Sunday, September 06, 2009

More thoughts to add to the Krugman discussion

I had a few more thoughts related to Paul Krugman's article in The New York Times (Magazine, it turns out) entitled "How Did Economists Get It So Wrong?" and my own response.

First, in addition to the fields of study I listed, namely, economics, finance, banking, the Federal Reserve and money, non-bank financial system, and overall financial system, I would add a few more:

  • Accounting
  • Management science and how businesses are structured, controlled, and operated
  • Risk management
  • Insurance
  • Derivatives
  • Commodities as an asset class rather than just a real resource
  • Real estate

The special role of hedge funds needs to be "covered", but does not fit into any neat category. The issue is simply size and when the dollar value of hedge funds suddenly becomes the tail that can wag the dog. See also predatory capital below.

The special role of leveraging needs to be "covered" as a systemic risk, but does not fit into a particular field of study or specific models of the overall financial system.

I am not sure how to categorize what I would call predatory capital which is a very destructive force in our financial system. Typically in comes in the form of hedge funds, but can also come from in-house proprietary trading desks at large financial institutions. It includes:

  • Large-scale short-selling of stock to attack, damage, and even destroy companies without offering any productive value to society.
  • Large-scale derivative bets that have the potential of severely damaging or even destroying the collective counter-parties.
  • Large-scale leveraged buyouts which damage the financial health of the target companies, such as causing them to take on enormous debt loads.

The mis-marketing of auction-rate securities (ARS) as the equivalent of money market mutual funds is just one example of information mismanagement, which can cripple all or part of the financial system. Brokers in the field were misled to believe that ARS were as good as money market funds when that simply was not the case. Brokerage customers were then in turn misled, but it was the internal mismanagement of information that initiated the problem. Sure, the fine print, or at least some of it, was there, but brokers were misled to believe that it could safely be ignored. Traditional money market funds also have this problem, but the failures last year were limited and the U.S. Treasury introduced a temporary guaranty program, but that expires this month. All of us money market fund investors sincerely believe that the fund managers will make good no matter what, but the simple fact is that there is no FDIC-like program in place for money market funds. This constitutes information mismanagement and will likely become a problem someday. Fund managers are basically perpetrating a fraud and government regulators are permitting it. ARS was relatively small, but money market funds are a very large portion of money, capital, and credit.

-- Jack Krupansky

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