Nobody Can Understand the Global Economy Anymore!

Behind the recent bad news lurks a much deeper concern: The world economy is now being driven by a vast, secretive web of investments that might be out of anyone’s control.

THE PAST YEAR has been a harrowing one for the world’s financial markets, shaken by subprime crises, credit crunches, and other ills. Things have only gotten stranger in the past week, with stock prices swinging wildly in every major market – drastically down, then back up.

Last week the Federal Reserve announced the biggest cut in overnight lending rates in more than two decades. Congress, not to be outdone, is slapping together a massive deficit spending package aimed at giving the economy an emergency booster shot.

Despite the anxiety, nobody is stockpiling canned goods just yet. The prevailing assumption in today’s economy is that recessions and bear markets come and go, and that things will work out in the end, much as they have since the Great Depression. That’s because there’s a collective confidence that the market is strong enough to correct itself, and that experts in charge of the financial system will understand how to mount a vigorous defense.

Should we be so confident this time? A handful of financial theorists and thinkers are now saying we shouldn’t. The drumbeat of bad news over the past year, they say, is only a symptom of something new and unsettling – a deeper change in the financial system that may leave regulators, and even Congress, powerless when they try to wield their usual tools.

That something is the immense shadow economy of novel and poorly understood financial instruments created by hedge funds and investment banks over the past decade – a web of extraordinarily complex securities and wagers that has made the world’s financial system so opaque and entangled that even many experts confess that they no longer understand how it works.

Unlike the building blocks of the conventional economy – factories and firms, widgets and workers, stocks and bonds – these new financial arrangements are difficult to value, much less analyze. The money caught up in this web is now many times larger than the world’s gross domestic product, and much of it exists outside the purview of regulators.

Some of these new-generation investments have been in the news, such as the securities implicated in the mortgage crisis that is still shaking the housing market. Others, involving auto loans, credit card debt, and corporate debt, are lurking in the shadows.

The scale and complexity of these new investments means that they don’t just defy traditional economic rules, they may change the rules. So much of the world’s capital is now tied up in this shadow economy that the traditional tools for fixing an economic downturn – moves that have averted serious disasters in the recent past – may not work as expected.

In tell-all books, financial blogs, and small-circulation newsletters, a handful of insiders have begun to sound the alarm, warning that governments and top bankers may simply no longer understand the financial system well enough to do anything about it.

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But when the mortgage crisis broke last summer, it opened a window on something else: The existence of a huge wilderness of investments in the financial sector that are nearly impossible to track or measure, and which operate out of the view of both investors and regulators. It emerged that investment banks, hedge funds, and other financial players had issued, bought, and sold hundreds of billions of dollars’ worth of esoteric securities backed in part by other securities, which in turn were backed by payments on high-risk mortgages.

When borrowers began defaulting on their loans, two things happened. One, banks, pension funds, and other institutional investors began revealing that they owned huge quantities of these unusual new securities, called collateralized debt obligations, or CDOs. The banks began writing them off, causing the massive losses that have buffeted the country’s best-known financial companies. And two, without a market for these securities, brokers stopped wanting to issue risky mortgages to new home buyers. Home values began their plunge.

In other words, a staggeringly complex financial instrument that most Americans had never heard of, and which many financial writers still don’t fully understand, became in a matter of months the most important influence on home values in America. That’s not how the economy is supposed to work – or at least that’s not what they teach students in Economics 101.

The reason this had been happening totally out of sight is not difficult to understand. Banks of all stripes chafe against the restraints that federal and state regulators place on their ability to make money. By cleverly exploiting regulatory loopholes, investment banks created new types of high-risk investments that did not appear on their balance sheets. Safe from the prying eyes of regulators, they allowed banks to dodge the requirement that they keep a certain amount of money in reserve. These reserves are a crucial safety net, but also began to seem like a drag to financiers, money that was just sitting on the sidelines.

“A lot of financial innovation is designed to get around regulation,” says Richard Sylla, professor of economics and financial history at NYU’s Stern School of Business. “The goal is to make more money, and you can make more money if you don’t have to keep capital to back up your investments.”

The hiding places for these financial instruments are called conduits. They go by various names – the SIV, or structured investment vehicle, is one that’s been in the news a great deal the past few months. These conduits and the various esoteric investments they harbor constitute what Bill Gross, manager of the world’s largest bond mutual fund, called a “Frankensteinian levered body of shadow banks” in his January newsletter.

“Our modern shadow banking system,” Gross writes, “craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever.”