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August 16, 2007



Fundamentally, this concerns the regulation of derivatives usage by financial institutions. Frank Partnoy (Law professor at U. San Diego) spoke about these issues at length in the aftermath of Enron. Highly recommended.


Per Kurowski

Dani asks “And why did the crisis happen when it did? It is natural to ask whether there is some specific reason for these events to occur when they did. Can we identify a specific trigger?”


The pure nonsense idea that credits could be objectively and correctly rated was used by the bank regulators in Basel, behaving like central planners from Moscow, to impose on much of the market, through specific prohibitions to invest or capital allocation formulas, that it had to follow the criteria of some few credit rating agencies. This as anyone who has walked the streets of finance should know introduces the building up of some systemic risks of unimaginable proportions. The "unknown knowns" of Rumsfeld are nothing in comparison.

The most worrying part of it all is that most discussions are turning into how to fix the system so as to get better quality ratings, and not to scrapping the system as they should. Let me inform you about a real nasty real life fact. The better the credit rating agencies get… the more confidence we will have in them… and the greater the future catastrophe.

Of course credit rating agencies should be free to rate, but the markets should also be free not to follow them.

One of the biggest problems we face is that it was the bank regulators who empowered the credit rating agencies and they are now looking for ways of hiding their own responsibility in that. We urgently need new regulators, in central banks, Basel and IMF that have no major ego investments in how the current system runs but the problem is that a central banker is a central banker, no matter where he comes from, and they all tend to circle the wagons in solidarity when questioned.

What to do? Hard to say but I have always been a believer in that “the bigger they are the harder they fall… on us” and so I have always liked the idea of a tax on size.



If the Bush administration created an era of unprecedented prosperity, why did so many people need subprime financing?

Could Larry Kudlow be wrong? Is freer trade not good for the middle class?



If the Bush administration created an era of unprecedented prosperity, why did so many people need subprime financing?

Could Larry Kudlow be wrong? Is freer trade not good for the middle class?



If the Bush administration created an era of unprecedented prosperity, why did so many people need subprime financing?

Could Larry Kudlow be wrong? Is freer trade not good for the middle class?



If the Bush administration created an era of unprecedented prosperity, why did so many people need subprime financing?

Could Larry Kudlow be wrong? Is freer trade not good for the middle class?


Not long ago, US Banks could not deal in Financial Derivatives and other speculative (soft) investments.

1. Rubin and his Wall Street mates found a way to recind that law. So, today, CityBank is one of the largest trader in financial derivatives.

2. The sub-prime mortgage derivatives were master-minded by Banks - including their financial investment houses - which based on their laissez faire sales promotion is primarily responsible for the current meltdown!

3. The culture of current WallStreet is NOT one of (moral) financial transaction but finding and identifying cash-cows and squeezing them for their worth (before sunset!).

4. ECB led the rescue in EU because PNB (Paris) is largest in France and EU.
Cascading financial malise is one ECB cannot allow under its statutes. I suppose FRB was forced into it because of ECB initiative - since market meltdown started in FarEast (sun rise!).

5. The MORAL of the game is simply that ECB/FRB and other central banks are (now) codifying immoral financial derivatives transactions and their unregulated marketing across national frontiers by crooks (my definition).


Let's not be too hasty here. We aren't simply talking about mis-valuation we're talking about mis-management; the Greenspan put is so called for a reason after all. A significant part of the catalyst in this crisis has been the withdrawl of this put option.

Not only that but one has to remember the current extent of this 'crisis'. i.e. only today did it cause enough of a sell-off on the major stock markets to be called a 'correction'. It's not even a 'crash' yet (typically 20%).

megan adams

The 'Greenspan put' shows that the Fed's ideology of deregulation of markets is fundamentally flawed: deregulation requires frequent bailing out the financial industry through interest rate cuts, as a result of bubbles and excessive speculation. Our liquidity seesaw has resulted in low wage growth for most Americans and soaring incomes for financiers. Of course it's not economically stable, but I think events will show it is not politically stable either.


I can vouch if Congress should decided to investigate this whole sub-prime mortgage scandal and how/why it originated, the greediness of wall street mafia will be exposed for the public to see.

Greenspan's put option is irrelevant to sub-prime scandal.

Justin Rietz

To those who follow the Austrian school of economics, what is occurring now is a classic boom - bust cycle that was easily predicted, easy to describe, and easy to solve (though without much pain).

The Federal Reserve kept interest rates below their natural (market) rates during the 1990's and the first half of this decade. This drove malinvestment, i.e. people and businesses invested in things they wouldn't have if interest rates were higher, i.e. at the natural rates. To oversimplify, during the 1990s, mal-investment was made in tech. This decade, it has been real estate (people being fearful of the stock market given the 2000-2002 drop).

