Somewhere in the debate on inheritance or death taxes lies the core of the difference in the two parties.

The difference is not in which party favors the rich over the common man, which party feels entitled to privilege at taxpayers’ expense or which party  succumbs to individual greed over the common good.

The difference is which party believes your property is yours.

If your property is yours then it is your decision what happens with it when you live and when you die. Whether it is a thousand dollars or a billion dollars why should it become the property of the government when you die? Why should government, only at that point,  decide that your children do not deserve it because they did not earn it?  Why should Barney Frank decide how much your children deserve?

We have all seen children waste a generous inheritance.  We have seen them squander it in poor investments, become slothful and just consume conspicuous luxuries, and seen it psychologically destroy families who cannot manage the impact of sudden wealth in their lives.  There are many wealthy who would roll over in their graves if they could see how their inheritance was spent.  But this does not mean that the government is therefore entitled to the money instead.

We have also seen children manage their inherited wealth prudently and responsibly, continuing family legacies and businesses, creating charitable trusts, investing in new productive enterprises, and deploying their inherited capital in ways that everyone benefits from.  Are we to lose their acumen because someone thinks it is unfair that they have money they did not earn, because they were a member of the “lucky sperm” club?

Families pass down heirlooms and values.  Are we to look at a family as a single generation?  All of us stood on the shoulders of those who came before us, and most of us want to leave our families with improved circumstances, both material and otherwise. What gives any elected official the right to expropriate family wealth because in their eyes family concerns should only last a single generation?

How will the incentive to create legacies, financial and otherwise, be hampered when we are forbidden to consider how we can benefit our children and grandchildren?  Family is a much bigger motivator than the greed that redistributionists are so wrongly focused on.

This chapter of the book on class warfare is the heart of our society.  Is your property yours or open to serve the ‘common good’?  Are you free to determine what is best for your family and grandchildren or is your work to be confiscated to serve someone else’s political self interest?

If you have the cue ball and just one other ball on the pool table lined up for shot in the corner pocket, AND you are a reasonable competent pool player then you can determine with some degree of accuracy and consistency that you will have a high degree of probability of sinking that shot.  If the shot is not lined up perfectly and you must hits the ball at some angle or if you must bank the shot off the side bumpers, then the possibility of missing the shot escalates.

Now add another ball between you and the target ball, and the risk of missing the shot escalates enormously especially if the second ball is off center. By the time you add several balls to the table the likelihood of making the shot drops to near zero. The analogy is that the more variables you add to a system the less you are able to predict with any certainty.

You can predict with great certainty that you will miss the shot when several balls or variables are added to the scenario because the uncertainties and variables are very visible.  If there were several balls on the table and they were invisible, then you would look at the table and discern that you had a much greater chance of making the shot that you would actually have.

In retrospect the collapse of the financial system showed plenty of visible signs of impending doom.  There were several prominent analyst who warned us. One of them was Nassim Nicholas Taleb, author of The Black Swan (the pool table analogy is partially from that book).

The handicappers used risk models with two large defects.  The models were created in a world where all the pool balls were visible, where the chances of gain and loss were subject to measurement and where the amount that could be lost was somewhat limited even if possibly severe.  Taleb called this world Mediocristan. These models were applied to a world where the pool balls could become invisible, where risks were less subject to being known and measured and where the losses could prove fatal to the system.  It is foolish to decree with some delusional certainty that there is only a one per cent chance of a loss without considering the size of the potential loss.

It was foolish to apply game theory to a world void of the fundamental assumptions of the theory and it was even more foolish to consider risk of loss without considering the amount.

Why do we use such flawed thinking?  We seek the comfort of order where there is none. We are reluctant to admit that we do not know.  The more complicated our systems get (not just financial systems) the more we depend on intellectuals and academics for the answers.  These people do not thrive by focusing on what they do not know.

To use another analogy from Taleb’s book, it is like being lost in the Alps and using a map of the Pyrenees because that is the only map you have, and it is thus better than nothing.  No it isn’t: you are far better to use your own eyes and senses than a flawed model.

