The Emperor’s New Clothes and feedback loops

Yes, the title was supposed to intrigue you. What do the story of the Emperor’s New Clothes and feedback loops have to do with anything?

We are at an extremely critical and dangerous moment right now. The world’s financial system, in the end, depends on everyone believing that it is safe and stable and solvent. As long as everyone believes that, business can continue as usual. But like the Emperor in the story, when someone finally voices the obvious – that he has no clothes – the illusion disappears in an instant, and in the financial world that instant has come. Years of reckless borrowing and reckless lending practices have begun to come home to roost, and now major banks are failing, one after another, like dominos falling.

The feedback loop part of the story is that once confidence is shaken, people try to pull their money out, making things all that much worse. Yesterday there were literal “runs on the bank” in AGI offices in Asia. We now have all sorts of feedback loops making things worse. The stock market is in free fall, so stockholders are fleeing to bonds, and all those buyers who bought on margin are having to sell to meet margin calls, further depressing the market. Home prices have plummeted, so that mortgage holders no longer have the equity on their books that they used to have, weakening them more. And now it is getting harder to get loans, making it even more difficult to sell homes and further depressing the real estate market. And so on and so on.

There are more big shoes to drop – more banks will likely fail or have to be saved by the government or a buyout in the next few months. But there is a much bigger shoe that we ought to be worried about – all that federal bail-out money in the end comes largely from money that the government borrows on the world bond market. There is a very real danger that the world bond market will get spooked and stop buying our bonds, which cuts off that supply of bail-out money (and indeed the money that pays for most of the government these days). Since the treasury needs to sell many of these bonds just to roll over existing 30-, 60- or 90-day debt, if the world stops buying US bonds, we suddenly owe trillions of dollars to other nations that we can’t pay.

I would be happier if there were the slightest indication that our politicians had a clue what to do to get us out of this mess, but I have no such confidence. The Bush administration, a lame-duck administration in any case, seems to be mentally on vacation. Rhetoric and charisma aside, Obama and Palin are both untried newcomers to national politics, and McCain and Biden are both political insiders (personally attractive, but still insiders) from a Congress that has been remarkably inept and ineffective for years under the control of either party. The fact that in this crisis neither political party has been able to formulate more than trite partisan sound bites to address the problem says a lot about how bad our problem is.

One promising light is that the Federal Reserve at least seems to be thinking fast and doing what is necessary to keep the boat afloat for the moment. But it will take more than that to handle this crisis. It will take far-sighted bipartisan statesmanship and close cooperation with most of the other nations in the world to solve this problem.

The other promising light is that underneath it all, American productivity and innovation is essentially unaffected by all this turmoil. America still has the vast natural resources and the highly-skilled workforce and the great higher education system that it had before this crisis began, and in the end (but perhaps after some painful times) we will pull out of it, probably in better shape than most of the rest of the world.

But this crisis ought to remind us again that the world is a complex and demanding place, and we ought to require leaders and a government of higher quality than we have put up with in recent decades. Both presidential tickets have pledged to end partisan sniping, and then gone right on with the usual partisan sniping. Both have made politically popular but economically meaningless promises. Both political parties are enamored of their respective ideologies to the point that they have lost sight of the real world. And this fecklessness will go on unless and until the American electorate forces it to halt by refusing to support such candidates and such parties.