Could you please translate that first paragraph quote into something approximating English. I studied humanities for god's sake.

Maybe the best way to put it that it's too hard to make obscene and endlessly increasing amounts of money on old-fashioned responsible financial transactions (unless you're Warren Buffett), and too easy to do it with the latest "financial engineering" scams - at least if you're big enough for the Fed to have your back. If the Fed hadn't bailed out LTCM back in the 90's, you can bet that investors would have been a lot more leery of wild leverage rates.

Of course, a mania for leverage is nothing new: the stock market crash of 1929, for example, was partly fueled by low margin requirements that caused investors to take huge losses when the market started to tank.

Pikers! The best you could do on a pre-crash stock purchase was 10:1 leverage (you actually had to put 10% down). Nowadays 30:1 or more is common. That's more in Charles Ponzi's territory.

Could you please translate that first paragraph quote into something approximating English.
It says that a tax cut for rich people would solve our financial crisis. I'm sure John McCain could explain this to you, if you asked him nicely.

All this is fun for the sake of speculation, but it's dangerous to implement policies, even to recommend the implementation of policies, when the problem you are trying to remedy is A) not understood, and B) still in the process of unwinding. The Acts which still largely regulate the securities industry were passed in 1933 and '34 -- four years after the Crash of '29. I wonder what those Acts would have looked like if they'd been written and implemented in 1929.

We're already restructuring our federal banking system, which has taken an unprecedented amount of authority over the economy in the past few weeks and is about to get even more. We're passing stimulus bills, running an election, a war -- you're demanding that too many balls be thrown into the air at once, especially considering the idiot who would be juggling them for the next several months. Let's try to separate things into manageable chunks, here. First, let's get things stable, then find out what went wrong, then, and only then, start talking about ways to remedy it and minimize the possibility of a recurrence.

http://markharrison.wordpress.com/2007/12/11/the-subprime-crisis-as-explained-by-bird-and-fortune/

Here's a clear explanation of the sub-prime crisis

Martin: Actually, I agree with you. Especially the part about waiting to do anything serious until the current occupant of 1600 Pennsylvania Avenue is safely ensconced in Crawford clearing brush. Which is about the most complex thing I'd trust him with.

Still, it seems useful to talk about this stuff now as a way of guiding the conversation.

Maybe the system of financial derivatives is really a pyramid scheme in which the downwards direction in the pyramid are financial products of exceedingly complicated risk structure. The financial stuckees in the system are those that got bamboozled into investing in these intricate schemes.

Stated more formally, the picture is as follows: The financial products at level n being are derivatives of products at level n-1. The ability to create such products is supposed to make the market more efficient by eliminating arbitrage opportunities and other market imperfections. However, the risk structure at each level becomes progressively more complex. the likelihood that some risk assumption will fail (or even be misunderstood by both buyers and sellers) increases, much the same way that the likelihood of a ponzi scheme collapsing increases as the base increases.

Yup, if the take away point of the Internet bubble was "A Ponzi scheme without a Ponzi", then the takeaway point of this bubble is fantasies of "20% risk free returns", fueled by no reserve requirements leading to uncontrolled leverage ratios.

But a question. How feasible is it to mandate capital requirements for everybody - i.e. in effect, to outlaw uncontrolled leverage ratios?

If straight out outlawing too much leverage is not possible, this is one situation where disclosure could make a difference.

You can imagine wealthy investors believing a hedge fund's pitch about "20% risk free returns", but you can't imagine them buying the sales pitch from a hedge fund which had to disclose it was leveraged 10 or even 3 to 1.

I think the "exuberence" Kevin refers to is related to a topic I've only recently begun to read about: financialization. Financialization is a change in the nature of an economy, a shift from the actual production of goods and services to the generation of fees and commissions.

In short, I fear we're becoming a nation of money-changers.

Mandating uniform capital reserve requirements is silly -- no one would even know what uniformity meant. Does an insurance company need the same capital reserve as a local savings bank?

It makes no sense.

What would make sense is a modern version of Glass-Steagall. Forget universal banks and financial conglomerates. Create some walls. If there's a commercial banking sector that is boring, but safe, we can afford to have an investment banking sector, which is wild and crazy. (I am not saying that cb/ib, a la Glass-Steagall has to be the division -- we could be a little more clever than that. I'm just saying, specialization and variety are economically desirable for a variety of reasons.)