The problem with mal-investment is twofold: first, the prices of items in which the "cheap money" is invested are driven up, and once it becomes apparent that the demand isn't there (think housing demand over the past 6 months), prices drop. The investment doesn't pay off causing a profit loss, and in the worst case, bankruptcy results. Again, this could be a business that makes a poor business investment (think internet companies) or individuals (think mortgage defaults.) We have a double whammy now because people were able to withdraw equity from their homes and use this money for consumption. Now that housing prices are plummeting and adjustable rate mortgages are flipping, these types of loans are no longer being made, and a portion of people who have them are defaulting. Result: retail takes a hit.

An additional problem is that below-market interest rates (combined with fractional reserve banking) also cause inflation. Hence why Bernanke and Co. are in a bit of a bind. However, like an alcoholic who drinks another whiskey to cure a hangover, continually fighting economic problems with lower interest rates only sets up the economy for a bigger fall.

How to solve the problem: let interest rates be determined by market forces and get rid of the Federal Reserve system. No regulation needed. There will be pain in the adjustment, just like an alcoholic going through withdrawal. Simple laws against fraud take care of shady mortgage bankers and realtors.

We also have the side issue of bank runs. There is a simple solution, though not necessarily easy to implement - get rid of fractional reserve banking. Fractional reserve banking is by definition fraud. How many people know that when they put their money into a demand deposit account (i.e. a checking account), their money doesn't actually stay in the bank, but is lent out multiple times over? For example, if the reserve rate is 10%, for every $100 put into a checking account, the bank can make $900 in loans. If everyone with demand deposits at a bank tried to cash out at the same time, the bank couldn't do it, and with loan defaults the bank would never be able to recover even if it gets an injection of liquidity from the Fed.***(See note below on sweeps).

For the sake of the empiricists, look at the money supply and its rate of change over time
(http://globaleconomicanalysis.blogspot.com/2007/05/money-supply-is-soaring-right.html). Combined with an inverted or bowl-shaped yield curve, it more or less precedes every recession going back to 1960 (I don't have data before this date).

***Sweeps are another factor. I bet 99.99% of the population does not know that their bank moves a portion of their (the depositors') money into money market-like accounts, allowing the bank to side-step fractional reserve requirements altogether, from my understanding.

Nicole Foss

Check out this primer on the developing credit crunch:



I do love the Austrian school of economics "solution", namely hope that banks will not act like capitalists and that the credit market will always be in equilibrium.

That is what the "natural" rate of interest is, an equilibrium rate. And this is something they usually deny is possible in any real market!

Then, of course, there is the assumption that "mal-investment" only occurs because of banks lending too much credit. This assumes that banks and investors do not make mistakes, do not contribute to bubbles, do not flock to boom markets and so over-invest.

In other words, they assume (like the neo-classical economists) that capitalists have perfect knowledge and foresight. Something, again, they usually deny is possible.

For example, look at Rothbard's critique of Schumpeter's crisis theory: "There is no explanation offered on the lack of accurate forecasting . . . why were not the difficulties expected and discounted?" (America's Great Depression, p. 70) So because Schumpeter does not show how entrepreneurs cannot predict the future his theory is false!

Interest rates, in other words, do not provide sufficient or correct information for investment decisions. Thus "mal-investment" could still occur as the future is unpredictable and capitalists make mistakes, mistakes which can be made worse by real interest rate rises as well as spread throughout the market.

As for banks (or the Fed) lowering the interest rate "artificially" by creating credit, well they do so to make profits. Fractional reserve banking was not imposed by the state, but evolved by banks seeking to make money. Attempts to stop them doing so would simply mean new schemes of avoiding the state imposed regulations -- simply in an attempt to make more cash.

As Adam Smith put it with regards to the Scottish system of market-based banks of his time, "the high profits of trade afforded a great temptation to over-trading" and that while a "multiplication of banking companies . . . increases the security of the public" by forcing them "to be more circumspect in their conduct" it also "obliges all bankers to be more liberal in their dealings with their customers, lest their rivals should carry them away."

If the Austrian solution were imposed, it would not be a reformed or true banking system. It would be the abolition of the banking system. It would also involve quite a bit of state regulation to enforce, which would be ironic given that they are meant to be against State interference with capitalists!

In summary, there is a good reasons why Hayek lost the debate over the business cycle in the 1930s. The Keynesians (like Sraffa and Kaldor) exposed the flaws in the Austrian case extremely well. Unsurprisingly, Austrian tend not to discuss this awkward fact.


Dani - This is a serious issue of unregulated globalization of financial derivatives - for which national legal entities have no control over.

The question is: how can this geney be put back into the bottle? If not, there's not only a growing distrust of so-called market mechanism (positive-economic thinker's) but also inevitable demand by national regulators to find ways and means to control this laissez faire reach of unregulated trade in financial derivatives.

