Platt Perspective on Business and Technology

Open markets, captive markets and the assumptions of supply and demand dynamics 12

Posted in book recommendations, macroeconomics by Timothy Platt on May 20, 2016

This is the twelfth installment to a brief series on underlying assumptions as they arise and play out in economic systems, and in production and marketplace systems (see Macroeconomics and Business 2, postings 230 and loosely following for Parts 1-11.)

I have been discussing economic friction through the course of writing most of this series, and have been discussing its politically grounded manifestation in that since Part 8. And to orient this installment with that preceding flow of discussion, I begin here by repeating two term-defining bullet points that I have been building from (with some minor changes added for clarity):

• Economic friction and business systems friction are the consequential outcomes of miscommunication and communications delays, and of failures in acquiring and acting upon essential business intelligence in a sufficiently timely manner. (There, the primary distinction between economic, and business systems friction is one of scale where business systems friction arises and plays out at the levels of the individual business and the individual business-to-business collaboration, while (macro)economic friction arises at higher and more far-reaching organizational levels. Business systems friction could be deemed in this context as representing microeconomic friction, though the word friction per se is probably used more by macroeconomists than it is by microeconomists.)
• Politically grounded economic friction is economic friction that arises as a result of adherence to preconceived ideologically driven vision, and even when that means acting in denial of direct empirical evidence to the contrary. Politically grounded economic friction arises and flourishes when politically driven ideological purity overwhelms empirical reality as a source of guiding principle.

I briefly outlined in Part 11, how ideologically driven political decisions led the United States into profound recession in late 1929. And I went on to at least briefly sketch out how further purblind politics turned that recession, that might have been recovered from as such, into a truly global Great Depression, with the key legislative action that forced that outcome going into law on June 17, 1930.

Then at the end of Part 11, I stated that I would continue its core line of discussion here, turning to the, as of this writing still quite recent Great Recession. I will focus on that here. And after adding that piece to a conceptual puzzle that I am assembling in this series, I will turn to consider China and its current economy and its current behavior, both nationally and internationally. In anticipation of that narrative to come, I will explore something of China’s current economic predicament and its prospects moving forward. And I will do so both in terms of this posting and its observations, and in terms of the history that I laid out in Part 10 of this series (where the nation under direct consideration there, was Japan.)

• But my first step in all of that discussion to come is to at least briefly and selectively analyze the Great Recession that began in 2007, doing so in terms of consequences faced and lessons that were learned and then forgotten coming out of the Great Depression.

And in anticipation of that, I developed and offered Part 11 of this series as what amounts to a checklist of issues and actions that led to the Great Depression and that later-generation business professionals have more recently collided with in bringing us the Great Recession. I note here in anticipation of that discussion to come, that different nations and groups of them entered the Great Recession at different times, and that they stayed mired in it for different lengths of time. So the issues that I write of here, globally span a much longer period of years for their direct impact than might be apparent when only considering this economic catastrophe in terms of any single affected countries.

But as noted above, I begin here in approximately 2007 and in the years leading up to it when the Great Recession and a growing potential for it first really took hold. And I begin analyzing that progression of events by summarizing and listing some of the key checklist elements from Part 11 that I would reconsider here, as representing key points where history has pivotally been repeated.

George Santayana wrote (in The Life of Reason, 1905): “Those who cannot remember the past are condemned to repeat it.” This is often paraphrased as “those who do not learn history are doomed to repeat it,” and it is often offered in that or similar forms as if the original quote. But whatever the form of this assessment that might be preferred, the basic message in it remains the same – and history proves it equally, compellingly valid however stated, and over and over again.

The Great Depression arose the way it did as a consequence of a great many actions and decisions, and both in the private sector, and politically and governmentally. And the key to understanding their role there on both sides is that those decisions and follow-through actions fit toxic patterns, and in ways that both enabled and encouraged bad practices as standard practices. This is important:

• The Great Depression did not arise as a consequence of a few bad actors making essentially one-off, one-time decisions and acting upon them.
• The Great Depression arose because the entire business and economic system had become risk-laden from bad behavior and from even worse standard practices that had come to be all but universally followed,
• And certainly for multiple key industries and the businesses that operated in them,
• And for much of the political ideology then prevalent, and for the politicians and elected officials who enacted that ideology into law.

