Speculators need to be reigned in (but not squashed)

Linda Beale commented (Angry Bear) on Darrell Duffie's defense of speculators' role in the financial system, and I felt compelled to offer another two cents. In his opinion published in the WSJ (Feb 24), Duffie cited standard arguments from economic theory. As far as that goes, fine: speculation is useful, and speculators have their place.

But what theory suggests that speculators require or deserve or ought to have access to credit that gets them to leverage (debt-equity) ratios of 20 or 30? Some staunch free-market advocates (although I am not pulling these words from Duffie's mouth) might say, "If the market gives them that kind of access, then it's OK; it must be efficient". BULLCRAP! The downside here is obvious: you can't get blood from a stone. So as long as the liability of bankrupts is protected by law, the leverage that speculators are allowed to take on should be regulated, as well.

In principle, I see no reason why speculators should be allowed to take asset-capital positions exceeding one. (Heh heh!) OK, that's entirely unrealistic, since we would be hard pressed to parse "speculation" from "investment". But only speculators (or very poor managers) pilot financial institutions with leverage exceeding 20 times capital. When institutions in such condition are large, they make the entire financial system more risky. (Note the conflict here with Duffie's emphasis on speculators' absorption of risk.) I have a hard time seeing that Duffie's arguments apply unaltered to these institutions. At the very least, they should be subject to the same sort of regulation that commercial banks are.

Effect of a change of Chinese monetary policy?

I would like to put out a call for some (more?) evidence on the quantitative effects of an appreciation (at the extreme edge, a float) of the Chinese currency. Simon Johnson's post suggests that the U.S. need fear neither inflation nor spiraling interest rates from such an event. I'm a little skeptical about this, and I would like to hear more about evidence supporting such claims. I will now express my prior beliefs, the seeds for my skepticism.

On inflation, who knows? At the very least, the sluggish adjustment of prices would likely mitigate the hurt of the effect on inflation.

But I buy into the Global Saving Glut theory; and if the accumulation of U.S. assets has pushed down U.S. interest rates, then I have to think that the discontinuance (or reversal) of that kind of behavior would work in the opposite direction with the same degree of force. Moreover, Johnson's claim that the Fed can do much to mitigate such pressure seems hollow. The Fed controls some short rates, and can influence long rates buy buying long-bonds. But it is my understanding the Fed's expressed goal is to reduce the size of its balance sheet over the longer term. In any case, I don't think the Fed can counteract global flows on that scale.

In summary, I am more inclined than some to believe that this has the potential to end badly for the U.S. I think U.S. interest rates have to rise, and that rise has to potential to happen very quickly to devastating effect. I think the strongest reason for optimism lies in the impressive degree of control that the Chinese have shown over their currency peg. In particular, it strikes me that the Obama administration ought to be encouraging the Chinese to perform the kind of artwork they exhibited during their managed appreciation from 2005 to 2008. That seems likely to offer the best outcome to all concerned (a certain class of currency speculators excepted).

Who are the counterparties?

I read this morning in the WSJ that the price of insuring a portfolio of Greek sovereign bonds has risen dramatically in recent weeks. This is natural, and unsurprising in itself; however, it reminds me to ask, Who are the counterparties to these insurance policies? I don't know the answer, but it seems important.

In my mind, of course, is the collapse after the Lehman default of AIG, brought about by the its CDS obligations.

Here's a metaphor for the AIG collapse. A bunch of delinquent financiers decide that selling insurance against the failure of the sun to rise would be good business. I mean, it's not going to happen! ("And even if it does, the buyers won't be able to find us in the dark", they must have thought.) Unfortunately, there were no buyers for this instrument. Why? Because it's not going to happen. So they decided to sell insurance against something that might happen, but probably won't. Unfortunately, the "it's not going to happen" part of the plan was the crucial element that made "sun insurance" a good idea. The AIG losers didn't plan for the Lehman default scenario any better than they would have prepared for the failure of the sun.

Now, I (half?) expect that the community of high finance practitioners has noticed the difficulty, and worked it out this time. That is, that someone has taken steps to verify that counterparties to these CDS things will have sufficient capital to service obligations should Greece default. But even so, I still want to know how! Is there no such thing as systemic risk anymore? Have the financial engineers worked out sun insurance, too?