EU Commission has already issued notice on agency responsible for regulating quality/standard of this subprime trade, and if there is reason to belief it was not transparent.

In US, GWB/Paulson have been demanding removal of (legal) impediments to free flow of global financial transactions; namely, Congressional enactments after 9/11.

Justin Rietz

Anarcho -

I had a good chuckle as yesterday I was just rereading sections of Rothbard's America's Great Depression, specifically the first 80 pages or so - was it that obvious? ;-)

I agree that the Austrian theory's reliance on entrepreneurship has its flaws, but I think you may be misinterpreting some of the finer points of Austrian theory:

1. The interest rate IS the profit rate. As the profit rate will be different for investments with different levels of risk, there is no one interest rate. Moreover, these interest rates will fluctuate as the market adjusts to participant actions, new information, changes in time preferences, government policy changes, etc. As Rothbard points out in his critique of neo-keynesians, we are dealing with multiple interacting factors ("more than one margin" as he says).

2. It is the en masse mistakes of entrepreneurs that are the problem. There will always be market winners and losers, but even something as basic as the law of averages suggests that the probability of an en masse mistake is fairly low. You mention the herd mentality - the periods in recent economic history we have seen herd mentality have almost all been immediately preceded by significant Fed action in the markets.

One refinement I suggest to the Austrian theory is that artificially low interest rates force herd mentality via a fairly simple game theoretic mechanism. An example: if as a software company in the 1990's I did not take advantage of the free-flowing venture capital money, there was little chance I would survive against my competition flush with VC dollars. Hence, in order to survive until the next round (in game theory terms, not necessarily VC funding lingo) I take the money, even though in the long run this may not be to my benefit. Why did VCs take on such risk investments? Because they wouldn't make enough money to attract investors with less risky ventures because the interest rate (i.e., the profit rate) was too low, again due to government intervention.

Also, it is the fact that entrepeneurs are NOT omniscient that contributes to what appears to be the herd mentality. A distortion in the market adds conflicting signals, thus further reducing an entrepenuer's ability to make good business decisions.

3. As far as fractional reserve banking and sweeps, remember that true capitalism involves honest and open interaction between participants (though perhaps you disagree with this definition). Hence, straight forward laws against fraud are inherently part of capitalism. I must say, however, that I don't completely understand your statement that the Austrian school expects banks not to behave as capitalists.

I assume you have read it, but Rothbard's textbook "The Mystery of Bank

spurious correlation

The problem here is not the use of derivatives per se, which have been an important and welcome addition to financial markets (helping to diversify risks and lower lending rates). The current problem stems from a number of sources: (1) weak regulations for issuing mortgages (low documentation, interest only, variable rate etc...); (2) inadequate risk assessment from the rating agencies; (3) conflicts of interest relating to rating agencies (remunerated by the institutions whose assets they are rating); (4) the hubris, leverage and excessive risk-taking that is typical of prolonged financial market booms (over confident traders get involved with instruments they know little about). History suggests there is not much you can do about #4...but lessons need to be learnt from #1-3.

What were believed to be AAA assets turned out to be risky mortgages (that should never have been lent in the first place). Over confident traders (typically using leverage) take a hit. A lack of confidence in credit ratings spreads to other instruments. Self-fulfilling fear (of bank failures) causes markets for securitized assets and interbank loans to freeze...and suddenly you have a lqiuidity crisis.

Willem Buiter has posted an excellent article on the appropriate central bank response here: http://www.voxeu.org/index.php?q=node/459

Justin Rietz

Sorry, my last line got cut off when I did a copy and paste. Should read:

"I assume you have read it, but Rothbard's textbook "The Mystery of Banking" is quite good and is freely available at http://www.mises.org/mysteryofbanking/mysteryofbanking.pdf."


What is Justin Rietz talking about? The central claims of mistaken Austrian business cycle theory are not about "herd mentality". They are about entrepreneurs responding rationally to price signals, including intertemporal prices.

Per Kurowski

spurious correlation opines “The current problem stems from a number of sources: (2) inadequate risk assessment from the rating agencies; … A lack of confidence in credit ratings spreads to other instruments.”

Come on, when in a hole stop digging!

It was an excessive confidence in the risk assessment from the rating agencies that managed to catapult what should only have been a small local problem of badly awarded mortgages into a global mass-confusion. And that excessive confidence sprang out of the fact that our regulators, going against what all human wisdom should have taught them, empowered the credit rating agencies to implicitly and explicitly decide so much about where market should go.

The real truth we have to face is that the better the credit rating agencies get at what they are supposed to do, the larger the build up of really dangerous systemic risks and the bigger the ensuing explosion.

I am not against credit rating agencies. I will use them. But please let unshackle the markets from having to use them. Otherwise I guarantee you all that what will happen is that sooner or later 100% of spurious correlation’s pension fund is going to end up in illiquid junk, beautifully dressed up though in AAA designs.

