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Friday January 16, 2009

We are in the beginnings of the collapse of a fiat currency. Actually, it's the collapse of a type of credit that has been treated as though it was currency, but it's rise and fall closely mimics the natural history of fiat currencies. Back in the 19th century banks would issue their own currency, backed by government bonds that would be held as security by the Treasury Department. Starting in the 1990s, financial institutions began doing something like this again, although this time around the currency has been the triple-A rated tranches of mortgage-backed securities (MBS) and collateralized debt obligations (CDO). And, while our forbears in the 19th century could assure themselves that a bank note was supported by the credibility of the U.S. government, this new currency was backed by the paid-for opinion of the rating agencies. Assured by Triple-A ratings that these instruments were money good and completely liquid, bankers thought they had discovered the philosopher's stone -- a risk-free, high-yielding asset -- and this new credit/money has found its way into every corner of the financial system from teacher's pensions to commercial paper to money market funds. Moreover, once the printers of this new fiat currency realized that there was an appetite for their product among yield-starved institutional investors, they did what every unrestrained ruler with a printing press has done since the dawn of money: they began minting more of it. In this case, credit/money was inflated through the re-securitization of already securitized assets. The Mugabes of hyperinflation in this case were the rocket scientists in structured finance, and the Zimbabwian extreme are so-called synthetic CDOs, arcane confections which invest in tranches of CDOs. These "innovations" leverage the underlying subprime assets to dizzying multiples so that tens of billions of dollars in subprime originations might ultimately support of a trillion dollars in CDO tranches. At the tail end of this whip, tiny variances from the assumptions about the performance of the underlying assets can vaporize the value of these supposedly rock solid assets. This new fiat currency exploded during the period of skyrocketing home price appreciation, but it should be noted that almost everything worked during that period. What securitizers and holders are discovering, however, is that a fiat currency rests on nothing more than the willingness of someone else to accept it. And, now that the market, most ominously the vast commercial paper market, has discovered that credit is not money, the contraction has begun. The question of the moment is whether anything can be done to slow it, much less stop it? Eugene linden [ Huffington Post ran this in Aug. 2007. I put it up now because Sheila Bair has just suggested the solution proposed in the last paragraph] If the Federal Reserve lowers rates, it risks a precipitous fall in the dollar and a big rise in long term rates, which would only worsen the situation for over-indebted consumers and homeowners. Similar risks accompany other Fed strategies by which they might inject liquidity (the only reason that the euro did not fall more after the ECB's massive liquidity injection was that central bankers around the world were all doing the same thing). Most likely, the best we can hope for is an orderly blood-letting with pain apportioned where it is deserved. The device that might help accomplish that might be a public-private corporation (largely funded by the big banks that promoted and profited from this mess) set-up to exchange currently illiquid CDO/MBS tranches for tradable notes in the enterprise. This will not solve the many other problems attending this credit contraction (including counter-party risk in the CDS market), but it will buy time, and time is everything when bills come due. We've done this before (Felix Rohayton's creation nicknamed Big MAC calmed markets during New York City's financial crisis in the 1970s), and it will help supply liquidity and price transparency in this vast market. A fix like this won't much reduce the pain for either investors or overstretched homeowners, but it could reduce the growing risk of panic, paralysis and systemic collapse. It will also minimize moral hazard by doling out financial punishment mostly to those who deserve it.

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Short Take



An oped involves extreme compression, and so I thought I’d expand on why I think the initial IPCC reports so underestimated the threat. Make no mistake, the consensus in the summaries for policy makers in the first two assessments did underestimate the threat. The consensus was that permafrost would be stable for the next 100 years and also that the ice sheets would remain stable (there was even a strong sentiment at that time that the East Antarctic sheet would gain mass). Moreover, in 1990, the concept of rapid climate change was at the periphery of mainstream scientific opinion. All these things turned out to be wrong

Of course, there were scientists at that time who raised alarms about the possibility of rapid climate change, collapse of the ice sheets, and nightmare scenarios of melting permafrost, but, fairly or not, the IPCC summary for policy makers was and is taken to represent the consensus of scientific thinking.

In my opinion such documents will always take a more conservative (less dramatic) position than what scientists feel is justified. For one thing the IPCC included policy makers, most of whom were more incentivized to downplay the threats. For another, many of the national governments that were the customers for these assessments barely tolerated the exercise and gave strong signals that they didn’t want to see anything that called for dramatic action, and this being the UN, there was a strong push to present a document that as many governments as possible would accept.

And then there is the nature of science and the state of climate science at that point. There is an inherent structural lag built in to the nature of science. For instance, the 1980’s were marked by the rapid development of proxies to see past climate changes with ever more precision. By the mid-late 80’s the proxies and siting had been refined sufficiently that the GISP and GRIP projects could confidently get ice cores from Greenland that they felt represented a true climate record and by then they also had the proxies with the resolution to see the rapid changes that had taken place in the past. Given the nature of data collection, interpretation, peer-review and publishing, it wasn’t until 1993 that these results were published.

It took nearly another decade for this new, alarming, paradigm about how rapidly global climate can change to percolate through the scientific community, and, even today, much of the public is unaware that climate can change on a dime.

As for the ice sheets, when I was on the West Antarctic Ice Sheet in 1996, there was talk about the acceleratio of  ice streams feeding the Thwaites and Pine Island glaciers, but the notion that there might be a significant increase in runoff from the ice sheet over the next hundred years was still very much a fringe idea.

With permafrost, the problem was a sparsity of data in the 80s and early 90s and it is understandable that scientists didn’t want to venture beyond the data.

The problem for society as a whole was that the muted consensus on the scale of the threat diminished any sense of urgency about dealing with the problem. Perhaps the best example of this was the early work of William Nordhaus. Working from the IPCC best estimates in the early 1990s Nordhaus published one paper in which he predicted the hit to the US GDP from climate change in 2100 would be about ½ of 1%. Nobody is going to jump out of their chair and demand action if the hit to the economy was going to be 0.5% of GPD a hundred years laterLibertarians such as William Niskanen seized on this and testified before Congress that there was plenty of time to deal with global warming if it was a threat at all.  

And then there was the disinformation campaign of industry, particularly fossil fuel lobbyists, as well as pressure from unions (the UAW in particular) and the financial community. These highly motivated, deep-pocketed interests seized on scientific caution to suggest deep divisions among scientists and that the threat was overplayed. Little wonder then that the public failed to appreciate that this was a looming crisis that demanded immediate, concerted action.


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