Opinion

Edward Hadas

Madoff/subprime – spot the difference

Edward Hadas
Jan 15, 2014 15:36 UTC

Bernard Madoff still has some magic. The public finds anything connected to the fraudster’s case fascinating, from a prison interview to JPMorgan’s agreement last week to pay $2.3 billion for Madoff-related sins. And why not? Madoff was a grandmaster of the confidence trick. But there is more to it than that. His way of doing business was alarmingly close to the perfectly legal practices which brought down the financial system in 2008.

To see that, compare Madoff to a hypothetical pre-crisis hedge fund manager – one with a special interest in U.S. subprime residential mortgage securities. The common tale starts with a commitment to provide higher returns than the economy can safely offer to financial investors. Both Madoff and the hedgie took in funds without making any specific promises, but their investors’ expectations were lofty.

Madoff, of course, knew that he could not live up to those expectations. That makes him smarter than the hedgie, who was either foolish, if he thought American house prices would keep rising for many years; or arrogant, if he was confident that he could sell out before the losses hit.

Both Madoff and the hedgie relied on the inability of most investors to accept deep in their hearts that market skills very rarely produce portfolios that massively outperform the overall market and the economy for a long time. It is not surprising that almost no one at JPMorgan was bothered by the consistent 10.5 percent annual returns. A similar complacency about investment returns cost investors far more in subprime losses. Financial engineers got away with claims that subprime housing could be turned into financial assets that combined high rewards with low risks.

When trying to attract funds, Madoff and the fictional hedgie made similarly exaggerated claims about their strategic expertise. Madoff just lied. The hedgie had to put together the data in a way that helped them tell clients what they wanted to hear. But gullible investors are all too often looking for a story that calmer souls would consider too good to be true. They are willing to trust doubtful claims, whether Madoff’s new wrinkle in options strategy or the hedgie’s new paradigm of housing finance.

An early obituary for bitcoin

Edward Hadas
Jan 8, 2014 15:09 UTC

Bitcoin is not over yet. But the pseudo-currency is close enough to collapse to merit an early retrospective.

My prediction is controversial. Many fervent fans are persuaded that this government-free currency is for real. Their ardour may keep it going for a while, but equally bitcoin could disappear very quickly – that’s the way with speculative bubbles. So now is the moment to learn some economic lessons before the whole phenomenon is forgotten. Here are five.

Money without government appeals to people without law.

Legal tender has the backing of the issuing state. The government has a proprietary interest in maintaining a reliable currency. It also has the necessary powers to do so. It can regulate lending institutions, pursue fraud and create new money to keep the system afloat.

A Christmas message for lenders

Edward Hadas
Dec 18, 2013 15:30 UTC

For many shoppers, Christmas is a time to rack up debts in the expression of seasonal goodwill. For policymakers, it should be the holiday of debt forgiveness.

The inspiration for that religious-sounding thought comes from the atheist philosopher Hannah Arendt. She argued that forgiveness has a central role in human affairs, and the secular world should be grateful to Christianity for the discovery. Arendt was of course talking about forgiveness in the common understanding of the term – a pardon for a wrong, the cancellation of “you owe me one”. But her understanding of this as enabling people to “begin something new” works just as well when thinking about the financial equivalent: a willing erasure of material obligations.

Consider a loan from parents to a son or daughter who wants to start a business. If the new venture fails, a tough demand for repayment is likely to spawn resentment. Debt forgiveness will breed gratitude and closer ties.

How not to do healthcare

Edward Hadas
Dec 11, 2013 16:26 UTC

Almost every healthcare system in the world is a lesson in how not to do it. The pricing-based model fails miserably in the United States. The rationing model works almost as badly in the UK. Both fail in the core task of ensuring that the right healthcare goes to the right people.

Price systems should provide clear information to consumers and producers, helping both make sounder decisions. They can help make hard decision about what care is worth giving, but only if the prices accurately reflect the costs. But that doesn’t happen in American healthcare.

Every service and each drug has many prices, depending on who is providing and who is paying. Almost none of the prices bear any clear relation to costs. The New York Times reported earlier this month that the price of a dose of codeine ranges from $1 to $20 in San Francisco. Hospitals routinely send much higher bills to uninsured patients than to people with insurance. The uninsured have less ability to pay, but they have no clout pre-treatment and less clout than insurance companies in the inevitable post-bill negotiations.

The pope takes on economics’ pro-rich bias

Edward Hadas
Dec 4, 2013 16:29 UTC

The leading theories of economics and finance are usually produced for the rich. Pope Francis deserves praise for suggesting an economics for the poor.

The typical criteria of economic success – such as efficient pricing, fully competitive markets and rapid GDP growth – sound uncaring. And they often are. One problem is that most of the leading theories have an implicit pro-rich bias. For example, the Capital Asset Pricing Model, a basic tool in finance, assumes that the rich investors who can afford to take big bets deserve extra-large rewards when things go well. Or consider how most governments’ economic policy aims first and foremost at GDP growth, basically ignoring the uncomfortable truth that the already rich typically take a disproportionate share of additional production.

