PHILADELPHIA REFLECTIONS
Musings of a Philadelphia Physician who has served the community for six decades

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Much of the early development of the electronic computer took place in Philadelphia. We lost the lead, but it might return.

Dislocations: Financial and Fundamental
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Banking Panic 2007-2009 (1)
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Right Angle Club 2011
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www.philadelphia-reflections.com/topic/158.htm

Causes of the 2007 Crash: Political and Technological

Dealing with a topic as complicated as the causes of the 2007 financial crisis, it's quite possible for two viewpoints to be entirely in agreement, until abruptly coming to different conclusions. In this paper, we consider the relative merits of blaming government housing subsidies in various forms, relative to blaming the unanticipated effects of the computer revolution. The subsidy argument has just been succinctly and effectively argued by a lawyer, Peter J. Wallison. Agreeing with every word he writes, I nevertheless hold the perspective that disruptive effects of the computer revolution were equally responsible, if not more so. Politics versus technology, choose your poison.

{Federal Reserve}
Federal Reserve

Mr. Wallison served as a lawyer in the financial loins of Washington, and thus has the perspective of a Reaganite who sees government as the main problem; with the significant distinction that his proposals for solution also lie in government corrective action, particularly "covered bonds" and step-wise privatization of the Federal Housing Authority (FHA). While agreeing with both reform proposals, my concern here is about too little general recognition in the analysis of how vulnerable the banking system has become, to revolutions made possible by even primitive computers of the 1960s. Such revolutions soon grew many times magnified by the inexpensive high-speed internet. If that analysis is correct, it predicts mere legislative action for the housing industry will prove inadequate; banking has taken a radical new direction.

Mr. Wallison's argument in the January 3, 2011 edition of the Wall Street Journal is admirably succinct. He points out the New Deal Federal Reserve deliberately suppressed interest rates to the benefit of the housing industry, but made a significant exception for the Savings and Loans. (It was forced to abandon that approach by the innovation of money market funds, in turn made feasible by widespread adoption of the IBM 360 computer.) When the S&Ls collapsed, that segment of the market was awarded to the GSEs (Fannie and Freddy Mac, insured by FHA). In 1992, Congress imposed the goal of promoting "affordable housing" on the GSEs, which is to say the subsidization of "subprime" (i.e. high risk) mortgages. By 2007, half of all mortgages were subprime, and by September 7, 2008 Fan and Fred were insolvent, effectively replaced by the Federal Reserve (i.e. the taxpayers) as the final guarantor against national insolvency. It will take a decade to restore the economy from its present setback, but Mr. Wallison's proposals do indeed have some chance of eventually leading to a viable economy. He proposes the threshold for "jumbo" mortgages be reduced by $50,000 every six months until mortgages are effectively privatized. And he also suggests we create a pool of mortgage assets as security for a bond issue, thus privatizing existing mortgages in the way Europeans describe as a "covered bond" system. Go ahead, do it; it might work, and nothing else is on offer.

{IBM 360 Computer}
IBM 360 Computer

Meanwhile take a look at banks; we seemingly can't get along without them. But other institutions are undermining them, with cheaper products made possible by computers. For two centuries, banks transformed short-term borrowing into long-term loans; no one else could do it. It's a simple idea, and it works, that a constant or even rising pool level can be maintained by a steady inflow of short-term deposits. But it is risky; the risk is that some event will precipitate a sudden rush of withdrawals, a run on the bank. Sooner or later, the law of averages catches up. The risk is real, it happens every few years. A price in the form of interest must be imposed to maintain reserves against occasional bank runs, and collectively the whole nation must maintain a central "bank", charging interest to maintain reserves against simultaneous runs on multiple banks. No device has ever been created for a nation to protect against a universal bank panic, which is as effective as placing the risk in the hands of private bankers who can expect to be stripped and shorn if things get out of control. Robert Morris demonstrated this point in 1779, and the nation seemingly must re-learn it every few decades.The IBM 360 computer made it possible to transform short-term into long-term in greater volume and lower cost by allowing banks to get bigger; but it could also perform the short-long transformation in cheaper ways than depository banks do, and from there the bank-competitive process we know as securitization has gone on to commercial credits, auto loans, credit cards, high-velocity stock trading, and mortgage-backed securities. These approaches are often cheaper and more convenient that the trusty old banking system, and Credit Default Swaps show its power isn't exhausted; any legislation to prohibit CDS is sure to to be circumvented. Insurance is also on the edge of being threatened. An industrial revolution of this magnitude takes decades of tweaks to become stabilized, but it will suffice for now, if we can establish reasonable protections against the risk shifted into the securitization or investment banking arena. As risk shifts, remuneration for accepting risk must shift as well. This new system for generating capital must not be starved because depository bankers resist the loss of their share of profitability; politics will have much to answer for if that happens.

Most likely, the main obstacles to getting this system fixed will come from overseas. Fifty years of disillusionment with the United Nations will make nations, the United States chief among them, resist loss of sovereignty in something so vital as finance. But that's for the future. For nearly a century, the past has been disrupted by idle notions of the fairness of coerced redistribution, in ways Mr. Wallison has succinctly described. But meanwhile we almost willfully ignore technological upheavals which everyone welcomed but no one fully anticipated.

(2049)

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