Rather than replace one horribly flawed model with another we need to recognize that we are in a game with invisible balls, unknowable risks, and with risks that can kill the host.  Much of the risk can be addressed by eliminating excessive and dangerous debt. More can be done by breaking larger units into smaller units but we must also reduce or eliminate interrelated risks.  We are no better off with smaller units so related than they will all go up and down together.  The last crisis saw unhealthy large institutions tied to every other large institution with activity so interrelated that it behaved like a single diseased entity.

The new Frank Dodd Financial reform addresses none of this. It assumes that we can compensate for the miserable failure of regulations and regulators with more regulators and regulations.  In 2006 Barney Frank angrily denounced those who warned Congress of the looming dangers  in Fannie Mae and Freddie Mac. Fannie and Freddie were exempt from most regulatory oversight from the Treasury, the SEC , and the FDIC; they were regulated by Congress themselves with Frank and Dodd in the most responsible positions as head of the House and Senate Banking Committees.

The monumental failure of Fannie and Freddie was at the center of the financial collapse, yet both are exempt from the financial reform package.

Those who believe that in light of the severity of the collapse that we must do “something” are still lost in the mountains and they are still using the wrong map.

George Melloan writes in The Wall Street Journal,  The Lessons of Basel’s Bean Counters

Summarized:

In 1988 the banking regulators from  20 leading industrial nations of the International Monetary Fund met in Switzerland and created Basel I to create a common set of banking standards by setting risk based capital standards, and assigning degrees of risk.

But the Japanese banks were bragging about their compliance when they tanked in the 1990’s.

So they created Basel II.  Standards were toughened to include trading in securities and derivatives. All of this seemed irrelevant in stopping the meltdown of 2008.

Excerpt:

The international banking tumult of 2008 was not a result of insufficient rules or even primarily of noncompliance with the rules. Banking is perhaps the world’s most regulated major industry. As in Japan in 1990, the imperatives of politics simply overrode what the rule makers and rule enforcers were trying to accomplish, turning their labors to dust.

The 2008 crisis resulted when the Fed-created credit bubble collapsed and soaring housing prices deflated as well. To promote “affordable” housing, Bill Clinton had excused the two giant government-sponsored housing finance agencies, Fannie Mae and Freddie Mac, from normal banking rules, allowing them leverage ratios far in excess of the limits on ordinary lenders. Banks were forced to write risky mortgage loans, a large number of which were then folded into mortgage-backed securities that Fannie, Freddie and others sold internationally with triple-A ratings.

This business seized up, crippling banks throughout the world, when holders began to realize that the assets that backed the securities, home mortgages, were going under water at an alarming rate. One of the great ironies of our times is that the two strongest defenders of the Fannie-Freddie shell game, Chris Dodd and Barney Frank, are now in charge of reforming banking regulation.

The better solution is clear rules, commonly understood financial prudence, and control of debt.  Yet our current government administration, which practices none of this, proposes to fix our financial system. I have yet to hear a peep out of Congress taking any responsibility for our financial mess.  This will only increase the likelihood or repeating or worsening the next crash.

(this was published previously in the Macon Telegraph)

Being in the middle of a record economic crisis presents a rare learning opportunity.  Several books are worthwhile for those seeking to understand what just happened.

Too Big to Fail by Andrew Ross Sorkin details the action of the Fed under Benanke and Treasury under Paulson during the crisis period between August and December.  While Geitner as head of the New York Fed was also featured the central player of this crisis was Hank Paulson.

Monumental decisions involving billions of dollars of assets were made in days, sometimes hours.  Both Paulson and Geitner had a sense that the market was due for a correction long before the crisis hit, but they probably did not see it coming as fast and as broad as it did. Bernanke noted that just as there are no atheists in foxholes there are no ideologues in economic crisis either. Neither Republicans or Democrats wanted to bail out Wall Street , but the crisis dictated actions that were against the grain of capitalists of both parties.

Paulson worked tirelessly to find appropriate merger partners for weak players like Merrill Lynch, Wachovia, and Lehman.  He almost had Barclays ready to buy Lehman when the British Financial Services Authority ( FSA) refused to approve the acquisition/merger because of the risk it brought to the British financial system.

