When we do the same thing and expect a different result... (Financial Regulation edition)

There's a phrase that rather perfectly describes last week's big news on Wall Street.  I think I heard it for the first time on a Method Man track, but I think the origin might be Stephen King's book Dreamcatcher (which is about aliens that take over people's minds by giving them explosive diarrhea; I'm dead serious).  The phrase is SSDD (because I don't like to curse on here, you can Google it).

JPMorgan's massive basis trade blow-up that's cost it $2 billion (and possibly counting) has reopened the debate about the Volcker Rule and Too Big To Fail at the big banks.  Of course, massive trading losses are nothing new. A rogue trader at Soc Gen lost that bank a few billion.  Another rogue trader at UBS lost the big Swiss bank $2 billion.  A big directional bet on subprime lost Morgan Stanley around $9 billion during the financial crisis.  And that's just in the last few years.  The notable thing about this loss isn't necessarily its size ($2 billion for a bank the size of JPMorgan is a lot, but it's not life-threatening) or its nature (this wasn't a rogue trader; it was the investment office) or even its legality (details have been scarce, but it appears the trade was compliant with the regulations in place to this point).  What's really interesting here is it happened at JPMorgan, the banks that, under the leadership of CEO Jamie Dimon, has been leading the charge against financial regulation in the aftermath of the financial crisis.

The crux of Dimon's argument has been, essentially, that further regulation is unnecessary.  He proudly points to his own bank as a model of fantastic management, and began claiming that more regulation was unnecessary the instant the markets stabilized in the aftermath of the panic.  This loss blows a big hole in his argument.  Now, I've never really gotten the obsession with Jamie Dimon in the press and among pundits and politicians.  Sure, JPMorgan came through the crisis better than most of the other big banks (mostly because it shrank its subprime portfolio in 2006 rather than waiting for the markets to sound the alarm), but that's always smelled more like dumb luck to me than great leadership.  In all honesty, I haven't seen or read any great insight from Dimon, or seen any evidence that he's anything special as a leader-- most of the hype seems to center on him looking like a leader and being outspoken (where Lloyd Blankfein is short and looks like one of those bald aliens on Star Trek with the giant ears and wrinkled foreheads).

The details on the trade are fuzzy.  From what I can gather, the trade was in JPMorgan's derivative book, and their claim is that it was a "flattener" meant to hedge their overall credit portfolio (the bet was that short and long yields would "flatten", meaning shorter-duration bond yields would converge with longer-duration bond yields; generally, a flat yield curve is a bad sign).  But it looks like someone lost control of the trade and ended up with massive next exposure in one direction that went bad (at least that's the benign version; it could well have been an outright bet).  

Of course, Dimon is trying to minimize the impact of the trade-- he claims the press and politicians are "making a mountain out of a molehill" and it's not that big a deal.  And while he's right that the loss won't sink his firm, the fact is that $2 billion in a relatively calm market is a BIG loss.  The same kind of trade in a market like the one we had in the second half of 2008 would have put his company on the brink.  And that just makes the case for better oversight clear.  While I don't necessarily think that splitting up market-making and commercial banking is the solution, I do think that size is a problem.  And JPMorgan is enormous.  If this loss had been bigger, or even if it had happened in a more turbulent market, the bank would have been in line for a bailout.  And it would have gotten it because a bank with around $2.3 trillion in assets like JPMorgan can't fail without sending the economy off a cliff after it.  Lehman Brothers, which was about 1/4 the size of JPMorgan, less interconnected, and had no depositors, sparked a panic when it failed in September 2008.  JPMorgan is a few orders of magnitude bigger.

The point this makes isn't very complicated-- it's that, when someone like Jamie Dimon comes out and says that banks don't need more regulation because people like him are too good at risk management to make bad judgments that could require public help, the response should be, "Baloney".

European elections (a little late)

For the last month or so, I've been on an exam-mandated posting break.  The NBA playoffs will warrant a post sometime soon, but 1) all the injuries in the first round still have me a little depressed, and 2) that post will take more thought and research than this one.  So, European elections.  The most recent round of elections had what appears to onlookers to be a leftward tilt-- the Socialist Party won the presidency in France for the first time since 1995, and the leftist Syriza coalition has the opportunity to form a government in Greece now that the center-right New Democracy party failed to secure a coalition after willing a tiny plurality of the vote.

Much of the American left sees this as an affirmation of their principles.  I don't think this is right.  I don't think Europeans are voting along ideological lines the way most Americans do-- I think at this point, they're voting to reject the ridiculous austerity push that's destroying Europe.  What that means, I think, is that Europeans aren't voting for a bigger welfare state, for higher corporate taxes, and for a later retirement age.  There's already a pretty robust progressive consensus in literally all of those countries on universal health care, income security, and other issues that seem to divide Americans.  Rather, their vision for the short run (which, as Larry Summers has poignantly pointed out, can quickly crystallize into the long run if economies stay depressed long enough) differs dramatically from the proven failure that the governing parties provided.

