What to do and how to stay sane

If you are interested in macroeconomics at all you have surely been following the developments in global financial markets and the debacle that the last 15 years have caused. As everyone is adding their opinion, here are some of my own thoughts.

It is clear that this is not the fault of individual companies or people. Nor is it the fault of the market. Their behaviour has been a rational set of actions dictated by what we all know their incentives to be. Companies want to profit and individuals want value. No, I don't blame them for doing what is obvious they would do. Much like previous crises, this is a severe failure of regulators and legislators to ensure that the incentives were balanced with safeguards. There is a reason why regulation exists at all, isn't there? So why wouldn't people think that there is such as thing as not enough (or too much) of it? And if the debate is on the degree of regulation, isn't it pretty clear that the current events are proof that there hasn't been enough?

The crisis occurred because there were lax regulation on the origination of loans and on the ability of companies to leverage this risk. Now, I also blame pure ignorance (of the good kind: now knowing something that hasn't been discovered). You see, the creation of new instruments based on mortgages on paper sounded like, and still does, like a good idea. I can't see why the risk mitigation scheme doesn't work beyond the fact that it does. Perhaps it is simply a measure of optimism (see my post below on "the making of a mortgage CDO". I guess they shouldn't have expected to loose only 10% to defaults, and should instead have priced it much higher. I suspect this is the big failure in the model.

I haven't seen an analysis of how the CDO structure fell (with numbers) to see how wrong they were. It would be nice to see that.

There is also the issue of the procyclical nature of leveraging. As the SEC waived rules that limited the amount of leveraging that some companies could do, they gave them the rope with which to hang themselves. I don't believe for a minute that these people didn't understand what the risks were. Just that they didn't care (remote risks against immediate gratification - like me with chocolate).

There must be mechanisms in place to act counter-cyclically. But before talk of reform can be started, we have to get through the worse. And we are not there yet. Emerging markets (China!) has not really seen a strong impact on the real sector (I don't much care for stock market indices aside from their effect on pensions and such, as as indicators of sentiment once you discount the bubbles).

So brace yourselves and buy government bonds.