Justin Rietz

RE: Robert:

Perhaps I was not clear enough, but again, I was proposing my own twist to Austrian theory ("One refinement I suggest to the Austrian theory...").

Under Austrian theory, when the Federal Reserve keeps interest rates artificially low, a larger portion of of entrepneurs make bad business decisions and this is what causes the economic boom / bust. This "larger portion" may appear to be following irrational herd mentality (in non-Austrian terms), and I was trying to explain why in fact they would be acting rationally. Because I was using a thesis of my own making rather than anything I pulled directly from any Austrian school material, I labeled it as a refinement. I apologize if this wasn't clear.

Justin Rietz

RE: Per Kurowski -

Or perhaps we make the credit agencies strictly liable (legally speaking) when they don't follow their stated guidelines for ratings. Seems to me businesses are always more afraid of lawyers and lawsuits than regulators...

Per Kurowski

RE: Justin Rietz suggests:

Well clearly what Rietz suggests of having the lawyers take care of the credit rating agencies would be the American way to fix it. At this moment they cannot be sued since, quite surrealistic, they are only giving their “opinions” and are thereby are covered under the First Amendment; and which in that case would only leave us with having to sue those regulators that force us to heed their opinions.

That said I do not like this American route, not only because lawyers suing-market is already much too buoyant to need further stimulus, but primarily since by doing so, one way or another, you would be sending the markets the utterly wrong and extremely dangerous signal that indeed credits could be correctly rated over time.

Justin Rietz

I agree with Kurowski that one of the problems is that credit rating companies are treated as though they are only giving "opinions."

As I have said, I would go one step further up the chain - the whole problem could have been avoided if interest rates had not been held artificially low.

Per Kurowski

What we most have to make sure happens is that the market regains its total freedom and that it has not any longer have to follow, in any way or form, the by nature limited criteria of some credit rating agencies. Frankly, between us, how could the regulators even have thought of this? I said it before, I suspect some unemployed soviet central planners made it to Basle and got a new lease on life, regulating.

And do not for a second believe I am a runaway libertarian. I just know about the things that you do not do if you want to avoid the risk of building up monumental systemic risks. The bank regulators need urgently to sit down and revise all their policies based on that simple old warning that states… do no harm!


"It is the en masse mistakes of entrepreneurs that are the problem. There will always be market winners and losers, but even something as basic as the law of averages suggests that the probability of an en masse mistake is fairly low."

To use an analogy. Traffic jams happen all the time. Each commuter is rationally pursuing their self-interest but the collective results of their actions are irrational. It is the en masse mistakes of commuters that are the problem but there need not be any problem with the signals each of them reacts to.

As such, the business cycle can happen without banks reducing the interest rate below its equilibrium rate (and it is banks, the government does not force them to do it). And assuming that interest rates are not in equilibrium, then so are the prices of all other commodities -- so in terms of "incorrect" signals, interest rates are just one of many.

For example, capitalists may rush to invest in an industry whose prices are out of equilibrium, causing "mal-investment" there. When the market adjusts, the bad results of these decisions spread across the economy. Interests rates being in equilibrium would not stop that.

"Hence, straight forward laws against fraud are inherently part of capitalism."

Ah, yes, fractional banking is "fraud." Except, of course, everyone knows that banks do it and have do so for centuries. So capitalists know exactly what they are getting into yet, for some reason, they do not "expect" and "discount" the obvious "difficulties." I wonder why? And where are all the "honest" banks who meet the market demand for "real" money?

"I must say, however, that I don't completely understand your statement that the Austrian school expects banks not to behave as capitalists."

Banks practice fractional banking to make more profits. Like any capitalist. And, like any capitalist, they object to regulation (such as laws against fractional banking).

I'm sure if such a law were passed (and, to be honest, it is never going to happen as the capitalists would never allow it) then the banks would innovate and develop means to get around it, to meet the demands of their clients and their profit balances. They always have. That was why fractional banking developed in the first place.

I would suggest you consult Kaldor's critique of Monetarism -- an experiment which proved, btw, that the state does not control the money supply, it adjusts to the needs of the economy (i.e., the banks trying to make profits). Or any post-Keynesian analysis of finance.


Regulation can only go so far in keepng the financial system on track. Only constant vigilance by fund managers when they buy secrities with our money will prevent them falling into traps set by the greedy. They must go further than just following rules and look at what lies beneath when they invest. I have tried to explain simply how we got into this mess in this post:


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The mortgage crisis is quite recurrent and has been seen that many companies and lenders originated mortgages to customers without thinking that what would if they are not capable of repaying the loan. The increase rate of foreclosure is set to be a spectacular deterioration.


The loosened regulations from the HUD and SEC in 2004 have made the private sectors more off active member in subprime mortgage, apparently to coerce the subprime mortgage market.


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