A lot of fearmongering in the US comes, in particular, from those opposed to Hollande.  In particular, his proposal to hike marginal tax rates on millionaires to 75% is seen as class warfare.  Now, the rhetoric of class warfare is silly, but a 75% top rate is almost certainly bad economics (it might make sense, say, for incomes over $10 million, but for all but the mega-rich, a marginal tax of 75% is probably not good policy). But, as bad policy goes, I don't think it's catastrophic, even if it were enacted (which I don't think it will be; to me it smells like election-year pandering).  But in the US, there's a strong reaction to Hollande-- the political left sees his election as a vindication of activist government, and the right sees it as a disaster-- spoiled constituents turning to an irresponsible leftist promising a free lunch.

But, for me, the election is about neither; it's a typical election-year play, just like the 2008 election was in the US.  In short, when things are improving, incumbents get re-elected.  When they're deteriorating, incumbents get tossed out.  And in Europe, the situation is certainly deteriorating.  The root of that deterioration is the austerity imposed on Europe by the Merkel-Sarkozy axis in Germany and France; hopefully the French public's election of Hollande represents the beginning of the end for that destructive alliance.

For the Germans especially, the desire is to see the problems in southern Europe and Ireland as a morality play; the southern Europeans were irresponsible, and they need to pay for their irresponsibility with austerity.  There's a "necessary period of suffering" to restore the economies.  That's almost complete baloney.  The "almost" is in there because irresponsibility was the story in Greece.  But, as I've probably mentioned before, Spain had a substantially smaller debt burden than Germany, and a budget surplus in 2007.  Exactly what "irresponsibility" are the Spanish supposed to pay for? Ireland is a similar story-- it had an even smaller debt burden than Spain, and very little public debt.  Then the crisis struck.  Ireland's played the good soldier and endured the bleeding treatment prescribed by Dr. Merkel.  The result has been... nothing resembling a recovery (no matter what Europe's wise men might proclaim, austerity in Ireland has been rewarded with... high unemployment and terrible suffering.  The market haven't expressed "confidence" in the Irish either-- their borrowing costs remain sky-high.

So who can save Europe? Well, to begin with, the ECB and Germany.  Germany's favorite prescription for the problem countries is to "do a Germany"-- that is, reform their economies in order to restore competitiveness.  Success, they claim, will follow.  And, on the surface, they're right.  The way out is to "do a Germany"... except the German story of what "doing a Germany" means looks nothing like the reality.  Because, if you look at the data, what really got the German economy buzzing about 15 years ago was... an export boom to the rest of Europe.  That export boom came about because of... an inflationary boom in the peripheral countries.  It wasn't the Zimbabwe-style hyperinflation that Ron Paul thinks is inevitable all the time, but it was a period of higher inflation in southern Europe than in the north.  Interestingly, that inflationary boom was fed largely by German banks.  In short, German banks made loans to the European periphery, which drove up costs in those countries and made German exports more competitive in those countries.  As a result, all Germany had to do was keep wages and prices from rising relatively less than they did in southern Europe and, voila, they had an export boom to those countries that put millions of Germans to work and allowed their economy to get going.  Restoring prosperity in the south requires a reversal of that process.  The Germans, in short, need to consume more.  The resulting inflationary boom would reverse the massive balance-of-payments imbalance plaguing Europe (because that's really at the core of Europe's crisis) and allow southern Europe to export its way out of trouble.  Except that Germany's inflationary boom would need to be substantially bigger than the one that southern Europe experienced about a decade ago, since the capital imbalances now are so much bigger than they were then.

This approach is the functional equivalent of southern Europe and Ireland experiencing deflation to restore competitiveness, except that it's actually feasible.  A massive debt overhang arising from the bursting of huge real estate bubbles in Ireland and Spain (both of which were even bigger than the one in the US) has left the private sectors (consumers and businesses) deeply underwater.  Deflation would mean cutting wages to workers.  But that's self-defeating when it comes to actually repaying the debts, since debt is denominated in nominal terms.  Imagine you make $100,000 and have annual debt payments of $20,000.  Now imagine you lose your job and your income falls to $60,000.  All of a sudden, making those debt payments is a lot harder.  In a lot of cases, it's essentially impossible.  Yet that's what deflation across Europe would mean for southern Europe.

Of course, most of this is wishful thinking.  The Germans accepting higher inflation (in the 5% range) is about as likely as the US electing a Socialist Party candidate president.  But, if the goal is to keep the Euro-zone together, accepting that much inflation may be the least painful way out.  Just don't tell that to the Germans.  If the leech therapy doesn't work, the problem must be too few leeches.  If they keep it up long enough, the leeches will suck Europe dry.