In any otherwise inexplicable financial event, the people who profit from it may be understood to have caused it. --Ben Stein
Not too very long ago, I got into a shouting match with a Prominent Economist, or rather, the PE got into a shouting match with me. Perhaps “shouting match” is the wrong term, since the conversation occurred in the cyber-space of the internet, where no one can hear you scream. Nevertheless, I thought I could distinctly hear the PE shouting through his keyboard. The PE was also a Prominent Member of the Left, with a sinecure at a left-wing think tank. My own bias is that “think tanks,” whether of the right or the left, are places where Prominent Thinkers are paid to stop thinking and start producing propaganda.
The particular question at issue was the cause of economic “bubbles”; my position is that they are caused by inequality in rewards (see The Investor's Dilemma.) The PE, on the other hand, seemed to be arguing that, one, there are no such things as bubbles, and; two, they are caused by a lack of regulation. I suppose that there is a sort of odd consistency in his position: things that don't exist are indeed caused by a lack of something. But for things that do exist, like bubbles, a lack of something can permit them to be, but cannot cause them to be. It is simply a mistake in the understanding of causation. As to the existence of bubbles (as if the reality of the current housing and credit bubbles were not enough to convince one), I quoted an economist as to the process of bubble formation, but I did not tell him who it was that I was quoting. He attacked and ridiculed the quotation. I then revealed that the quotation was from the Prominent Economist himself, from an article he had published not one month earlier.
I discovered that you can make either a Fool or a Friend of a PE, but not both. Needless to say, I did not make of him a Friend. Neither did I make of him a Fool; he did that by himself; my only intent was to present him with a source he could not impeach, a source with he then proceeded to make foolish. Still, his rage was boundless and his rhetoric so untethered from reality that it was amusing, so much so that I would almost rather (it is uncharitable to say this) have him as my Fool than as my Friend. But whether as Fool or Friend, he outlined “reforms,” some of which have been a part of banking regulations for 25 years now; it is typical of PE's that the deeper they go into think tanks, the farther they retreat from reality. In any case, he was suggesting any number of “new” regulations, but they all seemed to me to be merely ad hoc, to be an exercise in hindsight without any real principle behind them to distinguish good and bad regulations, between the necessary and the unnecessary or even harmful. In the course of the debate, he shouted that “Aristotle is not a good guide to today's financial system.”
On the contrary, Aristotle would grasp our problem immediately, since he addressed, more than 2 and a half millennia ago, precisely the same problems we are having today. Aristotle was himself a pretty fair economist, and there was not then the unfortunate divisions in knowledge which he have today, the endless “specialties” which not only keep students from getting a real, unifying education, but which keep the branches of knowledge from communicating with each other. But that's another topic. Back then, a philosopher was expected to be able to comment on practical matters. It would be considered foolish to have figured out everything and not be able to apply it to anything. In any case, the Aristotelian category which describes the subprime meltdown, and provides a principle of regulation, is the difference between natural and unnatural exchange.
Commentators have often regarded the distinction as a mere attack upon trade. It is nothing of the kind. Aristotle came from a trading nation and understood the importance of trade to the Greek city-states. He did understand, however, what modern economists have forgotten: that economic activity had a purpose, and one could judge economic activity by how well or how badly it fulfilled that purpose. The purpose of an economy was the material provisioning of the household, so that the family could flourish, and flourish not only economically, but socially, artistically, spiritually, and in every other way. For there is a material base to everything we do, and a proper economy is necessary for that material provisioning. Note here that Aristotle's economics begins not with the “autonomous individual” (as in modern economics), but with the needs of the family. And his economics had a purpose, household provisioning. Exchanges which aided in this purpose were “natural,” exchanges which did not were “unnatural.” That is, exchanges which were related to getting the things needed for the household were natural, because they fulfilled the purpose of economics and therefore had a natural limit. On the other hand, exchanges that were carried out only for the purpose of obtaining money had no natural purpose and therefore no natural limit; money can be extending infinitely, and infinite extension is the essence of the unnatural.
To understand the distinction, think about buying bread. If you are doing it to provision the family, you buy a certain amount commensurate with their needs, and no more. There is a natural limit; it makes no sense to buy up every loaf in the store, or every loaf in every store. On the other hand, if your purpose is merely to make money for its own sake, then there might be a point in buying up every loaf, of cornering the market and setting the price to increase your profit. Such trade is endless, with neither point nor purpose. It is unnatural.