Lehman was singular in the fact that it was not acquired or bailed out and thus had to go bankrupt.  Part of this was timing; Congress was just in no mood to bail out a Wall Street player.  Part of the reason was George Bush’s cousin who worked for Lehman and his brother Jeb’s association with the firm. Such close political relations probably worked against the interests of the firm.

In retrospect bailing our Lehman’s may have forestalled the panic that engulfed the rest of the system. With Bear Sterns gone and now Lehman’s gone, depositors wondered who was next and there began a run of the other banks like J.P Morgan and Morgan Stanley.

While Paulson’s association with Goldman was suspect the fact was he had to severe his tie and sell his stock ($485 million worth) in order to take his job at Treasury. Since his actions were so scrutinized he was careful to avoid even conversations that would indicate favoritism toward his old firm.

The most difficult decision was to bail out AIG whose credit default swaps acted as insurance against many of the cdo’s (collateralized debt obligations) that infected the financial markets. As the underlying assets plummeted in value AIG was downgraded and had to put up more capital that it could not provide.

Having to make such massive changes and decision in such short time meant that perfection was not obtainable. Barney Frank justifiably wanted some assurance that compensation to the executives would suffer from their misdeeds, but there simply was not enough time to rule of thousands of contracts during the time period that decisions had to be made.

Wall Street clearly engaged in risks it did not understand, but neither did the regulators such as Greenspan and his successor Bernanke. Complicated risk models gave the CEO’s delusional certainty, but eventually the party came crashing down for the same reason all bubbles burst;  lack of trust and confidence.

But Sorkin spends little space getting into the detail of the causes of the crash and suitably stays focused on the urgency and the actions required in response. 

For more information on the background that caused the crisis I recommend The Housing Boom and Bust by Thomas Sowell,  Financial Fiasco by Johan Norberg, most of all After the Fall: saving Capitalism from Wall Street – and Washington by Nicole Gelinas.

Sowell and Norberg focus more on the misguided Government fiscal and monetary policies that inflated the housing bubble, but Nicole Gelinas also analyzes which good regulations were unfortunately removed (and by who) and which bad ones were inappropriately applied.

A crisis of this nature required the perfect storm of many great errors to all focus their retribution at the same time. Unfortunately the media large engages in partisanship and demonization and few people will take the time to understand what happened and why.  It is complicated but engaging the problem reveals basic principles of sound policy that were violated as they were in previous bubbles.

History repeats itself but never the same way.

There are those who see our financial problem as a moral failure. In one sense it is, but not in the sense those who wish to frame it in moral tones believe.

To blame greed for the meltdown is simplistic and irrelevant. Greed has been with us forever. Why would it appear in its ugliness now?

I would say that our economic collapse was the fault of a moral supremacy that ignored sound economic principles and common sense.  In an effort to encourage home ownership for the poor, the government demanded that prudent lending standards be forced out of the system. To assure a market the government through Fannie Mae guaranteed mortgages and ridiculous financial instruments to feed the market.

When alarms were being sounded the regulators and legislators were being hounded with political pressure from lobbyists for the very firms they were regulating. Chris Dodd, Hillary Clinton and Barak Obama were among the largest recipients of campaign funds from Fannie Mae.  Barney Frank and many others loudly protested those who warned of a problem, insisting that these programs providing housing for the lower income were somewhat sacrosanct.

It was the unwillingness to understand the limits of government to fulfill our moral wishes that fed this mania.  It was our pursuit of moral justice through government force that led taxpayer funded ACORN to pressure banks to make high risk loans to those who otherwise would not have qualified.

It was not greed or the absence of morality that caused this disaster; it was the ignorance of basic economic principles and the belief that the government can create wealth by making promises it can’t fulfill and that it can erase risk by ignoring it.  In its malfeasance it made the poor worse off and destroyed equity value for millions of the middle class.

If there is a moral failure it is that the government refused to accept its limitations, and that the voters wanted a government that will promise them everything.

The greed of those who wanted a modest house they could not afford caused us more damage than the titans on Wall Street who found a way to get rich delivering the voters their delusion.