A Kevlar Bubble

I may be late to the party, but is this Moldbug in 2006 predicting the 2008 recession? I don’t know enough about finance to understand the details of the conversation, but CPDOs seem to be a play on credit default swaps, so Moldbug is obviously playing the prophet here.

The Big Short oversold the narrative that NO ONE SAW THIS COMING. Plenty of people saw it coming, but their voices were drowned out by the bulls, and, in fairness to Michael Lewis, it is true that only his protagonists actually bet their money on the housing bubble bursting.

At any rate, here’s Moldbug’s comment in full, posted 30 December 2006. 


The big picture in CPDOs is that they are a classic example of government failure. Nothing like a CPDO could possibly exist in an unregulated economy. Of course, that doesn’t mean the best choice for this far-from-unregulated economy isn’t to find some way of regulating the damn things out of existence. But fortunately this is not my job.

CPDOs exist because NRSROs exist. Rating agencies (Moody’s, S&P) are not private actors. They are granted enormous official authority. Imagining the market price of NRSRO status, sold with no questions asked – for example, to a company which could shake down its clients for ratings – is one way to conceive of the scale of this delegation of power.

In a transparent, professional system of government such as ours, authority of this kind must never be personal and arbitrary. Old John Moody, perhaps, could tell his customers that Joe’s Railroad was a shoddy outfit run by notorious shysters, whose bonds shouldn’t be touched with a ten-foot pole no matter how many payments they’ve made. If his successors rate JRX, they have to justify their result with some serious math. Nothing else would be compatible with “nationally recognized” status.

As Mises pointed out in the ’20s, excessive dependency on calculation is the general flaw in central planning. The planners are constantly being forced to calculate things that cannot possibly be calculated. Credit default probabilities, especially aggregate spread projections, are a classic example.

So Moody’s can’t issue a report saying that these CPDO things just don’t smell right. It can’t call Stratfor, get a ballpark number on the chance of an Israeli-Iranian war, and factor that into the probability of a generalized credit panic. It has to do what it does – run the things through its models. Which predict, as usual, future results from past performance.

And it’s not just that Moody’s has to do this. It’s that it can do this. Because it is effectively a government agency, it has transferred all of its risk for this behavior to the state. It is Uncle Sam that will take the hit if the models fail, and rightly so. Moody’s only existential risk is failure to comply with its own properly approved policies and procedures.

Fortunately, Uncle Sam is perfectly capable of insuring the risk of the models. He can, after all, print more dollars. Which will then be used to buy bonds – keeping those spreads svelte. Moreover, with this same mechanism, he can stimulate the economy, keeping the people who actually have to make their payments flush.

This is a perfect example of an expansionary ratchet. It is a political mechanism that causes immediate pain if the presses are stopped. Hyperinflation happens because the political cost of a liquidating recession exceeds the political cost of continuing around the spiral. Systems that increase sensitivity to default, like the system that the CPDO is gaming, make the spiral harder to escape.

In other words, the more CPDOs are outstanding, the more stress the financial system will suffer in the case of a sharp credit spread widening that overpowers the “stabilizing” reaction when the CPDOs automatically react by selling protection. The CPDO machine sets up a critical point, below which it is a “stabilizing” feedback loop that causes spreads to converge (as CPDOs gear up), and above which it is a thoroughly destabilizing one, that causes them to diverge (as CPDOs max out and fail).

It is, in other words, major “bubble skin.” The lovely old metaphor of a bubble, which really just means “disequilibrium,” can easily be extended to other materials than the usual soapy water. If your bubble is made out of latex, for example, it can get much bigger and sustain a much higher internal pressure. It is harder to pop, but it makes more noise when it does.

With CPDOs, and ultimately with the power of the printing press, the bubble is the size of the Hindenburg, its interior could easily be mistaken for the atmosphere of Jupiter, and its walls are Kevlar and nanotubes. As Steve says, it is very hard to break.

And it is very important to note that it is not just the personal whim of “bulimic CBs” that supports it – it itself enforces exactly that bulimia. The bubble skin is not really the critical point of the CPDOs. It is the fact that CBs cannot allow spreads to reach that critical point.

For all the hawkish talk, they will accept any level of consumer price inflation first. It is much easier to tweak the index again (maybe it could just be the GCPI, the Game Console Price Index, measured in triangles per second per dollar) and suffer the occasional human-interest story in the Times or Post about how the man on the street thinks prices are too high, despite the fact that there is no inflation.

So fasten your seatbelts, everyone. If I am even close to right, there are no brakes on this thing, and we are headed north in a hurry. It may be a happy 2007 indeed.

  1. Hurlock said:

    Yes, that is exactly what he is doing, he is predicting the Great Recession.
    I don’t see how this is new, however. I always thought Moldbug predicted the recession because I believe he was the real author of this fine little piece (highly recommended): http://www.safehaven.com/article/5205/why-the-global-financial-system-is-about-to-collapse
    There is also a second part: http://www.safehaven.com/article/5206/why-the-global-financial-system-is-about-to-collapse-part-2

    I may be wrong, of course.
    At any rate, even if he wasn’t the actual author of that piece, Moldbug was an Austrian and he demonstrated some very in-depth knowledge of the specific causes of the Great Recession in his economics and finance posts at UR, which is more than enough to assume that he predicted the whole thing before it happened.


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