So how does this apply to the subprime and the other financial follies? Let me suggest that banking that is unrelated to the natural ends of banking is unnatural, and likely to lead precisely to the mess we are in. Think about mortgages way back in the dark ages, that is, the 1980's. You went to the old Bailey Savings and Loan, the banker (who may not actually have looked like Jimmy Stewart) squinted at you real hard to determine if you were the kind of person who would pay the bank back for 30 years. And if your credit and collateral were in order, they gave you the money and you bought the house, you “provisioned” your family. This was called “3-6-3” banking: you paid the depositors 3%, charged the borrowers 6%, and were out on the golf course by 3pm. The depositors got a little return, the borrowers got a source of funds at a steady rate, and the village idiot got a prestigious job. The banker was using the bank's money, and was not likely to allow you to buy more house than you could reasonably pay for.
Compare that with modern banking. You go to the bank, the kindly banker squints at you real hard to determine if you will pay him back for two weeks. Because after two weeks, he will have sold the loan to somebody else, and you will be their problem, not his. He doesn't make his money from lending the bank's funds, but from originating loans, loans which he has no intention of holding on to. And if your credit and collateral are a little shaky, no problem, he'll help you doctor it up a bit, so that it looks a bit better to the fool who buys your loan.
In the first case, the loan is “natural”; it is well related to the credit of the borrower, the quality of the collateral, and the needs of the family. The bank and the borrower are in a long-term relationship, and if there are problems (as there always are in the course of life), banker and borrower can meet to determine the best course of action. The second case is quite different. Borrower and the real lender never meet, never know each other. The connection between the physical collateral and the loan gets broken and lost. The loan is packaged into MBSs (mortgage-backed securities), CDOs (collateralized dept obligations, CDOs-squared (or even cubed), and so forth. The trade is for the money only, poorly related to actual collateral and credit quality. And when things go wrong, there is little prospect that lender and borrower can find each other to work things out.
But subprimes are only a part of the unnatural trades. Even bigger, and more unnatural, are the other derivatives, such as options, warrants, and credit swaps. These are bets placed on the direction a particular market will move. The numbers involved are staggering. Bear Stearns had $15 Trillion worth (notional value) on their books, an amount exceeding the Gross National Product of the United States. And they were a small player; the overall market is estimated to be in excess of $500 Trillion, which exceeds the planet's GNP. Of course, the real exposures are only a fraction of the notional values, usually less than 1%. Still, the extent of these unnatural trades is staggering. There is no natural limit to these amounts; they can grow forever, and each increment of growth is an increment of risk, not just to the players, but to the whole economy; that's why the Fed is forced to bail them out, even though it means they profit at our expense. Ben Stein nailed it.
The derivatives are unnatural in another way: they are completely different from investing. Investing is the serious business of providing capital to entrepreneurs to expand and maintain production. Investing is always, potentially, a “win-win” situation: You invest in a factory, the factory is successful, and everybody wins. You make some money, the entrepreneur makes some money, the workers get jobs, the public gets an increased supply of some good, the productive capacity of the nation is expanded, and the commonweal enriched. The transaction is both natural and beneficial, and families are provisioned. But the derivatives are generally “win-lose” propositions; they are bets placed at either pole of a market, up or down. One person's gains are measured precisely by another person's losses. There is no net benefit to society. Whatever gains there are, are unnatural in being at the expense of someone else's losses.
The two kinds of exchange require two kinds of regulation. Natural exchange requires very little regulation, mainly enough to prevent fraud (the terms offered to the borrower are actually the terms delivered), and foolishness (adequate capital coverage, for example.) Beyond this, not much is needed. The banker is not going to encourage foolish borrowing, because he is using his own banks money. The process is self-limiting. Unnatural exchange, on the other hand, requires a positively unnatural amount of regulation. Every aspect must, potentially, be scrutinized by hard-nosed accountants and financial cops, with authority to look into every aspect of the business. It needs a corps of Elliot Spitzer's, but without the hookers. And since the exchanges affect not just the parties involved, but have the potential of bringing down the whole economy, then the body politic certainly has the natural right to regulate such unnatural exchanges, and regulate them to death, if needs be.
Of course, modern regulation tends to be just the opposite: we regulate to death natural exchanges, while letting unnatural exchanges go completely unregulated, even unmeasured. The only involvement of the body politic comes at the end, and only then to pay the bill. Brain-dead denizens of think tanks propose endless regulations that profoundly miss the point because they do not grasp the point. And they do not grasp the point, because they do not grasp Aristotle; they believe he has nothing to teach them. But in truth, there is nothing new under the sun, only new forms of ancient follies.