By contrast, pro-poor concepts receive almost no attention. Mainstream thinkers rarely say that the rich people who have gained from the economy have an obligation of solidarity with the poor who have lost out. Most of them have never heard of the idea (common in Catholic circles) that private property comes with a “social mortgage”, a debt to the society which makes that property valuable.

Bitcoin is a step back not forward

Edward Hadas
Nov 27, 2013 16:00 UTC

The developers of bitcoin are trying to show that money can be successfully privatised. They will fail, because money that is not issued by governments is always doomed to failure. Money is inevitably a tool of the state.

Bitcoin relies on thoroughly contemporary technology. It consists of computer-generated tokens, with sophisticated algorithms guaranteeing the anonymity, transparency and integrity of transactions. However, the monetary philosophy behind this web-based phenomenon can be traced back to one of the oldest theories of money.

Economists have long declared that currencies are essentially a tool to increase the efficiency of barter, which they consider the foundation of all organised economic activity. On this view, money is a convenient instrument used by individuals to get things done. It is not inherently part of the apparatus of government.

Favour labour over consumption

Edward Hadas
Nov 13, 2013 16:09 UTC

Unemployment is a problem in most developed economies. Any politician, central banker or professional economist in the United States or Europe will admit that the published rates are unacceptably high, that too many people have left the paid labour force and that young people starting out have a particularly bad deal.

Americans often say their problem was caused by the 2008 financial crisis. That isn’t exactly wrong. After the failure of Lehman Brothers, many indicators of labour market depression – for example, the proportion of unemployed people who have been unemployed for more than six months – jumped to the highest levels on record (generally since 1948). Most of these indicators have improved, but remain uncomfortably high.

However, I think that the recession only uncovered longstanding structural weaknesses, and the problems I have in mind are not exclusively American. They just showed up in European statistics much earlier. Unemployment rates there have been persistently high, especially among the young, for decades. And the recorded unemployment numbers are flattered everywhere by the expansion of what might be called the non-labour force: those classified as suffering from incapacity, involuntary students and healthy retirees.

Small is beautiful in finance

Edward Hadas
Nov 6, 2013 16:14 UTC

Some economic activity makes the world better, some is a cost of making the world better, and some actually makes the world worse. Where does the business of finance – lending, borrowing and securities trading – fit in? Mark Carney, the new governor of the Bank of England, recently said: “a vibrant financial sector brings substantial benefits.” The implication is that more finance is a good thing, as long as it is safe. That is simply wrong.

True, empirical studies show that financial activity increases along with incomes in poor countries. But this correlation has little bearing on developed economies with mature financial systems. In these countries, additional financial activity unquestionably adds to GDP, but the same can be said for the substitution of expensive medical care for cheap preventative action. The question is whether additional finance promotes overall economic good.

It can do so, but not directly. Finance is a cost. It is a means not an end, an input not an output. People and companies should engage in financial activity only to help them do other things – most notably to preserve or increase wealth, to coordinate expenditure with incomes and to help organise real investments, production and distribution.

Economists overvalue stock markets

Edward Hadas
Oct 31, 2013 13:07 UTC

Is it possible to construct portfolios which perform better than the overall stock market? Two of the three recipients of the latest Nobel prize in economics have tried to answer that question. Roughly speaking, Eugene Fama said that all efforts are in vain, while Robert Shiller said that they are not.

These nearly contradictory views are typical of an intense but inconclusive argument stretching back four decades. Market researchers have produced a mountain of studies, but they rarely consider the macroeconomic, ethical and social meaning of equity investing. That’s a shame. If more attention were paid to these issues, everyone could calm down.

Start with the economics. For the economy as a whole, changes in individual stock prices are basically irrelevant. The companies receive no cash when existing shares trade hands, whatever the price. The trading shareholders may have gains and losses, but they cancel each other out. The net economic effect of frenetic stock markets is zero.

A call for radical financial reform

Edward Hadas
Oct 9, 2013 14:56 UTC

The governments of developed countries have the power to rescue economies from defective finance. There is a radical solution. It would be relatively easy and at least as fair as the current slow generation-long recovery from the 2008 financial collapse.

I have been suggesting massive “start from scratch” financial reform for several years. The response is usually a mix of incredulity (it’s too hard to do) and indignation (it would be unjust). A thought experiment might help deal with those objections. Pretend that the current situation – excessive debts and deficits, unprecedented and risky monetary policy, overly powerful banks, slow GDP growth and unacceptably high levels of unemployment – was the result of a recent war.

Under those tragic circumstances, it would not be strange to say that the prevailing financial order was a relic from a lost period. Perhaps the arrangements were effective and fair back then, leaders would say, but the old promises, practices and privileges are now helping the few, hurting the many and holding the economy back. So finance needs to be reconstructed.

  •