Saturday, October 25, 2008

Knowing what you don't know - Where's that data, Mr. Paulson

Two pieces out today, outlining a topic near and dear to this blog's screed: policy response that anticipates knowing what you do not know (as a modus of action, not a paralytic).

The sad part is that at lot of the "unkowns" are "known unkowns", at least to those who have a grasp of financial markets structure and modern financial instruments. That is, 'the collective' is smart enough today, there is enough expertise mucking about, that we know the data that we need, for decision and risk mitigation (even crisis risk mitigation). For some reason, that data is either behind closed doors or no one is (or has been) gathering it, in a systematic fashion. What's more, the people looking at it *may* not know how to interpret it, have events moving so fast they haven't the time to stop and 'think it over', or have actually reached the wrong conclusions, for any number of reasons, some good (poor but reasonable inference), some not (ideological).

Greg Mankiw: But Have We Learned Enough? (NYT) As always, Greg does an excellent job explaining things (in my no-count estimation, that is). He slips when he goes for the NLRB, while mentioning housing, yet skips the Home Loan Board. via Blodget, They Didn't See the Great Depression Coming, Either.


The foundations of the current panic are rooted in two great uncertainties: the value of home collateral backing assets and the overall asset quality of major bank's balance sheets.

The first was laid bare last year, as a threat to financial institutions, against the backdrop of rising policy rates.

The impact of the first uncertainty on the second has been greatly misjudged. Policy makers - and others - failed to understand early on the caustic market impact that the unkown scope of the problems would create, the risk-aversion that would result. At the same time, estimates of the impact ranged from the modest ($100-$200 billion, losses on subprime issuance) to the fantastic (Nouriel Roubini, et. al.), with no systematic data or regulatory voice with enough authority to ... adjudicate those figures or their systemic ... implications (i.e. how the distribution of the risk was spread throughout the interlocking system).

The propagation of the panic occured when the small, but meaningful, steps taken to quell the initial faultline ... stopped working. Managements, who had just raised modest amounts of capital, assured investors (and regulators?) that asset quality was 'manageable', and then went bust, bankrupt, with vague explanations, like, "a run on the bank". Regulators were unable (or unwilling) to mitigate these steps in the chain, lacking central authority and a generalized, systematic plan for the both the scope and the individual asset classes at the root of the problem. Although they did prevent AIG's massive book of derivatives from a bankruptcy, the resulting mixed record has only mitigated, but not quelled, the two main uncertainties. Why? Well, it is in part because that record has also raised questions about the Treasury/Reserve's ability to continue to quell The Great Unkowns. The Fed usually wins such Titan clashes, but it's hard to "bring that to the bank", this time (pun intended).

Of course, once you unleash the hounds of war, so to speak, the Pandora's box is open. People are free to let their imaginations wander, to discount every impending crisis, to indulge in "doom" (and profit from it). What's important analytically is not to confuse these imaginings with the two principle uncertainties, at least in the early part of the crisis. (Later on, it is a multi-front war, arguably).


Now, "the system" has already been through one "feedback step" of a loop - the outcome of the first step is now the input to the next, by my reckoning only (there is always Hope that I'm wrong). Authorities have used all their conventional tools, almost to the maximum, but have failed to come up with a plan, yet, to deal decisively with the two uncertainties.

There are many paths to dealing with uncertainty. Standing by - standing by - with a bucket of taxpayer capital to throw around generically when 'the system' migrates to the next phase seems like a poor choice, whether or not it eventually works.

On the other hand, amounts can be tallied and made known, alongside plans to reduce leverage and risk through systemic unwinds, particularly of certain derivatives and leveraged spread risks. One of the key tools of the USG, its guarantee and its long-term holding period, can be used at the margin, to provide a stochastic floor under the value of home collateral, to directly reduce uncertainty. This may prove costly, in the short and mid-term, but it is sure-footed.

I'm sure there are plenty of other proposals to weigh and consider. It's easy enough to figure out whether they will 'work' to address the two large uncertainties.


A general fiscal stimulus is not sufficient to either of the primary uncertainties. Although it may smooth-over the eventual, realized risks, it does almost nothing ex-ante to reduce the uncertainties in any quantifiable way.

The best way to think about the fiscal stimulus, therefore, might be as dealing with the ... er, "choppy outcome" of the first step (unless we are fortunate, yet, that it reverses, even to a large degree).

Given that the scope and size of the problems remain ... unquantified and not decisively mitigated, going into part two, "stimulus" ought to focus on the long-term and on structural advances that raise the expectation, not of reflation (even in the mid-term), but of long-term variables, such as productivity, efficiency, and future capital availability.

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