Build some walls. Regulate inside those walls. Don't try to regulate everything in the same way.

Today I heard the best explanation for what went so wrong with the financial markets and the economy in Terry Gross's Fresh Air interview with law professor Michael Greenberger (former commissioner on the futures trading commission).

The sub-prime mortgage crisis, credit defaults, CDOs, SIVs, the shaky future of other types of loans and what we can expect from the U.S. financial markets--it's all here: http://www.npr.org/templates/rundowns/rundown.php?prgId=13

The surprising thing was that it can be traced back to two bills introduced in 1999 and 2000 by Phil Graham (now McCain's economic adviser). An amazing interview that clearly explains how the shadow financial system was created and kept free from regulation, transparency and accountability.

Maybe the best thing I've heard on Fresh Air . . . and I've heard a lot of good programs there.

DevilDog has it right.

Here's a link:

http://www.npr.org/templates/story/story.php?storyId=89338743

Another possibility is that the high-end tax rates are too low. There's a big pile of money looking for returns, and the last dollar invested is probably not as productive, or as intelligently invested, as the first dollar invested. Shrink that pile, people will invest it a little more carefully.

This would have a beneficial effect on our deficit and debt, too.

I believe that Kevin Drum is trying to remember a post by Alex Tabarrok on the blog Marginal Revolution on March 27, 2008 entitled "Interpreting Tylerian Science Fiction." I don't know how to post links in comments or I would.

I think dr2chase is half right that the supply of investment funds is one of the big problems - there's so much money chasing what have become fairly small overall returns in these days of low interest and inflation that it makes it very hard to do anything impressive without employing huge amounts of leverage. However, there's a whole host of reasons for this, not just the high-end tax rates: increasing overall household wealth, larger pension funds, money coming in from the developing world, including sovereign wealth funds (remember that the effect of the removal of financial controls in the 90s was an outflow of funds from the developing world to the West).

The massive increase in hedge funds in recent years is based on the premise that there has been a big increase in market inefficiencies that managers are able to exploit. Alternatively, the ability of managers to exploit market inefficiencies has improved.

Neither premise seems likely to me.

I also agree about the tax rates on the high end being too low. They need to go to 70% for the top 1%-you could eliminate corporate taxes in exchange combined with incentives for domestic investment. That should put the brakes on the obscene CEO pay structures and get more modestly paid, but more responsible and competent people in charge. Stop rewarding incompetence.

duncan is on the mark. the problem is that there is a huge amount of dollars, euros, yen flying around the world at electronic speed looking for outsized returns. this flow of funds greatly exceeds the amount of economically viable investments. the financial types have created investment vehicles to soak up that flow and theoritically create positive returns for the investors. its a ponzi scheme because most of the investors will never get a positive return and may even lose a high percentage of their principal. $43 trillion in derivative contracts are out there -- does anyone seriously believe that all of those bets will be paid off?

"Leverage" A new off off Wall Steet Drama

"Who's knocking on our door" the CFO of a huge investment bank asked.
"Why it's the government Banking Auditor. It's his day of the week to ask us to mark our assets to market."
"Are we in shape for his visit?"
"Uhm, Yes and no. Sorta good news, bad news."
"What's the good news?"
"We've done the math and we figure our remaining mortgages on the books, good and bad, are worth $43 billion, so we're okay."
"What's the bad news?"
"Uhm, well, nobody will buy any mortgage paper at the moment and auditors have been saying, no valid quotes, no value."
"That's absurd. That would mean we have negative equity."
"Shhh! He's leaving. Bernanke called him off."

However, the risk structure at each level becomes progressively more complex. the likelihood that some risk assumption will fail (or even be misunderstood by both buyers and sellers) increases, much the same way that the likelihood of a ponzi scheme collapsing increases as the base increases.

Perhaps the point was to increase the likelihood that buyers might misunderstand the risk, and therefore might overpay. And that's how you get 12% returns selling loans paying 8%. But eventually there are no more suckers.

