause nuclear explosions in ordinary use. What do you think policy response should be?

As always with the IMF their recommended longer term solutions involve more austerity for the ordinary people; and more privatisation

But they are doomed to failure if they believe their own nonsense: because what they say they are trying to achieve is


That is bucking the market which they tell us cannot be done. in another part of the forest.