And two of the more impactful factors encompassed there leading to the Great Depression as noted in Part 11, that were reprised and repeated in bringing us the Great Recession were:

• A politically motivated and driven laissez-faire ideology, according to which any regulatory control or oversight is bad for business, and that regulatory oversight per se is fundamentally anti-free market and contrary to democratic principles or the needs of a democratic society.
• And a largely politically supported if also largely automatically assumed attitude of caveat emptor (let the buyer beware) in the marketplace, coupled with a “sales and profits at any cost and in any way” attitude, and in real estate, financial investment, banking and a host of other industries and sectors.

Together, these societally shaping allowed-realities led to essentially the same toxic consequences, both times,

• With extreme opacity in the marketplace, where investors and buyers could not access the information that they would need in order to make prudent, risk and benefits based analyses on where and whether to buy or invest.
• And to complicate this even more for the consumer, businesses and certainly in banking and investment arenas exhibited profound levels of conflict of interest, where for example banks that presented themselves as offering safe and secure investment opportunities, also had under their roofs their own investment product development business lines and even their own in-house hedge funds – where they made a profit by in effect betting against those same presumably safe investments. This practice became the norm for essentially all major banks as they sought to expand their business reach and their profitability, and it is of course is a (non-)working example from the years leading up to the recent Great Recession, and just as much as it represents one of the sources of structural weakness that led to the Great Depression.

But to add some (non-)working examples to the first of those bullet points and citing just one industry sector where that type of intentional and contrived opacity prevailed, I would turn to hedge funds and even to investment services in general, and to real estate backed investments in particular as a source of consumer investment opportunity. And I raise note here of how mortgage loans were bundled as investment opportunities into aggregated investments, mixing low and high risk loans into single investment offerings and in ways that made it essentially impossible for any investor to know what was actually in them. So high risk, poor credit rating mortgages were mixed in with low risk, high credit rating mortgages into single investment offerings, and with opacity and deception as to the true balance of good and bad included in them. And these offerings were in turn bundled into larger and more complex investment derivatives, and they were in turn combined together to form secondary derivatives, and so called synthetic derivatives.

And the principle ratings agencies: (Moody’s and Standard and Poor’s) kept assigning all of these investment offerings the highest credit rating scores possible, and when they and their analysts did not themselves know what they were actually evaluating; they could not see through the complexities of how all of this was packaged either and they knew that. And to highlight the conflicts of interest inherit there, these ratings agencies received their income from the very same financial institutions that were putting these offerings together that they were evaluating. And the managers in both of those ratings agencies knew that if they only offered lower, more prudent ratings evaluations on these investment offerings, those businesses that created them as bundled offerings and that they were paid by, would take their business to the competition. If they lowered their ratings offered on these investments, that would very significantly and very directly impact on their own revenue flow.

I couch this in immediately pre-2007 Great Recession terms and this did significantly contribute to the collapse of the housing market and the economy as a whole then. But this did have its direct counterparts in the late 1920’s too. Once again, history was repeating itself. (See this piece on tranches for a brief orienting discussion of how structured financial investments are assembled from different investment class ratings pools. And see Derivative (finance) for a corresponding introductory discussion of collateralized debt obligations, credit default swaps and the menagerie of derivative variations that were constructed leading up to 2007 and that went into making the Great Recession both possible and inevitable.)

And in anticipation of future postings here, look up a brand new twist on this story that is coming into its own as I write this: the new (but not really) bespoke collateralized debt opportunity (bespoke CDO) and its single slice of the pie variation: the bespoke tranche opportunity. And see The Bubble Is Complete: ‘Smart Money’ Buys Into Bespoke Tranche “Opportunity” (Again). There is a reason why I said “and history proves it” and again and again when I quoted Santayana above.

I am going to continue this discussion in a next series installment, where I will focus on the role of legislatively enacted law in all of this, discussing among other issues: the Glass-Steagall Act and the Dodd–Frank Wall Street Reform and Consumer Protection Act. And I will also, of necessity, discuss the politics of challenge to reform that arose when these and similar laws have been drafted and brought into effect. Not everyone sees positive benefit as a likely outcome from these efforts at reform, and even as they are explicitly offered as regulatory restraints to prevent a next Great Recession or Great Depression. Then, as noted above I will turn to consider China in this context.

Meanwhile, you can find this and related postings at Macroeconomics and Business and its Page 2 continuation.

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