Kevin Phillips:

'However, I would say that the two most important underpinnings of financialization lay in the rise of public and private debt as a mainstay of American culture and economics and the perpetual liquidity and bail-out support of the Federal Reserve Board under Alan Greenspan. During Greenspan's 1987-2005 tenure, the sum of public and private debt in the United States quadrupled from just over $10 trillion to $43 trillion. Finance became the industry that was not allowed to fail but was permitted to enlarge and metastasize its behavior almost at will. Regulation was minimal. Favoritism was omnipresent.' - http://www.huffingtonpost.com/kevin-phillips/the-destructive-rise-of-b_b_94351.html The Destructive Rise of Big Finance

And:

"....the Wall Street ethos: If you take big, even reckless, bets and win, you have a great year and you get a great bonus -- or in the case of hedge funds, 20 percent of the profits. If you lose money the following year, you lose your investors' money rather than your own, and you don't have to give back last year's bonus. Heads, you win; tails, you lose someone else's money." - Allan Sloan

Is it really so hard to believe that this mess arose because smart but unprincipled people sold garbage to other people they knew wouldn't understand the risks? The silk ties and the acronyms don't change the fact that this is all based on a swindle. Fancy names, complexity for its own sake, slicing and dicing assets and debts for no purpose other than to hide what needs to be hidden. It's fraud. And the human motivation behind it is really, really simple.

Martin Gale,

We're already restructuring our federal banking system, which has taken an unprecedented amount of authority over the economy in the past few weeks and is about to get even more.

I hope you are not referring to the proposed overhaul by Bernanke. The proposed policies remove regulation and oversight while claiming to do the opposite.

But I must admit I am completely confused. I thought the Libertarian freemarket utopia (tm) will come about when we remove all financial regulations? So what went wrong with harnessing people's greed? Shouldn't we be rejoicing the innate human desire to attain more and more money regardless of the risks? Won't that lead to paradise on Earth? Money for nothing and the chicks for free?

Something else must have gone wrong. It can't be a flaw in the ideology.

One other way How big finance fleeces the public

… In 15 Pennsylvania school districts, officials entered into interest-rate-swap deals worth $28 million since 2003, according to data compiled by Bloomberg. Of that dollar amount, the schools took in $15 million, and banks and advisers got the rest as fees, Bloomberg data show.
``The school districts are getting fleeced,'' Pennsylvania Governor Edward Rendell says. The governor, 64, a Democrat who has been in office since 2003, says the state might in the future advise schools and municipalities on derivatives contracts before they sign with banks. Christopher Cox, chairman of the U.S. Securities and Exchange Commission, says he's concerned that municipalities are taking on more risk than in the past when they raised money primarily from bond sales….
[via Dean Baker]

Tripp erects, and battles, the typical strawman of the statist; that those who favor less regulation promise utopian outcomes. No, those that generally favor less regulation simply recognize that malregulation by centralized powers is evry bit as likely, and often more likely, to produce disastrous outcomes as failure to regulate. The greatest economic disaster in this country's history was due to malregulation. The terrible economic performance of the '70s was greatly exacerbated by malregulation. Tripp is certain, however, that the right "experts" are available this time, however, to regulate things just as they should be, for this is always the case with such ideologues.

As to the particulars of the current situation, if there is going to be a lender of last resort for large, highly leverage institutions, then the lender of last resort is going to seek to regulate in some way. Don't count on it being done well, however, no matter who holds power. The U.S. and global economy isn't getting less complex, and although central bankers and other "experts" certainly have a better grasp of economics than was the case eighty years ago, they aren't even close to having a handle on such an inherently chaotic system. Pure random chance rules as always, and the best we can do is to muddle through as best we can.

It wasn't only Wall Street that ended up in big trouble on the wrong side of leverage. It's the same thing that created the home mortgage crisis in the first place- people with not enough money down. As pointed out here, leverage works both ways. When the elevator is on the way up, it's a great ride, and everyone who isn't stretched to the max is a sucker. Just like Wall Street, homeowners borrowed big on houses they couldn't afford (and were bigger than they needed), then cashed out on rising prices to buy the furniture to put in them and the cars to put in the garages. But when the ride is over it ALL goes away.

An interesting real world sidelight of this, is that when almost everyone is stretching like crazy to make payments on something they can't really afford, the whole basis of neighborhoods is undermined. People can't afford to keep up the houses they're in because the mortgage is sucking up all of the money and then some. The whole place becomes one big low-rent neighborhood and cascade of failure.